MS 04 PDF

Accounting and its Functions
UNIT 1 ACCOUNTING AND ITS

FUNCTIONS
Objectives
After studying this unit, you should be able to appreciate the:

• nature and role of accounting;
• activities of an accountant; and
• roles of accounting personnel and the accounting function in an organization.
Structure
1.1 Introduction
1.2 Scope of Accounting
1.3 Emerging Role of Accounting
1.4 Accounting as an Information System
1.5 Role and Activities of an Accountant
1.6 Accounting Personnel
1.7 Nature of Accounting Function
1.8 Organisation for Accounting and Finance
1.9 Summary
1.10 Key Words
1.11 Self-assessment Questions/Exercises
1.12 Further Readings
1.1 INTRODUCTION
Accounting is often called the language of business. The basic function of any lan-
guage is to serve as a means of communication. In this context, the purpose of ac-
counting is to communicate or report the results of business operations and its various
aspects. Though accounting has been defined in various ways. According to one
commonly accepted definition. "Accounting is the art of recording, classifying and
summarising in a significant manner and in terms of money, transactions and events
which are; in part at least, of financial character and interpreting the results thereof'.
Another definition which is less restrictive interprets accounting as "The process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by the users of information"
1.2 SCOPE OF ACCOUNTING

The scope of accounting can be presented in a diagrammatic form as shown in
Figure 1.1.
Data creationr and collection is the area which provides raw material for
accounting. The data collected is `historic' in the sense that it refers to events which
have already taken place. Earlier, accounting was largely concerned with what had
happened, rather than making any attempt to predict and prepare for future.
After the historic data has been collected, it is recorded in accordance with generally
accepted accounting theory. A large number of transactions or events have to be
entered in the books of original entry (journals) and ledgers in accordance with the
classification scheme already decided upon. The recording and processing of informa-
tion usually accounts for a substantial part of total accounting work. This type of
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Accounting Framework
Source: Adapted from R.J. Bull, Accounting in Business, Butterworths, London, 1969,p.2.
activity of accounting may be called recordative. The processing method employed

for recording may be manual, mechanical or electronic. Computers are also used
widely in modern business for doing this job.
Data evaluation is regarded as the most important activity in accounting these days.
Evaluation of data includes controlling the activities of business with the help of
budgets and standard costs (budgetary control), evaluating the performance of busi-
ness, analysing the flow of funds, and analysing the accounting information for
decision-making purposes by choosing among alternative courses of action.
The analytical and interpretative work of counting may be for internal or external
uses and may range from snap answers to elaborate reports produced by extensive
research. Capital project analysis, financial forecasts, budgetary projections and
analysis for reorganisation, takeover or merger often lead to research-based reports.
Data evaluation has another dimension and this can be known as the auditive work
which focuses on verification of transactions as entered in the books of account and
authentication of financial statements. This work is done by public professional
accountants. However, it has become common these days for even medium-sized
organisations to engage internal auditors to keep a continuous watch over financial
flows and review the operation of the financial system.
Data reporting consists of two parts-external and internal. External reporting refers
to the communication of financial information (viz., earnings, financial and funds
position) about the business to outside parties, e.g., shareholders, government
agencies and regulatory bodies of the government. Internal reporting is concerned
with the communication of results of financial analysis and evaluation to
management for decision-making purposes.
You will note that accounting theory has been shown in the centre of the diagram.
We will turn to the role of accounting theory in the next unit.
The central purpose of accounting is to make possible the periodic matching of costs
(efforts) and revenues (accomplishments). This concept is the nucleus of accounting
theory. However, accounting is moving away from its traditional procedure-based
record-keeping function to the adoption of a role which emphasises its social impor-
tance.
Activity 1.1
List the various accounting activities that your organisation is undertaking. Can you
ascribe any particular reason as to why your organisation is undertaking these ac-
counting activities?
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Accounting Activity Reason Accounting and its Functions
1……………………………… 1……………………………
2……………………………… 2……………………………
3……………………………… 3……………………………
4……………………………… 4……………………………
5……………………………… 5……………………………
6……………………………… 6……………………………
7……………………………… 7……………………………
8……………………………… 8……………………………
1.3 EMERGING ROLE OF ACCOUNTING
The history of accounting indicates the evolutionary pattern which reflects changing
socio-ecoiom conditions and the enlarged purposes to which accounting is applied.
In the present context four phases in the evolution of accounting can be
distinguished.
Stewardship Accounting
In earlier times in history, wealthy people employed `stewards' to manage their

property. These stewards rendered an account of their stewardship to their owners
periodically. This notion lies at the root of financial reporting even today which
essentially involves the orderly recording of business transactions, commonly known
as 'book-keeping'. Indeed the accounting concepts and procedures, in use today for
systematic recording of business transactions have their origin in the practices em-
ployed by merchants in Italy during the 15th century. The Italian method which
specifically began to be known as `double entry book-keeping' was adopted by other
European countries during the 19th century. Stewardship accounting, in a sense, is
associated with the need of business owners to keep records of their transactions, the
property and tools they owned, debts they owed, and the debts others owed them.
Financial Accounting
Financial accounting dates from the development of large-scale business and the
advent of Joint Stock Company (a form of business which enables the public to
participate in providing capital in return for `shares' in the assets and the profits of the
company). This form of business organisation permits a limit to the liability of their
members to the nominal value of their shares. This means that the liability of a
shareholder for the financial debts of the company is limited to the amount he had
agreed to pay on the shares he bought. He is into liable to make any further contribu-
tion in the event of the company's failure or liquidation. As a matter of fact, the law
governing the operations (or functioning) of a company in any country (for instance
the Companies Act in India) gives a legal form to the doctrine of stewardship which
requires that information be disclosed to the shareholders in the form of annual
income statement and balance sheet.
Briefly speaking, the income statement is a statement of profit and loss made during
the year of the report; and the balance sheet indicates the assets held by the firm and
the monetary claims against the firm. The general unwillingness of the company
directors to disclose more than the minimum information required by law and the
growing public awareness have forced the governments in various countries of the•
world to extend the disclosure (of information) requirements.
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The importance attached to financial accounting statements can be traced to the need
of the society to mobilise the savings and channel them into profitable investments.
Investors, whether they are large or small, must be provided with reliable and suffi-
cient information in order to be able to make efficient investment decisions. This is
the most significant social purpose of financial accounting.
Cost Accounting
The industrial revolution in England presented a challenge to the development of

accounting as a tool of industrial management. Costing techniques were developed as
guides to management actions. The increasing awareness on the part of entrepreneurs
and industrial managers for using scientific principles of management in the wake of
scientific management movement led to the development of cost accounting. Cost
accounting is concerned with the application of costing principles, methods and
techniques for ascertaining the costs with a view to controlling them and assessing
the profitability and efficiency of the enterprise.
Management Accounting
The advent of management accounting was the next logical step in the developmental
process.-The practice of using accounting information as a direct aid to management
is a phenomenon of the 20th century, particularly the last 30-40 years. The genesis of
modern management with its emphasis on detailed information for decision-making
provide a tremendous impetus to the development of management accounting.
Management accounting is concerned with the preparation and presentation of ac-

counting and controlling information in a form which assists management in the
'formulation of policies and in decision-making on various matters connected. with
routine or non-routine operations of business enterprise. It is through the techniques
of management accounting that the managers are supplied with information which
they need for achieving objectives for which they are accountable. Management
accounting has thus shifted the focus of accounting from recording and analysing
financial; transactions to using information for decisions affecting the future. In this
sense, management accounting has a vital role to play in extending the horizons of
modern business. While the reports emanating from financial accounting are subject
to the conceptual framework of accounting, internal reports-routine or non-routine are
free from such constraints.
Social Responsibility Accounting
Social responsibility accounting is a new phase in the development of accounting and

owes its birth to increasing social awareness which has been particularly noticeable
over the last two decades or so. Social responsibility accounting widens the scope of
accounting by considering the social effects of business decisions; in addition to the
economic effects. Several social scientists, statesmen and social workers all over the
world have been drawing the attention of their governments and the people in their
countries to the dangers posed to environment and ecology by the unbridled
industrial growth. The role of business in society is increasingly coming under
greater scrutiny\ The management is being held responsible not only for efficient
conduct of business as expressed in profitability, but also for what it contributes to
social well being and progress. There is a growing feeling that the concepts of growth
and profit as measuredin traditional balance sheets and income statements are too
narrow to reflect the social responsibility aspects of a business.
Human Resource Accounting
Way back in 1964 the first attempt to include figures on human capital in the balance
sheet was made by Hermansson which later. came to be known as Human Resource
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Accounting. However there had been a great socio-economic shift in the 1990's with Accounting and its Functions
the emergence of "Knowledge economy", a distinctive shift towards recognition of
human and intellectual capital in contrast to physical capital. Human Resource
Accounting is a branch of accounting which seeks to report and emphasis the impor-
tance of human resources (knowledgeable, trained, loyal and committed employees)
in a company's earning process and total assets. It is concerned with "the process of
identifying and measuring data about human resources and communicating this
information to interested parties". In simple words it involves accounting for invest-
ment in people and replacement costs as well as accounting for the economic values
of people to an organisation. Generally the methods used for valuing and accounting
of human resources are either based on costs or on economic value of human
resources., However providing adequate and valid information on human assets
(capital), which are outside the concept of ownership, in figures is very difficult.
Nevertheless HRA is a managerial tool providing valuable information to the top
management to take decisions regarding adequacy of human resources and thus
encouraging managers to consider investment in manpower in a more positive way.
Inflation Accounting
Inflation Accounting is concerned with the adjustment in the value of assets (current
and fixed) and of profit in the light of changes in the price level. In a way, it is con-
cerned with the overcoming of limitations that arise in financial statements on
account of the cost assumption (that is recording of the assets at their historical or
original cost) and the assumption of stable monetary unit (these are discussed in
detail in the next unit). It thus aims at correcting the distortions in the reported results
caused by price level changes. Generally, rising prices during inflation have the
distorting influence of overstating the profit. Various approaches have been
suggested to deal with this problem.
If this little introduction of HRA and Inflation accounting provokes you to know
more about them, we suggest that you listen to the audio programme "Emerging
Horizons in Accounting and Finance-Part II and III" which deal with these two
topics. You may also read "Money Measurement Concept" explained in the next unit
which has a bearing on inflation accounting.
Activity 1.2
In the context of your organisation, describe some of the cost and management
accounting related activities. Please also identify any particular accounting practice in
the area of social responsibility.
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1.4 ACCOUNTING AS AN INFORMATION SYSTEM

While discussing the scope of accounting you must have observed that accounting
involves a series of activities linked with each other, beginning with the collecting,
recording, analysing and evaluating the data, and finally communicating information
to its users. Information has no meaning unless it is linked with a certain purpose. 9
Accounting as a social science can be viewed as an information system since it has
all the features of a system. It has its inputs (raw data), processes (men and
equipment), and outputs (reports and information). If we consider accounting as an
information system, then we are in a position to make some important observations.
First, the goal of the system is to provide information which meets the needs of its
users. If we can correctly identify the needs of the users, we are then able to specify
the nature and character of the outputs of the system. Secondly, it is the output
requirements that . determine the type of data which would be selected as the inputs
for processing into information output.
There are several groups of people who have a stake in a business organisation-
managers, shareholders, creditors, employees, customers, etc. Additionally, the
community at large has economic and social interest in the activities of such
organisations. This interest is expressed at the national level by the concern of
government in various aspects of the firms' activities, such as their economic well-
being, their contribution to welfare, their part in the growth of the national product, to
mention only a few examples.
We shall now briefly discuss what the information needs of various users are.
Shareholders and Investors: Since shareholders and other investors have invested
their wealth in a business enterprise, they are interested in knowing periodically
about the profitability of the enterprise, the soundness of their investment and the
growth prospects of the enterprise. Historically, business accounting was developed
to supply information to those who had invested their funds in business enterprises.
Creditors: Creditors may be short-term or long-term lenders. Short-term creditors

include suppliers of materials, goods or services. They are normally known as trade
creditors. Long-term creditors are those who' have lent money for a long period,
usually in the form of secured loans. The main concern of the creditors is focused on
the credit worthiness of the firms and its ability to meet its financial obligations. They
are therefore concerned with the liquidity of the firms, its profitability and financial
soundness. In other words, it can also be stated that creditors are interested mainly in
information which deals with solvency, liquidity and profitability so that they could
assess the financial standing of the firms.
Employees: The view that business organisations exist to maximise the return to
shareholders has been undergoing change as a result of social changes. A broader
view is taken today of economic and social role of management. The importance of
harmonious industrial relations between management and employees cannot be over-
emphasised. That the employees have a stake in the outcomes of several managerial
decisions is recognised. Greater emphasis on industrial democracy through employee
participation in management decisions has important implications for the supply of
information to employees. Matters like settlement of wages, bonus, and profit sharing
rest on adequate disclosure of relevant facts.
Government: In a mixed economy it is considered to be the responsibility of the

Government to direct the operation of the economic system in such a manner that it
subserves the common good. Controls and regulations on the operations of private
sector enterprises are the hallmark of mixed economy. Several government agencies
collect information about various aspects of the activities of business organisations.
Much of this information is a direct output of the accounting system, for example,
levels of outputs, profits, investments, costs, and taxes, etc. All this information is very
important in evolving policies for managing the economy. The task of the Government
in managing the industrial economy of the country is facilitated if accounting
information is presented, as far as possible, in a uniform manner. It is clear that if
10 accounting information is distorted due to manipulations and window-dressing in the
presentation of annual accounts, it will have ill-effects on the measures the government Accounting and its Functions
intends to take and the policies it wishes to adopt.
Management: Organisations may or may not exist for the sole purpose of profit.
However, information needs of the managers of both kinds of organisations are
almost the same, because the managerial process i.e., planning, organising and
controlling is the same. All these functions have one thing in common and it is that
they are all concerned with making decisions which have their own specific
information requirements. The emphasis on efficient and effective management of
organisations has considerably extended the demand for accounting information. The
role of accounting as far as management is concerned was highlighted earlier when
we discussed about management accounting.
Consumers and others: Consumers' organisations, media, welfare organisations and

public at large are also interested in condensed accounting information in order to
appraise the efficiency and social role of the enterprises in different sectors of the
economy, that is, what levels of profits and outputs are being achieved, in what way
the social responsibility is being discharged and in what manner the growth is being
planned by the enterprises in-accordance with the national priorities etc.
The above discussion perhaps has indicated to you that the information needs of the
various users may not necessarily be the same. Sometimes, they may even conflict
and compete with each other. In any case, the objective of accounting information is
to enable information users to make optimum decisions.
1.5 ROLE AND ACTIVITIES OF AN ACCOUNTANT

Having discussed the scope of accounting and its emerging role, we are now in a
position to describe as to who is an accountant. In an attempt to answer this question
we reproduce below some statements in this regard:
a) An accountant is one who is engaged in accounts-keeping.

b) An accountant is a functionary who aids control.
c) An accountant keeps the conscience of an organisation.
d) An accountant is a professional whose primary duties are concerned with
information management for internal and external use.
e) An accountant is a fiscal adviser.
f) An accountant produces an income statement and a balance sheet for an
accounting period and maintains all supporting evidence and classified facts
that lead to the final accounting statements.
g) An accountant verifies, authenticates, and certifies the accounts of an entity.
Tell us about your reactions. Perhaps you do have your own ideas but our thinking is
that each of the foregoing statements contain some truth in it as it highlights some
aspects of the functions of an accountant, except one statement which presents a
somewhat comprehensive view. Can you identify this statement? We will help you in
doing this.
Statement (a) defines a person who maintains accounts. Statement (f) echoes almost a
similar notion but extends his role to the production of financial statements. The
work implied in these statements is that of score-keeping and the person performing
such activity is known as a financial accountant (or maintenance accountant).
Statement (b) is about the role which an accountant can play in the management control
process. It is concerned with attention-directing and problem-solving. The functionary
may be designated as management accountant (or a controller as in the United States). 11
Statement (e) underlines a narrow, specific role of an accountant, though of critical
significance. In view of high incidence of taxes on business in India, tax planning
assumes a vital role in fiscal management. By planning the operations of the enterprise in
a particular manner, the tax adviser attempts to minimise the liability of the firm by
availing the concessions and incentives provided for in the applicable tax laws.
Statement (g) stresses the àudit', `watchdog', or `certification role' of the accountant
who is not an employee of a business but who performs an external verification of
accounts. Such a functionary is a trained and qualified professional who, like any
other professional, has an educational status and a prescribed code of conduct.
Chartered Accountants in India, England-Wales, and Certified Public Accountants in
USA belong to this category of accountants.
Statement (c) presents the accountant as a conscience-keeper. He is seen as a person

whose mission is to protect and promote the interest of the employer in a positive
manner. He is there to see to it that none of the staff of the organisation carries on this
work in an unethical way or in a manner prejudicial to the long-term legitimate
interests of the firm.
We are now left with statement (d) which defines an accountant as a professional and
underlines his pre-occupation withi management of information for internal use
(management accounting function) and for external use (financial accounting func-
tion). We are sure, our discussion of accounting as an information system has made it
easier for you to comprehend this role of the accountant. We may clarify that
information management is not necessarily associated with sophisticated (or hi-tech)
area of computers. Small firms may `manage' information without a substantial
degree of mechanisation or automation. Often the role of accounting in small
businessis not properly recognised. It is widely known that a large number of small
businesses fail and do not survive beyond a few years. One of the main reasons for
their failure is that they do not have an adequate information system to help their
managers to control costs, to forecast cash needs and to plan for growth.
Organisations which have poor accounting system often find it considerably difficult
to obtain finance from banks and outside investors.
1.6 ACCOUNTING PERSONNEL
There is hardly any organisation which does not have an accountant. His role is all
pervasive and he is involved in a wide range of activities, particularly in a large and
complex organisation. The exact duties of an accountant might differ in different
organisations. However, a broad spectrum of responsibilities can be identified.
The accountants can be broadly divided into two categories, those who are in public
practice and those who are in private employment. The accountants in public practice
offer their services for conducting financial and or cost audit. As such, they are
known as auditors. The auditor examines the books of account and reports on the
balance sheet and profit and loss account of the company as to whether they give a
true and fair view of the state of affairs of the company and its profit respectively.
The auditor in a company is appointed by the shareholders to whom he reports.
Public accountants are generally members of professional bodies like the Institute of
Chartered Accountants of India or the Institute of Cost and Works Accountants of
India. In addition to conducting financial or cost audit (in accordance with the
requirements of the Companies Act), as the case may be, they may also provide
consultancy services for design Qing or improving accounting and management
control systems.
Accountants in employment may be in various business or non-business organisations

to perform a variety of accounting and management control functions. Accountants at
higher levels generally belong to professional accounting bodies but those who are at
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lower levels need not be so. Accounting chiefs in different organisations, depending Accounting and its Functions
upon their nature of work, are variously designated as finance officers or internal
auditors or chiefs accounts officers, etc. The term `controller' as the head of the
accounting and finance function is not very popular in India but of late it has been
catching up. Several large organisations, both in the public and private sectors, have
now controllers. Let us have an idea of who these people are and what they do.
Internal Auditor: Internal Auditor is an employee of the organisation in contrast to

an external auditor who is paid a fee for his services. The internal auditor is
responsible for performing monitoring activities and other services, including
designing and operating the system of internal control, auditingthe data reported to
the directors ofthe company, and assisting external auditors. The head ofthe internal
audit function reports directly either to the ch iefexecutive or to the audit committee
of the Board of Directors.
Internal audit includes continuous verification of entries appearing in the books of

account with the original vouchers and proper accounting of assets. Further, it at-
tempts to ensure that the policies and procedures regarding financial matters are
being complied with. Internal auditing is also concerned with administering the
system of internal check so that mistakes, innocent or intentional, are prevented
from taking place.
We should distinguish an internal auditor from an external auditor. While an internal

auditor devotes his entire time and energy to the needs ofone company (i.e, his
employer), an external auditor serves many clients. The primary function ofthe
external auditor, as pointed out earlier, is to safeguard the interests ofthe shareholders
(by whom he is appointed ) by an independent and impartial appraisal ofthe financial
transactions ofthe company so that he could report on the net profit earned by the
company and its financial position. His role is that ofan objective outsider, expressing
expert opinions tothefinancial condition and operating results ofthe client's business.
A part from shareholders, other parties such as banks, lending institutions, govern-
ment agencies, etc. reply on the fairness of such financial reports in making certain
decision about a given company. An auditor is bound by a set of professional regula-
tions which include an examination on technical competence and adherence to a code
of ethical conduct.
Controller : Controller- the other name for Chief Accountant- is usually the head of
the whole area of accounting, including internal audit. He is overall in - charge of all
the activities comprising financial accounting, cost accounting, management account-
ing, tax accounting etc. He exercises authority both for accounting within the
organisation and for external reporting. The external reports include reports to
government revenue collecting and regulatory bodies, such as Company Law Board
and Income Tax . Department He may also supervise the company's internal audit
and control systems. In addition to processing historical data, he is expected to supply
a good deal of accounting information to top management concerning future
operations, in line with the management's planning and control needs. Besides, he is
also expected to supply detailed information to managers in different functional areas
( like production, marketing, etc.) and at different levels of the organisation.
We may enumerate the functions of the controller as follows:
a) Designing and operating the accounting system
b) Preparing financial statements and reports
c) Establishing and maintaining systems and procedures
d) Supervising internal auditing and arranging for external audit
e) Supervising computer applications
f) Overseeing cost control
g) Preparing budgets
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h) Making forecasts and analytical reports
i) Reporting financial information to top management
j) Handling tax matters.
Treasurer : He is the custodian arid manager of all the cash and near-cash resources
of the firm. The treasurer handles credit reviews and sets policy for collecting receiv-
ables (debtors of the firm to whom the firm has sold goods or services) He also
handles relationships with banks and other lending or financial institutions.
The Financial Executive Institute (of United States of America) makes the following
distinction between controllership and treasurership functions:
Controllership Treasurership
Planning and Control Provision of Capital
Reporting and Interpreting Investor Relations
Evaluating and Consulting Short-term Financing
Tax Administration Banking and Custody
Government Reporting Credit and Collections
Protection of Assets Investments
Economic Appraisal Insurance
Finance Officer: Finance is the life blood of business. Procuring financial resources
and their judicious utilisation are the two important activities of financial manage-
ment. Financial management, includes three major decisions: investment decision,
financing decision and dividend decision. Investment decision is perhaps the most
important decision because it involves allocation of resources . It is concerned with
future which being uncertain involves risk. How the firm is allocating its scarce
resources and is planning growth will largely determine its value in the market place.
Financing decision is concerned with determining the optimum financing mix or
capital structure. It examines the various methods by which a firm obtains short-term
and long -term finances through various alternative sources. The dividend decision is
concerned with question like how much of the profit is to be retained and how much
is to be distributed as dividends. The finance manager has to strike a balance between
the current needs of the enterprise for cash and the needs of the shareholders for a
adequate return. The financial management of a large company is usually the respon-
sibility of the finance director who may be in place of, or in addition to the controller.
Often finance manager and controller are inter-changeable terms and only one of
these two positions may be found in a company. The finance manager when there is a
controller also in the organisation, is concerned with implementing the financial
policy of the board of directors, managing liquidity, preparation of budgets and
administration of budgetary control system, managing profitability, etc.
Though financial management is regarded as a separate area, this function is per-

formed in several countries, including India, by the Accountant( or the Financial
Controller) Several large organisations however have a financial executive besides
the ch ief accountant. Often, finance and accountingfunctions are clubbed together in
one persons in small organisations.
Activity 1.3
Please meet one or more of the following personnel in any organisation and talk to
them about their respective roles within the organisation.
Accountant
1……………………………………………………………………………………
2……………………………………………………………………………………
14 3……………………………………………………………………………………
4…………………………………………………………………………………… Accounting and its Functions
5……………………………………………………………………………………
Chief Accountant
1……………………………………………………………………………………
2……………………………………………………………………………………
3……………………………………………………………………………………
4……………………………………………………………………………………
5……………………………………………………………………………………
Controller
1……………………………………………………………………………………
2……………………………………………………………………………………
3……………………………………………………………………………………
4……………………………………………………………………………………
5……………………………………………………………………………………
Finance Manager
1……………………………………………………………………………………
2……………………………………………………………………………………
3……………………………………………………………………………………
4……………………………………………………………………………………
5……………………………………………………………………………………
Internal Auditor
1……………………………………………………………………………………
2……………………………………………………………………………………
3……………………………………………………………………………………
4……………………………………………………………………………………
5……………………………………………………………………………………
1.7 NATURE OF ACCOUNTING FUNCTION
Accounting is a service function. The chief accounting executive (by whatever name
he is called) holds a staff position except within his own department where he exerts.
authority. This is in contradistinction to the roles played by production or marketing
executives who hold line authority: The role of the accountant is advisory in
character. He works through the authority of the chief executive. The accounts and or
finance department(s) do`not exercise direct authority over line departments. In
decentralised structure with a number of units and divisions, the accounting executive
however exercises what is known as the functional authority over all the accounting
staff deployed in different segments.
There are two facets to the role of the accountant. For the top managers he works as a
watchdog and for middle and lower level managers he acts as `helper'. The watchdog
role is usually performed through `score-keeping' task of accounting and reporting to
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Accounting Framework all levels of management. The `helper' role is usually performed through the task of
directing managers' attention to problems and assisting them in solving problems.
Mutual understanding and rapport between the accountant and the manager, in the
tasks of attention-directing and problem-solving can be enhanced if accountant and
his staff frequently interact with the line managers and guide them in matters
concerned with preparation of budgets and control documents with which they might
not be conversant. This will instill confidence among line managers regarding the
reliability of reports.
1.8 ORGANISATION FOR ACCOUNTING AND

FINANCE
A typical organisation chart for accounting and finance function is presented in

Figure 1.2. You will note that the person at the helm of affairs the Director (Finance)
who is a member of the Board of Directors. Reporting to him may be one or more
general managers. If there is only one General Manager, he may be designated as
General Manager (Finance), or General Manager (Finance and Accounts), or
Controller or Financial Controller. In a large company four or five (as shown in
Figure 1.2) Deputy General Managers incharge of different areas like systems and
data processing, accounts, finance, internal auditing may report to him. Following the
American pattern, a tendency has recently been observed among large companies,
especially in the private sector, to designate General Manager (Finance) as President
(Finance, or Finance and Accounts) and a Deputy General Manager as Vice-
president. Each of these Deputy General Managers is assisted by a number of senior
managers who look after different components of similar activities, e.g., financial
accounting, tax planning and administration, management auditing, etc. Management
audit is a comprehensive review of the various sub-systems of the organisation like
objectives and goals, structure, technical system, personnel policies, (including
succession planning), control and coordination policies and procedures, adequacy and
effectiveness of communication system, etc. This type of audit is usually done by a
team of people comprising the internal resource persons drawn from various
functional areas and external management consultant.
Figure 1.2: Organisation Chart for Accounting and Finance
16
We hope you now have a reasonably good idea of what accounting is, what its scope Accounting and its Functions
is, and what are the different types of activities which are generally included in
accounting. While basic functions of accounting and finance are performed in all
types of organisations, their relative emphases or relevance might differ in different
types of organisations. Keeping this in view we have prepared an audio programme
"Accounting and Finance Function in Different Types of Organisations" and we
suggest that you listen to this tape. This will not only augment your familiarity with
the basic aspects and functions of accounting but will also develop your appreciation
for relative divergencies.
1.9 SUMMARY
Accounting is an important service activity in business and is concerned with collect-

ing, recording, evaluating and communicating the results of past events. The history
of accounting development reflects its changing role in response to the changing
business and social needs. With the emergence of management accounting, the focus
of ac-counting has been shifting from mere recording of transactions to that of aiding
the management in decisions.
Accounting can be perceived as an information system which has its inputs, process-
ing methods and outputs. The usefulness of accounting lies in its capacity to provide
information to various stakeholders in business so that they could arrive at the correct
decisions.
The top accounting personnel are designated with various nomenclature. The practice
in this regard djffers in different companies. The organisational setting for accounting
and finance function may also vary in different organisations, depending upon their
peculiarities, nature and size of business, technology and structural form. At the helm
of affairs is usually the Director of Accounts and Finance who is a member of the
Board of Directors. Fle is assisted by a General Manager who in turn is helped by
Deputy General Managers incharge of various sub-functions like, accounts, finance,
internal audit, and data processing, etc. Each of the sub-functions is further sub-
divided into activities which are the responsibility of a subordinate manager.
1.10 KEY WORDS
Accountant is a professional who is responsible for the processing of financial data

for score-keeping, attention-directing and problem-solving purposes.
Controller of the management accountant is a staff-functionary who uses accounting

information for management planning and control.
Auditive work of an accountant comprises authentication of accounting statements.
Recordative work extends to routine recording and classified posting of financial

transactions and events.
Score-keeping is the process of data accumulation or record-keeping which enables

interested parties (internal and external) to ascertain how the organisation is
performing.
Attention-directing role of accounting consists of directing managerial attention to

situations where corrective action is needed in the case of unfavourable (or even
favourable) differences in operations, outputs or inputs.
Information system is a system, sometimes formal and sometimes informal, for

collecting, processing, and communicating data at the most relevant time to all levels
of management. The data flowing through the system is helpful to managers for 17
decision-making in the areas of planning and control, or is otherwise needed for
financial reporting required under the laws. An essential requirement of information
system is feedback, i.e. communicating the results of performance to operating
managers for needed modifications.
External reporting is the production of financial statements for the use by external
interest groups like, shareholders and government.
Planning is goal identification and decision-making.
Control is the action that implements the planning decision and evaluates perfor-
mance.
Feedback comprises the performance reports which managers can use for improving
their decision-making.
Staff function is performed in an advisory capacity and without line or decision-

making authority.
1.11 SELF-ASSESSMENT QUESTIONS/EXERCISES

1 "Financial Accounting is an extension of Stewardship Accounting".
Comment.
2 What new developments in Accounting have taken place over the past 20-25
years? Examine the main factors which have affected such developments.
3 State the group of persons having an interest in a business organisation and

examine the nature of their information needs.
4 Discuss the role of accountants in modern business organisations.
5 Differentiate between recordative, interpretative and auditive functions of

Accounting.
6 How can accounting reports, prepared on a historical basis after the close of a
period, be useful to managers in directing the activities of a business?
7 Distinguish management accounting from financial accounting.
8 How does the accountant help in the planning and control process of a large
commercial organisation?
9 State whether the following statements are true or false:
a) To have an accountant is the privilege ofa joint stock True/False

company only.
b) A controller is entrusted with the responsibilities of True/False

raising funds
c) Management control differs from engineering True/False

control since the latter is fully automatic and the
former is highly complex.
d) An accountant is the custodian of the properties and True/False

financial interests of a business enterprise.
Answers to Self-assessment Questions/Exercises

18 9 (a) False, (b) False, (c) True, (d) True,
Accounting and its Functions
1.12 FURTHER READINGS
Anthony, Robert N. and James S. Reece, 1987. Accounting Principles, All India
Traveller Book Seller: New Delhi (Chapter I).
Bhattacharya S.K. and John Dearden, 1987. Accounting for Management: Text and
Cases, Vikas Publishing 1-louse: New Delhi. (Chapter I).
Paul Collier, May 09.2003. Accounting for Managers : Interpreting Accounting

Infornration.for Decision Making. Wiley Publishers : Canada. (Chapter I),
19
UNIT 2 ACCOUNTING CONCEPTS AND
STANDARDS
Objectives
After studying this unit, you should be able to:
• appreciate the need for a conceptual framework of accounting:
• understand and appreciate the Generally Accepted Accounting Principles

(GAAP); and
• develop an understanding of the importance and necessity for uniformity in

accounting practices.
Structure
2.1 Introduction
2.2 Accounting Framework
2.3 Accounting Concepts
2.4 Accounting Standards
2.5 Changing Nature of Generally Accepted Accounting Principles (GAAP)
2.6 Attempts towards Standardisation
2.7 Accounting Standards in India
2.8 Summary
2.9 Key Words
2.1 INTRODUCTION
Any activity that you perform is facilitated if you have a set of rules to guide your
efforts. Further, you find that these rules are of more value to you if they are
standardised. When you are driving your vehicle, you keep to the left. You are in fact
following a standard traffic rule. Without the drivers of vehicles adhering to this rule,
there would be much chaos on the road. A similar principle applies to accounting
which has evolved over a period of several hundred years, and during this time
certain rules and conventions have come to be accepted as useful. If you are to
understand and use accounting reports-the end product of an accounting system-you
must be familiar with the rules and conventions behind these reports.
2.2 ACCOUNTING FRAMEWORK
The rules and conventions of accounting are commonly referred to as the conceptual
framework of accounting. As with any discipline or body of knowledge, some underly-
ing theoretical structure is required if a logical and useful set off practices and proce-
dures are to be developed for reaching the goals of the profession and for expanding
knowledge in that field. Such a body of principles is needed to help answer new
questions that arise. No profession can thrive in the absence of a theoretical frame-
work. According to Hendriksen (1977), Accounting theory may be defined as logical
20
reasoning in the form of a set of broad principles that (i) provide a general frame of Accounting Concepts and
reference by which accounting practice can be evaluated, and (ii) guide the develop- Standards
ment of new practices and procedures. Accounting theory may also be used to
explain existing practices to obtain a better understanding of them. But the most
important goal of accounting theory should be to provide a coherent set of logical
principles that form the general frame of reference for the evaluation and
development of sound accounting practices.
The American Institute of Certified Public Accountants (AICPA) discusses financial

accounting theory and generally accepted accounting principles as follows.
Financial statements are the product of process in which a large volume of data about
aspects of the economic activities of an enterprise are accumulated, analysed, and
reported. This process should be carried out in accordance with generally accepted
accounting principles. Generally accepted accounting principle incorporate the
consensus at a particular time as to which economic resources and obligations should
be recorded as assets and liabilities by financial accounting, which changes in assets
and liabilities should be recorded, when these changes should be recorded, how the
assets and liabilities and changes in them should be measured, what information
should be disclosed and how it should be disclosed, and which financial statements
should be prepared.
Generally accepted accounting principles encompass the conventions, rules and

procedures necessary to define accepted accounting practice at a particular
timegenerally accepted accounting principles include not only broad guidelines of
general application, but also detailed practices and procedures.
(Source: AICPA. Statements of the Accounting Principles Board No.4 "Basic

Concept and Accounting Principles Underlying Financial Statement of Business
Enter-prises", October, 1970, pp.54-55)
The word `principles' is used to mean a "general law or rule adopted or professed as a
guide to action, a settled ground or basis of conduct or practice". You will note that
this definition describes a principle as a general law or rule that is to be used as a
guide to action. This implies that accounting principles do not prescribe exactly how
each detailed event occurring in business should be recorded. Consequently, there are
several matters in accounting practice that may differ from one company to another.
Accounting principles are man-made. They are accepted because they are believed to
be useful. The general acceptance of an accounting principle (or for that matter any
principle) usually depends on how well it meets the three criteria of relevance,
objectivity, and feasibility. A principle is relevant to the extent that it results in
meaningful or useful information to those who need to know about a certain business.
A principle is objective to the extent that the information is not influenced by the
personal bias or judgement of those who furnished it. Objectivity connotes reliability
or. trustworthiness which also means that the correctness of-the information reported
can be verified. A principle is feasible to the extent that it can be implemented
without undue complexity or cost.
2.3 ACCOUNTING CONCEPTS
Earlier in Unit 1 we had described accounting as the language of business. As with

language, accounting has many dialects. There are differences in terminology. In
dealing with the framework of accounting theory, one is confronted with a serious
problem arising from differences in terminology. A number of words and terms have
been used by different writes to express and explain the same idea or notion. Thus,
confusion abounds in the literature insofar as the theoretical framework is concerned. 21
Accounting Framework The various terms used for describing the basic ideas are: concepts, postulates,
propositions, basic assumptions, underlying principles, fundamentals, conventions,
doctrines, rules, etc. Although each of these terms is capable of precise definition,
general usage by the profession of accounting has served to give them loose and
overlapping meanings. The same idea has been described by one author as a concept
and by another as a convention. To take another instance, the idea implied in Conser-
vatism has been labelled by one author as a (modifying) convention, by another as a
principle and yet by another as a doctrine. The wide diversity in terminology to
express the basic framework can only serve to confuse the learner.
Without falling into the trap of this terminological maze, we are explaining below
some widely recognised ideas and we call all of these concepts. We do feel, however,
that some of these ideas have a better claim to be called `concepts', while the rest
should be called `conventions'. Fundamental accounting concepts are broad general
assumptions with underlie the periodic financial accounts of business enterprises. The
reason why some of these ideas should be called concepts is that they are basic
assumptions and have a direct bearing on the quality of financial accounting informa-
tion. The alteration of any of the basic concepts (or postulates) would change the
entire nature of financial accounting.
Business Entity Concept
In accounting we make a distinction between business and the owner. All the records
are kept from the viewpoint of the business rather than from that of the owner. An
enterprise is an economic unit separate and apart from the owner or owners. As such,
transactions of the business and those of the owners should be accounted for and
reported separately. In recording a transaction the important question is how does it
affect the business? For example, if the owner of a shop were to take cash from the
cash box for meeting certain personal expenditure, the accounts would show that cash
had been reduced even though it does not make any difference to the owner himself.
Similarly, if the owner puts cash into the business, he has a claim against the business
for capital brought in.
This distinction can be easily maintained in the case of a limited company because a
company has a legal entity (or personality) of its own. Like a natural person it can
engage itself in economic activities of producing, owning, managing, storing,
transfer-ring, lending, borrowing and consuming commodities and services.
Distinction, however, is difficult in the case of partnership, and even more so in the
case of one-man business. Nevertheless, accounting still maintains separation of
business and owner. This implies that owner's personal and household expenses or
obligations (e.g., expenditure on food, clothing, housing, entertainment, debts,
mortgages, etc.) will not appear in the books of account. It may be clarified that it is
only for accounting purposes that partnerships and sole proprietorships are treated as
separate and apart from the owners though law does not make such distinction. A
creditor would be justified in looking to both the business assets and the private
estate of the owner for satisfaction of his claim. One reason for this distinction is to
make it possible for the owners to have an account of the performance from those
who manage the enterprise. The managers are entrusted with funds supplied by
owners, banks and others; they are responsible for the proper use of the funds. The
financial accounting reports are designed to show how well this responsibility has
been discharged.
Activity 2.1
Apart from the reason mentioned above, can you think of any other reason for
justitfication of Business Entity Concept?
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22 .........................................................................................................................................
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......................................................................................................................................... Standards
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Activity 2.2
The proprietor of a firm withdrew Rs. 50,000 for his personal use. This was shown as
an expense of the firm. Profits were reduced to pay a lower tax. Is this right from
accounting point of view?
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Money Measurement Concepts
In accounting, only those facts which can be expressed in terms of money are
recorded. As money is accepted not only as a medium of exchange but also as a store
of value, it has a very important advantage since a number of widely different assets
and equities can be expressed in terms of a common denominator. Without this
adding heterogeneous factors like five buildings, ten machines, six trucks will not
have much meaning.
While money is probably the only practical common denominator and a yardstick, we
must realise that this concept imposes two sever limitations. In the first place, there
are several facts which, though vital to the business, cannot be recorded in the books
of account because they cannot be expressed in money terms. For example, the state
of health of the Managing Director of a company who has been the key contributor to
the success of business is not recorded in the books. Similarly, the fact that the
Production Manager and the Chief Internal Auditor are not on speaking terms, or that
a strike is about to begin because labour is dissatisfied with the poor working condi-
tions in the factory, or that a competitor has recently taken over the best customer, or
that it has developed a better product and so on will not be recorded even though all
these events are of great concern to the business.
From this standpoint, one could say that accounting does not give a complete account
of the happenings in the business. You will appreciate that all these have a bearing on
the future profitability of the company.
Secondly, use of money implies that a rupee today is of equal value to a rupee ten
years back or ten years later. In other words, we assume stable or constant value of
rupee. In the accounts, money is expressed in terms of its value at the time an event is
recorded. Subsequent changes in the purchasing power of money do not affect this
amount. You are perhaps aware that most economies today are in inflationary condi-
tions with rising prices. The value of a rupee of 1980's has depreciated to an
unbelievably low level in the 90s. Most accountants know fully well that purchasing
power of rupee does change but very few recognise this fact in accounting books and
make allowance for changing price level. This is so despite the fact that accounting
profession has devoted considerable attention to this problem and numerous
suggestions have been made to account for the effects of changes in the purchasing
power of money. In fact, one of the major problem of accounting today is to find
means of solving the measurement problem, that is, how to extend the quality and the
coverage of meaningful information. It will be desirable to present in a
supplementary analysis the effect of price level changes on the reported income of
the business and the financial position. 23
Accounting Framework Activity 2.3
Suppose the Managing Director of a company is killed in a plane crash. To the extent
"an organisation is the lengthened shadow of a man", the real value of the company
will change immediately and this will be reflected in the market price of the company
shares. Will this have any effect as far as the accounts of the company are concerned?
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Continuity Concept
Accounting assumes that the business (an accounting entity) will continue to operate
for a long time in the future unless there is good evidence to the contrary. The enter-
prise is viewed as a going concern, that is, as continuing in operation, at least in the
foreseeable future. The owners have no intention nor have they the necessity to wind
up or liquidate its operations.
This assumption is of considerable importance for it means that the business is

viewed as a mechanism for adding value to resources it uses. The success of the
business can be measured by the difference between output values (sales or revenues)
and input values (expenses). Therefore, all unused resources can be reported at cost
rather than at market values.
The assumption that the business is not expected to be liquidated in the foreseeable
future, in fact, establishes the basis for many of the valuations and allocations in
accounting. For example, depreciation (or amortisation) procedures rest upon this
concept. It is this assumption which underlies the decision of investors to commit
capital to enterprise. The concept holds that continuity of business activity is the
reasonable expectation for the business unit for which the accounting function is
being performed. Only on the basis of this assumption can the accounting process
remain stable and achieve the objective of correctly recording and reporting on the
capital invested, the efficiency of management, and the position of the enterprise as a
going concern. Under this assumption neither higher current market values nor
liquidation values are of particular importance in accounting. This assumption
provides a basis for the application of cost in accounting for assets.
However, if the accountant has good reasons to believe that the business, or some
part of it, is going to be liquidated or that it will cease to operate (say within a year or
two), then the resources could be reported at their current values (or liquidation
values).
Activity 2.4
A company revalues its buildings which were purchased at a cost of Rs. 5,00,000 in
1985 to Rs. 50,00,000 in 2003 and records the difference of Rs. 45,00,000 as profit
for the year 2003. Is this practice right?
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24 ..............................................................................................................................
Cost Concept Accounting Concepts and
Standards
The resources (land, buildings, machinery, property rights, etc.) that a business owns
are called assets. The money values that are assigned to assets are derived from the
cost concept. This concept states that an asset is worth the price paid for or cost
incurred to acquire it. Thus, assets are recorded at their original purchase price and
this cost is the basis for all subsequent accounting for the assets. The assets shown on
the financial statements do not necessarily indicate their present market worth (or
market values). This is contrary to what is often believed by an uninformed person
reading the statement or report. The term `book value' is used for amount shown in
the accounting records.
In case of certain assets the accounting values and market values may be similar;
cash is an obvious example. In general, the longer an asset has been owned by the
company the lesser, are the chances that the accounting value will correspond to the
market value.
The cost concept does not mead that all assets remain on the accounting records at
their original cost for all time to come. The cost of an asset that has a long but limited
life is systematically reduced during its life by a process called `depreciation' which
will be discussed at some length in a subsequent unit. Suffice it to say at this point
that deprecation is a process by which the cost of the asset is gradually reduced (or
written off) by allocating a part of it to expense in each accounting period. This will
have the effect of reducing the profit of each period. In charging depreciation the
intention is not to change depreciation equal to the fall in the market value of the
asset. As such, there is no relationship between depreciation and changes in market
value of the assets. The purpose of depreciation is to allocate the cost of an asset over
its useful life and not to adjust its cost so as to bring it closer to the market value.
You must be wondering as to why assets are shown at cost even when there are wide
differences between their costs and market values. The main argument is that the cost
concept meets all the three basic criteria of relevance, objectivity and feasibility.
Accrual Concept
The accrual concept makes a distinction between the receipt of cash and the right to
receive it, and the payment of cash and the legal obligation to pay it. In actual busi-
ness operations, the obligation to pay and the actual movement of cash may not
coincide. The accrual concept recognises this distinction. In connection with the sale
of goods, revenue may be received (i)before the right to receive arises, or(ii) after the
right to receive has been created, The accrual concept provides a guideline to the
accountant as to how he should treat the cash receipt and the rights related thereto. In
the former case the receipt will not be recognised as the revenue of the period for the
reason that the right to receive the same has not yet arisen. In the latter case the
revenue will be recognised even though the amount is received in the subsequent
period.
Similar treatment would be given to expenses incurred by the firm. Cash payments
for expenses may be made before or after they are due for payment. Only those sums
which are due and, payable would be treated as expenses. If a payment is made in
advance (i.e. it does not belong to the accounting period in question) it will not be
treated as an expense, and the person who received the cash will be treated as a
debtor until his right to receive the cash has matured. Where an expense has-been
incurred during the accounting period but no payment has been made, the expense
must be recorded and the person to whom the payment should have-been made is
shown as a creditor.
25
The accounting year of a firm closes on 31st December each year. The rent for
business premises of Rs 50,000 for the last quarter could not be paid to the owner on
account of his being away in a foreign country. Should the rent payable be taken into
account for computing the firm's income for the accounting year?
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Activity 2.6
A government contractor supplies stationery to various government offices. Some

bills amounting to Rs. 10,000 were still pending with various offices at the close of
the accounting year on 31st March. Should the businessman take the revenue of Rs.
10,000 into account for computing the net profit of the period?
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Concept of Conservatism
The concept of conservatism, also known as the concept of prudence, is often stated as
"anticipate no profit, provide for all possible losses". This means an accountant should
follow a cautious approach. He should record lowest possible value for assets and
revenues, and the highest possible value for liabilities and expenses. According to this
concept, revenues or gains should be recognised only when they are realised in the
form of cash or assets (usually legally enforceable debts) the ultimate cash realisation
of which can be assessed with reasonable certainity. Further, provision must be made
for all known liabilities, expenses and losses whether the amount of these is known
with certainty or is at best an estimate in the light of the information available. Probable
losses in respect of all contingencies should also be provided for. A contingency is a
condition or a situation, the ultimate outcome of which-gain or loss-cannot be
determined accurately at present. It will be known only after the event has occurred (or
has not occurred). For example, a customer has filed a suit for damage against the
company in a court of law. Whether the judgement will be favourable or unfavorable to
the company cannot be determined for sure. Hence, it will be prudent to provide for
likely loss in the financial statements. As a consequence of the application of this
concept, net assets are more likely to be understated than overstated, and income is
more likely to be overstated than understated. Based on this concept is the widely
advocated practice of valuing inventory (stock of goods left unsold) at cost or market
price. whichever is lower. You will note that this convention, in a way, modifies the
26
earlier cost concept. It should be stated that the logic of this convention has been under Accounting Concepts and
stress recently; it has been challenged by many writers on the ground that it stands in Standards
the way of fair determination of profit and the disclosure of true ad fair financial
position of the business enterprise. The concept is not applied as strongly today as. it
used to be in the past. In any case, conservatism must be applied rational Y as over-
conservatism may result in misrepresentation.
Materiality Concept
There are many events in business which are trivial or insignificant in nature. The
cost of recording and reporting such events will not be justified by the usefulness of
the information derived. Materiality concept holds that items of small significance
need not be given strict theoretically correct treatment. For example, a paper stapler
costing Rs. 30 may last for three years. However, the effort involved in allocating its
cost over the three-year period is not worth the benefrt than can be derived from this
operation. Since the item obviously is immaterial when related to overall operations,
the cost incurred on it may be treated as the expense of the period in which it is
acquired. Some of the stationery purchased for office use in any accounting period
may remain unused at the end of that period. In accounting, the amount spent on
entire stationery would be treated as expense of the period in which the stationery
was purchased, notwithstanding the fact that a small part of it still lies in stock. The
value (or cost) of the stationery lying in stock would not be treated as an asset and
carried forward as a resource to the next period. The accountant would regard the
stock lying unused as immaterial. Hence, the entire amount spent on stationery would
be taken as the expense of the period in which such expense was incurred.
Where to draw the line between material and immaterial events is a matter of judge-
ment and common sense. There are no hard and fast rules in this respect. Whether a
particular item or occurrence is material or not, should be determined by considering
its relationship to other items and the surrounding circumstances. It is desirable to
establish and follow uniform policies governing such matters.
Consistency Concept
In practice, there are several ways to record an event or a transaction in the books of
account. For example, the trade discount on raw material purchased may be deducted
from the cost of goods and net amount entered in the books, or alternatively trade
discount may be shown as the income with full cost of raw material purchased
entered in the books. Similarly, there are several methods to charge depreciation
(which is a decrease in the value of assets caused by wear and tear, and passage of
time) on an asset or of valuing inventory. The consistency concept requires that once
a company has decided on one method and has used it for some time, it should
continue to follow the same method or procedure for all subsequent events of the
same character unless it has a sound reason to do otherwise. If for valid reasons the
company makes any departure from the method it has been following so far, then the
effect of the change must be clearly stated in the financial statements in the year of
change.
You will appreciate that much of the utility of accounting information lies in the fact
that one could draw valid conclusions from the comparison of data drawn from
financial statements of one year with data of the other year. Comparability is
essential so that trends or differences may be identified and evaluated. Inconsistency
in the application of accounting methods might significantly affect the reported profit
and the financial position. Further, inconsistency also opens the door for
manipulation of reported income and assets. The comparability of financial
information depends largely upon the consistency with which a given class of events
are handled in ac-counting records year after year.
27
A company had been charging depreciation on a machine at Rs. 10,000 per year for
the first 3 years. Then it began charging Rs. 9,000 for 4th year and Rs. 7,800 for 5th
year and so on. Is this practice justified? Give reasons for your answer.
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Periodicity Concept
Although the results of operations of a specific enterprise can be known precisely

only after the business has ceased to operate, its assets have been sold off and
liabilities paid off, the knowledge of the results periodically is also necessary. Those
who are interested in the operating results of business obviously cannot wait till the
end. The requirements of these parties therefore force the accountant to report for the
changes in the wealth of a firm for short time periods. These time periods in actual,
practice vary, though a year is the most common interval as a result of established
business practice, tradition and government requirements. Some firms adopt calendar
year, some others financial year of the government. But more and more firms are
changing to the `natural' business year the end of which is marked by relatively lower
or lowest volume of business activity in the twelve-month period. The custom of
using twelve-month period is applied only for external reporting. The firms usually
adopt a shorter span of interval, say one month or three months, for internal reporting
purposes.
The allocation of long-term costs and the difficulties associated with this process
directly stem from this concept. While matching the earnings and the cost of those
earnings for any accounting period, all the revenues and all the costs relating to the
yearn question have to be taken into account irrespective of whether or not they have
been received in cash or paid cash. Despite the difficulties that arise in allocations
and adjustments, short-term reports (i.e., yearly reports) are of such importance to
owners, management, creditors, and other interested parties that the accountant has
no option but to resolve such difficulties. Obviously, the utility of the periodic
financial statements outweighs the difficulties.
Some other concepts e.g. Matching concept, Realisation concept and Dual Aspect
concept are discussed in Units 4 and 5 and as such they have not been taken up here.
While going through all these concepts, probably you have developed a feeling that
they come in conflict with each other. You are right. We illustrate this by
considering. some of these concepts in the context of valuation of business
properties. Suppose, a firm acquired a piece of land in 2000 fora price of Rs.
6,00,000. Factory premises were constructed in 2001 and operations commenced in
2002. The firm has been successful in achieving desired profit for the past year. The
Balance Sheet ( a statement of assets and liabilities) for the year 2003 is being
prepared and `Land' is required to be valued. The estimated current market price of
28 this land is Rs. 60,00,000.
Should you recommend that the land be valued at Rs. 60 lakhs? The answer is `no' Accounting Concepts and
obviously. Land would be carried on the Balance Sheet at its original cost of Rs, Standards
6,00,000 only. This decision is supported by several of the concepts discussed in this
section. In the first place, the stability of purchasing power of money implied in the
money measurement concept prevents us from recognising accretion in values as a
result of changing price levels. Then, the realisation concept will not allow
unrealised profits to be included as long as land is held by the company and not sold
away. You may note that the continuity or going concern concept makes any
possible market value of land irrelevant for balance sheet because the firm has to
continue in business and land will be needed by it for its own use. In this connection,
it could be argued that if land were shown on the balance sheet at its estimated
current market value, the owner might decide to discontinue the business, sell the
land and retire. The principle of objectivity is now introduced into the argument. It
can be easily seen that in a situation like this the cost of acquisition of land at Rs.
6,00,000 in 2000 is the objective fact because it is based on a transaction that actually
took place and this objective evidence is capable of being verified. In contrast, the
estimate of current market value figure may be suspect. It raises many questions. Do
you have a market quotation for an identical plot of land? Has a similar plot of land
been sold recently and can we pick it up as verifiable evidence of the current market
price? It may be said that even if market price for an identical plot of land is not
available, estimates by an accredited valuer may be accepted as verifiable evidence of
the market price. Further complications may be noticed if buildings and facilities
have been erected on the plot of land. Is it possible to estimate the value of land
without factory buildings and other facilities constructed on it? The answer is a flat
`no' and the conservatism concept will then deter you from accepting an estimate of
market value since it cannot be ascertained with reasonable accuracy.
2.4 ACCOUNTING STANDARDS
The basic concepts discussed in the foregoing paragraphs are the core
elements in the theory of accounting. These concepts (postulates or
conventions), however, permit a variety of alternative practices to co-exist. As
a result, the financial results of different companies cannot be compared and
evaluated unless full information is available about the accounting methods
which have been used. The variety of accounting practices have made it
difficult to compare the financial results of different companies. Further, the
alternative accounting methods have also enabled, the reporting of different
results, even by the same company.
Need for Standards: The information contained in published financial

statements is of particular importance to external users, such as shareholders
and investors. Without such information they would not be able to take right
decisions about their investments. As in several other countries, Parliament in
India has specified in the Companies Act the type and minimum level of
information which companies should disclose in financial statements. It is the
responsibility of the accounting profession to ensure that the required
information is properly presented. It is evident that there should not be too
much discretion to companies and their accountants to present financial infor-
mation the 'way they like. In other words, the information contained in
financial statements should conform to carefully considered standards. Public
confidence in accounting information contained in financial statements will
grow if they are satisfied as to the logic, consistency and fairness of the
figures shown therein. For instance, a company could incur a loss and still
"pay dividends by manipulating the loss into a profit. In the long run this
course may have a disastrous effect on the company and its investors.
29
Accounting Framework You would be better able to appreciate the function of accounting standards by
relating them to the basic purpose of financial statements which is the
communication of information affecting the allocation of resources. Ideally, such
information should make it possible for investors to evaluate the investment
opportunities offered by different firms and allocate scarce resource to the most
efficient ones. In theory, this process should result in the capital distribution of
resources within the economy and should maximise the potential benefit to society.
In this context unless there are reasonably appropriate standards, neither the purpose
of the individual investor nor that of the nation as a whole can be served. The purpose
is likely to be served if the accounting methods used by different firms for presenting
information to investors allow correct comparisons to be made. For example, they
should not permit a company to report profits which result simply from a change in
accounting methods rather than from increase in efficiency. If companies were free to
choose their accounting methods in this way, the consequences might be that
deliberate distortions are introduced, leading eventually to misapplication of
resources in the economy. The relatively less efficient companies will be able to
report frctitious profits, and as a result scarce capital of society will be diverted away
from the more efficient companies which have adopted more strict and consistent
accounting methods.
2.5 CHANGING NATURE OF GENERALLY ACCEPTED

ACCOUNTING PRINCIPLES (GAAP)
Generally accepted accounting principles are usually developed by professional

accounting bodies like American Institute of Certified Public Accountants (AICPA)
and Institute of Chartered Accountants of India(ICAI). In developing such principles,
however, the accounting profession has to reflect the realities of social, economic,
legal and political environment in which it operates. Besides academic research,
regulatory and tax laws of the government e.g., Companies Act, 1956, income Tax
Act, 1961 etc., in a large measure, influence the formulation of acceptable accounting
principles. Stock exchanges and other regulatory agencies like Controller of Capital
Issues (CCI) have laid down rules for disclosure and extent of accounting
information.
Since the environment in which business operates, undergoes constant changes as a

result of changes in economic and financial policies of the Government and changes
in the structure of business, continued evaluation of the relevance of generally
accepted accounting principles is required. In this sense, the principles of accounting
are not ever-lasting truths. You will appreciate that it is the development of relevant
accounting principles in tune with the present day needs of the society that would
make it possible for the business enterprises to develop financial statements which
would be acceptable and of value to the end users.
Now we give you a brief account of the development of standards in the United
Kingdom, United States of America, India, and at the international level.
2.6 ATTEMPTS TOWARDS STANDARDISATION
Standardisation in UK and USA: Though the Institute of Chartered Accountants in

England and Wales began making recommendations since 1942, the real progress
started with the establishment of Accounting Statements Committee (ASC) by the
Institute in 1969 in the wake of public criticism of financial reporting methods which
permitted diverse practices. As a result of diversity in practices some big investors
had suffered heavy losses on their investments in well known companies. The main
objective of ASC has been to narrow areas of difference and variety in accounting
practices. The procedure used for standardisation is initiated by the issue of an
30
"Exposure Draft" on a specific topic for discussion by accountants and the public at Accounting Concepts and
large. Comments made on exposure draft are taken into consideration when drawing Standards
up a formal statement of the accounting methods for dealing with that specific topic.
The statement is known as a Statement of Standard Accounting Practice (SSAP).
Once the statement of standard accounting practice is adopted by the accounting

profession ( the fact that a statement has been issued by the Institute in itself signifies
the acceptance by the profession), any material departure by any company form the
standard practice in presenting its financial reports is to be disclosed in that report. So
far, nineteen statements of standard accounting practice, in addition to some exposure
drafts under consideration, have been issued by the ASC.
The need for evolving standards in the USA was felt with the establishment of
Securities Exchange Commission (SEC) in 1933. The SEC is the Government agency
to regulate and control the issuance of and dealings in securities of the companies. A
research-oriented organisation called the Accounting Principles Boards (APB) was
formed in 1957 to spell out the fundamental accounting postulates. The Financial
Accounting standards Board(FASB) was formed in 1973. The FASB pronounces
statement from time to time articulating the generally accepted accounting principles.
The constant support given by SEC to FASB pronouncements has given considerable
credibility to its accounting policy statement. The FASB till 1985 has issued five
statement of concepts and eighty-eight statements of financial accounting standards.
Standards at International Level: In view of the growth of international trade and

multinational enterprises, the need for standardisation at international level was felt.
An international Congress of Accountants was organised in Sydney. Australia in
1972 to ensure the desired level of uniformity in accounting practices. Keeping this
in view, International Accounting Standards Committee (IASC) was formed and was
entrusted with the responsibility of formulating international standards. All the
member countries of IASC resolved to conform to the standards developed by IASC
or at least to disclose variations from recommended standards. After its formation in
1973, the IASC has issued 40 international accounting statement todate. Another
professional body, the International Federation of accountants (IFAC) was
established in 1978.
Attempts have also been made in countries of European Economic Community

(EEC) and Canada for standardisation of accounting practices regarding disclosure
and consistency of procedures.
2.7 ACCOUNTING STANDARDS IN INDIA

With a view to harmonrse varying accounting policies and practices currently in use
in India, the Institute of Chartered Accountants of India (ICAI) formed the
Accounting Standards Board (ASB) in April 1977 which includes representatives
form industry and government. In line with the procedure followed in other countries,
the preliminary drafts prepared by the study groups and approved by ASB are
circulated amongst various external agencies, including the representative bodies of
trade commerce and industry. So far, twenty eight standards have been issued by
ASB, a brief description of which is provided in Appendix Ito this unit.
The standards are recommendatory in nature in the initial years. They are recom-
mended for use by companies listed on a recognised Stock Exchange and other large
commercial, industrial and business enterprises in the public and private sectors.
We advise that you read all or at least some of these standards in order to get a
feel of that these standards are all about. What policies and procedures of
accounting these standards aim to standardise and why? Do not worry if you
are unable to understand some of the ideas or expressions contained in the
standards. You may like to come back to these standards after you have been
through all the blocks of this course in order to have a better grasp of them. 31
Accounting Framework Regarding the position in India, It has been stated that the standards have been
developed without first establishing the essential theoretical framework. Without
such a framework, it has been contended, any accounting standards and principles
developed are likely to lack direction and coherence. This type of shortcoming also
existed in UK and USA but then it was recognised and remedied long back. In the
United States the first task which FASB undertook was to develop a conceptual
framework project which aimed at defining the objectives of financial reporting ( a
sample of which is presented in Appendix II). This was to be followed by the spelling
out of concepts and standards establishing what have been frequently referred to as,
generally accepted accounting principles (GAAP). Any attempt to develop a
conceptual frame work regarding the objectives of reporting will have to take into
consideration the answers to the following questions:
i) Who are the users of financial reports ?
ii) What decisions these user groups have to take?
iii) What information can be provided which would assist them to take such
decisions.
The objectives, as you have already noted, depend upon the economic, social, legal
and political environment of the country.
At this point it will be useful for you to watch Video Programme: Understanding
Financial Statement - Part I.
2.8 SUMMARY
Accounting as a field of study in its developmental process has evolved a theoretical

framework consisting of principles or concepts over period of time. These concepts
enjoy a wide measure of support of the accounting profession ; that is why they are
known as Generally Accepted Accounting Principles (GAAP) . Several concepts and
their implications for business and information users were discussed in this unit.
Since the accounting principles are broad guidelines for general application, they
permit a wide variety of methods and practices. The lack of uniformity in accounting
practice makes it difficult to compare the financial reports of different companies.
Moreover, the multiplicity of accounting practices makes it possible for management
to conceal economic realities by selecting those alternative presentations of financial
result which allow earnings to be manipulated. The financial statements prepared
under such conditions, therefore, may have limited usefulness for several users of
information. This problem has been recognised all over the world and various profes-
sional bodies are engaged in the task of standardising accounting practices. There is a
movement towards consensus building even at the international level. Such profes-
sional bodies, in fact , first look at the practices used by practising accountants They
then try to obtain a refinement of those practices by a process of consensus. It is in
this manner that the theory of accounting is built . In India also, some headway has
been made by establishing twenty eight standards for accounting practice.
2.9 KEY WORDS
Accounting framework includes generally accepted accounting principles (GAAP)

or the basis of which accounting data is processed, analysed and reported.
Accounting theory is a set of inter-related principles and propositions which provide

a general frame work for accounting practice and deal with new developments in the
32 area.
Consistency concept envisages that accounting information should be prepared on a Accounting Concepts and
consistent basis form period of period, and within periods there should be consistent Standards
treatment of similar items.
Conservatism concept forbids the inclusion of unrealised gains but advocates provi-
sion for possible losses.
Entity concept separates the business from owner(s), from the standpoint of
accounting.
Going concern concept refers to the expectation that the organisation will have
indefinite life. This assumption has an important bearing on how the assets are to be
valued.
Materiality concept admonishes that events of relatively small importance need not
be given a detailed or theoretically correct treatment. They may be ignored for
separate recording.
Money measurement concept ignores intangibles like employee loyalty and
customer satisfaction as they cannot be expressed in money terms. It also assumes
records on the basis of a stable monetary unit.
Objectivity principle requires that only the information based on definite and verifi-
able facts be recorded.

1. Examine the role of accounting concepts in the preparation of financial
statements.
2. Is it possible to give a true or a fair view of a company's posrtion using
accounting information?
3. Do you find any of the accounting concepts conflicting with each other ?
Give examples.
4. In what way can accounting information help in the proper allocation of
resources?
5. Why accounting practices should be standardises? Explain.
6. What progress has been made in India regarding standardisation of
accounting practices?
7. Answer whether the following statement are true or false:
a) The materiality concept refers to the state of ignoring True/False
small items and values from accounts
b) The generally accepted accounting principles prescribe
a uniform accounting Practice. True/False
c) The conservatism concept leads to the exclusion of all True/False
unrealised profits.
d) Statements of Standard Accounting Practice, were
formulated by the Financial Accounting standards True/False
Board of USA.
e) The Securities Exchange Commission of USA has
played an important role in evolving the conceptual
framework for accounting True/False
8. Conceptual frame work of accounting implies

i) Making entries in the books of accounts
ii) a code of conduct for the accounting profession
iii) general principles for the preparation of accounting information
iv) planning and control of enterprise operations
v) none of the above. 33
Accounting Framework 9. Accounting Standards are statements prescribed by
i) Law
ii) Government regulatory bodies
iii) bodies of shareholders
iv) Professional accounting bodies
v) none of the above
10. Accounting concepts are
i) broad assumptions
ii) Methods of presenting financial accounts
iii) bases selected to prepare a specific set of accounts
iv) none of the above
11. Name the accounting concept violated, in any of the following situations:
a) The Rs, 1,00,000 figure for inventory on a Balance Sheet is the
amount for which is could be sold on the balance sheet date.
b) The Balance Sheet of a retail store which has experienced a gross
profit of 40% on sales contains an item of merchandise inventory of
Rs. 1,15,00,00(Mechandise inventory ( at cost) Rs. 69,00,000.
c) Company M does not charge annual depreciation, preferring instead
to show the entire difference between original cost and proceeds of
sale as a gain or loss in the period when the asset is sold. It has
followed this practice for many yea's.
Answers to Activities
1. If separate entity concept ` is not observed, it becomes difficult to calculate

the profitability of business and ascertain its financial position. It would be
particularly difficult if the owner has several distinct businesses.
2. Proprietory withdrawals reduce the capital of the enterprise unless they are in
lieu of anticipated profits. It is not proper to show them as operating expense.
They are also not admissible as deductions form profits for tax purposes.
3. No, the money measurement concept does not permit the recording of such
events What effect this event will have on the business cannot be objectively
determined
4. Revaluation violates several concepts like, cost concept, conservatism

concept and continuity concept. To take credit for an extraordinary gain like
this, is normally, not considered justified. However, were substantial gap
exists between historical cost of a fixed asset and its market value, it has been
observed that the accounting profession has been supporting such
revaluations so that balance sheet could show a realistic position of the
enterprise
5. It should be taken into account otherwise profit would be overstated.
6. It should be taken into account otherwise profit would be understated.
7. It violates the consistency concept unless there is a solid reason for departing
from the earlier practice.
Answer to self-assessment Questions Exercises
7. a) False, b)False, c)True, d) False, e) True.

34
8. (iii)
9. (iv) Accounting Concepts and
Standards
10. (i)
11. (a) conservatism concept, (b) no violation, (c) periodicity concept.

Maheshwari, S.N. and S.K. Maheshwari, 2000. Financial Accounting, Vikas Publish-
ing House: New Delhi (Chapter 2)
Anthony, Robert, N. and James Reece, 1987. Accounting Principles, All India
Traveller Book Seller : New Delhi ( Chapters 1-3)
Meigs, Walter, B. and Robert F. Meigs,1987. Accounting. The Basis for Business
Decisions, McGraw Hill: New York ( Chapter 1)
Hendriksen, E. S., 1984. Accounting Theory, Khosla Publishing House Delhi (Chap-
ters 2,3 and 6)
35
Appendix I
Accounting Standards Board
Institute of Chartered Accountants of India (ICAI) has so far issued twenty eight
standards:
Framework for the Preparation and Presentation of Financial Statements
(AS 1) Disclosure of Accounting Policies
(AS 2) Valuation of Inventories
(AS 3) Cash Flow Statements
(AS 4) Contingencies and Events Occuring after the Balance Sheet Date
(AS 5) Net Profit or Loss for the period, Prior Period and Extraordinary Items and
Changes in Accounting Policies
Announcement-Limited Revision to Accounting Standards (AS) 5
(AS 6) Depreciation Accounting
(AS 7) Accounting for Construction Contracts
Revised Accounting Standard (AS) 7, Construction Contracts, 28-05-2002
(AS 8) Accounting for Research and Development
(AS 9) Revenue Recognition
(AS 10) Accounting for Fixed Assets
Announcement- Status of certain provisions of AS 10, Accounting for Fixed Assets
pursuant to the issuance of AS 19, Leases and As 16, Borrowing Costs
(AS 11) Accounting for the Effects and Changes in Foreign Exchange Rates
(AS 11) (Revised 2003). The Effects of Changes in Foreign Exchange Rate 21-02-
200 (AS 12) Accounting for Government Grants
(AS 13) Accounting for Investments
(AS 14) Accounting for Amalgamations
(AS 15) Accounting for Retirement Benefits in the Financial Statement of Employers
(AS 16) on Borrowing Costs
(AS 17) Segment Reporting
Disclosure of corresponding previous year figures in the first year of application of
Accounting Standards (AS) 17, Segment Reporting
Accounting Standard 18, Related Party Disclosures
Applicability of Accounting Standards (AS) 18, Related Party Disclosures
(AS 19) Leases
(AS 20) Earnings Per Share
(AS 21) Consolidated Financial Statements
(AS 22) Accounting for Taxes on Income
Clarification on Accounting Standards (AS) 22, Accounting for Taxes on Income
(AS 23) Accounting for Investments in Associates in Consolidated Financial
Statements
36
(AS 24) Discontinuing Operations
Announcement- Accounting Standards (AS) 24, Discontinuing Operations Accounting Concepts and
Standards
(AS 25) Interim Financial Reporting
(AS 26) Intangible Assets
(AS 27) Financial Reporting of Interests in Joint Ventures
(AS 28) Impairment of Assets 30-05-2002
For further details, please visit : http://www.icai.org/resource/o_ac_standard.html
37
Appendix II
Financial Accounting Standards Board (FASB)
Concepts No. 1: Objectives of financial reporting by business enterprises'
The three objectives which are included in concepts No. I are reproduced below:
1) Financial reporting should provide information that is useful to the present

and potential investors and creditors and other users in making rational
investment, credit and similar decisions. The information should be
comprehensible to those who have a reasonable understanding of business
and economic activities and ai willing to study the information with
reasonable diligence.
2) Financial reporting should provide information to help present and potential

investors and creditors and other users in assessing the amounts, timing and
uncertainty of prospective cash receipts from dividends or interest and the
proceeds from the sale, redemption, or maturity of securities or loans. Since
investors' and creditors' cash flows are related to enterprise cash flows,
financial reporting should provide information to help investors, creditors
and others, assess the amounts, timing, and uncertainty of prospective net
cash inflows to the related enterprise.
3) Financial reporting should provide information about the economic resources

of an enterprise, the claim to those resources (obligations of the enterprise to
transfer resources to other entities and owners' equity), and the effects of
trans-action, events, and circumstances that change its resources and claims
to those resources.
38
UNIT 3 ACCOUNTING Accounting Information and
its Applications
INFORMATION AND ITS
APPLICATIONS
Objectives
After studying this unit, you should be able to appreciate the:
• nature of accounting information
• major purposes of accounting information;
• role of information in the control process;
• the uses of earnings information; and
• uses of information contained in balance sheet.
Structure
3:1 Introduction
3.2 Purposes of Accounting information
3.3 Accounting and Control in Organisation
3.4 Profit and Cash Balance Distinguished
3.5 Uses of Earnings information
3.6 Uses of Balance Sheet
3.7 Summary
3.8 Key Words
3.9 Self- assessment Questions/Exercises
3.1 INTRODUCTION
As you have observed in Unit I, historically, accounting developed as a system for

reporting information to the owners including shareholders and other investors of the
business. In the process of its evolution, accounting has branched off into two distinct
directions- one dealing with information processing for external uses and the other
dealing with information processing for internal (or managerial) uses. We refer to the
first one as financial accounting and the second as managerial accounting. But when
we talk about accounting information, we generally look at it in a broader sense to
encompass information processing for both internal and external uses. In this unit we
shall deal with some illustrative uses of accounting information so as to give you a
feel of what accounting could contribute.
3.2 PURPOSES OF ACCOUNTING INFORMATION

At the outset, let us share with you that accounting information is useful for (1)
score-keeping, (2)attention-directing, and (3) problem-solving . Let us ask a question:
What precise information should the accountant provide for these purposes?
Obviously, the type-coverage of information needed may vary from organisation to
organisation. Further, the specific information needs in the actual decision-making
process at different organisational levels influence the scope of an accounting
information system. 39
Score-keeping: The score keeping function is one of the primary purposes of account-
ing information. It basically deals with the financial health of the enterprise. In other
words, it answers: How are we doing ? Good , bad, or indifferent? Though it appears
to be a simple question, a moment's reflection will show that it is not that simple. It
involves answering questions such as : What is doing good? What is doing bad? Is
profit earned good? If so, how much? Is it that profit alone is not sufficient? Thus we
can go on increasing the string of questions intending to further clarify the basic
question. Thus, score-keeping has two aspects, one is that of keeping record of actual
data on performance- a constant process of measurement and valuation. The other
aspect is concerned with putting the data in relation to predetermined standards. In
order to answer the question whether the performance is good, bad or indifferent we
have to have a constant process of comparison against some norms, standards or
benchmarks. This is achieved by preparing a series of reports based on comparison of
actual data with the planned data.
Activity 3.1
Complete five questions (two are already given below ) that will lead to the assess-
ment of the financial health of a business organisation.
1. How much profit was made by the organisation in the preceding accounting
year?
2. Does the organisation have sufficient funds to meet its day to day
expenditures?
3. …………………………………………………………………………………
4. …………………………………………………………………………………
5. …………………………………………………………………………………
Attention directing : Attention-directing is nothing but the process of giving a signal

to the user of accounting information about the need to take a decision. As such the
accounting information supplied arouses the user's attention to take a decision. For
example, a report from an accountant comparing the actual performance data against
budget data is a score-keeping record. In the hands of a decision-maker it is an
attention-directing information. This would enable him to immediately focus his
attention on the deviations or variances from the budgets or the plans. A whole series
of actions will be triggered by this, namely, evaluation of reasons for the deviation,
remedial actions to be taken, modifications in the feedback for future and so on Most
of the formal reporting takes the form of annual reports. An annual report is the score
card of activities for an accounting period. If properly analysed, this report can be
helpful in understanding the problems of overall nature faced by the enterprise. It can
also help the shareholders in assessing the actual performance of the company vis-a-
vis their expectations.
Problem-solving : The problem-solving function of accounting information involves

provision of such information which enables the manager to find solutions to the
problems. There are many problems which accounting information could highlight
and provide for their possible solutions, such as make or buy decision with respect to
component, parts or products, continue or drop decisions with respect to product lines
leasing or acquisition decisions with respect to assets etc. Problem-solving is
therefore an important purpose of accounting information system.
Let us summarise the purposes of accounting information:
Accounting, in its score card role, accumulates data and enables interested persons,
both internal and external, to understand and take stock of the organisation's
performance
40
In its attention-directing role accounting information, by reporting and analysing the
data, focuses a manager's attention on operational deficiencies, weaknesses, threats - Accounting Information and
and opportunities. In this role accounting complements day to day operational its Applications
planning and control activities.
In its problem-solving role, accounting enables quantification of the different alterna-
tive solutions, their relative merits and demerits.
Activity 3.2
Fill in the blanks:
1) Financial accounting deals with reporting information for ………..uses and
……………deals with reporting information for managerial uses.
2 Accounting information addresses itself to three distinct activities
(i)……………….…(ii)………………...….(iii)…………….……..…
3 Score-keeping activity involves two functions, first, keeping ……..and
…………second a constant process of………….
4) Attention-directing information triggers the need for taking………in the
recipient's mind.
5) Problem-solving in accounting involves provision of………..to enable
managers to find…………..to problems.
3.3 ACCOUNTING AND CONTROL IN

ORGANISATION
In this course we shall deal with financial and management accounting together. You,
probably know that both these branches of accounting, after all, are concerned with
providing information about the same business.
One of the tasks of the management is to control the operations of the organisation.
Accounting is closely connected with control system in an organisation. To understand
this, let us have a look at the control system in an organisation as shown in Figure
3.1. You know that the organisation is a system of inter-related parts and is linked with
the environment. It derives its inputs from the environment and transforms them with
the help of the operating system into outputs which it delivers to the environment. To
control organisational system, we have first to measure inputs, operations and
outputs. The measurements obtained men have to be evaluated against standards.
This information has to be supplied to the concerned managers so that they could
take appropriate actions form future point of view. In all these activities i.e,
measuring evaluating and providing feedback the accountant is deeply involved. The
process of evaluation brings out deviations which provide the basis for feedback in a
system and lead to changes in inputs for operations to achieve desired outputs.
Figure 3.1 Structure of Control in an Organisation.
41
The annual accounts or financial statements of a business comprise balance sheet and
profit and loss account. Sometimes they also include the fund flow statement.
All these statements have only historical significance since they relate to an account-
ing period which has already expired. However, balance sheet and profit and loss
account provide valuable information linking the profit to investment or assets used in
business. We try to measure organisational performance using this information.
The idea of relating profit to asset use can provide a basis for judgement about the
efficiency of an organisation. As business often operates in an environment of
uncertainty, estimation of `normal' profit is not easy. By making the best use of
accounting information of the past in relation to the expectations of future, we try to
make integrated financial plan for an organisation. Such plan includes projections
about level of activity, resource, profit, financial assets, and car resources.
From Figure 3.1 it is obvious that controller (or accountant) and managers obtain such
information which enables them to diagnose the situation and to identify and define the
problem at hand.
Let us try to identify and define a problem in a hypothetical setting. Suppose you are
managing a firm which sells three products p1, p2, p3,. You are confronted with a
problem that the profit of your firm is decreasing. Now falling profit may be. due to
many reasons. The first thing that you would like to do is to identify the problem more
precisely before you set about solving it, Some of the possible hypotheses are: which
of the three products is losing money? Are all of them losing money? If all of them are
losing money, are they losing money to the same extent? Is the firm losing money due
to increasing cost or decreasing prices? Many such question would enable you in
diagnosing the problem more accurately. In general, such questions enable a manager
to specify the causes of the problem.
Let us examine how the accounting information could be helpful in identifying a

problem of this nature. The following table is the summarised profit and loss account of
a firm whose situation has been described above.
Figures in Rs.
Year 2002 2003
Sales 1000 1000

Less:
Cost of goods 400 500
Depreciation 200 200
Other operating expenses 100 700 100 80
Profit 300 200
From the above, it is clear that in one year the profit has declined by Rs. 100. An
examination of the profit and loss account would show' that sales have remained the
s a m e a n d all expenses other than the cost of goods sold have also remained the
same: We are now in a position to state the problem thus:
Problem : Decrease in profits during the period has come about as a result of overall
increase in the cost of goods sold.
If the organisation was dealing with a single product, the problem is easily identifi-
able. But as it is dealing with three products, you have to answer the question: Which
product is losing money? The product-wise accounting information with respect to .
sales and costs can help us in identifying the problem better.
42
Year 2002 2003
Accounting Information and
Products P1 P2 P3 P3 P3 its Applications
Sales 300 300 400 400 400 200

Less: Cost of sales 150 150 100 200 200 100
Gross Profit 150 150 300 200 200 100
(Please recall that other costs which are common to all the products did not change)
With the above additional information on different products you can now redefine the
problem more precisely
Problem: 1 Sales of P1 and P. have increased. Cost of sales retains the same
relationship with sales.
2. Sales of P3 had decreased. Cost of sales in relation to sales had doubled.
What we have done is nothing but a very simple use of accounting information to
pin-point the problem so that we could initiate action.
3.4 PROFIT AND CASH BALANCE

DISTINGUISHED
How do we evaluate the results of a firm ? The answers could be many depending on
what your interests are. But there is no difference of opinion regarding two important
aspects.
1. What is the worth of the business?
2. How much does it earn?
The results of-these two inquiries usually become the basis for several decision of the
management and their action plans. The initiatives the management takes in connec-
tion with improving the profitability of the enterprise and its worth will, in a large
measure, be a reflection of managerial effectiveness.
Illustration
Shyam decided to start a small casting and machine shop. He undertakes job orders .
for castings. He hired a shop floor with a backyard, bought the necessary equipment
and hired a few workers. Shyam though he had very successful operation during the
first year, because he was engaged throughout the year.
He tried to prepare his accounts and discovered that his collection from customers
was Rs. 24,000 and he had borrowed Rs. 30,000 from the bank. He had spent Rs.
72,000 for running the business. He had run down his savings substantially (Exhibit
3.1). Shyam discussed the situation with his friend who is a graduate student of
management. He worked out Shyam's operating results for the period (Exhibit 3.2).
Exhibit 3.1
Shyam Enterprises
Summary of Cash transactions
Figures in Rs.
Receipts Payments
Receipts from bank loan 30,000 Wages to employees 12,000
Collections from customers 24,000 Materials purchased 36,000
Payment of installment for
equipment purchased 5,000
Electricity charges 1,000
Withdrawals for personal use 15,000
Other Payments for Expenses 3,000
54,000 72,000
Excess payments over Rs. 18,000
receipts 43
Shyam's friend with the help of Exhibit 3.2 could convince Shyam that the situation
not very bad. For proper appreciation of the situation he gathered several pieces of
information, as given below:
1. He made sales of Rs.36,000 (at selling price), one-third of it (Rs.12,000) is

yet be collected. In other words, on an average 4 month's sales remain
uncollected.
2 Even though he purchased materials worth-Rs. 36,000 he consumed only one-

half of it for- production and sales. In other words, materials sufficient for
one yea consumption remain in inventory.
3. Cash generation during the year was Rs.54,000 whereas the need for
payment amounted to Rs. 72,000
Exhibit3.2
Shyam Enterprises
Operating Summary
Figures in Rs.
Collections from sales 24,000
Sales yet to be collected 12,000
36,000
Less:
Cost of sales:
Purchases of materials paid 36,000
Inventory at close 18,000 18,000
Wages 12,000
Electricity 1,000
Other expenses 3,000
Total expenses 34,000
Net profits 2,000
Exhibit 3.2 is based on the additional information presented above and shows that
shyam has made a profit of Rs. 2,000 on sales of Rs.36,000. You will appreciate that
there is a fundamental difference in approach and utility of information contained in
the two Exhibits. While Exhibit 3.1 looks at the problem purely from the viewpoint a
increases and decreased in cash. Exhibit 3.2 summarises all the revenues and
expensed which belong to the period of one year irrespective of whether or not all the
revenues have been received in cash and whether or not all the expenses have been paid
in cash In fact, in doing so we are making practical use of Accrual Concept
(discussed in the preceding unit) and principles of revenue recognition ( discussed in
unit 5). You may note that cash balance is not synonymous with net profit earned by
the business. A business firm might have earned a profit and still be short of cash and
vice-versa. In this particular example you have seen that the business has earned a
profit of Rs. 2,000 but without cash balance showing any surplus. In fact, payments,
as shown in Exhibit 3.1, have far. exceeded in receipts. The excess of payments over
receipts amounted to Rs.18,000 and this deficit was financed through the personal
savings of Shyam. Since payments can never be more than receipts, the deficit must
have been made good through Shyam's personal sources. This subject will be further
expanded in Unit 6 dealing with funds flow and cash flow analysis.
3.5 USES OF EARNINGS INFORMATION
The earnings information is useful for (1) measuring accomplishment, (2) deciding
how much could be withdrawn from the business without impairing its current level of
44
operations, (3) identifying the problems. and (4) determining a market value for the
Accounting Information and
enterprise. its Applications
Accomplishments : Profit is an important indicator of the accomplishment of
business. Other things remaining the same, higher the profits greater is the
accomplishment. Accomplishment of Shyam's enterprise can be summarised as
follows:
It has earned a net profit of Rs. 2,000 during the year (Exhibit 3.2)
At the same time, it should be seen from Exhibit 3.1 that there is a severe cash con-
straint. Understandably, it was the start up situation which might have been respon-
sible for the cash constraint.
The profit earned in the very first year of operations shows that the business could be
viable. But Shyam will have to predict several aspects such as whether sales can
increase, whether costs remain the same, whether the earnings rate remains the same,
and so on. At the same time, he will have to ensure better management of his cash
resources.
Appropriation Decision : An important question with which owners of a business are

often confronted is: How much money can be withdrawn without impairing its current
level of operations? This question in fact is concerned with appropriation decision. A
prudent management would not only like to maintain the capital or the present
capability of the enterprise intact but would also plan for future growth. The maxi-
mum amount that the owners can withdraw from business for their personal expenses
should be I limited to the amount of earnings which remain after making good all the
resources that have been used (or consumed) in the process of generating those
earnings. In other words, it is the net profit after charging depreciation and all other
losses incurred in the course of business operations that is available to the owners for
withdrawal, provided the business has no tax liability. In case the business has tax
liability the amount that can be withdrawn will be reduced by the estimated amount of
tax liability. Thus, the remainder is the amount which is available for withdrawal
without impairing its current level of operations. However, if business has any plan
for future growth, the amount available for withdrawal by or distribution among
owners shall be further reduced by a portion of profit ( or cash) needed for future
growth depending upon the judgement of the management . in this context, the with-
drawal by Shyam of Rs.15,000 against a profit of Rs.2,000 cannot be defended.
Problem Identification Using Earnings Data: From the earnings data several
problem areas can be identified. This is best done by computing ratios i.e, by examin-
ing the relationship of one item of earnings statement with another item. This will be
taken up in details in a subsequent unit. At this stage it may only be stated that the
lower earnings may be on accounts of excessive cost of inputs, excessive expenditure
on overheads or low margin of profit on sales or excessive piling of inventories or
other unanticipated losses. Insofar as Shyam's enterprise is concerned, we can
identify two problems even from the very limited data that we have regarding his
business. They are:
1) The inventory acquisition was not in tune with production and sales. This has
led to large amount of accumulated inventory to the tune of one year's
consumption.
2) Credit granted to customers, shown by credit sales, amounts to four months,
sales. This shows either grant of credit on liberal terms or slow collection of
receivables.
However, an analysis of operating summary along with cash summary will show that
the business is facing a cash crisis since the present cash needs and cash availability
are not in tune with each other.
Determining the market value of a Firm: You will recall that we have viewed the
business as a distinct operating entity. The economic value of the firm is determined 45
by the size and reliability of the stream of earnings (cash flows) produced by the
business. Let us attempt the valuation of a hypothetical firm. Bharat Kitchenaids,
which was incorporated as a company in 1998 by four non-resident young Indians to
market a simple but revolutionary cooking gas lighter invented by one of its
founders. In order to conserve its limited capital the company opened its business in
rented premises with Rs.80,000 worth of equipment used mainly for research and
development work. Arrangements were made with an established manufacturer to
make the gas lighter on order under rigid supervision of one of the members of the
young team. Because the gas lighter was able to meet a long felt need, the company
reported a modest profit in its very first year of operations.
The four-man team was remarkably well balanced combining talents in engineering
research, marketing and management. In the next two years they developed three
more appliances that were well received in the market. By 2003 the turnover had
grown to about Rs. crore and net profit amounted to Rs. 14 Lakhs. At this point the
total investment (or equity) of the owners amounted to Rs.32 lakhs. Annual earnings,
therefore, represented an after tax rate of return of approximately 4 4 per cent of the
equity. The high return could be attributed to using the facilities of other manufactur-
ers rather than building their own, the patents that the company registered and the
scientific and managerial skill the team possessed.
An interesting development then took place. A large manufacturer in the household

goods sector wanted to acquire the company and offered the owners a very attractive
price. The four owners wanted to consider the offer (and make a decision) but asked
for a few weeks time to make up their mind.
The owners knew that they had established a solid position in the industry and had no
doubt that they would be able to maintain this position. They, however, felt that the
potential for further growth was limited . They drew very good salaries which they
would continue to enjoy even if they were to sell the business.
To work how much equity in the Bharat Kitchenaids was worth to them so that they .
could take a decision on the price offered, the four men started by forecasting the
company's future profits or cash flows( we shall assume here that the figures of
profits and cash flows are the same). They believed that the net profit would continue
to be around Rs.14 lakhs each year for the next 10 years. Further, if they did not sell
out in 2004, they could sell their interest in business (that is their equity) 19 years
later for about Rs.50 lakhs. In accordance with these estimates the anticipated net
earnings from continued ownership would be as follows:
Year Earnings
1 to 10 14 lakhs a year
10 50 lakhs
You know that money has time value. You attach more value to an amount to be
received now than the one to be received, say, a year or two later. Rs. 14 lakhs of
profit to be received in the second year will be of lesser value to you than Rs. 14 lakhs
to be received in the first year. Similarly Rs. 14 lakhs to be received in the third year
will be of lesser value to you than Rs.14 lakhs to be received in the second year, and
so on. In other words, the value of amounts to be received in future will progressively
decline as time passes by. The process of reducing the future earnings to present
values is known as discounting, but for this purpose a discounting rate is required.
The discounting rate is nothing but the return which the owners desire to earn on their
investment. The desired rate of return in a way is a rate of return which satisfies the
owners of investment.
The owners in this case thought that the rate of 15 per cent after taxes was a satisfactory
return on investment for the type of business they were engaged in. The question
46
before them was how much the anticipated earnings were worth presently at this rate.
A t 15 per cent desired rate they calculated the present value of the stream of earnings Accounting Information and
of Rs. 14 lakhs a year for ten years plus Rs.50 lakhs they were to receive at the end of its Applications
10th year. They found that the present value was Rs.82.62 lakhs. You must be won-
dering how they calculated this figure. The mechanics of calculating the present value
of future earnings (or cash flows) will be explained in Unit -15 (Block-4). Till then we
ask you to hold your inquisitiveness. However, in accordance with the concept of
present value that we have just explained, you will agree with us that the present value
of earning of Rs.140 laths to be received over a period of 10 years and lump sum of
Rs. 50 lakhs to be received at the end of 10th year. i.e., a total amount of Rs. 190
lakhs, must be considerably less than this amount.
Under these assumptions, therefore, the owners would not accept an offer of an
amount less than say Rs. 80 lakhs which is the present value of the business or their
equity. However, if the owners feel that Bharati Kitchenaids would continue to
produce Rs. 14 lakhs a year indefinitely if it is managed adequately, the present value
can be calculated simply by dividing the annual earnings by the desired rate of return:
On this basis the value of owner's business would be 93.33 lakhs. The process of
ascertaining the value of business with the help of earnings and a desired rate of
return is also known as the capitalisation of earnings. It means that if Rs. 93.33
lakhs is paid for infinitely long series of payments of Rs. 14 lakhs a year, the rate of
return on investment will be 15 per cent:
3.6 USES OF BALANCE SHEET
The balance sheet is a summary of a firms' assets and liabilities, including share
capital and reserves at a defined moment in time. That is why it has been described as
a snapshot or still picture of the financial position of a business entity. It is also called
the position statement.
In addition to profit and loss account, the various groups interested in the company
can also draw useful inferences form an analysis of the information contained in the
balance sheet. Shareholders usually have twin interests: an interest in receiving a
regular income and an interest in the appreciation of their investment in shares. The
market worth of their shares depends not only on the dividends they receive but also
on the extent of retained earnings which the company has accumulated over the years.
The materialisation of the shareholders' expectations regarding bonus shares also
depends on the retained earnings built up by the company. Investment decisions of the
prospective investors and disinvestment decisions of the existing investors are influ-
enced by the composition of assets and liabilities shown in the balance sheet.
The main interest of the trade creditors, centres on the liquidity position of the com-
pany. They would like to make an assessment as to whether the company will be able
to meet its obligations when the occasion arises. They are, therefore, concerned about
the working capital available with the enterprise and its cash resources. All this
information can be gleaned form the balance sheet. The interest of long-term creditors
lies in two things; they are interested in the regular servicing of their debts ( that is
payment of periodic interest) and repayments of their loans after the expiry of
stipulated period.
47
They are interested not only in the profitability of the enterprise but also in its long-
term solvency and financial viability. A study of the balance sheet of the company
over the past several years can yield a lot of useful information to such long -term
investors.
Similarly, other interested parties like regulatory and developmental agencies of the
Government, consumer and welfare organisations can derive useful conclusions from
a study of the balance sheet about the working of the corporate sector and its
contribution to the national economy.
It should be emphasised here that it is not the profit and loss account and the balance
sheet in isolation with each other but both of them in conjunction with each other that
can yield a harvest of information for the interested parties or analysts. All this
pertains to the broad area of analysis of financial statements which will be taken up in
details in a subsequent unit.
Activity 3.3
1 Mention four important uses of earnings information.
i)……………………………………………………………………………….
ii)………………………………………………………………………………
iii)……………………………………………………………………………...
iv)……………………………………………………………………………...
2. Mention the three parts into which net profits are usually appropriated.
i)……………………………………………………………………………….
ii)………………………………………………………………………………
iii)……………………………………………………………………………...
3. Value of a firm is determined mainly on the basis of ……………of earnings.
3.7 SUMMARY
Accounting information system addresses itself to three important business related
problems, namely, score-keeping , attention-directing and problem-solving .
Accounting information acquires relevance only in the context of an organisation. In
this context accounting is closely related to control, Accounting helps in the process
of guiding actions of the organisation into desired directions. In the process of
initiating control actions, it helps the whole gamut of activities involving planning,
organising and controlling.
There may not necessarily be an exact correspondence between cash balance and the
profit earned during an accounting period.
The earnings information is useful for several purposes. It helps in measuring

achievement of business and its management. It provides a basis for appropriation
decisions and for determining the market value of the firm. It helps to identify the
problems currently faced by the enterprise.
They balance sheet reflects the financial position of the enterprise. It provides useful
information to various users of information who might be interested in the firm. A
proper analysis of the information contained in the balance sheet can enable them to
draw conclusions which in turn help them in taking decisions.
48
3.8 KEY WORDS Accounting Information and
its Applications
Problem-solving role of accounting consists of supplying such information as would
be useful to managers for taking a variety of routine and non-routine decisions.
Profit and loss Account is a summary of the revenues and expenses, including gains
and losses from extraordinary items of a business unit for an accounting period.
Balance Sheet is a statement of financial position of a business unit disclosing an.

given moment of time its assets, liabilities and ownership equities.
Appropriation of net profit means the (allocation) disposal of net profit for various
purposes. In the case of non-corporate entities, the net profit is distributed to the
owners. In the case of corporate entities usually a part of the net profit is provided for
estimated tax liability, a part is retained in business to strengthen its financial position
and for, future growth, a part is distributed to shareholders in the form of dividends
and any amount left is carried forward to the next ,period.

1. What are the purposes of accounting information? Explain briefly. What purpose, in
your opinion, is the most important and why?
2. "Accounting is closely connected with control". Elaborate the statement and discuss
the role of accounting feedback in the process of control.
3. Explain the uses of earnings information. Can you think of uses other than the four
uses mentioned in this unit?
4. What is a Balance Sheet and what information it conveys to an outsider?
5. What groups of people would be interested in accounting reports and why?
6. "An outsider, who reads the data relating to the business as revealed by the ac-
counting statements, tends to assume that accounting gives an exact picture of the
business." Utilising your understanding of accounting concepts, including the limi-
tations imposed by such concepts on accounting information, discuss the above
statements with your fellow students/accounting colleagues/office friends.
7. Ram invested Rs.20,000 of his own money in small service business and borrowed
another Rs. 10,000 from a bank, also for business use. At the end of his first year of
operations, he found that there was Rs.34,000 in the enterprise's bank account. He
owed his suppliers Rs. 6,000 and had not repaid the bank loan. His business assets
other than cash were negligible. During the year he had paid himself his salary of Rs.
12, 000.
a) What conclusions would you draw about his first year's operations?
b) For what decisions would this information be used? What additional information
would the decision makers be likely to call for in making these decisions?
Activity 3.2
1. External, management accounting.
2. (i) Score-keeping, (ii) attention-direction and (iii) problem-solving.
3. Records of actuals, comparison.
4. Decisions.
5. Information, solutions. 49
1. (i) Measuring accomplishment,
(ii) Profit distribution
(iii) Identifying problems
(iv) Market valuation of the firm
2. (i) Taxation
(ii) Distribution to owners
(iii) Retained earnings
3. Future stream

Paul D. Kimmel, Jerry J. Weygandt, Donald. E. Kieso, March 2003. Financio
Accounting: Tools for Business Decision Making, 3rd Edition. Wiley Pub ;hers :
Canada.
Meigs, Walter, B. and Robert F. Meigs, 1987. Accounting: The Basis for Business
Decisions, McGraw Hill: New York (Chapter 1)
Gray, Jack and Kenneth S. Johnston, 1977. Accounting and Management Ac 9n,
Tata McGraw Hill: New Delhi (Chapter 2).
50
Construction and Analysis of
UNIT 4 CONSTRUCTION AND Balance Sheet
ANALYSIS OF BALANCE
SHEET
Objectives
After having studied this unit, you should be able to:

• understand and explain the terms used in a balance sheet
• classify the different assets, liabilities and capital accounts as they would
appear on a balance sheet.
• apply simple principles of valuation of assets
• understand the idea of balance sheet equation.
Structure
4.1 Introduction
4.2 Conceptual Basis of a Balance Sheet
4.3 Constructing a Balance Sheet
4.4 Balance Sheet Contents
4.5 Form and Classification of Items
4.6 Summary
4.7 Key Words
4.1 INTRODUCTION
One of the basic objectives of accounting is to convey information. This is achieved by
different accounting reports prepared by an entity. One of the most important reports
is the Balance Sheet.
Balance sheet is concerned with reporting the financial position of an entity at a

particular point in time. This position is conveyed in terms of listing all the things of
value owned by the entity as also the claims against these things of value. The
position as represented by the balance sheet is valid only until another transaction is
carried out by the entity.
4.2 CONCEPTUAL BASIS OF A BALANCE SHEET

The above concept can be elaborated by an example.
I want to purchase a car costing Rs. 8,00,000. To do so, I have to borrow. A bank
agrees to finance me if I can invest Rs. 3,00,000 on my own.
Now let us follow the sequence of events when I approach the bank with the proposal.
Granting my ability to repay the loan, the banker will ask two specific questions:
1. What are the things of value you own?
2. How much do you owe, and to whom?

5
Understanding In other words, the banker would like to know what I am worth in material terms. My
Financial Statements replies to the questions could be tabulated as follows:
Things of value owned by me Amount owned by me
Rs. Rs.
Balance with bank 3,50,000 Personal loan from friend 1,00,000
Fixed deposits 1,50,000
Other personal belonging 5,00,000
10,00,000 1,00,000
This implies I own Rs. 10,00,000 worth things of value, Rs. 3,50,000 of this could be
withdrawn at any time in cash. We say I have Rs. 3,50,000 in liquid form. Another
Rs. 1,50,000 is in monetary investment and the remaining Rs. 5,00,000 is in non-
monetary property. Further, I owe Rs. '1,00,000 to friend of mine. In other words, he
has got a claim against the things of value owned by me to the extent of Rs. 1,00,000.
In brief, we can say I am worth Rs. 10,00,000, claim against my worth is Rs.
1,00,000 and hence my net worth is Rs. 9,00,000. This implies Rs. 9,00,000 is my
own claims against the things of value owned by me or my net worth.
Now I can present my financial position in the following form:
Financial Position Statement 1

Things of value owned Claims against things of value
Rs. Rs.
Balance with bank 3,50,000 Personal loan from friend 1,00,000
Fixed deposits 1,50,000 Own claim or net worth 9,00,000
Other personal belongings 5,00,000
10,00,000 10,00,000
Now that the bank grants me the loan of Rs. 5,00,000 and I buy the car for
Rs.8,00,000. After purchase of the car my financial position statement will change as
follows:
Financial Position Statement 2
Things of value owned Claims against things of value

Rs. Rs.
Balance with bank 50,000 Personal loan from friend 1,00,000
Fixed deposit 1,50,000 Mortgage loan from bank. 5,00,000
Car 8,00,000 Own claim or net worth 9,00,000
Other personal belongings 5,00,000
15,00,000 15,00,000
Now, as a result of this transaction my worth has increased from Rs. 10,00,000 to Rs.
15,00,000. However, since there is also an equal increase in claims against my worth
in the form of mortgage loan from the bank, my net worth remains the same.
Things of monetary value possessed by an entity are referred to as assets.

Accountants use the term assets to describe things of value measurable in monetary
6 terms.
The amount owed by an entity or individual which represent claims against it or his Construction and Analysis of
Balance Sheet
assets by outsiders are liabilities. It is the claims of outsiders which are legally
enforceable claims against an individual or entity that are referred to as liabilities.
The assets owned by the entity, less liabilities or outsider's claims, is the net worth.
Since the net worth represents the claims of owner(s) in case of an entity, it is
referred to as owner's equity.
Now we can understand that the position statement is a summary of the assets,
liabilities and net worth as of a specific point in time.
A comparison of the two position statements before and after purchase of the car will
help to clarify some of these ideas better.
Comparative Financial Position Statement
Assets Liabilities and Net Worth
Before After Before After
I II I II
Balance 3,50,000 50,000 Personal loan 1,00,000 1,00,000
with Banks from friend
Fixed Deposits 1,50,000 1,50,000 Mortgage loan - 5,00,000
from bank
Car - 8,00,000
Other personal 5,00,000 5,00,000 Net Worth 9,00,000 9,00,000
belonging
10,00,000 1,50,000 10,00,000 15,00,000
The following points may be noted from the above example:

1. Even after purchasing the car, my net worth remains the same. This is due to
the fact that increase in assets of Rs. 5,00,000 was balanced by increase in
liability of Rs. 5,00,000. However, it could be noticed that the Rs.3,00,000
spent from my savings amount to only a transformation of my assets from
bank deposit to motor car.
2. Outsiders' claim has priority over the owners' claim on the assets and hence
net worth or owner's equity is a residual claim against assets. It follows from
this that at any point in time, owners equity and liabilities for any accounting
entity will be equal to assets owned by that entity. This idea is fundamental
to accounting and could be expressed as the following equalities:
ASSETS = LIABILITIES + OWNERS EQUITY (1)
OWNERS EQUITY = ASSETS - LIABILITIES (2)
It could easily be visualised that the position statements we prepared are nothing but
the equality (I). In simple terms, a position statement which shows the balance
between assets owned by an entity and its liabilities and owner's equity is referred to
as a balance sheet. Our position statements were based on a personal situation and a
single transaction. In a business situation there can be scores of such transactions.
However, these impacts could be reflected on the fundamental equality in the same
way. This equation represents the corner-stone on which the accounting edifice is
built. It shows the duality represented by `benefit-sacrifice' from the point of view of
an entity. In other words, assets of an entity, are always equal to the claims of the
outsiders and owners. This equality enables us to reduce impact of all transactions in
term of the following possibilities:
1. An increase in assets is followed by an increase in liabilities and/or equity
and vice versa.
2. A decrease in assets is followed by a decrease in liabilities and/or equity and
vice versa.
3. An increase in an asset is followed by a decrease in another asset and vice
versa.
4. An increase in a liability is followed by a decrease in another liability and vice
versa. 7
Understanding Activity 4.1
Financial Statements
Please answer by completeing the blanks.
1. An increase in assets in a position statement is possible:
a)…………………………………………………………………………
b)…………………………………………………………………………
c)…………………………………………………………………………
2. An increase in liability could result in:
a)…………………………………………………………………………
b)…………………………………………………………………………
c)…………………………………………………………………………
3. Outsiders claim against assets of an entity is called:
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………..
4. Things of value to the entity are called by accountants as:
………………………………………………………………………………………
………………………………………………………………………………………
………………………………………………………………………………………..
Activity 4.2
Mark whether the following statements are `True' or `False' by circling T or F
opposite each statement.
1. An increase in asset always results in increase in owner's equity T/F
2. Assets = liabilities + owner's equity is always true T/F
3. Outsiders claim against business is a residual claim T/F'
4. An increase in assets could be equalled by increase in liabilities T/F
5. Losses result in increase in owner's equity T/F
6. All assets in the balance sheet are valued at their realisable value T/F
Activity 4.3
Answer the following questions by filling in the boxes with figures or words.
1. The fundamental accounting equation could be written as:
8
4.3 CONSTRUCTING A BALANCE SHEET Balance Sheet
Now, let us examine how the ideas we have learned so far could be used in a business
situation. Please recall that based on the entity principle we shall be dealing with the
`business' as distinct and separate from the owners. We shall demonstrate this by
means of an illustration:
Ram starts a store on, January 1, 2003 with an investment of Rs.2,00,000 from his
personal savings. He decides to call his venture Ramstore.
Suppose now, we want to prepare the balance sheet of Ramstore on January 1, 2003.
How do we proceed? Based on the equality we have studied, we have to answer the
following questions:
1 What are the assets of Ramstore on that date?
2. What are the liabilities of Ramstore on that date?
If we have answers to these questions it also follows that assets minus liabilities is
Ram's equity and this information would complete the equality and hence the balance
sheet. Answer to the first question is that the only asset of Ramstore on January 1,
2003 is Rs.2,00,000 in cash. Answer to the second question is that Ramstore has no
liability on that date or, in other words, it does not owe anything to outsiders. Thus it
follows that the only claim on the assets in that of Ram. This could be represented as
the balance sheet below:
RAMSTORE
Balance Sheet as on January 1, 2003
Assets Liabilities and Owner’s Equity
Cash Rs. 2,00,000 Owner’s equity Rs. 2,00,000
On January 2 the Store purchases a shop for Rs.5,00,000 paying Rs.1,00,000 cash
and signing a mortgage for Rs.4,00,000. This transaction changes the balance sheet
as on January 2 as follows:
1. Cash is reduced by Rs.1,00,000 on account of payment for the shop

premises. hence cash balance is Rs.1,00,000.
2. A new asset, shop, is acquired worth Rs.5,00,000.
3. A new liability, mortgage on the shop, is contracted in the amount of

Rs.4,00,000.
4. Owner's equity = Total asset - liabilities
= Rs.6,00,000 - Rs.4,00,000 = Rs.2,00,000.
That is, there is no change in the owner's equity since increase in an asset is followed
by an increase in liability. Thus the new balance sheet will be as follows:
RAMSTORE
Balance Sheet as on January 2, 2003
Assets Liabilities & Owner’s Equity
Rs. Rs.
Cash 1,00,000 Mortgage on shop 4,00,000
Shop premises 5,00,000 Owner’s equity 2,00,000
6,00,000 6,00,000
9
Understanding On January 3, the store purchased Rs.50,000 worth of merchandise paying cash and
Financial Statements Rs.1,50,000 worth of merchandise on credit from Mr. Vanik. The impact of these
transactions is that the assets in the form of merchandise increase by Rs.2,00,000.
These assets are intended for resale and hence have a short life span. However, part
of this increase is accounted by decrease in another asset, cash. The other
Rs.1,50,000 increase is accounted by the liability owed to Vanik. The amounts
payable on account of purchases of merchandise are called accounts payable or
sundry creditors. Usually these are short duration liabilities to be paid at the end of
the normal credit period. The balance sheet on January 3, 2003 reflects the position
of the business after these transaction.
RAMSTORE
Balance Sheet as of January 3, 2003
Assets Liabilities & Owner's Equity
Rs. Rs.
Cash 50,000 Accounts payable 1,50,000
Merchandise inventory 2,00,000 Mortgage on shop 4,00,000
'
Shop premises 5,00,000 Owner s equity 2,00,000
7,50,000 7,50,000
On January 4, he sells half the merchandise inventory (that is Rs. 1,00,000 worth
inventory) for Rs.1,50,000 cash. Apparently, this transaction shows the
transformation of an asset into another asset at higher monetary value. This is yet
another basis of economic transaction where business profits are earned in the
process of exchange of utility differential for a monetary differential. The balance
sheet after this transaction will clarify some of the conceptual issues arising out of
this transaction.
RAMSTORE
Balance Sheet as of January 4, 2003
Assets Liabilities & Owner's Equity

Rs. Rs.
Cash 2,00,000 Accounts payable 1,50,000
Merchandise inventory 1,00,000 Mortgage on shop 4,00,000
Shop premises 5,00,000 • Owner's equity 2,50,000
8,00,000 8,00,000
Please note the change in owner's equity figure. For the first time since we started
following the transactions of Ramstore, the owner's equity figure has changed. How
did this come about? The answer is simple. We followed the equality of "Assets -
liabilities = Owner's equity". Thus the increase in owner's equity is the result of
increase in assets arising out of exchange of merchandise inventory for cash at a
higher monetary value. Thus we find that the owner's equity increases to the extent of
revenue earned over the cost of earning that revenue. In this case the revenue earned
is Rs.1,50,000 (the amount realised from sales of merchandise is usually referred to
as sales revenue). The direct cost of earning that revenue was the merchandise
inventory parted within the amount of Rs.1,00,000. We refer to this as cost of goods
sold.
10 Another important fact should also be noted in this context. All along we represented
the assets on the balance sheet at the original cost. The unsold inventory is still valued
at the original cost. This is yet another concept we follow in the preparation of balance Construction and Analysis of
sheet. As a general principle all assets are valued at their original cost. Balance Sheet
The increase in the owner's equity is equal to the profit earned out of trading.
Normally, it is profitable operation which increases the owner's equity. Thus owner's
equity could be understood as comprising of two parts, namely, contributed capital
and retained earnings. Retained earnings is the profits earned and not withdrawn by
the owners. This relationship could be expressed by yet another equality:
OWNER’s EQUITY = CONTRIBUTED CAPITAL + RETAINED EARNINGS(3)
The above illustration would enable us to evaluate the balance sheet in the context of
accounting concepts.
• The dual aspect principle has particular relevance to balance sheet. This is
shown by the equality of assets to liabilities and owner's equity.
• All the figures are expressed in monetary units irrespective of its nature. In
our example we had cash, merchandise inventory and shop premises all
expressed in monetary quantities.
• All the transactions we reflected were in respect of only the business entity,
Ramstore' rather the methodology was applied to the specific entity.
• All the valuations were based on the assumption of a going concern, and not
based on break up value.
• All the assets were based on cost as the basis of valuation.
Activity 4.4
Complete the following blanks:
1. Balance sheet is prepared at the end of a specified period. This period in

accounting is variously referred to as:
a) _________________________ ___________________________
b) _________________________ ___________________________
c) _________________________ ___________________________
2. Balance sheet prepared at the end of an year summarises the balances in :
a) ___________________Accounts b) _________________Accounts
c) __________________Accounts.
3. Assets on a balance sheet are usually grouped together as:
a) ___________________assets b) _________________assets
c) __________________assets.
4. Claims against the assets on the balance sheet are summarized as:
a) _________________ liabilities b_________________liabilities
c) _________________equity.
4.4 BALANCE SHEET CONTENTS

Having examined the conceptual basis of the balance sheet we now try to study the
balance sheet itself. We have seen that every transaction affects the financial position.
Since it is not feasible to draw up a balance sheet after every transaction, it is pre-
pared at the end of a specified period, usually, an year. This period is referred to as
accounting period or fiscal year or financial year. This period as a convention has
become one calendar year, though, there is no accounting justification for it.
11
Understanding The balance sheet as prepared at the end of the accounting period shows the year end
Financial Statements status of each of the assets of the firm and the various claims on these assets. We
could also say that the balance sheet shows the year end balance in the asset,
liability and capital accounts.
Read the following illustration carefully. It is a typical summarised balance sheet. We
shall follow this balance sheet for subsequent discussions. It shall be useful if you
could copy it on a sheet of paper for ready reference. It may be clarified that there are
two conventions of preparing the Balance sheet- the American and the English.
According to the American convention, assets are shown on the left hand side and the
liabilities and the owner's equity on the right hand side. The English convention is
just the opposite. i.e., assets are shown on the right hand side of the Balance Sheet
and the liabilities and the owner's equity on the left hand side. In India, generally the
English conventions is followed. However, in all our illustrations and working here
in this booklet, we shall be using the American pattern because it appears to be more
logical as it is in tune with the way the transactions are recorded in the books of
account and the balances are taken out.
Illustration
Table 4.1: RAMSONS LTD.
Balance Sheet as on December 31, 2003
(Rupees in thousands)
Assets Liabilities and Owner's Equity
Current Assets Current Liabilities
Cash 500 Notes Payable 600
Marketable Securities 200 Accounts Payable 1,200
Notes/Bills Receivable 300 Accrued Liabilities 800
Accounts Receivable 1,000 Income Tax Payable 400

Less: Estimated Loss 100 900 Total Current Liabilities 3,000
on collection
Long term Liabilities
Merchandise Inventory 1,100 10% Debentures 1,000

Prepaid Expense 500 Secured Long-term loan from IFCI
2,000
Total Current Assets 3,500 Total Liabilities 6,000
Property, Plant & Equipment Shareholders' equity
Land 9% Cumulative Preference Shares
2,000 of Rs.100 each 500
Buildings, Plant 3,000

Less: Accumulated Ordinary Shares of Rs. 10 each 2,000
Depreciation 1,000 2,000 Capital Reserves 500
Reserves & Surplus 1,000
Other Assets 1,500
Deferred Expenditure 1,000 Total Liabilities and
Total Assets 10,000 Shareholder's equity 10,000
4.5 FORM AND CLASSIFICATION OF ITEMS

The balance sheet lists assets, liabilities and capital separately. It is an accepted
convention that the assets and liabilities are shown into sub-groups and listed in the
order of their liquidity. Liquidity implies the length of time required to convert them
12 into cash. Assets which are likely to be converted into cash in the near future are
grouped as current assets. Similarly, liabilities which are due for payment in the
short run are classified as current liabilities.
The balance sheet in our example is presented in the I account form. That is the assets Construction and Analysis of
are listed on one side and liabilities and owners' equity on the other. Another Balance Sheet
commonly used way of presentation is the report form where liabilities and capital
are listed below the assets. However, the presentation matters very little since the
balance sheet represents the equality between assets, liabilities and capital.
Current Assets
Current assets are assets which will normally be converted into cash within a year or
within the operating cycle. The operating cycle is the duration in time taken by a unit
of cash to circulate through the business operations. For example, in a simple trading
operation, we use cash to buy merchandise and sell it to recover cash. The operating
cycle in such a situation will consist of the period for which cash, merchandise
inventory, and receivable are held. The cycle starts with cash and ends with the
collection of cash.
The items comprising current assets are listed in the order of their relative liquidity
and hence, cash is listed first.
Cash
Cash is usually taken to include currency (legal tender), cheques or any other
document that circulates as cash. Cash is usually classified as a current asset when it
is available for a firm's day-to-day operations. It includes cash kept in the cash chest
as also deposits on call on current accounts with banks. If cash is specifically ear-
marked for any purpose and not available for transactions it is better classified as
other assets.
Temporary Investments
Whenever firms have short-term excess cash it may be invested in readily marketable
securities. These securities may include shares, debentures and Government
securities. These assets are readily marketable and could be sold whenever cash is
required. They are classified as current assets only when these investments are held
with the objective of realisation within a year.
These securities are usually recorded at cost at which they are acquired. Since they
are only held for short duration and should reflect their cash value, the principle of
accounts receivable to their estimated realisable value. For instance: lower than the
original cost, they are valued at their market price or realisable value.
Apparently, the valuation rule `lower of cost or market price' may look contradictory.
Why should one not value the securities at higher than cost? This distinction is made,
based on the generally accepted accounting principles. We do not anticipate gains
but only losses. Gains are recognised in accounting only when outside transaction
takes place. This is the essence of conservatism in accounting.
When the firm values its securities at cost or market price, whichever is lower, we
say the firm is conservative. That is, whenever presented with two alternatives the
firm chooses the one which shows the lower valuation of assets or higher valuation of
liabilities.
Accounts Receivable
Accounts receivable are amounts owed to the company by debtors. This is the reason
why we also use the term sundry debtors to denote the amounts owed to the firm.
This represents amounts usually arising out of normal commercial transactions. In
other words, àccounts receivable' or sundry debtors represent unpaid customer
13
Understanding accounts. In the balance sheet illustration these represent amounts owed to the firm
Financial Statements by customers on the balance sheet date. These are also known as trade receivables,
since they arise out of normal trading transactions. Trade receivables arise directly
from credit sales and as such provide an important information for management and
outsiders. In most situations these accounts are unsecured and have only the personal
security of the customer.
It is normal that some of these accounts default and become uncollectable. These
collection losses are called bad debts. It is not possible for the management to know
exactly which accounts and what amount will not be collected. However, based on
past experience , it is possible for the management to estimate the loss on the
receivable or sundry debtors as a whole. Such estimates reduce the gross value of
accounts receivable to their estimated realisable value. For instance:
Accounts Receivable 7,50,000
Less: Estimated collection loss at 10% 75,000
Net realisable value of accounts receivable 6,75,000
The estimated collection loss is variously referred to as reserve for doubtful debts,
reserve for bad debts or reserve for collection losses. It is a common practice to refer
to this as a provision instead of reserve.
It is a usual practice for debts to be evidenced by formal written promises to pay or

acceptance of an order to pay. These formal documentary debts represent
promissory Notes Receivable or Bills Receivable. These instruments used in trade
are negotiable instruments and hence enable the trader to assign any of his
receivables to another party or a bank for realizing immediate liquidity.
It is also usual for accounts receivables to be pledged or assigned mostly to banks

against short-term credits in the form of cash credits or overdrafts.
Inventory
In a trading firm inventory is merchandise held for sale to customers in the ordinary
course of business. In case of manufacturing firms inventory would mainly consist
of materials required to manufacture the products, namely, raw materials, materials
remaining with the factory at various stages of completion i.e., work in process and
goods ready for sale or finished goods. Apart from these there may be inventory of
stores and supplies. Thus we have raw material inventory, work in process
inventory, finished goods inventory and stores and supplies inventory.
It is common to refer to inventory as stock-in-trade and thus we could come across

stock of raw materials, stock of work in process and stock of finished goods..
Inventory is usually valued on the basis of "lower of cost or market price". Market
price is taken to mean the cost of replacement either by purchase or by reproduction
of the material in question. As a general principle, inventory is valued on cost at
situation. It implies that all normal costs incurred to make the goods available at the
place where it can be sold or used are treated as costs of inventory.
In trading firms, inventory costs include freight-in, transit insurance costs, import
or entry levies as also the invoice cost. Warehouse costs, handling costs, insurance
costs in storage and interest costs are not included as costs. They are treated as
expenses of a period of the firm.
In case of manufacturing units, valuation of inventory costs is more complex and

14 involved. As a general rule all costs of materials, labour and plant facilities used for
manufacturing the goods are included in the valuation of inventory.
In valuing inventory at lower of cost or market price, care should be taken to see that Construction and Analysis of
the valuation does not exceed the realisable value or selling price in the ordinary Balance Sheet
course of business.
Prepaid Expenses
In many situations, as a custom, some of the item of expenses are usually paid in
advance such as rent, taxes, subscriptions and insurance. The rationale of including
these prepayments as current assets is that if these prepayments were not made they
would require use of cash during the period.
Fixed Assets
Fixed assets are tangible, relatively long lived items owned by the business. The
benefit of these assets are available not only in the accounting period in which the cost
is incurred but over several accounting periods. Current assets provide benefits to the
organisation by their exchange into cash. In the case of fixed assets. value addition
arises by facilitating the process of production or trade. In other words, benefits from
fixed assets are indirect rather than direct.
All man made things have limited life. In accounting we are concerned with useful life
of the assets. Useful life is the period for which a fixed asset could be economically
used. This implies that the benefits from the fixed assets will flow to the organisation
throughout its useful life. Another aspect of this is that the cost incurred in the period
of purchase of the asset will be providing benefits over the useful life of the asset.
Valuation of the fixed assets is usually made on the basis of original cost. However,
since the assets have limited life the cost will be expiring with the expiration of the
life. Thus, valuation of the asset is reduced proportionate to the expired life of the
asset. Such expired cost is referred to as depreciation in accounting. We shall discuss
this idea in more detail in a subsequent unit. The conceptual basis could be clarified
with an example.
Suppose a trader buys a delivery van at a cost of Rs. 10,00,000. Assume that the van
will have to be discarded as junk at the end of five years. At the time of purchase:
Delivery van at cost Rs. 10,00,000

At the end of first year it will be represented as:
Less: Depreciation to date 2,00,000
Net Value Rs. 8,00,000
At the end of second year it will be:

Less: Depreciation to date 4,00,000
Net Value Rs. 6,00,000
The process of providing depreciation for each year will continue. At the end of five
years the valuation of the asset will be zero. The value of the assets at cost is usually
referred to as gross fixed assets and the amount of depreciation to date as accumu-
lated depreciation. Net value of the asset is usually referred to as net fixed assets.
Please note that we reckoned the amount of depreciation by equally distributing the
cost of asset over its useful life. This is the simplest method of determining the annual
depreciation of the assets. Thus, we can say that the annual depreciation over the
useful life of the asset shall not exceed its net cost. We say net cost because the actual
15
Understanding cost of the asset to be depreciated is its purchase cost less any salvage value at the end
Financial Statements of its useful life. Hence depreciable cost of the asset is net cost which is equal to
original cost minus salvage value. The relationship between cost and depreciation could
be visualised as follows:
Year 1 Year 2 Year 3 Year 4 Year 5

Depreciation Depreciation Depreciation Depreciation Depreciation
Rs. 2,00,000 Rs.2,00,000 Rs., 2,00,000 Rs. 2,00,000 Rs. 2,00,000
Cost of the asset : Rs. 10,00,000
Depreciation represents the cost of earning revenue in an accounting period on account

of use of fixed assets. Fixed assets are valued on the basis of cost making the asset
available and ready for use. Thus cost includes the price as well as charges for delivery,
assembly and erection.
Fixed assets normally include assets such as land, building, plant, machinery and motor
vehicles. All these items, with the exception of land, are depreciated. Land is not subject
to depreciation and hence shown separately from other fixed assets.
Intangible and Other Assets
Intangible assets are assets or things of value without physical dimensions. They cannot
be touched, they are incorporeal, representing intrinsic value without material being.
One of the most common of these assets is goodwill. Goodwill reflects the ability of a
firm to earn profits in excess of normal return. Almost all firms may have some
goodwill. However, they appear in the books and balance sheet only when it has been
purchased. Usually, when a going concern is purchased, the purchase price paid in
excess of the fair value of the assets is considered goodwill. The amount is classified as
another asset `goodwill' on the balance sheet.
Many intangible assets have limited life too. Examples are patent rights, copy rights,
franchise rights, incorporation costs and so on. Since they have limited useful life, the
cost of acquiring such assets have to become expired costs over such useful life. This
process of expiration of the cost of intangible assets is called amortisation. Even those
intangible assets which have almost infinite life are amortised over a limited period. In
reality the material effect of amortisation and depreciation is almost the same.
The category "Other Assets" is used to classify assets which are not normally classified
as current, fixed and intangible.
Current Liabilities
We have studied that liabilities are claims of outsiders against the business. In other
words, these are amounts owed by the business to people who have lent money or
provided goods or services on credit. If these liabilities are due within an accounting
period or the operating cycle of the business, they are classified as current liabilities.
Most of such liabilities are incurred in the acquisition of materials or services forming
part of the current assets. As was the case with current assets, current liabilities are .
also listed in the order of their relative liquidity.
Acceptances and Promissory Notes Payable
Acceptances are bills of exchange accepted by the firm usually for goods purchased.
Similarly, promissory notes are written promises to pay the debts at specified future
dates. Both these liabilities specify the amount payable on due date and any other
16
conditions of payment. If such notes or bills payable are for longer duration than one Construction and Analysis of
year, then the portion which is due for payment during the current period alone is Balance Sheet
treated as current liability. Long-term bills may be used for purchase of machinery.
Accounts Payable
Accounts Payable or sundry creditors are usually unsecured debts owed by the firm.
These are also referred to as payables on open accounts. They are not evidenced by
any formal written acceptance or promise to pay. They represent credit purchase of
goods or services for which payment has not been made as on the date of the
statement.
Accrued Liabilities
Accrued liabilities represent expenses or obligations incurred, in the previous

accounting period but the payment for the same will be made in the next period. In
many cases where payments are made periodically, such as wages, rent and similar
items, the last month's payment may appear as accrued liabilities (especially if the
practice is to pay the same on the first working day of a month). This obligation
shown on the balance sheet indicates that the firm owed the said amount on the
balance sheet date.
Provisions or Estimated Liabilities
Where the liabilities are known but the amounts cannot be precisely determined, we
estimate the liability and provide for it as a liability. A common example is income
tax payable. Unless the tax liability is determined the amount payable cannot be
accurately determined. There could be other examples too, such as product warranty
expenses to be met and so on. The common practice is to estimate these liabilities
based on past experience.
Contingent Liabilities
Contingent liabilities should be distinguished from estimated liabilities. Estimated

liabilities are known liabilities where the amount is uncertain. Contingent liabilities
on the other hand are no liabilities as of now. They become liabilities only on the
happening of a certain event. In other words, both the amount and the liability (or
obligation) are uncertain till the specified event occurs in future. These may include
items like a claim against the company contested in a court. Only if the court gives
an unfavourable verdict, it becomes a liability. They are not listed as liabilities in the
body of the balance sheet. However, in order to give a fair view of all known facts
about the affairs of the firm, contingent liabilities are disclosed as foot-notes to the
balance sheet. They are not mentioned in the balance sheet as the firm is not liable as
on that date; they are mentioned as notes because all those who are concerned may
know that there is possibility that the events might occur.
Long-term Liabilities
Long-term liabilities are usually for more than one year. They cover almost all the
liabilities not included in the current liabilities and provisions. These liabilities may
be unsecured or secured. Security for long-term loans, are usually the fixed assets
owned by the firm assigned to the lender by a pledge or mortgage. All details such as
interest rate, repayment commitment and nature of security are disclosed in the
balance sheet. Usually, such long-term liabilities include debentures and bonds,
borrowings from financial institutions and banks.
17
Understanding
Activity 4.5
Fill in the blanks:
1. As a convention, items appearing on the balance sheet are listed in the
order of their relative……………….
2. Balance sheet could be presented either in
a) ………………………………….from, or
b) …………………………………………………………
3. Operating cycle is the duration…………………………………………..
4. Temporary investments are valued in the balance sheet by applying the
principle of……………………………………………
5. Accounts receivable are also referred to as…………………………………..
6. Expired cost with respect to a fixed asset is referred to
as………………………… expense.
7. Expiration of cost of intangible assets is referred to
as………………………...
8. Sundry creditors are also referred to as………………. ,
………………………
Activity 4.6
1. We judge an item as a current asset if it is converted into cash during
and………………………………………….
2. Liquidity refers to nearness of an item to……………………………….
3. Items classified as current assets are usually listed in the order of their
relative……………………………………………………………..
4 The basis of valuation as applied to temporary investment is……………….
5. Asset losses expected out of non-collection of receivables are
called…………………………………
6. Formal written/documented debts refer to………………………………….
7. Items commonly referred to as inventory include (i) ………, (ii)……….and
(iii)……………………
8. Inventory is usually valued on the basis of………………………………
Capital
We have seen earlier in this unit that the fundamental accounting equality states:
assets = liabilities + owners equity. From the example of balance sheet we can
easily establish this. See Rainsons balance sheet:
Total assets Rs. 1,00,00,000
Total liabilities Rs. 60,00,000
'
Owner s equity Rs. 40,00,000
We also know that the owner's equity consists of the contributed capital and the
retained earnings of the firm. If Ramsons were an individual proprietorship business,
the owner's equity will be reflected directly as:
Capital Rs 40,00,000
If 'Ramsons' were a partnership firm with four partners W, X, Y and Z all sharing
equally, the capital would be represented as:
Capital- Partner W Rs. 10,00,000
Partner X Rs. 10,00,000
Partner Y Rs. 10,00,000
18 Partner Z Rs. 10,00,000
Total Rs. 40,00,000
In our example the balance sheet was titled `Ramsons Ltd.', implying that it was an Construction and Analysis of
incorporated limited company. We did not provide the detailed balance sheet Balance Sheet
incorporating all the legal requirements in order to avoid confusion. According to the
company law the capital has to be disclosed in greater detail. This requirement could
be related to the corporate legislation's need for ensuring maintenance of capital or
keeping the firm's assets intact. This is ensured by insisting that the distribution by
way of dividends to shareholders is made only out of accumulated earnings.
According to the legal requirements, the owner's equity section of the company
balance sheet is divided into two parts: (1) the share capital representing contributed
capital and (2) reserves and surplus representing retained earnings. The contributed
capital is the amount paid by shareholders. Share capital is the joint stock
predetermined by the company at the time of registration. It may consist of either
ordinary share capital or preference share capital (having preferential right to fixed
dividend and repayment of capital at the time of liquidation), or both. This share
capital stock is divided into units or shares. Thus if the company decides to have a
share capital it could be either ordinary shares alone or ordinary and preference
shares.
A company has an authorised share capital of Rs. 2,00,000 divided into 15,000
ordinary shares of Rs. 10 each and 500 10% cumulative preference shares of Rs. 100
each.
This will be represented as:
Authorised capital:
15,000 ordinary shares of Rs. 10 each Rs. 1,50,000
500 10% cumulative preference shares of Rs. 100 each Rs. 50,000
Total Rs. 2,00,000
The company need not raise the entire amount of-the predetermined or authorised
capital. That portion of the authorised capital which has been issued for subscription
is referred to as issued capital.
Suppose the company offered to the public 7500 ordinary shares and 500 preference
shares for cash which were fully subscribed and paid up.
The share capital of the company in summary will be:
Authorised Capital:
15,000 ordinary shares of Rs. 10 each Rs.1,50,000
500 10% cumulative preference shares of Rs. 100 each 50,000 Rs. 2,00,000
Issued Capital
7,500 ordinary shares of Rs. 10 each 75,000
500 10% cumulative preference shares of R§. 100 each Rs. 50,000 Rs. 1,25,000
Subscribed, called up and paid up
7,500 ordinary shares of Rs. 10 each 75,000
500 10% cumulative preference shares of Rs. 100 each 50,000 Rs, 1,25,000
In the above example, even though the company was authorised to issue 15,000
ordinary shares, it needed only part of the capital and hence choose to issue only one
half of the total authorised ordinary shares. The implication of authorised capital is
that it is the maximum amount of capital a company may raise without altering the
registration deed.
19
Understanding Ordinary and Preference Shares
Preference shares are so called because they have some preferences over the ordinary
shares. These preferences relate to repayment of capital and payment of dividend. In
the event of liquidation of the company the assets that remain after payments to
creditors are first distributed to preference shareholders. Similarly, whenever the
company earns profits and decides to distribute dividends the preference shareholders
are first paid their pre-fixed dividend in preference to ordinary shareholders.
Preference shares could be made redeemable after a specified period. Similarly, the
preference shares could be granted the right to cumulate unpaid dividends. It is also
possible to provide to preference shareholders the opportunity to share the excess
profits (i.e. over and above their fixed dividends). Under the company law it is not
necessary that a company should have preference shares.
Ordinary shares have no preferential or fixed rights with respect to either repayment
of capital or distribution of profits. They have the residual claims against assets after
the claims of creditors and preference shareholders have been met.
We have hinted earlier that even if the company earns profit, shareholders,
including preference shareholders, have no right to dividend unless the company
decides to distribute it. However, in case of cumulative preferences sareholders
such unpaid dividends will accumulate and will have to be paid before any dividend
can be paid to ordinary shareholders.
Reserves and Surplus
Reserves and surplus or retained earnings normally arise out of profitable

operations. It is a surplus not distributed by the firm as dividends. In other words,
these are profits decided to be retained within the business. When a firm starts its
operations it has no retained earnings. If in the first year it earns say Rs. 10,000
profit and decides to distribute Rs. 5,000 as dividends, the reserves and surplus at
the end of the year will be Rs. 5,000. During its second year of operation if the firm
makes a loss of Rs. 3,000 then the retained earnings at the end of the year will be
Rs. 2,000. Retained earnings (or reserves and surplus) are in the nature of earned
capital for the firm. We have seen earlier that the dividends are limited to retained
earnings. This implies that at no point in item the original capital of the firm is
depleted. In other words, the capital originally contributed is maintained intact.
It is possible to allocate the profits earned and accumulated as reserves or retained

earnings to be earmarked for specific purposes. The earmarked reserves are not
distributed. Only non-earmarked or free reserves are available for distribution as
dividends.
Activity 4.7
Fill in the blanks with the correct word(s)
1. Balance sheet is a statement of……………………………………………….

2. …………………..............represents the owners' claim against assets of a
business.
3. …………………………………………….are claims of outsiders against
the business.
4. ………………………………………………………………..increase owners'
equity.
5. Amounts owed by a business on account of purchase of inventory are
usually called………………………..or………………………………………
20
6. Amounts receivable by a firm against credit sales are usually called……….
7. As a general rule all assets are valued at their …………………to the Construction and Analysis of
business. Balance Sheet
8. Owner's equity could be understood as comprising two

parts:…………………and………………………
9. The dual aspect principle has special relevance to………………………
10. All valuations in a balance sheet are based on the assumption about the entity
as a…………………………………………………………………………….
4.6 SUMMARY
Balance Sheet as we have seen is one of the most important financial statements. It is
a periodic summary of the position of the business. It is the statement of assets,
liabilities and owners' capital as of a particular point in time. This statement in itself
does not reveal anything about the details of operations of the business. However, a
comparison of two balance sheets could reveal the changes in business position. A
realistic understanding of the operations of the business would require two other
statements - Profit and Loss Account and Funds Flow Statement. We shall take them
up in subsequent units.
4.7 KEY WORDS

Asset: Anything, tangible or intangible, of monetary value to a business entity.
Liability: Any amount owed by one person (the debtor) to another (the creditor). In a
balance sheet all those claims against the assets of the entity, other than those of the
owners.
Current Assets: All of the assets held by a firm with the objective of conversion to
cash within the operating cycle or within one year whichever is longer. Current Assets
include items such as cash, receivables, inventory and prepayments.
Current Liabilities: All those claims against the assets of the firm to be met out of
cash or other current assets within one year or within the operating cycle, whichever
is longer. Usually include items such as accounts payable, tax or other claims
payable, and accrued expenses.
Intangible Assets: Any long-term assets useful to the business and having no physical
characteristics. Include items such as goodwill, patents, franchises, formation
expenses and copyrights.
Contingent Liability: A liability which has not been recognised as such by the entity.
It becomes a liability only on the happening of a certain future event. An example
could be the liability which may arise out of a pending law suit.
Fixed Asset: Tangible long-lived asset. Usually having a life of more than one year.
Includes items such as land building, plant, machinery, motor vehicles, furniture and
fixtures.
Owner's Equity: It is the owner's claim against the assets of a business entity. It
could be expressed as total assets of an entity less claims of outsiders or liabilities,
includes both contributed capital and retained earnings.

l. Explain the following terms giving examples;
Accounts Receivable
Inventory
Current Liabilities
Contingent Liabilities
21
Understanding 2. By definition , a balance sheet `balances'. Can you think of any advantages
Financial Statements that flow from accountants' adherence to this convention?
3. "Financial statements are most useful if they report only the value of assets
that are tangible". Do you agree?
4. "Current assets are producing assets. The most profitable firm will practically
have few assets which are current compared to other assets". Evaluate fully.
5. For a company, the excess of assets over liability is commonly represented
by several items. What are they? What is the caption placed over them?
6. "Fixed assets are physical assets that provide operating capacity for a number
of accounting periods". Explain with the help of suitable examples. Are all
fixed assets depreciable assets?
7. Peninsular Transport Company began trucking operations on January 1,
2003. The company's bank account showed a balance of Rs. 90,000 on
December 31, 2003, which was in agreement with the bank statement
received on the same date. The company had Rs. 6,000 cash in the office and
Rs. 4,000 worth cheques received from customers.
On December 31, receivables outstanding amounted to Rs. 3,00,000. Company also
had Rs. 30,000 worth promissory notes signed by their customers. Employees had
drawn festival advance, which was outstanding in the amount of Rs. 6,000.
Peninsular owed Rs. 3,60,000 to Southern Service Station as on December 31, 2003.
During the year Peninsular purchased stationery and office supplies costing Rs.
11,000 from Ramlinga lyer & Sons. The use of stationery and supplies during the year
was estimated at Rs. 8,000.
Peninsular purchased eight trucks during the year, each costing Rs. 4,00,000. They
owed Rs. 20,00,000 to Southern Sales and Finance at the end of the year on account of
trucks bought. The obligation was supported by hire purchase agreement for payment
at the rate of Rs. 50,000 per month. Depreciation was Rs. 80,000 per truck for the year.
Spare parts and tyres inventory amounted to Rs. 13,000.
Company had rented a garage on a 30 year lease, office space and parking space at
Rs. 1,00,000 a year on the NH 47 within the city limits. Because of the real estate
boom, Peninsular could easily sublet the premises for Rs. 1,50,000 a year. On January
1, 2003 when Peninsular started operations they had paid first two years' rent in
advance.
On December 31, 2003 Peninsular purchased an airconditioned car for office use
costing Rs. 1,00,000. Insurance and registration cost amounted to Rs. 8,000.
The company had a bulk storage tank for diesel needed for its trucks. The tank was
filled on 4 occasions with 50,000 litres each. On December 31 the meter reading
indicated that 1,80,000 litres had been used during the year. Average cost per litre of
diesel was Rs. 3.00.
Peninsular paid employees' salary on the last day of each month. Bonus for the
employees was due in the amount of Rs. 2,12,000 relating to 2003 and will be paid
along with first salary in 2004.
The owners of Peninsular originally invested Rs. 6,00,000. Net income for 2003 was
Rs. 2,08,000. Drawings by the owners during the year amounted to Rs. 1,00,000.
Prepare the balance sheet as on December 31, 2003 for Peninsular Transport
Company in the blank proforma provided as Table 4.2.
22
Table 4.2 Construction and Analysis of
Balance Sheet
Peninsular Transport Company
Balance Sheet as on 31st December, 2003
Assets Liabilities and Capital
Cash Hire purchase payment due
Cash at Bank in one year
Promissory Notes Accounts payable
Accounts receivable Bonus payable
Advances to employees
Office supplies inventory Long Term Liabilities
Prepaid insurance and license Hire purchase payable
Prepaid rent Capital
Inventory of diesel Owners’ Capital
Spare parts inventory Net income for the year
________
Less: Owner’s drawings
________
Plant and equipment
Trucks ______
Less: Accumulated
Depreciation ______ ________
Motor Car
Total Assets
Total Liabilities and Capital
8. The following Balance were extracted from the books of account of Punjab
Ceramics Limited, on 30th June, 2003 after the income statement for that
year had been prepared and all the relevant adjustments had been made.
Balance as on 30th June 2003

Rs.
Freehold land and building at cost 32,000
Bank overdraft 27,200
Cash in hand 1,680
Inventory 74,400
Creditors 18,560
10% Debentures 34,000
Dividends Proposed - 8% Preference shares 1,600
Ordinary shares 6,000
Accrued expenses 2,400
General reserves (at 1 July 2002: Rs. 8,000) 20,000
Share capital: 200 8% Preference share of Rs. 100 each 20,000
6,000 Ordinary shares of Rs. 10 each 60,000
Investments at cost 14,800
Motor vehicles at cost 37,200
Provision for depreciation on 30 June 2003 9,600
Plant and machinery at cost 84,960
Provision for depreciation on 30 June 2003 24,160
Retained income (At 1 July 2002, Rs. 28,000) 32,800
Share premium 14,240
Accounts Receivable 25,520
The authorised share capital consists of 400 8% preference shares of 100 each and
1,200 ordinary shares of Rs. 10 each.
Prepare the Balance Sheet of Punjab Ceramics Limited as on 30th June, 2003. Also
ascertain the net income for the year. 23
Understanding Answers to Activities
Activity 4.1
1 a) By a decrease in another asset. b) by an increase in liability . c) by an
increase in owner's equity.
2 a) an increase in asset. b) decrease in another liability. c) decrease in
owner's equity.
3 Liability
4 Assets.
Activity 4.2
1 F. 2 T. 3 F. 4 T. 5 F. 6 F.
Activity 4.3
1 Assets = liabilities + owner's equity
2 Rs. 25,000
3 Rs, 25,000= Rs. 1,00,000 - Rs. 75,000
4 Rs. 70,000 = Rs. 1,00,000 - Rs 30,000
Activity 4.4
1 (a) Accounting period (b) fiscal year (c) financial year
2 (a) asset (b) liability (c) capital
3 (a) current (b) property, plant (c) other
4 (a) current (b) long-term (c) shareholders.
Activity 4.5
1 Liquidity
2 a) T account form
b) Report
3 In time taken by a unit of cash to circulate through the business.
4 Lower of cost or market price
5 Sundry debtors
6 Depreciation
7 Amortisation
8 Accounts payable
Activity 4.6
1 Operating cycle
2 Cash
3 Liquidity
4 “Lower of cost or market price”.
5 Bad debts.
6 Promissory Notes receivable or bills receivable.
7 Raw material (ii) Work-in-Process (iii) Finished goods.
8 Lower of cost or market price if Ramsons were an individual proprietorship
business, the owners equity will be reflected directly as:
Activity 4.7
1 Assets, Liabilities and capital
2 Owners equity
3 Liabilities
4 Profits
5 Accounts payable or sundry creditors
6 Accounts receivable or sundry debtor
7 Original cost
8 Contributed capital and retained earnings
24 9 Balance sheet
10 Going concern.
Answers to Self-assessment Questions/Exercises Construction and Analysis of
Balance Sheet
7. Solutions:
Peninsular Transport Company
Balance Sheet as on 31st December, 2003
Cash 10,000 Hire purchase payment 6,00,000
Cash at Bank 90,000 due in one year
Promissory Notes 30,000 Accounts payable 3,60,000
Accounts receivable 3,00,000 Bonus payable 2,12,000
Advances to employees 6,000
Office supplies inventory 3,000 Long Term Liabilities 11,72,000
Prepaid insurance and license 8,000 Hire purchase payable 14,00,000
Prepaid rent 1,00,000 Capital
Inventory of diesel 60,000 Owners’ Capital 6,00,000
Spare parts inventory 13,000 Net income for the year
2,08,000
Less: Owner’s drawings
1,00,000 1,08,000
Plant and equipment
Trucks 32,000
Less: Accumulated
Depreciation 25,60,000
64,000 1,00,000
Motor Car
32,80,000
Total Assets Total Liabilities and 32,80,000
Capital

Horngren C.T. and Harrison, 01/23/2003, Financial Accounting, Prentice Hall : New
Delhi (Chapter 1)
Fraser Lyn M. and Aileen Ormiston, 04/10/2003, Understanding Financial

Statements, Prentice Hall : New Delhi (Chapter 2)
Glantier M. W. E., Underdown B. and A.C. Clark, 1979, Basic Accounting Practice,
Arnold Hieneman: Vikas Publishing House, New Delhi (Chapter 5, Section 2).
Bhattacharya, S. K. and John Dearden, 1984. Accounting For Management: Text and
Cases (2nd Ed.) Vani: New Delhi. (Chapter 3, 10 and 11)
Hingorani, N.L. and A. R. Ramanathan, 1986, Management Accounting, Sultan

Chand: New Delhi. (Chapter 3).
25
Understanding
UNIT 5 CONSTRUCTION AND ANALYSIS
OF PROFIT AND LOSS ACCOUNT
Objectives
The purpose of this unit is to introduce to you the profit and loss account. After you
have studied this unit, you should be able to:
• appreciate the importance of income measurement
• classify income and expense accounts
• prepare a profit and loss accounts
• appreciate the linkage between accounting records and profit and loss
account
• appreciate the linkage between profit and loss account and balance sheet.
Structure
5.1 Introduction
5.2 Profit and Loss Account and Balance Sheet: The Linkage
5.3 Measurement of Income
5.4 Preparation of Profit and Loss Account
5.5 Some Indirect Expenses
5.6 Methods of Depreciation
5.7 Form of Profit and Loss Account
5.8 Cost of Goods Sold
5.9 Methods of Inventory Valuation
5.10 Gross Profit
5.11 Operating Profit
5.12 Net Profit
5.13 Summary
5.14 Key Words
5.1 INTRODUCTION
The balance sheet, as we have studied in the previous unit, is intended for reporting
the value of assets, liabilities and owners' equity at a particular point in time. It does
not disclose anything about the details of operation of the business. All it tells about
are the details of operation of the business. It tells about the net change in owner's
equity brought about by operations during the period between the previous balance
sheet and present one. Was it a good year or a bad year? What was the volume of
operations? What was the margin available on sales? How was sales rupee distributed
among different expenses and profit? All these questions cannot be answered without
the help of an additional financial statement addressed exclusively to summarise
revenues and expenses of the particular period. This statement is what is referred to
variously as Profit and Loss Account, Income Statement or Income summary. This
statement is so named since it summarises all the revenues or incomes and all the
26 expenses for earning that revenue showing the net difference, that is profit or loss for
the period.
5.2 PROFIT AND LOSS ACCOUNT AND BALANCE Profit and Loss Account
SHEET: THE LINKAGE
When you sell an item costing Rs. 70 for Rs. 100, assuming no other costs, you earn
a profit of Rs. 30. What we have done is nothing but measurement of the net income.
This is achieved by comparing the revenue from sales against the cost of materials
parted with for earning that revenue. Net difference of this comparison, in simple
terms, represents the net income or profit.
The importance of profit and its measurement in accounting leads in turn to the
significance of profit and loss account. However, it will be interesting to see how this
document is related to the balance sheet. In the previous unit we have seen that the
earning of revenue increases owners' equity. Please recall the balance sheet equation
we had seen in the previous unit. It stated:
Assets = Liabilities + Owner's Equity..……..(1)
We also saw that owners equity at any point in time is represented by the following
relationship:
Owner's Equity = Assets - Liabilities……….(2)
This implies that except in the case of first balance sheet, owners' equity need not be
equal to contributed capital. We also saw that the owners' equity changed with the
sale transactions. How did this happen? It happened as follows:
l The amount of sales revenue realised increased the owner's equity.
2 The amount of goods 'parted with decreased the owner's equity.
Thus, resultant increase in owners' equity was equal to the net increase in assets. That
is, equal to the profit.
We explained owners' equity in the previous unit as:
Contributed Capital + Retained Earnings'
Assuming no withdrawals, `retained earnings' is nothing but all the revenue minus
expenses. Thus, we could write our relationship as follows:
Retained earnings = Revenue - Expenses (3)
Now, substituting right hand side of equality (1) in our earlier balance sheet equation
we have:
Assets = Liabilities + Contributed Capital + Revenue – Expenses..…………(4)
It is the last two terms in equality (4) above which is referred to as profit and loss
account or income summary. Thus, we find that profit and loss account is an integral
part of any balance sheet in that it is an expansion of one of the terms of the balance
sheet. In order to appreciate and understand profit and loss account, we should clearly
understand the conceptual basis of the same.
5.3 MEASUREMENT OF INCOME

Profit and loss account measures the income generated by the entity. The income is
generated from or with the use of its assets. Thus, the concern of the profit and loss
account is the income arising out of the assets, rather than the assets themselves. In
order to make this segregation and make the process of measurement practical, we 27
Understanding should have precise idea of what constitutes revenue and expenses. Recognition and
Financial Statements measurement of revenue and expense are based on the ideas of realisation, accrual,
accounting period, and matching.
Realisation
Realisation is technically understood as the process of converting non-cash resources

and rights into money. It is understood to mean sale of assets for cash or claims to
cash. As an accounting principle, it is used to identify precisely the amount of
revenue to be recognised and the amount of expense to be matched to such revenue
for the purpose of income measurement.
Realisation, thus, usually pertains to the recognition of revenue from sale or

provision of goods or services to customers. When should we recognised revenue?
This is the question that realisation principle tries to answer. There can be several
arguments for and against recognising revenue at the time when the inventory is
acquired, when the goods are made ready for sale, when the order is received, when
the goods are delivered, or when the sale proceeds are collected. In order to avoid
such confusion in accounting, revenue is generally recognised when goods are
delivered or services are rendered. This is done despite the fact that delivery is only
one of a series of events related to sale. The rationale is that delivery validates a
claim against the customer.
Realisation being the point of recognition of revenue, it also enables us in

recognising the expiration of costs incurred in making available such goods or
services. Thus, the realisation principle facilitates the process of income
measurement by identifying revenues and the expiration of costs with respect to such
revenues. By implication, if costs are incurred in producing the goods, such costs are
not considered as expenses unless sales are made.
There are two major exceptions to the notion that an exchange is needed to justify the
realisation of revenue. First, in case of long run construction contracts revenue is
often recognised on the basis of a proportionate or partial completion method. Thus in
this case revenue is recognised without satisfying the test of completion and delivery.
Second, in case of long run instalment sales contracts, depending on the
uncertainties involved, revenue is regarded as realised only in proportion to the actual
cash collections. In this case even though delivery is complete at the time of contract,
recognition of revenue is deferred and related to actual cash collections.
Accrual
It is generally accepted in accounting that the basis of reporting income is accrual.

Resources and obligations change in time periods other than those in which money is
received or paid. Economic activity of an enterprise in a short period is complete if
the cycle of productive resources to money is completed. In reality, continuous
production, use of credit, and long lived assets produce several overlapping cycles.
This makes the process of evaluation of income very complex.
Accrual principle tries to evaluate every transaction in terms of its impact on the
owners' equity. In simple terms it implies that recognised revenues result in increases
in the owners' equity while expired costs or recognised expenses result in decrease in
the owners' equity. The essence of the accrual concept is that net income arises from
events that change the owners' equity in a specified period and that these are not
necessarily the same as change in the cash position of the business. Thus,
realisation and accrual together lay down the ground rules for measurement of
income.
28
Activity 5.1 Construction and Analysis of
Profit and Loss Account
Fill in the blanks
1. Profit and loss account is summary of………..and…………for an accounting

period.
2. Realisation in accounting is the basis of ………………………..recognition.
3. Income measurement is achieved by matching……………………………..
4. Costs with respect to realised revenues are considered as …………………
5. Recognised revenue……………………………………..to owners' equity
6. Expenses result in…………………………………of owners' equity
7. Expenses could be recognised in relation to…………………..realised or

an………………….period.
Accounting Period
Once we accept the concept of `going concern', it is inconceivable to approach the

problem of profit measurement without a clear understanding of the idea of
accounting period. The most accurate way to measure the results of an entity's
operations will be to measure them at the time of liquidation.
Considering the whole life of the business, net income is nothing but the excess of
amount the owners get over what they have put into it (investment). But it is
inconceivable and impractical to imagine that one has to wait till the winding up of the
business for ascertaining the profit. Accountants choose some convenient segment of
time, such as a calendar year, to collect, summarise and report all information on
material changes in the owners' equity during that period. There is no sanctity about
an accounting period being a year. It has evolved as a convention out of convenience
over the years. There is some historical evidence to suggest that accounting periods
used to be a couple of years or the entire life time of a venture and so on, in the past.
Even now, there are firms which follow the system of certain number of weeks as an
accounting period. However, generally, as a convention, most enterprises try to have a
uniform length of accounting period for period to period comparison of results.
The crux of the matter is that the realisation and accrual principle, as we have seen
earlier, will have to be applied in the context of the accounting period. It is the revenue
which is realised during that accounting period which is treated as accruing to the
owners' equity. Thus, accounting period enables us to have a practical system of
valuation and measurement. Accounting periods are bounded by balance sheets at the
beginning and at the end of the period. Operations during the period are summarised
by income statements. This process can be illustrated in the following form:
Here accounting periods could be seen as links in the chain which makes up the life
of the enterprise. Accounting period is variously referred to as fiscal year and 29
financial year also.
Understanding Matching
In reality we match revenues and expenses during the accounting periods. Matching
is the entire process of periodic earnings measurement, often described as a process
of matching expenses with revenues. In a narrow sense this means deducting from
the revenues of a period the cost of goods sold or other expenses that can be
identified with such revenues of that period on the basis of cause and effect.
Revenue
In a broad sense revenue is the total amount realised from the sale of goods or
provision of services together with earnings from interest, dividend, rents and other
items of income. Revenue is recognised when the enterprise has a right to income. In
practice we make a segregation of an enterprise's income as obtained from its main
operations and from activities incidental to the main operations. The former is
referred to as operating income and the latter as other income or non-operating
income. Realised revenue as we have seen earlier need not be realised in cash. If the
right to receive that income is created or the time to which the income relates has
expired, we treat the income as accrued. For example, a credit sale to be collected
during the next accounting period is an income of this period. Similarly, interest to be
received on a specified date is treated as accrued and hence earned for the period
covered by the current accounting period.
Measurement of Expenses
Expenses are costs incurred in connection with the earnings of revenue. As such the
point of reference for recognition of expense becomes the recognition of revenue.
Costs incurred do not become expenses until the goods or services in question are
exchanged. Expense is sacrifice made, resource consumed in relation to the revenues
earned during an accounting period. Thus cost is not synonymous with expense. Only
costs that have expired during an accounting period are treated as expenses. Consider
the following example:
Rakesh purchases merchandise worth Rs. 1,000 during the period and sells one half
of this during the same period for Rs. 750.
Here, we have:
Cost : Rs. 1,000 The purchase price f the merchandise.

Revenue : Rs. 750 The sale proceeds realised in exchange of
one half of the merchandise.
Expense : Rs. 500 The cost of the merchandise parted with or
given over to the customer in exchange of
the revenue i.e. cost with respect to the
revenue earned and hence expired cost.
Inventory : Rs. 500 The unexpired cost. An asset i.e.
merchandise inventory (as a convention,
valued at cost).
Generally, unexpired costs represent assets. All assets which have limited life expire
as expenses with respect to revenue earned during their useful life.
Expense means a decrease in owners' equity that arises from the operation of a
business during specified accounting period. Thus, cost means any sacrifice, whether
or not the sacrifice affects the owners' equity during a given accounting period.
American Accounting Association provides the following description for expense:
30 Expense is the expired cost, directly or indirectly related to a given fiscal period of
the flow of goods or services to the market and of related operations. Recognition
of cost expiration is based on a complete or partial decline in the usefulness of Construction and Analysis of
assets, or on the appearance of a liability without a corresponding increase in Profit and Loss Account
assets.
Expenses of a given period are:

i) Expenses of this year. These are costs incurred during the accounting period
which become expired costs during the same period. Example: cost of material
bought and sold during the same accounting period.
ii) Costs incurred in a previous accounting period that become expenses or
expired costs during this year. Example: inventory purchased during the
previous period but sold during this period. The amount of inventory which
represented unexpired costs and hence an asset at the close of the previous
accounting period becomes expired cost and hence expense during the period
in which it is sold.
iii) Expenses of this year, the monetary outlay for which will be made during a
subsequent period. These are also expired costs of the current period, but the
costs are incurred by contracting a liability.
Expenses are recognised under the following circumstances:
a) Expenses are given recognition in the period in which there is a direct
identification or association with the revenue of the period. This implies that
recognition of expense is directly related to the realisation of revenue.
b) An indirect association with the revenue of the period. Example: rent, salaries,
insurance, depreciation and such other costs which are not usually inventoried.
c) Measurable expiration of assets though not associated with the production of
revenue for the current period. Example: loss from flood, fire and similar events.
Assets that become expenses

Examination of some specific cases of assets that become expenses will enable us to
understand the concept very clearly.
Inventories: Inventory of merchandise become expense when it is sold. In case of
manufacturing organisations all the costs incurred on transformation of raw materials
add value to the inventory. These costs are treated as expenses only when the
inventory in question is sold.
Prepaid Expenses: Prepaid expenses represent services or assets paid for, prior to
their actual use. Thus, they represent unexpired costs. They become expenses when
the services are used or assets are consumed.
Long-lived Assets: Fixed assets have a limited useful life. The costs of such assets
expire during the life of the assets in question. Such expiration of costs of the assets
are referred to as depreciation.
What we have examined so far are some of the conceptual bases necessary for the
understanding and preparation of a profit and loss account. In the subsequent part of
this unit we shall examine the mechanics of how to prepare a profit and loss account.
5.4 PREPARATION OF PROFIT AND LOSS

ACCOUNT
Profit and Loss Account, as we have seen, is a summary of all àccounts' dealing with
transactions relating to revenue and expenses. An account is a statement wherein
information is accumulated relating to an item or a group of similar items. This
accumulation is done in such a manner that it is fairly easy to summarise by
combining several such items. In case of profit and loss account, the process of
preparation is nothing but a summarisation of all individual accounts, accumulating 31
information on different items of expense and revenue.
Understanding We have seen the expanded balance sheet equation at the beginning of this unit
Financial Statements using abbreviations) as follows:
A=L+C+R-E ...(4)
where:
A = assets
L = liabilities
C = contributed capital
R = revenues
E = expenses
For the sake of simplicity we ignore withdrawals. However, if we consider
withdrawals, it will imply assets being less to that extent and equality being provided
with one more negative term of withdrawals or drawings. Thus, the equality will
be:
A=L+C+R-(E+D) ...(5)
Where D = dividends or drawings
By transposing this equality it is possible for us to write it without negative symbols.
Thus we have:
A+E+D=L+C+R ...(6)
This equality is the basic accounting equality. The quantities on the left hand side
(LHS) are normally referred to as `debit' or `Dr.' in short and quantities on the right
hand side (RHS) as `credit' or `Cr.'. in short. We have also seen that because of the
basic balance sheet equality, this accounting equality will always hold true.
The terms on the RHS and LHS are represented by one or more separate accounts
where information is accumulated using the same framework. LHS terms, namely,
A, E and D have debit balances. In other words, normally these accounts have debit
side entries more than or equal in value to entries on the credit side. Hence, for
those accounts: Debits - Credits > 0. When it is equal to zero there is no balance in
the account. Similarly, the accounts relating to the terms on the RHS of the
equality, that is L, C, and R, normally have credit balances. Hence, these accounts
imply: Credits - Debits >= 0.
The process of accumulating information is also simple. In the accounts representing

LHS terms, all increases of those items are debited in the respective accounts and
decreases are credited, net difference showing actual position at any point in time.
Similarly, in case of accounts representing RHS, increases with respect to an item are
credited in a particular account, and decreases are debited to that account. Net
difference shows balance of that item as of a point in time. From this, it is also clear
that the terms `debit' and `credit' in accounting have no more practical significance
than `left' and `right' of an account.
An account thus could be represented as a capital letter T denoting the nature of

information accumulated in that. Thus, we have `cash account' or `receivable
account' or ‘payables account’ or ìnventory account' and so on.
Example:
Cash Account
Dr. Cr.
32
In this case LHS will represent all cash receipts or increase and RHS will represent Construction and Analysis of
all cash payment or decreases. Profit and Loss Account
Let us illustrate the ideas we have discussed with the help of a simple example:
January 1 - Started business with Rs.1,000.
January 1 - Bought merchandise worth Rs.800 and stored it.
January 8 - Received order for half the merchandise from A.
January 10 - Delivered the merchandise, customer invoiced Rs.500.
January 15 - Received order for the other half of merchandise
January 17 - Delivered merchandise and cash received Rs.500
January 31 - Customer (A) pays.
Accounts of the above transactions

Rs. Debit Cash A/c Rs. Credit
Capital 1,000 Merchandise inventory 800
Sales 500 Balance 1,200
Receivable (A) 500 2,000
2,000
Balance 1,200
Rs. Debit Capital A/c Rs. Credit

Balance 1,000 Cash 1,000
1,000 1,000
Balance 1,000
Rs. Debit Mercantile Inventory A/c Rs. Credit

Cash 800 Cost of goods sold 400
Cost of goods sold 400
800 800
Rs. Debit Sales A/c Rs. Credit

Profit & Loss A/c. 1,000 Receivables (A) 500
Cash 500
1,000 1,000
Rs. Debit Receivables (A) A/c Rs. Credit
Sales 500 Cash 500
500 500 33
Understanding
Rs. Debit Cost of Goods Sold A/c Rs. Credit
Merchandise inventory 400 Profit & Loss A/c. 800
Merchandise inventory 400
800 800
Rs. Debit Profit & Loss A/c Rs. Credit

Cost of goods sold 800 Sales 1,000
Retained earnings 200
1,000 1,000
Rs. Debit Retained Earnings Rs. Credit

Balance 200 Profit & Loss A/c 200
200
200
Balance 200
Rs. Debit Balance A/c Rs. Credit

Cash 1,200 Capital 1,000
Retained Earnings 200
1,200 1,200
In the above example what we have attempted is to complete the accounting process
based on a very simple situation. The process of recording and summarising, we
resorted to could be explained as follows:
Starts business with Rs.1,000. This transaction affects two accounts: Cash increase -
entry on the debit side of the account. Capital increase - entry on the credit side of the
account.
Purchases merchandise and stores them. Merchandise inventory increase - entry on

the debit side of the account. Cash account decrease- entry on the credit side of the
account.
Receipt of order for half the merchandise. Receipt of order does not warrant any
record. We consider realisation of revenue only when goods are delivered.
a) Delivered goods and customer invoiced. Since cash is not collected

simultaneously, it represents a credit transaction. It results in an increase in
claims against À'. Accounts receivable is debited. Revenue is earned, sales
account is credited.
b) We should also consider the cost of sales. We part with merchandise inventory
worth Rs. 400. It is an expired cost, hence a reduction in owner's equity, is an
expense. Debit cost of sales account with increase in expense or expiration of
cost. We credit the merchandise inventory account to show the reduction in
34 inventory.
Cash received from sales. Debit cash and credit increase in revenue, sales. Construction and Analysis of
We also recognise expense by debiting cost of sales account and crediting
merchandise inventory account.
Receivables collected. Cash increase is recorded by debit in cash account and a credit
to receivables (A) account. The credit to receivables account shows the liquidation of
our claim (asset). In practice this amounts to repayment of the debt by A.
5.5 SOME INDIRECT EXPENSES

In the example discussed above, we dealt only with direct revenue and direct expense.
Revenue arose from two sale transactions-one on credit and the other on cash. The
expense was one simple direct item of expense-the cost of sale or the recognition of
expiration of inventory cost. Before we proceed to examine the detailed profit and
loss account, we should discuss some of the important indirect expenses.
Bad Debt Expense
In most business situations sale òn credit' is common. We also treat such sale as
‘realised’ since they produce a certain asset `receivable'. Thus, credit sale is
recognised at the point of sale during the accounting period in which the transaction
takes place. Uncollected balance at the close of the accounting period is reflected as
an asset on the balance sheet.
Now, if the customer could not make payment or will not make payment, both these
records (record as revenue of the period and record as asset at the close of the period)
will amount to overstatement in the records. However, we have no basis for
estimating the exact amount of such collection losses. This is so since the
'uncollectability is known only in a subsequent accounting period. It is this situation
which warrants us to estimate the amount of expense with respect to collection
losses. Let us consider the following example.
Suppose, a business makes four credit sales of Rs.250 each during a period. Cost of
sales for the same being Rs.500.
Rs. Rs.
Cost of sales 500 Sales 1,000
Profit 500
1,000 1,000
The balance sheet records arising from this transaction will be:
Balance Sheet
Assets Rs. Liabilities & Capital Rs.

Accounts receivable 1,000 Retained earnings 500
Now assuming that one of the accounts is going bad, the collection loss will
amount to Rs.250. If we do not take this into account, the implications are: we
have overstated receivables (asset in the balance sheet), sales (revenue in the
profit and loss account) and profit (retained earnings in the balance sheet). It is
possible for us to estimate these losses on account of bad debts and reduce the
revenues and thereby profits to that extent. It is achieved by recognising this
amount as our increase in expense-bad debts expense-thereby reducing profit. 35
Understanding Thus, we will prepare profit and loss account and balance sheet as follows:
Debit Rs. Rs. Credit

Cost of Sales 500 Sales 1,000
Bad debt expense 250
Profit 250
1000 1,000
Balance Sheet
Assets Rs. Liabilities & Capital Rs.
Accounts receivable 1,000 Retained earnings 250
Less: Estimated collection 250 750

loss
Usually the possible collection losses are estimated and provided for by charging them as
expenses of the period. Such estimate is reduced from the value of the asset receivables
to show the realisable value of the asset.
Depreciation on Fixed Assets
In our study earlier we have seen that fixed assets have long life and provide benefits
beyond one operating cycle. While discussing the idea of expense we saw that
expenses are expired costs. All costs incurred on any asset with limited life, thus, expire
during its life time. Now it is not difficult to perceive what depreciation is. Consider the
following illustration.
A machine purchased for Rs.5,000 having five year life and no salvage value is used in
a business. During the life of the asset, it will be able to earn a revenue of Rs.10,000.
It is simple arithmetic to say that by using the machine we make a profit of Rs.5,000
over its life time (Rs.10,000 revenues less Rs.5,000 cost of the machine) assuming no
other costs. The problem of depreciation arises when we have to measure the profits
annually. What should be the amount of profit to be recognised every year?
We can approach this problem diagramatically. Assume that the following scale shows
the amount of revenue earned. We take it that the revenue is earned in equal amounts
36
during the five years of the life of the asset. Assuming no other costs and no salvage Profit and Loss Account
value, the cost of the asset becomes expense over a five year period. Now the
question is how should we apportion this cost over the life of the asset? If we make
the simple assumption that the cost expires in equal proportion, we have the simplest
solution. This we could represent as follows:
Now, having made the assumption of spreading the cost equally, we have come to the
conclusion that one-fifth of the cost of the asset expires annually. That portion of the
cost of the asset which is reckoned to expire during an accounting period is what is
termed as depreciation expense. This also clarifies that, normally, the total amount
of depreciation of an asset shall not be more than the depreciable cost of the asset. It
is this èxpense' which is matched against the revenues of a period for determining
profit.
From the above example we can easily determine that the profit per annum is
Rs. 1,000, that is, Rs.5,000 over the useful life of the asset. Thus, to recapitulate,
depreciation expense is the cost of a fixed asset written off against the revenues of
different periods during which the asset is used.
5.6 METHODS OF DEPRECIATION

There are several methods of depreciation which differ from one another only
from the standpoint of how the cost is treated as expiring over the life of the
asset. We shall briefly discuss only two of the most commonly used methods.
However, in order to understand the methods we should be clear about the
following ideas:
Original cost of the asset: This is the cost incurred in making the asset available for
use in the first instance.
Salvage value: The expected recovery or sales value of the asset at the end of useful
life.
Useful life: The expected time period for which the asset is to provide economic
service i.e. the period for which the asset could be used for production.
Depreciable cost: This is original cost less salvage value. This is the amount of
expense the enterprise will be incurring on account of expired costs of the machine
over its useful or oreco?omic life.
Written down value: Written down value of an asset at any point of time is original
cost less depreciation to date (accumulated depreciation). This is also referred to as
book value.
Straight Line Method
Under the straight line method the depreciable cost of the asset is proportionately 37
allocated as expense against the revenues during each year of the useful life of the asset.
Understanding Assume that a company acquires a machine at the beginning of operations at Rs. 1,000.
Financial Statements It is expected that the machine will last 10 years and will have no salvage value at that
time.
The depreciation for the machine every year under straight line method will be Rs. 100,
or Rs. 1,000 =10. The written down value at the end of first year will be 1,000 - 100 =
900, at the end of second year 1,000 - (100+ 100) or (900 - 100) = 800 and so on,
becoming zero at the end of 10 years. Graphically, it could be shown as follows:
If we draw a graph showing the annual depreciation it will be a straight life parallel to
the base line. Hence the name straight line method (Figure 5.1). The accumulated
depreciation will be increasing annually at a uniform rate becoming equal to the
depreciable cost of the asset at the end of useful life (Figure 5.2 ). As shown in Figure
5.2 it is a straight line sloping upward to the right from origin whereas written down
value steadily declines to become zero at the end of useful life of the asset. Hence a
downward sloping straight line reaching origin at the end of useful life (Figure 5.3).
38
Figure 5.3 : Straight-line Method – Written down value Construction and Analysis of
Written Down Value method
Under this method depreciation at a certain rate is applied to the written down value
of the asset as at the beginning of each year. The effect of this method is that the
amount of depreciation charge every year is an Amount less than the previous year.
In other words, larger amounts are charged to depreciation during the initial years.
For example:
A company buys an asset at a cost of Rs. 1,000. It decides to depreciate it at the rate of 20
per cent per annum based on written down value method.
The annual book value, depreciation charge and accumulated depreciation will be as
follows (Table 5.1):
Table 5.1: Written Down Value Depreciation
Year Written down value at the Annual Accumulated

end of the year depreciation depreciation
0 1,000 - -
1 800 200 200
2 640 160 360
3 512 128 488
4 410 102 590
5 328 82 672
6 262 66 738
7 210 52 790
8 168 42 832
9 134 34 866
10 107 27 893
Annual depreciation under `written down' value method is the highest during the first
year and keeps on reducing over the subsequent years. This is shown by a rapidly
declining curve (Figure 5.4). However, the rate of decline reduces as the number of
39
Understanding
years approaches end of the life of the asset. Accumulated depreciation, similarly,
increases at a rapid rate during initial years and the rate of increase declines in later
years (Figure 5.5). The `written dowel' value of the asset is a declining curve (Figure
5.6). The unallocated portion of the cost is usually charged as depreciation in the last
40 year of the life of the asset.
Depreciation Method: Impact on profit Measurement Construction and Analysis of
What we could learn from the discussion of the depreciation methods is that,
depending on the method used, we have a different amount of charge for annual
depreciation. It may also be noticed that over the entire life of an asset the total
amount of depreciation charge cannot be different. Thus, the difference is only i n
terms of annual apportionment. The net effect of the methods is thus in terms of
showing less o r more profit in any particular year. This could be explained by
continuing with the example.
Suppose that the company using the machine in our earlier example earns Rs.500
per annum before depreciation. The difference in annual measurement of profit
under straight line and written down value methods will be as follows (Table 5.2):
Table 5.2:Profits under Written Down Value and Straight Line Method of
Depreciation
(1) (2) (3) (4) (5) (6)
Year Profit Straight line Net Profit Written Net profit
before depreciation under down value under
depreciation straight line depreciation written
method of down value
depreciation method of
(2) – (3) depreciation
Rs. Rs. Rs. Rs. Rs.
Rs. Rs. Rs. Rs. Rs.
1. 500 100 400 200 300
2. 500 100 400 160 340
3. 500 100 400 128 372
4. 500 100 400 102 398
5. 500 100 400 82 418
6. 500 100 400 66 434
7. 500 100 400 52 448
8. 500 100 400 42 458
9. 500 100 400 34 466
10. 500 100 400 134* 366
Total 5,000 1,000 4,000 1,000 4,000
* Includes the unallocated depreciation charge, since there is no salvage value for
the assets. Under this method there will always be a terminal unabsorbed
depreciation. Figures are rounded off.
5.7 FORM OF PROFIT AND LOSS ACCOUNT

So far we have been discussing profit and loss account in the àccount' format.That is,
listing all the revenues earned on the RHS and all the expenses incurred on the LHS
showing profit in case of a credit balance and loss in case of a debit balance.
Modern practice is to present the information in a summarised statement giving the

details in attached schedules. This achieves the same result because of the
relationship:
Revenue - Expense = Profit/Loss.
We give below a condensed profit and loss account in both the formats. We shall then
discuss the items presented. It may help you to copy out this profit and loss account
since Subsequent discussions will be based on this example.
41
Understanding TOOLS INDIA LTD.
For the year ending December 2003
(Rs. in Millions)
Debit Credit
Cost of goods sold (Schedule 3) 130 Sales net (Schedule 1) 255
Gross profit 130 Other income (Schedule 2) 5
260 260
Personal (Schedule 4) 49
Depreciation (Schedule 5) 11
Other Expenses (Schedule 6) 28 Gross Profit 130
Operating profit 42
130
Interest (Schedule 7) 12
Profit before taxes 30 Operating income 42
42
Income-tax provision 12 42
Net profit after tax 18 Profit before taxation 30
30 30
Alternatively, the same profit and loss account could be presented as follows:
TOOLS INDIA LTD.
For the year ending December 2003
(Rs. in Millions)
Debit Credit
Sales (Schedule 1) 255
Other income (Schedule 2) 5
260
Cost of goods sold (Schedule 3) 130
130
Gross profit
Operating expenses:
Personal (Schedule 4) 49
Depreciation (Schedule 5) 11
Other expenses (Schedule 6) 28 88
Operating Profit 42
Less: Interest expense (Schedule 7) 12
Net Profit before Income 30
Taxes 12
Less: Provision for Taxes
Net Profit 18
42
The condensed profit and loss account will be accompanied by schedules providing
details of various items forming the total. Construction and Analysis of
Sales: Net sales shown in the profit and loss account is after deducting Rs. 5
million front gross sales. Schedule l also provides the detailed break up of sales by
different divisions of the company as also domestic market and export sales.
Schedule 1: Sales
(Rs. in Millions)
Gross Sales 260
Less: Sales returns and 1.75
allowances 3.25 5
Sales discount
255
Net Sales (inland)
Machine Tools Group 83
Watch Group 87
Tractor Group 60
Lamp Group 13
Dairy Machinery Group 2
245
Export:
Machine Tools Group 6
Watch Group 2
Others 2 10
Total Net Sales 255
Sales Returns and Allowances: Sales records are prepared as and when goods are
shipped to Customers. Goods which are not according to specifications, damaged or
defective may be returned by the customers and refund or credit sought.
Such refunds or allowances are separately accumulated for the purpose of control
by management. At the time of preparation of profit and loss account such
allowances are set off against the gross sales and net sales taken as operating
revenue earned. Many companies may not disclose this information in published
accounts.
Sales Discount is a reduction from invoice price granted for prompt payment of the
invoice within a specified time limit. This is also sometimes called cash discount.
In our example, Tools India Ltd. allowed Rs.3.25 million in discounts to customers.
It is usual practice to state the discount offered to customer on the invoice.

Discounts or terms of payments are usually presented in short forms or symbols.
They may be `Net amount' or `No cash dicount' (N) Net Amount due at End of the
Month (N/EOM); Net amount due in 30 days of invoice, no cash discounts (N/30); 5
per cent discount if payment is made in 10 days, net amount to be paid in 30 days
(5/10, N/30).
An invoice of `5/10', N/30' simply means that 5 per cent discount will be allowed if
payment is made within ten days. It also implies that by not paying in 10 days you
could avail the normal credit of 30 days. Suppose you have Rs.1,000 invoice with
`5/10,N/30'. You are losing 5 percent for 20 days credit. In other words it costs you
360/20 x 5% = 90% per annum in equivalent interest. This knowledge will
definitely help you in planning your shortterm finances more effectively.
Trade discounts are used as adjustments in price and used when bulk sales are made
by wholesaler to retailers. These are novel- brought into accounts. Rather, the sales 43
are valued at net of trade discount.
Understanding Other Income : The revenue earned by an enterprise is usually bifurcated into
Financial Statements two parts, operating income and non-operating income. Operating income usually
refers to income derived from the main-line operations of the business. Other
income. usually arises from activities incidental to the business. Schedule 2 lists
the details of non-operating incomes of Tools India Ltd.
Schedule 2: Other Income
Rs. in Millions
Interest - Banks 0.50

Interest- Staff and Office 1.20
Export incentives 1.80

Sales agency commission 0.50
Profit on sales of assets 0.30
Dividend on trade investment 0.20
Other Miscellaneous income 0.50
Total 5.00
5.8 COST OF GOODS SOLD

Cost of goods sold is very complex in case of a multi-product, multi- division
company where you have large amounts of semi-finished goods. But in case of a
trader, who deals in commodities and where each unit bought could be identified
with each unit sold, it is very simple. We confront two major problems in this
regard. First is with respect to changes in the price per unit of purchases. At what
price should we identify the cost of goods sold? Second, how do we evaluate cost
of semi-finished goods?
Cost of goods sold in summary presented in our example could be understood

more clearly from schedule 3.
Schedule 3: Cost of Goods Sold
(Rs. in Millions)
Inventory
Add: Purchases 110 81
Freight in 1
Other direct material costs 15 135
216
Total goods available
Less: Raw material and semi- 71

finished
Inventory on December 31,
2003
Goods available for sale
145
Less: Finished goods
inventory on December 31,
2003 15

44
Activity 5.2 Construction and Analysis of
Relate items in Column A to all items in Column B.
A B
1. Gross Sales 1. Non-cash expense of the period
2. Sales returns and allowances 2. Total invoice value of goods sold
3. Depreciation during the period
4. Discounts 3. Reduction from invoice price

4. 2/5, N/30
5. Given effect when goods are returned
by customers
6. Adjustments to recorded sales.
5.9 METHODS OF INVENTORY VALUATION

The only thing certain with respect to price normally is that they are not
certain. This makes it necessary to evolve a strategy for charging, the cost of
materials sold. Two of the most commonly used systems are the `First in,
First out' (FIFO) which assumes that the sales are made in the order in which
they are. purchased and `Last in, First out' (LIFO), which assumes that goods
which are bought last are sold first.
This could be illustrated with a simple example.
No. of Units Cost per Unit Amount
Rs. Rs.
January 1 Inventory 500 3 1,500
January 5 Purchases 1,000 4 4,000
Total 9,500 47,500
Units
January I 1 Sales 1,000
January 14 Sales 500
January 16 Sales; 1,000
January 21 Sales 2,000
January 30 Sales 1,500
Total 6,000
If we value the cost of sales on the basis of FIFO we have the following
situation:
45
Understanding Table 5.3: Cost of goods sold and inventory under FIFO
Date Quantity sold Quantity Break-up Rate Amount Total
Amount
January 11 1,000 500 X3 1,500
500 X4 2,000 3,500
January 14 500 500 X4 2,000 2,000
January 16 1,000 1,000 X5 5,000 5,000
January 21 2,000 1,000 X5 5,000
1,000 X6 6,000 11,000
January 30 1,500 1,500 X4 6,000 6,000
Total Sales 6,000 27,500
Inventory 3,500 1,500 X4 6,000
2,000 X7 14,000 20,000
Total 9,500 47,500
Thus, cost of goods sold and inventroy under FIFO are:
Cost of goods sold 27,500
Inventory 20,000
Total 47,500
If we follow LIFO the picture will be as follows (Table 5.4):
Table 5.4: Cost of goods sold and inventory under LIFO

Date Quantity Quantity Rate Amount Total
Sold Amount
January 11 1,000 1,000 x5 5000 5,000
January 14 500 500 x5 2,500 2,500
January 16. 1,000 1,000 x6 6,000 6,000
,
January 21 2,000 2,000 x4 8,000 8,000
January 30 1,500 1,500 x7 10,500 10,500
Total Sales 6,000 32,000
Inventory 3,500 500 x3 1,500
1,000 x4 4,000
500 x5 2,500
1,000' x4 4,000
500 x7 3,500 15,500
Total 9,500 47,500
Thus, cost of goods sold and inventory under LIFO are:
Rs.
Cost of goods sold 32,000
Inventory 15,500
46 Total 47,500
From the example above we find that the FIFO cost of goods sold, which is based Construction and Analysis of
onprices of inventory procured earliest prior to sales, would amount to Rs. 27,500. Profit and Loss Account
And the closing inventory of 3,500 units will be valued at Rs. 20,000 which is based
on the most current purchase prices. The LIFO cost of goods sold, which is based on
the most recent prices of the inventory purchased, is Rs.32,000. Closing inventory,
based on the prices of earlier purchase, is valued at Rs. 15,500. In both cases
inventory plus cost of goods sold amount to the same, that is, Rs. 47,500 since it is
based on actual historical cost only.
Here again, over the entire life of the entity there will be no difference, irrespective of
the method used in valuing the cost of goods sold. There will also be no difference if
the entire inventory is sold. The differences again reflect one of the effects of
accounting periods on income measurement.
5.10 GROSS PROFIT
Gross profit obtained by subtracting the cost of goods sold has great managerial
significance. Cost of goods sold usually reflects the direct input costs which, to a
great extent, are available with the volume of operations. In other words, per unit cost
of goods sold holds a fixed relationship. The gross profit margin should be sufficient
to cover operating expenses.
Operating Expenses
All those expenses which are necessary to run the business enterprise but which are
not directly associated with the company's output or production or trading are usually
termed as operating expenses. Usually these expenses include all items of cost
concerned with providing administrative and general support to business operations.
It is the usual practice to segregate these costs as falling under two broad groups:
selling and distribution and general administrative expenses. The latter also covers
personnel expenses including staff and workmens' compensation and other benefits. In
case of Tools India Ltd., details of the expenses on account of personnel are given in
Schedule 4.
Schedule 4: Personnel Expenses
(Rs in Millions)
Salaries, Wages and Bonus 37.81
House rent allowance 2.19
Gratuity 0.75
Contribution to Provident Fund 2.75
Contribution to Employees State Insurance (ESI) 0.50
Workmen and Staff Welfare expenses 5.00
Total 49.00
Depreciation
Depreciation, as explained earlier, is the expiration of costs of fixed assets. It is usual

practice to classify the depreciation expense for different groups of assets. In case of
Tools India Ltd., Schedule 5 gives the break up of depreciation for different groups
of assets.
47
Understanding Schedule 5: Depreciation
(Rs. in Millions)
Fixed Assets 9.84
Tools and Instruments 0.02
Patterns„ Jigs and Fixtures 1.14
Total 11.00
Other Expenses
Other expenses' give detailed break up of most of the major items of operating
expenses other than personnel, depreciation and financing costs. In case of tool India
Ltd., the details are provided in Schedule 6.
Schedule 6: Other Expenses
(Rs. in Millions)
Power and Fuel 3.10
Rent 0.50
Rates and Taxes 0.40
Insurance 0.50
Water and Electricity 0.60
Repairs to buildings 0.20
Repairs to machinery 0.80
Printing and Stationery 0.90
Advertisement and Publicity 2.40
Training 0.10
Audit fees 0.05
Royalties 0.85
Sole Selling and other Agents' Commission 4.70
Directors' Fees 2.00
Provision for bad debts and advances 0.20
Loss on assets sold or discarded 1.30
Provision for warranty repairs 1,00
Miscellaneous expenses 8.40
Total 28.00
5.11 OPERATING PROFIT

Operating profit is the net result obtained from the operations after subtracting
depreciation, personnel, and other expenses from gross profit. The amount is earned
by the company irrespective of the method of financing, the only other expense to be
met being interest expense. This is a measure of operational efficiency of the
company, and is usually referred to as OPBIT (Operating Profit Before Interest And
Taxes) or EBIT (Earning Before Interest And Taxes).
Interest Expense.
Interest expense' arises out of management's decision to finance part of the expenses
from borrowed funds. The level of interest expense represents the amount of risk the
company is carrying in terms of fixed commitments, irrespective of the volume of
48 operations and profit. Schedule 7 shows the different items of interest commitments
of Tools India Ltd.
Schedule 7: Interest Construction and Analysis of
Rs. In Millions
Debentures 0.58
Fixed Deposits 1.50
Loans from Government 5.00
Team loans from Banks/Financial Institutions 0.42
Cash Packaging credit from banks 3.50
Others 1.00
Total 12.00
Net Profit Before Tax

Net profit before tax is surplus after meeting all expenses including interest. This is
the profit available to the company as a result of both operating and financing
performance. This profit is usually referred to as PBT (Profit Before Tax) or EBT
(Earnings Before Tax).
Income Taxes
The profit before tax determines the level of taxation. As per the tax laws the amount
of tax payable is not determined on the basis of reported net profit. In most cases
accounting profit arrived at has to be reclassified and recomputed for determining the
tax liability. Further, the tax liability, though certain, is determined only after the tax
assessment is completed. This is the reason why tax liability is always provided or as
a provision, implying that this liability is based on an estimate. When the amount is
actually determined later on, it is set off against this provision.
5.12 NET PROFIT

This is the amount ultimately available to the company for appropriation. That is, this
amount could be either distributed as dividends to shareholders (owners) or retained
in the business as retained earnings, thereby increasing the owners' investment or
equity in the business. This is variously referred to as PAT (Profit After Tax) or EAT
(Earnings After Tax). After subtracting dividends declared, any surplus remaining is
added to retained earnings, that is, Reserve and Surplus.
Activity 5.3
Classify each item listed in Column A under appropriate classification in item B,
assuming that the information relates to a small manufacturing firm. .
A B
1) Raw material consumed i) Operating revenue
2) Interest received ii) Non-operating revenue
3) Dividends received iii) Cost of goods sold
4) Wages paid to workers iv) Selling and distribution expenses
5) Carriage on goods sold v) Administrative expenses
6) Carriage on goods purchased vi) None of the above.
7) Salary of clerical staff
8) Rent for office
49
9) Power and fuel
Understanding 10. Selling agents' commission
11. Advertising
12. Auditors' fees
13. Sales tax
14. Municipal rates on office premises
15. Profit on sale of machinery
16. Bonus paid to workers
17. Sales discount
18. Purchase returns and allowances
19. Dividends paid
20. Interest expense on loans.
5.13 SUMMARY
In this unit we have developed and examined the profit and loss account. This account
shows the net profit or earnings generated by the company. Thus, this measures the
management's ability to generate income from assets.
The profit and loss account summarises the revenues and expenses of an accounting
period. As a result of this summary it shows the net profit or net loss experienced by
the company during the period. The reader of this account is provided with the past
cost structure and profitability.
The net profit after payment of dividends shows the amount retained and hence links
the balance sheet with the profit and loss account.
5.14 KEY WORDS

Revenue: Assets received from the sale of goods or services to customers. Also
includes income generated from assets and investments usually classified as non-
operating revenue. Revenues increase owners' equity.
Expense: Any reduction in owners' equity (total assets minus total liabilities) not
resulting from distribution to owners. Represents expiration of costs, use or loss of an
asset without being replaced by another asset.
Realisation: Recognition of the revenue in accounting based oil the assumption that
increase in owners' equity arises at the point of delivery or provision of goods or
services.
Accrual: Income measured on the realisation of revenue independent of the timing of

cash receipt and payment.
Profit: Revenue minus expenses for a given accounting period. Negative profit
(income) is known as loss.
Profit and Loss Account: The final summary of all revenues, gains, expenses and
losses during an accounting period. Shows the net profit or loss for the period.
Depreciation: The amortisation representing allocation of cost expiration of tangible

fixed assets over their useful life.
Cost: The amount paid or to be paid for acquisition of goods or services.
50 Matching: Income measurement based on comparison of expenses and revenues of a

period.
5.15 SELF-ASSESSMENT QUESTIONS/EXERCISES Profit and Loss Account
1. Explain the following:
Realisation Concept
Accounting Period Concept
Matching Concept
2. When should revenue be recognised?
3. What are bad debts? In what way do we deal with the problem of possible
bad debts in accounting?
4. What is depreciation and what is the rationale behind making a provision for
depreciation in the process of matching income and expenses?
5. Differentiate between:
a) Straight Line method and Written Down Value method of providing

depreciation:
b) Operating Profit and Net Profit
c) FIFO and LIFO methods of Inventory valuation.
6. Following is the summarised Profit and Loss Account of Shyam Enterprise

for five consecutive periods. Complete the same by supplying missing
information.
7. Following information relates to Ramsons operations for a period ending

December 31, 2002, the first year of operations. From this information
complete the accompanying Profit and Loss Account and Balance Sheet.
51
Understanding Revenues and expenses of the period are as follows:
Rs.
Depreciation expense 5,000
Purchases (raw material) 50,000
Wages 25,000
Purchase discount 5,000
Sales 1,00,000
Rent 3,000
Insurance 2,000
Returns inwards and allowances 2,000

Sales discount 1,000
Interest expenses 2,000
Miscellaneous expenses 5,000

Interest on deposits received 2,000
Balance shown by asset and liability accounts on 31st December 2002 is as follows:
Cash 15,000
Deposits with bank 20,000
Inventory of raw material 10,000

Land 10,000
Buildings and equipments 90,000
Advance tax paid 5,000

Tax Payable ?
Accounts receivable 20,000
Accounts Payable 19,500
Capital 75,000
Long term loan 50,000
Retained earning ?
RAMSONS
For the Year ending 31st December 2002
Rs. Rs.
Inventory Consumed ________ Sales ________
Wages ________ Less: returns and ________
Gross Profit ________ Allowances ________
Depreciation expense ________ Gross Profit ________

Rent ________ Purchase discount ________
Sales discount ________
Insurance ________
Interest expenses ________
Miscellaneous expenses ________
Operating Profit ________
Operating Profit ________
Net Profit before tax ________ Interest on deposite ________
Income Tax @ 50% ________ Net Profit before tax ________
52 Profits retained ________
RAMSONS Construction and Analysis of
Balance Sheet
As on 31st December 2002
Rs. Rs.
Current Assets Capital Liabilities
Cash ________ Account payable ________
Deposite with bank Tax payable
Account receivable ________ Total current liabilities ________
Inventory ________
Advance tax paid ________ Long – Term Loan ________
Total Current assets ________ Capital ________
________ Retained earnings ________
Fixed Assets
Land ________
Building & equipment ________
Less: Accumulated ________
depreciation
8. The following are the balances taken on 31st December, 2002 from the
books of account of Western Plastics Limited:
53
Understanding In addition, the following information is available:
a) The authorised share capital is:
20,000 10% Preference shares of Rs. 10 each,
24,000 Ordinary shares or Rs. 10 each
b) All the issued ordinary shares are fully paid
c) Depreciation to be provided for 2002 as follows
Property 2% on cost
Plant, etc. 10% on cost
d) Provide for the preference dividend due.
e) A final dividend of 10% on the ordinary shares is proposed Ignore taxation.

With the help of the above information:
i) Prepare an income statement for the year ended 31 st December, 2002 and a
Balance Sheet as at that date.
ii) Comment on the salient features of the financial statements you have
prepared so far as they provide meaningful information for users' needs.
iii) Identifythe main information objectives of shareholders and assess the extent
to which these objectives are satisfied by the financial accounts you have
prepared
Activity 5.1
1) Revenue and expenses
2) Revenue
3) Expenses to revenues
4) Expired costs or expenses
5) Accrues
6) Decrease
7) Revenue, accounting.
Activity 5.2
(1) A 1-B2 (2) A2-B 5, B6 (3) A3-B 1 (4) A4-B3, B4
Activity 5.3
1 (iii) 2. (ii) 3, 4. (iii) 5.(iv) 6. (iii) 7. (v) 8.(v) 9.(iii) 10.(iv) 11. (iv) 12.(v) In. (vi) 14.
(v) 15. (ii) 16. (iii) 17.(iv) 18.(iii) 19. (vi) 20. (v).
54
Answers to Self-Assessment Questions/Exercises Construction and Analysis of
7 Solution:
RAMSONS
Profit And Loss Account
For the Year ended 31st December, 2002
Rs Rs Rs Rs
Purchases 50,000 Sales 1,00.000
Less Inventor} 10,000*
Inventory consumed 40.000

Less purchase 1.0011 39,000 Less: Returns and 2,000 96,500
Wages 25,000 Sales discount 1,500
Gross profit 32,500
96.500 96,500
Depreciation expense 5,000 Grass Profit 32.500

Rent 3,000
Sales Discount 2.000
Insurance 2,000
Interest expense 2,000
Miscellaneous 5,000
Operating Profit 18,500
32,500 32.500
Net Profit before tax 20,500 Operating Profit 18,500

Interest on deposit 2,000
20,500 20,500
Incnmc '(e, 5(1 % 10,250 Net Profit before fax 20,500
Profit Retained 10,250
20,500 20,500
• Inventory figure has been obtained from the balances shown under asset and
liability accounts.
55
Understanding
Current Assets Rs. Current Liabilities Rs
Cash 15,000 Accounts payable IC
Deposit with bank 20,000 Taxes payable It
Accounts receivable 20,000
Inventory 10,000 Total current liabilities 28
Advance tax paid 5,000 Long Term Loan 50 00
Total current assets 70,000 Capital 75. 00

Retained earnings 10, 50
Fixed Assets
Land 10,000
Buildings and equipment 90,00
Less: Accumulated
depreciation 5,000 85,000
1,65,000 1,16,50
8. Gross Profit Rs. 1,52,300 Balance Sheet Total Rs. 4,14,930.

Operating Profit Rs. 74,400
Net Profit Rs. 45,120

Fraser, L.M. and Ormiston. Ailen 04/10/2003, Understanding Financial Statements
Prentice Hall : New Delhi (Chapter 3)
Hortagren, C.T., Sundem G.L. and Jhon, A. Elliot, 02/10/2002, b7frocluclion to

Financial Accounting Prentice Hall : New Delhi (Chapters 2-4)
Khan M.Y. and Jain P.K., 2002, Cost Accounting Land Financial Management,
Tata McGraw Hill (Chapter 3)
Bhattacharya, S.K. and John Dearden, 1984. Accounting f or Management Text and
Cases (2nd Ed) Vani: New Delhi. (Chapters 4,8,9 & 10.)
Glautier M. W.E., Underdown B. and A.C. Clark, 1979. Basic Accounting

Practivce Arnold Hieneman: New Delhi. (Chapters 2-4)
Hingorni N.L. and A.R. Ramanathan, 1986. Management Accounting Sultan

Chand New Delhi. (Chapters 3-5)
Meigs W.B. and Robert E. Meigs, 1987. Accounting : The Basis For Business
Decisions (7th Ed.), McGraw-Hill : New York. (Chapters 3 and 4.)
56
UNIT 6 CONSTRUCTION AND ANALYSIS Fund Flow and Cash Flow
Statements
OF FUND FLOW AND CASH FLOW
STATEMENTS
Objectives
After you have studied this unit, you should be able to:
• understand the idea of funds flowing through a business in a dynamic situation
• appreciate the role of working capital in the operations of a business
• understand the sources and uses of working capital as well as cash during an
accounting period from the financial statements
• understand and interpret changes in working capital identifying the causes of

these changes
• use the funds flow statement and the cash flow statement as analytical tools.
Structure
6.1 Introduction
6.2 Working Capital and its Need
6.3 Determining Working Capital Requirements
6.4 Sources of Funds
6.5 Uses (Applications ) of Funds
6.6 Factors Affecting Fund Requirements
6.7 Analysing Changes in Working Capital
6.8 Fund Flow Statement
6.9 Importance of Cash and Cash Flow Statement
6.10 Sources and Uses of Cash
6.11 Preparation of Cash Flow Statement
6.12 Summary
6.13 Key Words
6.14 Self Assessment Questions
6.1 INTRODUCTION
Depending on the user's purpose, the term `funds' may be used differently. Literally,
it means a supply that can be drawn upon. In this sense it is used to mean cash, total
current assets or working capital. We use it here in the sense of working capital
meaning total current assets less current liabilities.
Funds flow is used to refer to changes in or movement of current assets and current
liabilities. This movement is of vital importance in understanding and managing the
operations of a business.
We have seen in the unit dealing with balance sheet that every material transaction
changes the position statement (or Balance Sheet). This in other words implies a 57
dynamic situation involving continuous movement of resources into the business,
Understanding within the business and out of the business. The complexity of these flows increases
Financial Statements with the increasing size and volume of business. Directly or indirectly, all these flow
take place in business through the medium of funds.
Funds in the form of cash and cash equivalents, in the right quantity are necessary for
the smooth functioning of any business. The continuous movement of cash within the
business and out of the business could be understood by studying the cash flow
statement.
6.2 WORKING CAPITAL AND ITS NEED
We have earlier defined working capital as total current assets less current liabilities.
This, in other words, means all the assets held by the business with the objective of
conversion into cash (including cash) during an operating cycle of the business. Of
these assets, a part is financed by short-term credits which are to be met during the
operating cycle representing current liabilities. Thus current assets less current
liabilities or working capital implies amount of resources invested in current assets
from sources of finance other than current liabilities. This net amount is also the
amount available for use in the business in the form of fund. Consider the following
example.
Ramsons is a retail outlet dealing in domestic appliances and entertainment electron-

ics equipment, owned by Ram. The investment in the showroom, display counters,'
cash register, furniture, fixtures and so on is Rs. 6,00,000. Ram decides to use straigh
line depreciation at the rate of 10 per cent per annum.
Ramson's estimated sales is Rs. 1,50,000 per month: 50,000 cash sales and
Rs. 1,00,000 on credit to be collected in four equal monthly instalments. All sales are
made at 25 per cent margin on selling price.
Supply and sales constraints would warrant carrying three months sales requirement
in the form of inventory. Similarly, month's cash expense requirements have to be
held in cash balance.
Initial inventory is to be bought for cash and replenishment purchases will receive a
month's credit from suppliers.
Average monthly cash requirements for meeting operating expenses other than
payment for purchases amount to Rs. 26,000. Ram needs to withdraw Rs. 4,000 per
month for his personal needs.
1. How much working capital will Ramsons require to start operations?
2. Will he need additional working capital during the first four months? Or will he
have surplus working capital during the first four months?
You can instinctively answer these questions by saying that Ramsons needs working
capital to pay for inventory, for expenses and for keeping a safe cash balance. You
can also say that Ramsons will receive funds from operations to meet some of these
requirements. To be more specific, how much money does he require? This could be
done by working out a schedule of cash receipts and cash payments on a monthly
basis. It is also possible for us to prepare proforma monthly profit and loss account
58 and balance sheet. You can also notice that we have chosen the first four months
consciously since it completes one operating cycle of the business.
RAMSONS: Schedule of Cash Payments Construction and Analysis of
Fund Flow and Cash Flow
Month Explanation Amount Rs. Total Rs. Statements
January Operating Expenses 26,000
Withdrawals 4,000 30,000
February January Purchases 1,12,500
Operating expenses 26,000
Withdrawals 4,000 1,42,500
March February Purchase 1,12,500
April March purchases 1,12,500
RAMSONS: Schedule of Cash Receipts
Month Explanation Amount Rs. Total Rs.
January Cash Sales 50,000
Credit Sales of the month-
first installment 25,000 75,000
February Cash sales 50,000
Credit Sales of the month- 25,000
first installment
January sales-second installment 25,000 1,00,000
March Cash sales 50,000
Credit Sales of the month-first instalment 25,000
January sales-third instalment
February sales-second instalment 25,000
25,000 1,25,000
April Cash sales 50,000
Credit Sales of the month-first instalment 25,000
January sales-fourth instalment
February sales-third instalment 25,000
March sales – second instalment
25,000
25,000 1,50,000
Opening balance sheet of Ramsons will be as follows:
RAMSONS: Balance Sheet as of January 1,2003
Assets Rs. Liabilities and Rs.
Capital
Fixed Assets 6,00,000 Capital 9,67,500
Inventory 3,37,500
Cash 30,000
9,67,500 9,67,500
We have assumed that the entire asset requirements are financed by owner's capital.
Working capital of Ramsons on January 1, 2003 is as follows:
Current Assets: Inventory 3,37,500
Cash 30,000
Total Current Assets 3,67,500

Less: Current Liabilities Nil
Working Capital 3,67,500
59
Understanding RAMSONS: Schedule of Cash Balances
January February March April
Opening Balance 30,000 75,000 32,500 15,000
Cash Receipts 75,000 1,00,000 1,25,000 1,50,000
Total Cash available 1,05,000 1,75,000 1,57,500 1,65,000
Less: Cash Payments 30,000 1,42,500 1,42,500 1,42,500
Cash Balance 75,000 32,500 15,000 22,500
RAMSONS: Profit and Loss Account for the Month ending

31st January 28th February 31st March 30th April
Sales 1,50,000 1,50,000 1,50,000 1,50,000
Less: Cost 1,12,500 1,12,500 1,12,500 1,12,500
of Sales
Other 26,000 26,000 26,000 26,000
Expenses
Depreciation 5,000 1,43,500 5,000 1,43,500 5,000 1,43,500 5,000 1,43,500
Net Profit: 6,500 6,500 6,500 6,500
RAMSONS: Balance Sheet as at the end of

Assets 31st January 28th February 31st March 30th April
2003 2003 2003 2003
Fixed Assets 6,00,000 6,00,000 6,00,000 6,00,000
Less: Depreciation 5,000 10,000 15,000 20,000
Net Fixed Assets 5,95,000 5,90,000 5,85,000 5,80,000
Inventory 3,37500 3,37,500 3,37,500 3,37,500

Receivables 75,000 1,25,000 1,50,00 1,50,000
Cash 75,000 32,500 15,000 22,500
Total Current 4,87,500 4,95,000 5,02,500 5,10,000

Assets
Total Assets 10,82,500 10,85,000 10,87,500 10,90,000
Liabilities and
Capital
Capital 9,67,500 9,67,500 9,75,000 9,77,500
Add: Retained 2,500 5,000 1,12,500 1,12,500
Earnings
Owner’s Equity 9,70,000 9,72,500 9,75,000 9,77,500
Accounts Payable 1,12,500 1,12,500 1,12,500 1,12,500
10,82,500 10,85,000 10,87,500 10,90,000

60
RAMSONS: Schedule of Working Capital Construction and Analysis of
31st January 28th February 31st March 30th April Statements
2003 2003 2003 2003
Current Assets 4,87,500 4,95,000 5,02,500 5,10,000
Less: Current 1,12,500 1,12,500 1,12,500 1,12,500
Liabilities
3,75,000 3,82,500 3,90,000 3,97,500
Funds From Operations
Net Profit 6,500 6,500 6,500 6,500

Add: 5,000 5,000 5,000 5,000
Depreciation
Total funds 11,500 11,500 11,500 11,500

generated from
operations
Initial Investment (Capital)
Now with the example of Ramsons at hand, it is not difficult for us to understand that
Ramsons have invested the `money to make money'. Where has Ramsons invested
the money? It is easy to answer this question because the balance sheet of the
business tells us what all things Ramsons has done with the money. Refer to the first
balance sheet and you will find Ramsons has fixed assets (show room and facilities),
inventory (goods or merchandise) which he has purchsed for resale and some cash for
meeting expenses and personal needs. This is how Ramsons have invested the capital
to start with. Let us first review these items and accounts receivable:
Cash
It is difficult to perceive cash kept in the vault as an investment. Rather, you would
be thinking that if we invest cash, then how can cash itself be an investment? But you
will realise that a certain minimum amount of cash is necessary for any business.
Take a simple case: if you are a retailer, will you send away a customer who does not
have exact change? However, you can entertain him only if you keel) change. That is
your investment in cash; Similarly, you will have to pay your employees and
suppliers at a specific time. I n order to do that you need cash. Thus investment in
cash is that amount which is required to be kept on hand to meet day-to-day
requirements of cash. This amount is determined after taking into account the
regularity and amounts of inflows of cash, the amount and frequency of outflows, as
also the uncertaintues related to these. Obviously, as your business grows the need
for cash will also grow.
Receivables
In most situations it will be necessary to grant credit to customers. This may be
necessary either because of competition or because of the custom of trade. However,
when we grant credit to customers it implies that we have to finance the cost of
materials for the duration of such credit. In other words, you are financing your
customers' business to the extent of the credit granted. Whenever the business is
expanding, the volume of receivables will also expand. Please note that the need for
financing receivable is not to the full extent of the accounts receivables (sales). You 61
are actually financing only to the extent of cost of goods sold out of the receivables
(sales) in question.
Understanding Inventory, Supplies and Prepaid Expenses
You can well appreciate the need for carrying inventory. In order to carry on
operations unhindered we need to have sufficient amount of merchandise on hand
The quantum we have to keep in store will be determined by the availability and
regularity of supply, lead time for delivery and so on. All the same we should carry
some inventory in any case. Similar is the case with non-merchandise inventory such
as office and factory supplies. We have to carry a minimum stock of these to ensure
smooth operations. We also know that there are several expenses which are to be' Lid
before we actually use the services, such as rent, insurance and so on. In other words
we invest your money in these items of assets in order to ensure smooth operations
6.3 DETERMINING WORKING CAPITAL

REQUIREMENTS
Understanding the existing capital needs and how these are financed will help us in
understanding the process of financing of business and the flow of funds within the
business. The first question we have to answer is how much working capital is
needed to start the operation. We could determine the amount of capital required and
compare the same with existing capital to see whether it is sufficient and whether
there is any excess available for future use. Please note that we are not applying
precise techniques of cash management or liquidity planning since that is beyond
the scope of this unit.
We know from Ramsons that operating requirements of the business requires one
month's cash expenses other than payment for creditors to be kept in cash. That is a
minimum of Rs. 30,000 cash on hand is required by Ramsons (including Rs. 4,000
his withdrawal).
Ramsons have to keep three months sales in inventory. This means that during the
first month he starts with three months' sales in the form of inventory. We know that
the sales per month is Rs. 1,50,000 sold at a mark up of 25 per cent on sales.
Therefore, inventory required to be maintained is three times of 75 per cent of sales.
That is, 1,50,000 x .75 x 3 = Rs. 3,37,500
Similarly, we know from the information available that every month one-third of the
sales are made on cash and two-thirds on credit to be collected in four instalments.
This means, cash collection during the month will be cash sales plus one-fourth of
credit sales of the period and one-fourth of three previous months' credit sales.
Similarly, in the first month we will be really making one half of the sales for cash
and the other half of on credit. In our example.
Total Sales Rs. 1,50,000
Cash Sales Rs. 50,000
Credit Sales Rs. 1,00,000
First Instalment in Cash Rs.25,000
Total Cash Collection Rs. 75,000
Credit period of the sales will be as follows:

First month sales on credit less first instalment Rs. 75,000.
This means.
Rs. 75,000 credit for one month
Rs. 50,000 credit for one month
62
Rs. 25 000 credit for one month
This is equivalent to Rs. 75,000 sales made for two months' credit. In terms of Construction and Analysis of
working capital requirement, we require one month's financing of the cost of sales Fund Flow and Cash Flow
Statements
with respect to Rs. 1,50,000 sales. That is Rs. 1,12,500 is needed for financing this
amount.
Thus, we could summarise Ramson's need for funds for financing current asset to
start operations, as follows:
Rs
3 months' inventory 3,37,500
One month's expenses as cash 30,000

3,67,500
During the first month Ramsons will sell one-third of the inventory generating Rs.
75,000 in cash and the other half of Rs. 75,000 to be collected in three instalments.
Thus we need some additional funds to finance our granting credit to the customers.
Similarly, we would need to replenish the inventory and make payments for
expenses. We shall examine these with the help of the balance sheet and profit and
loss account of Ramsons for the first four months.
6.4 SOURCES OF FUNDS

We have seen that working capital is required to finance that portion of current assets
which is not financed by current liabilities. We also saw that the investments
represented by current assets are converted into cash during the operating cycle. This
implies that our need for financing is for one such cycle. Under normal circumstances
every unit of investment in working capital is converted into cash at the end of the
cycle at an added value, to the extent of profits.
When we are looking at the possible sources of working capital the most important
source is this ìnternal generation'. The very idea of internal sources implies that there
is something èxternal'.
Activity 6.1
1. Please put down what these ìnternal' and èxternal' sources are:
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
Internal Sources
When we are looking for sources funds it is but natural to start searching at home.
What do we have? While examining the need for working capital we could also make
an assessment as to whether the existing working capital is sufficient or not. Thus,
the first internal source is any excess working capital that we might be having.
If we have any non-current assets which do not have any use they could be disposed
off, thereby generating additional working capital. Please note that this is not a
regular and continuing source of funds.
We have seen earlier that every profitable sale brings with it funds in excess of what
was expended on the goods sold. In other words, profits generated by the business 63
contribute towards additional working capital. But you may also notice that whenever
Understanding we measure profits, we match the revenue against all expenses relating to the
Financial Statements revenue, whether it involves use of funds in the current period or not. Thus the profits
measured do not reflect the actual amount of funds available in order to assess t e
actual funds generated from current operations we should add back to the profits: all
those items of expenses not involving use of funds during the current period. One
major example of such an item is depreciation.
Thus we could summarise the important possible sources of funds as:
1. Funds generated from operations. That is, profit plus depreciation and o ter
amortisations.
2. Sale of non-current assets
3. Any surplus working capital. Did you guess correctly?
Funds from Operations
Refer to Illustration-6.1. The profit and loss account of TIL shows that operations
have provided gross addition of Rs. 360 million to funds during the period. These
funds represent the sale proceeds of goods and services by the company.
We also know what part of these funds is utilised for meeting the cost of input such
as material, personnel and other operating costs. Apart from these we have also to me
t the interest commitments and costs expiration of the machinery and equipment.
However, expiration of costs of the machinery and equipment (Depreciation) is one
item which does not require use of funds in the current period.
TOOLS INDIA LTD.
Summarised Profit and Loss Account
For the year ended December 31, 2002
(Rs. Million)
Rs.
Sales 350
Other Income* 10
360
Gross Profit 210

Profit expenses:
Personal 60.00
Depreciation and Amortisation 11.90
Other Expenses 13.10 85
Operating Profits 125

Less: Interest Expense 15
Net Profit before income taxes 110

Less Provisions for taxes 55
Net Profit 55
Less: Dividends 20
Net Profit Retained Rs. 35

64
* Other income includes Rs. 1 million profit on sale of furniture.
Thus the funds 'provided from the operations are in fact the revenues earned from Construction and Analysis of
operations (as also non-operating incomes) less all immediate costs of goods sold Fund Flow and Cash Flow
Statements
requiring use of funds. In other words, it is net income or profit after taxes plus all the
non-cash expenses, such as depreciation and amortisation.
The funds flow statement would show funds from operations of TIL as follows:
(Rs. in Million)
Operations 55
Net Income
Add: Depreciation and Amortisation 11.90
66.90
Less: Profit on sale of furniture 1.00
Total funds provided form operations 65.90
External Sources
External sources of funds are resources raised from outside the organisation to
augment funds availability for any of the uses to be discussed later. Normally, there
are only two ways of doing this:
1. By contributing or raising additional capital, and
2. By increased long-term borrowing.
Please note that short-term creditors are not included as a source of funds since we
have already defined funds as "current assets less current liabilities". Thus, working
capital represents long-term investment in current assets and hence short-term
borrowing will not increase working capital.
The sources of funds, as usually presented in the fund flow statement, are enumerated
below:
Sources of Funds
Operations:
Net Profit after taxes
Add: Depreciation
Other amortisations
Funds provided by operations
New issue of share capital
New issue of debentures/bonds
Additional long-term borrowing
Sale proceeds of fixed assets
Sale of long-term investment
6.5 USES (APPLICATIONS) OF FUNDS

Need for additional Funds
A business would require additional capital for two purposes:

65
1. Financing additional fixed assets, and
2. Financing additional working capital.
Understanding It should not be difficult to appreciate the necessity for having adequate fixed
Financial Statements facilities with which to conduct the business. The amount we have invested in the
shop, furniture and fixtures (refer to the example of Ramsons) has created the
facilities for carrying on the business. It also limits the capacity. We cannot expand
our business beyond a certain capacity which is limited by the facilities created by
fixed asses . In case of a manufacturing firm, it will be plant capacity; in case of a
transport undertaking it may be tonnage of trucks, ships or wagons; in case of show
business is and airlines it may be seating capacity, and so on. Any increase in such
capacity would require additional investment.
Thus, investment in fixed assets is required to expand capacity or to improve the

current operation. Usually, addition to investments are judged on the basis of its
ability to reduce the present costs or to increase the present output.
Additional working capital is required to finance Increased holding of inventory,

increased credit to customers and increased cash holding requirements. Obviously
current creditors would finance part of this requirements. Obviously, current creditors
would finance part of this requirement for working capital.
If Ramsons invests in another shop or in expansion of the existing shop, they will
require additional funds for investment in fixed assets as also for increased level o
current assets. You will notice that whenever additional investment is to be made i
non-current assets, we have to use the funds (working capital) available with us ur sss
separate arrangement is made for their financing. Likewise, when non-current asse
are sold they provide funds or result in sources of funds.
We could summarise the usual applications of funds as follows:
1. Acquisition of new non-current assets (fixed assets)
2. Replacement of non-current debt (loans)
3. Payment of dividends
4. Increase in the balance of working capital (current assets-current liabilities)
If the trading or business operations are unsuccessful, they may use funds rather that
provide funds. The uses of funds, as they are usually presented in the fund flow
statement, are enumerated below:
USES OF FUNDS
Dividends …………….
Non-operating losses not passed through P & L A/c …………….
Redemption of redeemable preference share capital …………….
Repayment of debentures/bonds …………….
Repayment of long-term loans …………….
Purchase of fixed assets …………….
Purchase of long-term –investment …………….
Increase in working capital …………….
6.6 FACTORS AFFECTING FUND REQUIREMENTS

From the discussions we had earlier, it is not difficult to come to the conclusion that
several factors affect the fund or net working capital requirements.
Fund requirements vary with the nature and type of business. A firm that provides
agency services may require less working capital compared to a firm which carries on
business of merchandising. The merchandising firm of course would. require to carry
some inventory, give credit and so on. However, a firm which manufactures products
66 may require more working capital than a retailer. The manufacturing company will
have to carry inventory of raw material, work-in-process and finished goods.
Working capital requirements are directly influenced by sales volume. With every Construction and Analysis of
growth in sales volume we need to carry larger inventory, increased number of Fund Flow and Cash Flow
Statements
customers or receivables as also the operating expenses. It is possible that all the
expenses may not move up proportionately. However, we will have to finance some
of these increases. It is also possible that all the expense may not move up
proportionately. However, we will have to finance some of these increases. It is also
possible that the increase in sales volume could be brought about by granting
extended credits. In other words, by investing more funds we increase the volume of
sales.
Fund requirements for the business may be seasonal. For example in industries using
agricultural raw materials, it may be more advantageous to procure raw materials
during harvest season. In case of consumer retailing it may be necessary to hold large
inventories during festive season. Most of the fund requirements are restricted to a
limited period, and if we provide it on a permanent basis we may have idle funds
during most part of the year.
Yet another important aspect which may condition fund requirement is the velocity
of circulation of current assets. In other words, the length of the operating cycle
will influence the need for funds. Shorter the duration of operating cycle faster is the
conversion of money invested in current assets into cash and hence lesser the need
for net working capital.
Net working capital requirement is also influenced by the terms available from the
suppliers. The credit terms extended by the suppliers will determine the amount of
additional funds required.
A firm which carries a month's inventory and grants one month's credit to customers,
has to fund the inventory cost of two months. If it could avail two months' credit
from the suppliers, the need for holding inventory and funding receivables is nil.
In another situation, suppose the firm carries a balance of Rs.10,000 of accounts

payable, payable in 30 days and an average accounts receivable balance of Rs.
15,000, receivable in 45 days, the firm will have to keep a net working capital for the
difference of receipts from customers and payments to creditors as follows:
Rs.
Fund required to meet payables due within 30 days 10,000
Less: Funds received from customers- 10,000
Received in 45 days, that is, Rs.15,000 x 30/45
Fund required in the form of additional net working capital Nil
Assuming the time taken for collection of receivable is 90 days the situation will be:
Rs.
Fund required to meet payables due within 30 days. 10,000
Less: Funds received form customers- Rs.15,000 x 30/90 5,000
Fund required in the form of additional net working capital
5,000
We could summarise the discussion in respect of the need for working capital by
saying that the ability of the firm to circulate the “cash Æ raw material inventory
work-in process Æ finished goods inventory Æ receivables Æ cash” is the most vital
and important factor in determining the amount of working capital. However, the
exact amount needed to be invested in all these will be determined by the period and
quantum of holding of each of these elements. This in turn is also influenced by the
factors we have discussed in this sections. 67
Understanding
6.7 ANALYSING CHANGES IN WORKING CAPITAL
In understanding the financial statements of a company, one of the first steps
involved is the study of the changes in current financial position of the company and
the reasons for the changes. We make an attempt at studying these changes and their
causes by using the data contained in the summarised comparative balance sheet.
(Illustration 6.2) and profit and loss account of Tools India Limited.
Illustration 6.2
Tools India Limited
Balance Sheet as on December 31, 2003
(Rs. in Million)
Assets December 31, 2003 December 31, 2003
Rs. Rs. Rs.
Rs.
Current Assets
Cash 19.50 10.87
Accounts receivable (Sundry 32.25 20.28
debtors)
Loans and advances 42.58 33.82
Other Current Assets 17.20 15.93
Inventory 12.92 99.10
Total Current Assets 232.00 180.00
Fixed Assets
Plant and equipment at cost 152.00 133.00
Less: Depreciation 71.00 81.00 60.00 73.00
Furniture & fixture at cost 14.50 8.60

Less: Depreciation 2.00 12.50 2.30 6.30
Investments 2.00
Intangible Assets
Technical Assistance fees 3.00 1.00
Less: Amortisation 0.50 2.50 0.30 0.70
Total 330.00 260
Liabilities and Capital

Current Liabilities
Acceptance 4.74 3.02
Sundry Creditors (Accounts 27.16 18.75
Payable)
Advances against sales 26.60 20.28
Other liabilities 8.86 7.95
Interest accrued but not due on 2.64 2.00
loans
70.00 52.00
Provisions
For taxation 25.55 20.45
Proposed dividend 2.25 2.25
For bonus 3.40 2.35
Other Provision 3.80 2.95
35.00 28.00
68 Total current liabilities & 105.00 80.00

Provisions
Long Term Liabilities
Statements
Bank loans 40.00 32.14
10.5% debentures 25.50 25.50
Loans from Financial Institutions 24.50 22.36
90.00 80.00
Total Liabilities 195.00 160.00
Capital
Authorised : 5,00,000 50.00 50.00
shares of Rs. 100 each
Issued Subscribed and

Paid-up 3,73,100 Shares of
37.31 37.31
Rs. 100 each
97.69 62.69
330.00 260.00
Total
As we have studied at the beginning of this unit, the net change in working capital
can be computed easily by subtracting the net working capital at the end of the year
from the net working capital at the beginning of the year.
TOOLS INDIA LTD
Change in Working Capital
(Rs. in Million)
December 31, 2002 December 31, 2003
Current assets 180.00 232.00

Less: Current Liabilities 80.00 105.00
Working Capital 100.00 127.00
Working capital on December 31, 2003 127.00

Working Capital on December 31, 2002 100.00
Increase in Working Capital 27.00
The Rs. 27 million increase in working capital of TIL shows the composite changes
in the operating assets. This does not tell us much in terms of operations of the
business. This change could be the net result of changes in all the accounts covered
by current items. May be there has been qualitative changes resulting from the
depletion of liquid items of current assets and increase in non-liquid items such as
inventory. In order to answer these questions we try to analyse the changes in each of
the working capital accounts.
Statement of changes in working capital
A statement of changes in working capital helps us in locating where these changes

took place. In the first instance we try to show the increase (decrease) in individual
items and then try to classify them in terms of increase and decrease in working
capital. Since working capital is measured by subtracting current liabilities from
current assets, any increase in current assets and any decrease in current liabilities
shows an increase in working capital. Similarly, a decrease in current assets and an 69
increase in current liabilities represent a decrease in working capital.
Understanding The statement of changes in working capital (Table 6.1) shows that the increases in
Financial Statements current assets amounted to Rs. 52 million, a major part of the increase arising out of
cash, receivable and inventory. Decrease in working capital came about mostly from
the increased accounts payable, advances from customers and taxes payable. Total
amount of decrease in working capital resulting from increase in current liabilities
amounted to Rs. 25 million, thus, showing a net increase in working capital of Rs. 27
million.
Table 6.1
TOLLS INDIA LTD.
Statement of changes in Working Capital for the year ending December 31, 2000
(Rs. In Million)
Dec. 31 Dec. 31 Increase Working Capital
2003 2002 (Decrease) Increase Decrease
Current Assets
Cash 19.05 10.87 8.18 8.18
Accounts receivable 32.25 20.28 11.97 11.97
Loans and advances 42.58 33.82 8.76 8.76
Other current assets 17.20 15.93 1.27 1.27
Inventory 120.92 99.10 21.82 21.82
Total 232.00 180.00 52.00
Current Liabilities &

Provisions
Acceptances 4.74 3.02 1.72 1.72
Accounts payable 27.16 18.75 8.41 8.41
Advances against sales 26.60 20.28 6.32 6.32
Other liabilities 8.86 7.95 0.91 0.91
Interest accrued 2.64 2.00 0.64 0.64
Taxes payable 25.55 20.45 5.10 5.10
Proposed dividend 2.25 2.25 - -
Bonus payable 3.40 2.35 1.05 1.05
Other provisions 3.80 2.95 0.85 0.85
Total 105.00 80.00 25.00 52.00 25.00
Working Capital 127.00 100.00 27.00
Increasing Working Capital 27.00
6.8 FUND FLOW STATEMENT

An analysis of the fluctuations of current assets and current liabilities i.e. working
capital tells us how the working capital has increased or decreased. We want to know
where the increased working capital is applied if it has increased, and from where
funds have been released if it has decreased. The profit and loss account gives some
indication of the results of operations and its impact on the funds position. We try to
integrate the impact of operations reported in the profit and loss account and balance
sheet by preparing a statement of changes in financial position. It describes the
sources from which fluids were received and the uses to which funds were put. This
statement of changes in financial position is usually referred to as fund flow state-
ment or statement of sources and application funds.
70 As the title indicates fund flow statement traces the flow of funds through the
organisation. In other words, it shows the sources from where the funds were raised,
and the uses to which they were put.
The statement of funds flow is usually bifurcated into two logical divisions: sources Construction and Analysis of
of funds or inflows during the periods and uses of funds or applications of funds Fund Flow and Cash Flow
Statements
during the period. The division showing sources of funds summarises all those
transactions which had the net effect of increasing the working Capital. Uses of funds
on the other hand deal with all those transactions which had the effect of decreasing
the working capital. We shall illustrate the primary structure of flows as follows
(Figure 6.1):
The flow of funds statement gives a summary of the impacts of managerial

decisions. As such it reflects the policies of financing, investment, acquisition and
retirement of fixed assets, distribution of profits, and the success of operations.
Let us further extend illustration 6.2 in order to prepare a Fund Flow Statement. From
a comparative balance sheet and profit and loss account we could obtain most of the
information we require for the preparation of a fund flow statement. We have studied
that changes in net-working capital amount are caused by the changes in non-
working capital items. This could be easily seen from the summarised balance sheet
of TIL (Table 6.2).
We have seen that the net working capital amount increased by Rs. 27 million during
2003, January 1 to December 31. This is other words implies that the working capital
from non-current sources should exceed non-current uses by Rs. 27 million.
The summarised balance sheet shows the net change in each account. That is, it does
not show the increases and decreases separately. Furniture and fixtures value, for
example, has increased by a net amount of Rs. 5.90 million. This increase shows an
application of funds. In reality, this account was both a source and an application of
funds. We purchased new furniture and fixtures worth Rs. 7.90 million (a use of
funds) and sold existing furniture and fixtures which had an original cost of Rs. 2
million and on which depreciation had accumulated to the tune of Rs. 1 million
(a source of funds). Since the purchase transaction was bigger in amount than the sale
transaction, the net result was in the “use of funds”. 71
Understanding Table 6.2
TOOLS INDIA LTD.
Summarised Balance Sheet
(Rs. in Millions)
December December Changes in
31, 2003 31, 2002 Working Capital
Source
Use
Working Capital 127.00 100.00 - 27.00
Fixed Assets
Plant and equipment at cost 152.00 133.00 19.00
Furniture and fixtures at cost 14.50 8.60 5.90
Investments 2.00 - 2.00
Intangible Assets
Technical assistance fees at 3.00 1.00 2.00
cost
298.50 242.60
Long-term Liabilities
Bank loans 40.00 32.14 7.86
10.5% debentures 25.50 25.50
Loans from Financial 24.50 22.36 2.14
Institutions
Allowance and
Amortisations
Accumulated depreciation 71.00 60.00 11.00
Plant and equipment 2.00 2.30 0.30
Furniture and fixtures
Amortisation of technical
assistance fees 0.50 0.30 0.20
Capital
Share capital 37.31 37.31
Reserves & Surplus 97.69 62.69 35.00
298.50 242.60 56.20 56.20
Notes: 1) Furniture and fixtures costing Rs. 2 million with an accumulated

depreciation of Rs. 1 million is sold for cash at Rs. 2 million.
2) Dividend paid during the year amounted to Rs. 2.25 million.
If we are to construct a statement showing sources and uses of funds during the year,
we need additional information. Some of this additional information is available from
the profit and loss account and the appropriation of net income. Some other
information like sales proceeds of assets will have to be obtained from other records
of the company.
72
Funds Flow statement Construction and Analysis of
(Rs. in Million) Statements
Sources of Funds
Funds from operations: 37.25
Net income* 1.00
Less profit on sale of furniture 36.25
Add: Depreciation, amortization, Provisions: 11.00

Plant 0.70
Furniture 0.20 48.15
Technical assistance fee
Other Sources of Fund

Sale of assets 2.00
Bank loan 7.86
Institutional loan 2.14 12.00
60.15
Uses of Funds
Payment of dividends 2.25

Purchase of Plant 19.00
Purchase of furniture 7.90
Investments 2.00
Technical assistance fees 2.00
Increase of working capital 27.00 60.15
* Net income has been obtained by deducting the previous year's balance of
Reserves and Surplus from the current year's balance i.e. 97.69 minus 62.69=35
million. To this, the proposed dividend for the current year of Rs. 2.25 million has
been added (as it must have been taken into account while determining the net
income to be transferred to Reserves and Surplus.
With the necessary background on Profit and Loss Account and Fund Flow
Statement having been prepared, you can now watch the Video Programme
"Understanding Financial Statement-Part II at your study centre.
Activity 6.2
1. Please list the four main sources of funds in your organisation.
…………………………………………….……………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
2. List the four main uses of funds in your organisation.
…………………………………………….……………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
……………………………………………………………………………………….…
6.9 IMPORTANCE OF CASH AND CASH FLOW
STATEMENT
Cash is another form of fund although in a narrow sense, it refers to a supply that can
be drawn upon according to the need. Here the term cash includes both cash and cash
equivalents. Cash equivalents are highly liquid short term investments which could
be easily converted into cash without much delay.
It may however be appreciated that the obligations and liabilities of a business arising
on a day to day basis must be met through "Cash" or "Cheque". We must also be able
to distinguish between "Profit" and "Cash". One cannot pay the creditors, electricity
bills, tax or even dividend by "Net Profit". For such and many other purposes, a
business needs either physical cash or balance or credit limits with banks. Not to be
73
Understanding able to meet the business comitments through cash as and when these arise can spell
Financial Statements disaster for a business even if it has a strong working capital and has earned
handsome profit.
So far we had seen that the balance sheet and profit and loss account provide
information about the financial position and the results of operations in a financial
period. The funds flow statement explained earlier traces the flow of funds through
the organisation. But neither of these financial statements can provide information
about the cash flows relating to operating, financing and investing activities.
To ensure that the right quantity of cash is available in accordance with the needs of a
business it is necessary to make a "cash planning" by determining the amount of cash
entering the business (cash inflow) and the cash leaving the business (cash outflow).
The statement which explains the changes that take place in cash position between
two periods is called the cash flow statement.
Cash flow statement is an important tool in the hands of the management for short
term planning and coordinating of various operations and projecting the cash flows
for the future. It presents a complete view about the movement of cash and
identifying the sources from which cash can be acquired when needed. The
comparison of the actual cash flow statement with the projected cash flow statement
helps in understanding the trends of movement of cash and also the reasons for the
success or failure of cash planning.
Cash flow and fund flow statements are similar to each other in many respects. The
main difference however, lies in the fact that the terms "fund" and "cash" import
different meaning. The term "fund" in fund flow statement has a wide meaning. A
fund flow statement examines the impact of changes in fund's position during the
period under review on the working capital of the concern (working capital refers to
current assets - current liabilities). Cash in the cash flow statement refers only to cash
and or balance with bank, i.e., a small part of the total fund, although very important.
The cash flow statement starts with the opening cash balance, shows the sources from
where additional cash was received and also the uses to which cash was put and ends
up showing the closing balance as at the end of the year or period under review.
Whereas there are no opening and closing balances in Funds Flow statement. Increase
in current assets or decrease in current liabilities increases the working capital,
whereas the decrease in current assets or increase in current liabilities increases the
cash flow.
6.10 SOURCES AND USES OF CASH
There are various activities undertaken by a business which prove to be either source
or use of cash. These can be classified under three broad categories, i.e., Operating
activities, Investing activities and Financing activities. A brief discussion of each
of these categories is given below:
Operating activities include cash inflows associated with sales, interest and
dividends received and the cash outflows associated with operating expenses
including payments to suppliers of goods or services, payments towards wages,
interest and taxes, etc. Increase or decrease in current assets, e.g., receivables,
inventory as well as increase or decrease in current liabilities, e.g., accounts payable,
wages payable, interest payable, taxes payable also reflect operating activities.
Investing activities refer to long life assets like land and building, plant and
74 machinery, investments and the like. Acquisitions of these assets imply cash outflow
whereas their disposal means inflow of cash.
Financing activities encompass changes in equity and preference capital, debentures, Construction and Analysis of
long term loans and similar items. Issuance of equity, preference and, debenture Fund Flow and Cash Flow
Statements
capital as well as raising of long term loans imply cash inflow. Retirement of capital,
dividend payments to shareholders, redemption of debentures, amortisation of long
term loans, on the other hand are associated with cash outflow.
The Cash Cycle: In order to deal with the problem of cash management we must
have an idea about the flow of cash through a firm's accounts. The entire process of
this cash flow is known as Cash Cycle. This has been illustrated in Figures 6.2 and
6.3. Cash is used to purchase materials from which goods are produced. Production
of these goods involves use of funds for paying wages and meeting other expenses.
Figure 6.3: Details of the Cash Cycle
75
Understanding Goods produced are sold either on cash or credit. In the latter case the pending bills
Financial Statements are received at a later date. The firm thus receives cash immediately or later for the
goods sold by it. The cycle continues repeating itself.
The diagram in Figure 6.2 only gives a general idea about the channels of flow of
cash in a business. The magnitude of the flow in terms of time is depicted in the
diagram given in Figure 6.3. The following information is reflected by Figure 6.3.
(a) Raw material for production is received 10 days after placement of order.
(b) The material is converted into goods for sale in 37 days (15+2+20) from
point of B to E.
(c) The payment for material purchased can be deferred to 17 days (15+2) after
it is received i.e. (the distance of time between points B to D), assuming that
it takes 2 days for collection of payment of the cheque.
(d) The amount of the bill for goods sold is received 32 days (30+2) after the
sale of goods as is depicted by duration of time between point E to G.
(e) The recovery of cash spent till point D is made after 56 days (20+30+2+2+2)
as shown between points D to J.
Managing these inflows (collections) and outflows (disbursements) are discussed in
detail in unit 16 in Block No.5.
Ativity 6.3
Meet a responsible executive of Accounting and Finance Department of a
manufacturing organisation regarding the following:
a) What is the length of its Cash Cycle?
Cash Cycle is approximately of …………………………..days.
b) Draw the sequence of Cash Cycle showing its successive events with the
respective number of days.
…………………………………………………………………………………………
…………………………………………………………………………………………
………………………………………………………………………………………….
c) Inquire whether or not the organisation is satisfied with its length of cash
cycle. What steps it proposes to take for reducing the Cash Cycle?
…………………………………………………………………………………………
…………………………………………………………………………………………
………………………………………………………………………………………….
6.11 PREPARATION OF CASH FLOW STATEMENT

To start with, we need two successive balance sheets and the operating statement or
profit and loss account linking the two balance sheets.
There are two ways in which this statement can be drawn up. One approach is to start
with the operating cash balance, add/deduct the profit/loss from operation to it and then
proceed to give effect to the change of each item of current assets and liabilities
together with the additions to and reductions in other assets and shareholders funds and
long term liabilities and finally arrive at the closing cash balance. This is known as the
"Profit basis" statement. For the sake of better understanding, the changes in items of
current assets, current liabilities, shareholders' fund, long life assets and long term
liabilities can be organised under the three broad categories of operating, investing and
76 financing activities (as discussed above), changes measured under each category, the
opening cash balance adjusted to these changes and the closing cash balance arrived at.
The second way is to deal only with cash receipts and disbursements. This does not Construction and Analysis of
consider non cash items like depreciation, preliminary expenses written off, etc. The Fund Flow and Cash Flow
Statements
latter type of cash flow statement is known as "Cash basis" statement.
Preparation of a cash flow statement on cash basis is a straight forward exercise and
left to the students. Here, we would take up the cash flow statement on "profit basis"
for further examination. A framework of the steps to be followed for this purpose is
appended below:
Steps involved in preparation of a "Profit basis" cash flow statement:
1. From the first of the two balance sheets, take the closing cash balance, which
will be the opening cash balance for the purpose of our cash flow statement.
2. Take the net profit figure. If it is not directly given and you are provided
with only Profit and Loss account balances in both the Balance Sheets,
ascertain it (net profit) by preparing an "Adjusted Profit and Loss account".
For this purpose, all items of profit appropriations as well as non-cash
expenses and income are to be added to and subtracted from the balance of
P&L account, as the case may be. This gives the figure of "Profit from
operation."
3. Adjust increase or decrease in each item of current assets and current
liabilities to the "Profit from operation" figure to arrive at the "Cash from
operation".
4. Revert back to the "Opening Cash Balance". Add the "Cash from operation"
to it. Also add, cash flow from other sources like non-current assets & non-
current liabilities, e.g., equity and debenture issue, raising term loan, sale of
fixed assets. Deduct, cash outflow to various uses, again involving non-
current or fixed assets and non-current liabilities, e.g., redemption of
preference shares/debentures, retirement of term loan, purchase of fixed
assets, etc.
5. The balance arrived at (4) above should tally with the closing balance of
cash in the second balance sheet.
Increases and decreases in various items of assets and liabilities as mentioned under
items 3 & 4 above can be optionally organised under operational, investment and
financing activities for clarity sake.
We use the above approach and procedure in preparing a "profit-basis" cash flow
statement in Illustration 6.3.
Illustration 6.3
M/s Navyug Udyog
Balance Sheets as at 31st March, 2002 31st March, 2003

Rs. Rs.
Assets:
Freehold Property 1,50,000 1,50,000
Plant and Machineries 1,10,000 1,70,000
Less: Depreciation
Goodwill 15,000 5,000
Investment 75,000 1,30,000
Debtors 1,08,000 1,32,000
Stock 70,000 1,02,000
Bills Receivable 42,000 53,000
Cash in hand and at bank 20,000 50,000
Preliminary Expenses 20,000 15,000
77
6,10,000 8,07,000
Understanding Balance Sheets as at 31st March, 2002 31st March, 2003
Rs. Rs.
Liabilities:
Share Capital 4,00,000 5,00,000

(40,000 Equity Shares @ Rs. 10/- per 60,000
share)
General Reserve 50,000 65,000
Dividend Equalisation Reserve 25,000 15,000
Profit and Loss a/c 40,000 55,000
Sundry Creditors 60,000 67,000
Prov. for Taxation 20,000 35,000
Bills Payable 15,000 10,000

6,10,000 8,07,000
Aditional Information:
1. Shares were issued at a premium of Rs. 1.50' per share.
2. During the year Taxation liability in respect of 2002 was Rs, 20,000 and
paid.
3. During the year, Rs. 11,000 was provided for depreciation on Plant and
Machinery.
4. An item of the plant the written down value Rs. 20,000 was sold at Rs.
25,000.
5. During the year, a dividend @ 7.5% was paid.
6. Part of the investment costing Rs. 30,000 was sold at Rs. 35,000 and the
profit was taken in Profit and Loss account.
Based on the above information, we first set ourselves to ascertain the cash inflow
and outflow in respect of Investment, Plant and Machineries and Tax, which cannot
be found out by a mere inspection of their balances in two balance sheets. The task is
accomplished by preparing the respective accounts and examining the effects of the
additional information on each of these. This is followed by preparation of an
"
Adjusted Profit and Loss a/c" to find out the actual net profit earned during the
period, in the light of the additional information now available. In the final stage, the
"Cash flow statement" is prepared (Table 6.3).
Investment Account
To Opening balance 75,000 By Sale 35,000

To P & L a/c (profit on sale) 5,000 By Closing balance 1,30,000
To Bank (Purchases) 85,000
1,65, 000 1,65, 000
Plant & Machinery Account
To Opening balance 1,10,000 By Sale 25,000

To P & L a/c (profit on sale) 5,000 By P & L a/c- 11,000
depreciation
To Bank 91,000 By Closing balance 1,70,000
2,06,000 2,06,000
78
Provision for taxation Construction and Analysis of
To Bank 20,000 By Opening Balance 20,000 Fund Flow and Cash Flow
By Closing balance 35,000 By P & L a/c 35,000 Statements
55,000 55,000
Adjusted Profit and Loss Account

To General Reserve 15,000 By Opening balance 40,000
To Dividend 30,000 By Dividend Equalisn. Reserve 10,000
To Provision for tax 35,000 By Plant and Machineries profit on sale 5,000
To Depreciation 11,000 By Investment-profit on sale. 5,000
By profit for the year
(balancing figure) 1,01,000
To Goodwill 10,000
To Preliminary expenses 5,000
To Closing balance 55,000
1,61,000 1,61,000
Table 6.3
Statement of Cash flow
for the period 1.4 2002 to 31.3.2003
Rs.
Opening Cash balance as on 1.4.2002 20,000
Add/(deduct): Cash flow from
Operating Activities
Net profit (Ref: P&L Adjustment a/c) 1,01,000
Add:
Decrease in current assets Nil
Increase in current liabilities:
Sundry Creditors 7,000
7,000
Deduct:
Increase in current assets
Debtors 24,000
Stock 32,000
Bills Receivables 11,000 67,000
Decrease in Current liabilities

Bills payable 5,000
Payment of tax 20,000
25,000
92,000 16,000
Investment activities
Add: Sale of Plant & Machineries 25,000
Add: Sale of Investment 35,000
60,000
Deduct: Purchase of Plant and 91,000
Machineries 85,000
Deduct: Purchase of Investments 1,76,000 (1,16,000)

Financing Activities
Add: Issue of share capital 1,00,000
Share premium 60,000
Deduct: Payment of dividend 1,60,000

Closing Cash Balance as on 31.3.2003 30,000 1,30,000
79
50,000
Understanding
Activity 6.4
Mention the four major operating activities included in a cash flow statement.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
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…………………………………………………………………………………………
………………………………………………………………………………………….
6.12 SUMMARY
In this unit we have tried to develop the idea of flow of funds within the organisation.
Starting with the funds requirement for an organisation, we have tired to trace the
sources and uses of funds.
We tried to study the important sources of funds, namely, the operations, sale of fixed
assets, long-term borrowings and issue of new capital. Similarly, important uses of
funds were traced to acquisition of fixed assets, payment of dividends, repayment of
loans and capital. The whole exercise reveals the areas in which funds are deployed
and the source from which they are obtained. Finally, we learned how to go about
doing the funds flow analysis with the help of published accounting information.
We learnt, distinguishing between cash and fund as also cash flow statement and
funds flow statement. The importance of cash and cash flow statement was dwelt
upon. Our discussion centered around cash flow statement on "cash basis" and "profit
basis". We learnt how to go about doing the cash flow analysis with the help of
accounting information and finally presenting the cash flows in the form of a "cash
flow statement".
6.13 KEY WORDS
Working Capital: Current assets minus current liabilities.
Funds from Operations: The change in working capital resulting from operations.
Difference between inflow of funds in the form of revenue and outflow of funds in
the form of expenses.
Sources of funds: The sources from which we obtain working capital for application
elsewhere. Sources include operations, extraordinary profits, sale of fixed assets, new
long-term borrowings, new issue of capital and the reduction of existing working
capital.
Use of Funds: Also referred to as application of funds means use of additional

working capital and includes amounts lost in operations (Operating loss), acquisition
of fixed assets, working capital used for retiring long-term loans, payment of divi-
dends and amounts utilised to increase working capital.
Cash from Operations: It refers to "Profit from Operation" duly adjusted against the
increase or decrease in the current assets and liabilities.
Cash Equivalents: These are highly liquid short term investments which could be
readily converted to cash and which are subject to an insignificant risk of changes in
value.
80 Cash Cycle represents the tithe during which cash is tied up in operations.
6.14 SELF-ASSESSMENT QUESTIONS/EXERCISES Fund Flow and Cash Flow
Statements
1. What is working capital and what factors affect the size of working capital in
an enterprise?
"
2. Current assets to an extent are financed by current liabilities" Explain.
"
3. Operations provide funds" Comment.
4. Differentiate between "Schedule of Changes in Working Capital" and "Fund

Flow Statement.
5. Does a substantial balance in Retained Earnings indicate the presence of

large cash balance?
6. "Net Profit of a business cannot pay dividend". Comment.
7. Explain the purposes of a cash flow statement.
8. What are the differences between a cash flow statement and funds flow
statement?
9. X Ltd. has a sales revenue of Rs. 1,000. Depreciation for the period is
Rs.200. Other operating expenses are Rs.900. Net loss for the period is
Rs.100.
a) What is the amount of funds generated from operations during the period by
X Ltd.?
b) Under what circumstances can the funds from operation be zero?
10. The following information and the balance sheet relate to Shyamsons Ltd.:
SHYAMSONS LTD
Balance Sheet as on 31st December
Year 1 Year 2 Net change during the year
Increase Decrease
Assets Rs. Rs. Rs. Rs.
Cash 10,000 15,000 5,000
Receivables 20,000 25,000 5,000
Inventory 20,000 35,000 15,000
Plant and Machinery Cost 85,000 85,000
Less: Accumulated depreciation (15,000) (10,000) 5,000
Total Assets 1,20,000 1,50,000
Liabilities & Capital 8,000 10,000 2,000

Sundry Creditors
Outstanding expenses 7,000 10,000 3,000
Debentures payable 10,000 5,000 5,000
Long-term loans 5,000 25,000 20,000
Capital 50,000 50,000
Retained earnings 40,000 50,000 10,000
1,20,000 1,50,000
Net profit for the period after charging Rs.5,000 on account of depreciation was Rs.
20,000. A piece of equipment costing Rs.25,000 on which depreciation accumulated
in the amount of Rs. 10,000 was sold for Rs. 10,000. Dividends paid during the year 81
amounted to Rs. 10,000.
Understanding Prepare a Sources and Uses of funds statement in the following format:
SHYAMSONS LTD.
Sources and Uses of Funds
(in Rs.)
Uses of funds Sources of Funds
Purchase of Plant and Operations:
Machinery Net income
Repayment of Add: Loss in sale of
Debentures machinery
Payment of dividends
Increase in working Add: Depreciation
capital Sale of equipment
Long-term loan
Total uses of Funds Total Sources of Funds
11. The Balance Sheet of Bestwood Limited as at 31st March 2002 and 31st
March 2003 are as follows:
31st March 31st March
2002 2003 2002 2003
Rs. Rs. Rs. Rs
Issued share 60,000 80,000 Freehold property 50,000 50,00C
capital at cost
Profit and Loss 54,000 46,000 Equipment (see 36,000 44,400
account note)
Corporation tax Stock in trade 32,800 35,600
due: Debtors 27,200 28,000
31st March 2002 12,000 - Bank 4,000 2,000
31st March 2003 - 8,000
Creditors 24,000 26,000
1,50,000 1,60,000 1,50,000 1,60,000
Note: Equipment movements during the year ended 31st March 2003 were:
Cost Depreciation Net
Rs. Rs. Rs.
Balance at 31st March 2002 60,000 24,000 36,000
Additions during the year 18,000 7,600

Depreciation provided during the year 78,000 31,600
Disposal during year 8,000 6,000
st
Balance at 31 March 2003 70,000 25,600 44,400
The company's summarised profit calculation for the year ended 31st March 2003 revealed:
Sales Rs. Rs.
Gain on Sale of equipment 2,00,000
800
2,00,800
Less: Cost of goods and trading expenses 1,73,200
Depreciation 7,600
1,80,800
Net Profit 20,000
Corporation tax on profits of the year 8,000
82 Retained profit of the year 12,000
During the year ended 31st March 2003 Bestwood Ltd. made a bonus issue of 1,000 Construction and Analysis of
ordinary shares of Rs. 10 each by capitalisation from the profit and loss account. Fund Flow and Cash Flow
Statements
With the help of the above information, prepare a fund flow statement for Bestwood
Ltd. revealing the sources and applications of funds during the year ended 31st
March 2003.
Answers to self-assessment Questions/Exercises
9. (a) Funds generated from operations = Rs. 100
(b) When operating cash expenses are equal to operating incomes or

revenues.
10. Solution:
SHYAM SONS LTD.
Sources and Use of Funds
Use of Funds Rs. Sources of Funds Rs. Rs.
Purchase of Plant and Operations:
Machinery 25,000 Net Income 20,000
Repayment of Debentures 5,000 Add: Loss on sale of Machinery5,000
Payment of dividends 10,000 Add Depreciation 5,000
Increase in net 20,000 30,000
working capital Sale of equipment 10,000
Long-term loan 20,000
Total uses of funds 60,000 Total Sources of Funds 60,000
Year 1 Year 2
Current Assets 50,000 75,000
Less: Current Liabilities 15,000 20,000
Working Capital 35,000 55,000
Increase in Working Capital 20,000

11. Decrease in working Capital Rs. 400
Funds from Sale of equipment Rs. 2,800.

Fraser Lyn. M and Aileen Ormiston, 04/10/2003 Understanding Financial
Statements, Prentice Hall: New Delhi (Chapter 4).
Pandey, I.M., 1999, Financial Management, Vikas Publishing House : New Delhi
Horngren, Charles T., Sundem Gary, L., 1994 (9th Ed.) Introduction to Management
Accounting, Prentice-Hall: Englewood-Cliffs of India Pvt. Ltd., New Delhi.
(Chapter 14)
Glantier, M. W. E., Underdown B. and A.C. Clark, 1979, Basic Accounting

Practices, Arnold Heineman: New Delhi: (Chapter 6, Section 6).
83
Hingorani, N.L. and A.R. Ramanathan, 1986, Management Accounting, Sultan
Chand : New Delhi. (Chapter 8).
Cost Management
UNIT 10 VARIANCE ANALYSIS
Objectives
This unit aims at:
• acquainting you with the ways in which the management can monitor and
guide the operations of a business to meet the desired goals, particularly in
respect of costs and sales.
• helping you in identifying the factors responsible for deviation of actual

performance from the standard performance and in taking such remedial
measures as may be necessary.
Structure
10.1 Introduction
10.2 Meaning of Variance
10.3 Cost Variances
10.4 Direct Material Variances
10.5 Direct Labour Variances
10.6 Overhead Variances
10.7 Sales Variances
10.8 Control of Variances
10.9 Variance Reporting
10.10 Summary
10.11 Key Words
10.1 INTRODUCTION
Profit making is the prime objective of business enterprise. Profit depends
basically on two factors-Costs and Sales. In order to achieve better performance, it
is necessary that you lay down your targets in respect of both of them. Your
objective should e to maximise the sales and minimise the costs. This will result
in maximisation of the profits and, in the long run the wealth of the firm.
Variance analysis is intimately connected with budgetary control which helps the
management in:
• planning future activities
• comparing actual performance with the budgeted performance
• identifying the variances as to their causes
• ensuring that remedial measures are taken at appropriate time.
10.2 MEANING OF VARIANCE

Variance is the difference between budgeted and the actual level of activity. Since, as
explained earlier, profitability of a business depends both on costs and sales, it will be
72
Cost variance is the difference between ` what should have been the cost' (popularly Variance Analysis
termed as standard cost) and `what has been the cost ` (i.e. actual cost). In case the
actual costs is less than the standard cost, the variance is termed as `favourable'.
However, if the actual cost is more than the standard costs, variance is termed as
àdverse' or ùnfavourable'.
Sales variance is the difference between `what should have been the sales'
(popularly) termed as Budgeted sales) and `what have been the sales ` (i.e. the
actual sales). In case the amount of actual sales is more than the budgeted sales,
the variance is termed as 'favourable'. However, if the amount of actual sales is
less than the budgeted sales, the variance is termed as àdverse' or ùnfavourable'.
Thus, variances may be classified into two categories:
In the following pages, we will explain both the above types of variances in
details.
10.3 COST VARIANCES

Cost variances can be put in the following chart:
Direct expenses constitute an insignificant portion of the total cost of the product.
Hence, direct expense variance is generally not calculated. If it is desired to
calculate the direct expense variance, it can be computed in the same way as the
variable overhead variance is calculated, since in most cases direct expenses are
variable.
At this point, however, we suggest that you have a look at Exhibit -10.1, given
towards the end of this unit, which presents a bird's eye view of all the variances
discussed in this unit and their inter-relationships. Whenever you are in doubt, a
reference to this Exhibit may prove helpful.
In the course of discussion in this unit, you will find that abbreviations for
different variances have been used. For your facility, we present below a list of all
such abbreviations together with the full names of the variances.
Abbreviations for Different Variances
DMCV - Direct Material Cost Variance 73

DMPV - Direct Material Price Variance
Cost Management DLCV - Direct Labour Cost Variance
DLRV - Direct Labour Rate Variance
DLEV - Direct Labour Efficiency Variance
OCV - Overhead Cost Variance
VOCV - Variable Overhead Cost Variance
FOCV - Fixed Overhead Cost Variance
FOEXPV - Fixed Overhead Expenditure Variance
FOVV - Fixed Overhead Volume Variance
SVV - Sales Value Variance
SPV - Sales Price Variance
SVOLV - Sales Volume Variance
10.4 DIRECT MATERIAL VARIANCES

Three types of direct material variances are explained here. The first one is Direct
Material Cost Variance (DMCV) which is equal to the difference between the
standard cost of direct materials specified for the output achieved and the actual cost
of direct materials used. The standard cost of materials is computed by multiplying
the standard price with the standard quantity for actual output, and the actual cost is
computed by multiplying actual price with the actual quantity.
Formula for Computation:

Direct Material Total Standard
Cost Variance = Cost for _ Total Actual Cost
(DMCV) Actual Output
(Standard Price x Std. Qty. for Actual Output) - (Actual Price x Actual Quantity)
If the actual cost is more than the standard cost, it would result in an adverse variance
and vice-versa. Let us take an example.
Standard output 800 units

Actual output 1,000 units
Std. qty. per unit 1 kg
Total actual qty. used 1,200 kg.
Std. rate per unit Rs.4 per kg
Actual rate per unit Rs. 5 per kg.
DMCV = Standard Cost for actual output Actual Cost

= 1,000 x 1 x 4-1,200 x 5
= Rs. 4,000 - Rs. 6,000
= Rs. 2,000 (Adverse)
If standard output and actual output are different as in this case, the variances are to.
be calculated keeping in view the actual output. The information regarding standard
74 output (which is different from standard quantity) is thus not relevant.
The material cost variance may arise either on account of change in price or Variance Analysis
change in quantity or both. Thus, material cost variance may be further analysed
as `material price variance' and `material usage variance'
Direct Material Price Variance

DMPV is concerned with that portion of the direct material cost variance which is
due to the difference between the standard price specified and the actual price
paid.
Formula for computation
If the actual price is more than the standard price, the variance would be adverse
and in case the standard price is more than the actual price, it would result in a
favourable variance.
The material price variance, on the basis of figures given in the above example will
be computed as follows:
DMPV = 1,200 x (4 - 5)
The reasons for price variance may be as under:
i) Fluctuations in market prices:
a) Market trends may be bullish or bearish.
b) Increase or decrease in prices on account of agreement between
various suppliers or on account of Government intervention. .
ii) Buying efficiency or inefficiency
iii) High or low costs of transportation and carriage of goods.
iv) Changes in or laxity in pursuing purchase policy:
a) Superior or inferior (non-standard) material might have been
purchased;
b) Purchases might have been effected in small quantities instead of in
bulk or vice versa;
c) Substitute and cheaper materials might have been used.
v) Emergency purchase- placing rush orders for immediate delivery at the
prevalent price.
vi) Fraud in purchases and loss of discounts.
vii) Incorrect: setting of standards.
Some of the facts may be controlled by the management if care or proper control is
exercised, while others may be beyond the control of management. If the factors are
controllable, the buying department is usually answerable for unfavourable
variations. 75
Cost Management Direct Material Usage or Quantity Variance
DMUV is that portion of direct material cost variance which is due to the difference
between the standard quantity specified (for the output achieved) and the actual
quantity used.
The actual quantity, if more than the standard quantity, would cause an unfavourable
variance and vice-versa.
The usage variance will be computed as follows on the basis of figures given in the
above example.
DMUV = 4 X (1,000-1,200)
= Rs. 800 (Adverse)
The total of material price and quantity variances is equal to material cost variance.
Thus, DMCV = DMPV + DMUV
= Rs.1200 (A) +800 (A)
= Rs. 2,000 (A)
The reason for direct material usage variance may be as under:
i) Inefficiency, lack of skill or faulty workmanship resulting in more

consumption of raw materials.
ii) Lack of proper unkeep and maintenance of plant and equipment, and
frequent breakdown during production process leading to wastage of material
iii) Non-consideration of product design and method of processing, etc. which

fixing standards.
iv) Incorrect processing of materials resulting in wastages.
v) Non-recording of returns of material to stock (or stores) or inter-transfers

from one job to another.
vi) Improper inspection and supervision of workmen resulting in adverse

quantity variance due to careless handling and processing.
vii) Too strict supervision or inspection resulting in excessive rejections of

materials.
viii) Substitution of specified materials with unspecified materials causing greater

consumption of the latter. Price variance could be favourable because
unspecified material is likely to be cheaper.
ix) Incorrect setting of standards, leading to variations.
x) Excessive wastage, scrap, Spoilage, Shrinkage, leakage, etc. causing an

adverse usage variance.
76
Computation of Various Direct Material Variances Variance Analysis
Illustration 10.1
Form the following particulars, let us find the(i) Material Cost Variance, (ii) Material.
Usage Variance, (iii) Material Price Variance.
Quantity of material purchased 4,000 units
Value of material purchased Rs.10,000
Standard quantity of materials per unit of
finished product 2 kg
Standard rate of material Rs.2 per kg
Opening stock of material 1,000 kg
Closing stock of material 2,000 kg
Finished products during the period 1;000 units
Standard Quantity of materials required : 1,000 x 2 = 2,000 kg.
Actual Qty. of Material used = Material purchased + Opening Stock - Closing Stock
= 4,000+1,000-2,000 = 3,000 kg.
Standard Price = Rs. 2 per unit.
Actual Price = Rs.10,000 = Rs.2.50 per unit.
4,000 units
*Presuming FIFO Method

ii) DMUV = Standard Price x (Standard Quantity - Actual Quantity)
= Rs. 2 x (2,000 - 3,000)
= Rs. 2 x (-1,000) = Rs. 2,000 (Adverse)
iii) DMPV = Actual Quantity x (Standard Price - Actual Price)
= 1,000 x (2 - 2) + 2,000 x (2 - 2.50) = Rs. 1,000 (Adverse)
It will be observed that the total of materials usage and material price variance is
equal to material cost variance.
Activity 10.1
Calculate: (i) material usage variance, (ii) material price variance, and (iii) material
cost variance in respect of a manufacturing concern which has adopted standard
costing. The firm furnishes the following information.
Standard data
Material for 100kg.of finished products (140 kg),
Price of materials Rs. 4 per kg
Actual data
Output 60,000 kg
Material used 80,000 kg
Cost of material Rs. 2,60,000
77
Cost Management 10.5 DIRECT LABOUR VARIANCES
The deviations in cost of direct labour may occur because of two main factors: (1)
difference in actual rates and standard rates of labour, and (ii) the variation in actual
time taken by workers and the standard item prescribed for performing a j( ) or an
operation.
Labour variances are very much similar to material variances and they can be very
easily calculated by applying the same techniques as used in calculation of mater .1
variances. (The readers can work out the various formulae for Direct Labour
Variances by simply putting the word `time' in place of `qty'. in the formula meant
for Direct Material Variances.) The various labour variances may be put as under.
It is the difference between the standard direct wages specified for the activity
achieved and the actual direct wages paid. Formula for computation.
Illustration 10.2
Standard output 200 units
Standard time per unit 2 hours
Standard rate per hour Rs. 3
Actual output 160 units
Total actual time taken 300 hours
Actual rate per hour Rs.3.50
DLCV = Rs. 3 x 160 x 2 - Rs. 3.50 x 300
= Rs. 960 - 1,050 = Rs. 90 (Adverse)
The direct labour cost variance may arise on account of difference in either rate of
wages or time. Thus, it may be further analysed as (i) Rate variance, and (ii) Ti e or
Efficiency variance. This has been shown in the chart below:
Direct Labour (Wages) Rate Variance
It is that portion of direct labour (wages) variance which is due to the difference
between the standard or specified rate of pay and actual rate paid. Formula for
78 computation.
Direct Labour Rate = Actual time x (Standard Rate - Actual Rate) Variance Analysis
Variance (DLRV)
If the actual rate is higher than the standard rate, it shall result in an unfavourable
variance and vice versa.
Taking the figures given in the above illustration, the direct labour rate variance will
be computed as follows:
DLRV = 300 hrs x (Rs. 3 - Rs. 3.50)
= Rs.150 (Adverse)
The reasons for direct labour rate variance may be as under:
i) Deployment of more efficient and skilled workers giving rise to higher
payment.
ii) Higher payment due to shortage of availability of labour.
iii) Lesser payment due to abundant availability of labour or high competition
among them for employment.
iv) Employment of unskilled labourers causing lower actual rates of pay.
v) Extra-Shift allowance to workers or overtime allowance (for work done after
normal hours) leading to higher wages.
vi) Higher piece rates for better quality production
vii) Change in the system of wage payment( from time wages to piece wages or
vice versa , introduction or withdrawal or incentive or bonus schemes etc.
viii) Change in wage rates, probably due to a revised agreement with labour
union/
ix) Higher rates during seasonal or emergency operations
Direct Labour Efficiency (Time) Variance
It is that portion of the direct labour variance which is due to the difference between
the standard labour hours specified for the activity achieved and the actual. labour
hours expended.
Labour Efficiency = Standard Rates x Standard time _ Actual time
Variance (for actual output)

Taking the figures given in Illustration 10.2, the labour efficiency variance will be
computed as follows:
Labour Efficiency Variance = Rs. 3 x (320 hrs -300 hrs). = Rs.60 (Favourable)
It will be seen that the work has been finished in 150 hours, compared to 160 hours-
the standard time set for the production. This could be attributed to efficiency of
workers. That is why, this variance is known as Labour Efficiency Variance. The
total of labour rate and efficiency variance is equal to labour cost variance.
Verification
DLCV = Labour Rate Variance + Labour Efficiency Variance
= Rs. 150'(A) + 60 (F)
= Rs. 90 (Adverse)
Labour efficiency variance may be caused by the following:
i) Defective or bad materials
ii) Breakdown of plant and machinery
79
iii) Failure of power
Cost Management iv) Efficient working by the labourers and fuller utilisation of time due to
incentives given.
v) Loss of time due to delayed instructions from management or delay in receipt
pf raw materials.
vi) Alteration in the method of production.
vii) More time taken by workers due to lack of proper supervision and control by
management, making the workers lazy and inefficient.
viii) Too rigid a system of inspection and control.
ix) Poor working conditions
x) Lower productivity due to lack of training, ability or experience on the part
of workers
xi) Labour turnover or change -over of workers form one operation or process c
department to another.
Computation of Labour Variances
Illustration 10.3
Form the following details calculate the direct labour variances:
Direct Labour Rate : Re. 1 per hour
Hours set per unit : 10 hours
Actual data are given below:
Units produced : 500
Hours worked : 6,000
Actual Direct Labour Cost : 4,800
Let us work out the various labour variances.
Standard Time = 10 hours x 500 units = 5,000 hours
Standard Cost = Standard Rate x Standard Time
= Re.1 x 5,000 hours = Rs.5,000
i) Direct Labour = Standard Cost - Actual Cost
Cost Variance
(DLCV) = Rs.5,000 - Rs.4,800 = Rs. 200 (F)
ii) Direct Labour = Actual Time X (Standard Rate -Actual Rate)
Rate Variance
(DLRC)
Hence, Labour Rate Variance = 6,000 hours x (Rs. 1.80 p.)

= Rs. 1,200 (F)
iii) Direct Labour Efficiency = Standard Rate x (Standard Time – Actual Time)
Variance (DLEV).
= Re.1 x (5,000 - 6,000 hours)
= 1,000 (Adverse)
Verification
DLCV = DLRV + DLEV
= Rs. 1,200 (F) + Rs. 1,000 (A)
80 = Rs. 200 (Favourable)
Activity 10.2 Variance Analysis
Calculate labour variances for Travancore Supply Company which produces a single
article. The product goes through two operating departments. The standard costs card
for this article indicated the following data:
Standard time Standard rate Total
Department A 2 hours Rs.5 Rs.10
Department B 1.5 hours Rs.6.00 Rs.9
The production for the month of July was, 2,000 units. The actual labour costs in the
two departments were:
Hours Cost
Department A 4,000 Rs. 24,000
Department B 2,000 Rs. 15,000
10.6 OVERHEAD VARIANCES
The term overhead includes indirect material, indirect labour and indirect expenses.
Overheads may relate to factory, office, or selling and distribution departments.
However, for the purposes of variance analysis, we can broadly divide the overhead
cost variance into two categories as shown below:
Each of these variances are discussed below:

Overhead Cost Variance (OCV)
It is the difference between the standard overheads for actual output (i.e. recovered
overheads) and actual overheads. It is the total of both fixed and variable overhead
variances.
Overhead Cost variance = Recovered Overheads - Actual Overheads Variable
Overhead
Cost Variance (VOCV)
It is the difference between standard variable overheads for actual output ( or recov-
ered variable overheads) and actual variable overheads.
VOCV = Recovered Variable Overheads - Actual Variable Overheads.
Causes of variance : This variance may be due to advance payment of expenses, or
outstanding expenses or payment of past outstanding expenses during this period, or
on account of certain abnormal expenses incurred such as, repairs of machinery due
to breakdown, expenses clue to spoilage or defective workmanship or excessive
overtime work, etc. 81
Cost Management Fixed Overhead Cost Variance (FOCV)
It is the difference between standard fixed overheads for actual output (or Recovered
Overheads) and actual fixed overheads.
FOCV = Recovered Fixed Overheads - Actual Fixed Overheads
Causes of variance : Difference between actual and recovered. fixed overheads ma;
be on account. (i) a higher or lower amount of fixed overheads, compared to budge :d
fixed overheads, might have been incurred for the same production during the same
period (ii) the same amount of fixed overheads might have been incurred for a high
or lower production than the budgeted production during the same period.
Computation of Overhead Variances
Illustration
Budgeted Output 10,000 units
Budgeted Overheads Rs. 10,000

Fixed 6,000
Variable 4,000
Actual Overheads 12,000
Fixed 6,000
Variable 6,000
Actual output 8,000 units
Let us calculate the various overhead variances.
It will be appropriate to make the following basic calculations before computing th
various Overhead Variances.
Standard/Budgeted Overhead = Budgeted Overheads
Rate per Unit Budged Output
Rs. 10,000 = Re.1

= 10,000
Standard/Budgeted Fixed = Budgeted Fixed Overheads
Overhead Rate per Unit Budged Output
= Rs. 6,000 = Re. 60
10,000
Standard/Budgeted Variable = Budgeted Variable Overheads
Overhead Rate per unit Budged Output
= Rs. 4,000 = Re. 0.40
10,000
Various Overhead Variances can now be calculated
OCV = Recovered Overheads - Actual Overheads
= Rs. 1 x 8,000 -12,000 = 4,000 (Adverse)
VOCV = Recovered Variable Overheads -Actual Variable Overheads
= 8,000 x Re. 0,40 - Rs. 6,000
= 3,200 = 6,000
= 2,800 (Adverse)
FOCV = Recoverd Fixed Overheads Actual Fixed Overheads
= 8,000 x Re. 0.60 - Rs. 6,000
82 = Rs. 4,800 - Rs. 6,000 = Rs. 1,200 (Adverse)
Verification Variance Analysis
OVC = VOCV + FOCV
4,000 (A) = 2,800 (A) + 1,200 (A)
Activity 10.3
Calculate different overhead variances from the following standard and actual data:
Standard Overhead rate: Per unit
Variable Rs. 3.00
Fixed (Rs. 36,000 / 3,000) Rs. 12.00

Rs. 15.00
Actual data during the period:
Output 2,400 units
Overhead:
Variable Rs. 6,000
Fixed Rs. 28,000 Rs. 34,000
Classification of Fixed Overhead Variance
Fixed Overhead Variance may be classified as shown in the following chart:
Fixed Overhead Expenditure or Budget or Controllable Variance (FOEXPV)
This variance is due to the difference between Budgeted Fixed Overheads and the
Actual Fixed Overheads incurred.
FOEXPV = Budgeted Fixed Overheads-Actual Fixed Overheads
Fixed Overhead Volume Variance (FOVV)
This variance arises on account of difference between standard and actual output
resulting in under or over-recovery of fixed overheads. It is, therefore, the difference
between overheads absorbed on actual output (or recovered overheads) and those on
budgeted output (or budgeted overheads).
FOVV = Recovered Fixed Overheads Budgeted Fixed Overheads.
Illustration 10.5
Calculate the Fixed Overhead Expenditure Variance and Fixed Overhead Volume
Variance on the basis of data given in Illustration 10.3.
FOEXPV = Budgeted Fixed Overheads -Actual Fixed Overheads
= Rs. 6,000 - Rs. 6,000 = Nil
FOVV = Recovered Fixed Overheads - Budgeted Fixed Overheads
83
= Rs. 4,800 - Rs 6,000 = Rs. 1,200 (Adverse)
Cost Management Verification
FOCV = FOEXPV + FOVV
1,200 (A) = Nil + 1,200 (A)
Activity 10.4
Caren late the overhead variance with the following data:
Item Budgeted Actual

No. of working days in a month 20 2
Man hours per day 6,000 6,400
Output per man hour in units 1.0 9
Overhead cost (Rs.) 1,20,000 1,28,000
10.7 SALES VARIANCES
Sales are affected by two factors (i) the selling price and (ii) the quantum of sales fhe
variations in the standards set and actuals for the purpose may be mainly due to
change in market trends. Normally, if the selling price increases, the volume of sales
will be lower than the standard. It may result in a favourable variance as to price Id
unfavourable variance as to quantity. It is to be borne in mind that higher price here is

to be viewed as a favourable variance (higher price paid for material, it will be
recalled, causes an adverse variance) and lower volume of sales is to be viewed a
unfavourable (in case of materials, it is the other way around, i.e. lower usage of
materials than the standard causes a favourable variance).
It is well known that demand and supply position in the market decides the quantity
of sales as well as the selling price. The variations may be on account of control lab :
as well as non-controllable factors. changes in market conditions and demand by
customers¬ are, of course, beyond the control of management, but certain factors like
urn ably high prices are controllable, and an effort should be made to check adverse
variations due to these factors.
Sales variances can be understood with the help of the following chart
Sales Value Variance
Sales Price Sales Volume Variance
Sales Value Variance
The difference between budgeted sales and actual sales results in Sales Value < xi-
ance. The Formula is:
Sales Value Variance = Budgeted Sales - Actual Sales
If actual sales are more than the budgeted sales, a favourable variance would '
reported and vice versa.
The difference in value may be on account of difference in price or volume of ales

which is therefore analysed further.
84
Sales Price Variance Variance Analysis
It can be calculated like material price variance. It is on account of the difference in
actual selling price and the standard selling price for actual quantity of sales. The
formula is:
Actual quantity sold X (Standard Price - Actual Price)

OR
Price Variance = Standard Sales - Actual Sales
Sales Volume Variance
It can be calculated like material usage variance. Budgeted sales may be different
from the standard sales. In other words, budgeted quantity of sales at standard price
may vary from the actual quantity of sales at standard prices. Thus, the variance is a
result of difference in budgeted and actual quantities of goods sold. The formula is:
Standard Price X (Budgeted Quantity - Actual Quantity)
OR
Volume Variance = Budgeted Sales - Standard Sales
If the standard sales are more than the budgeted sales, it would cause a favourable
variance and vice versa?
The total, of price and volume variances would be equal to sales value variance.
Computation of Sales Variances
Illustration 10.6
8 5
85
Cost Management Verification
Sales value variance = Sales Price Variance + Sales Volume Variance
= 18,000 (A) + 18,000 (F)
= Nil
*Budgeted Sales = Budgeted Price x Budgeted Quantity
10.8 CONTROL OF VARIANCES

After the variance have been computed and analysed, the next logical step for the
management is to trace the responsibility for the variances to particular individuals or
departments. The Management/Cost Accountant may be required to prepare
necessary report for this purpose. The report submitted to the management should
clearly indicate where action is required. On the basis of this report, the management
will try to identify the specific individuals for adverse controllable variances, which
being within their control could have been avoided. It was earlier mentioned that
certain factors, such as changes in market conditions, demand and supply position,
etc. are beyond the control of managers. Hence, action to pinpoint responsibility of
such uncontrollable variances is not called for.
In case of controllable variances, the responsibility could be traced as shown below to

the different departments for different variances.
86
It may be noted that variance analysis, in itself, would not help in achieving the Variance Analysis
desired objective of in minimising costs, unless managerial action is prompt and is in
the right direction. The direction, of course, shall be indicated by the analysis of
variances, but it is the executive side which would be responsible for taking
immediate action, exercising proper control, having a close watch over operations,
etc., so that economies may be effected inefficiencies minimised and performance
improved. A continuous and rigorous effort in the direction of cost control would
help the management to achieve the goal of standard costing.
10.9 VARIANCE REPORTING

As stated above, the deviations alongwith their causes should be reported to the
management regularly and at the opportune time so that corrective action may be
taken immediately. The person or department may be held responsible for any
adverse variations after duly accounting for it.
The information as to the profit earned by the business is presented through a simple
Profit and Loss Account where a system of historical costing is prevalent. Its
proforma is given below:
Trading and Profit and Loss Account
For the Year ending
To Direct Materials ... By Sales ….
" Variable Expenses …
" Fixed Expenses …
" Net Profit …
However, when a system of standard costing is in operation the information about the
standards, the actual and the variances alongwith their causes should be depicted
through a statement, so that the management may be able to take quick action in
respect of any inefficiencies thus revealed. The statement draws a reconciliation
between the Budgeted Profit/Standard Profit and Actual Profit. The preparation of
this statement can be understood with the help of the following
The profit statement, submitted to the management, should contain notes to explain
the causes of the variances. Since the rule of `management by exception' is followed,
greater attention in the reported statement is drawn towards the adverse variances, i.e,
the reasons for the failure or poor performance are highlighted in particular,
alongwith comments on general overall performance.
Illustration 10.7
From the following particulars let us try to draw a reconciliation between actual and
the budgeted profit explaining the variances due to the various causes:
Budgeted /Standards Actual
Units 4,000 3,500
Net price per unit Rs.20.00 21.00
Material per unit Kgs. 4.00 4.00
Rate of material per Kg. Rs. 2.00 2.25
Labour hours per unit Hrs. 5.50 4.50
Rate per labour hour Re. 0.50 0.60
Variable overhead per labour hour Rs. 0.80 1.00
Fixed overhead per unit Re. 1.00 1.20
Direct Material Price = Actual qty. x (Std. price - Actual price)
Variance (DMPV) = 14,000 x (Rs. 2.00 - Rs. 2.25)
87
Cost Management
88
Variance Analysis
89
Cost Management Activity 10.5
From the following details, reconcile the budgeted sales with actual sales and
standard profit with actual profit in terms of variances:
Activity 10.6
Identify the type of variance which will result in each of the stated situations and also
indicate whether the variance is favourable or unfavourable:
• Jammnadas, a worker in the finishing department of a furniture factory,has gone
on leave due to illness and is temporarily replaced by Gangaram. Jamanadas's
wages are Rs. 200 per day whereas Ganga is to be paid at Rs. 220 per day.
• Because of the machining error, the cutting department got only three table tops
from each piece of a teak board. Proper cutting should have resulted in four table
tops per sheet of teak board.
• Installation of a new office equipment reduced factory office cost by Rs.
1,00,000 a month.
• The price of teak board increased by 5 per cent. This price increase was
anticipated and was included in the computation of standard material cost.
• A shipment of lumber from Assam is delayed in transit because of transporters'
strike. As a result, it is necessary to substitute a more expensive type of lumber.
• The standard time for shaping legs is 16 minutes per table. A new manwas
assigned to this operation and while he was learning the job, his production rate
was three table legs every 21 minutes.
• The production level in 2002 was 22 per cent higher than estimated at the
beginning of the year, while total fixed manufacturing overhead costs were as
budgeted.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
10.10 SUMMARY
Profitability of a business enterprise depends basically on two factors; costs and
sales. The efforts of the management should be to minimise the cost without
compromising on the quality and pushing up the sales of the products. This requires
proper monitoring of both costs and sales performance. Targets have to be fixed and
the actual results should be compared with the pre-determined targets and variances
90 found out.
Variance refers to the difference between the standard (or budgeted performance) and Variance Analysis
actual performance. Variance analysis is mainly concerned with ascertaining the
quantum of variances together with the analysis of the causes responsible for such
variances.
It may be noted that in the case of cost variance, if the actual cost is more than the
standard cost, it is termed as an adverse variance. While in the case of sales
variances, if the actual amount of sales is more than the budgeted sales, it is termed
as a favourable variance.
Variance reports have to be submitted to the management from time to time. These
reports contain details regarding the budgeted/standard performance, actual perfor-
mance, the quantum of variances and the departments/executives responsible for
adverse variances. On the basis of these reports, the management can fix the
responsibilities on the executives for controllable variances, and takes necessary steps
so that such variances do not occur in future. For variances caused by uncontrollable
factors, management should try its best to minimise the effect of such factor or revise
budgeted/standard performance, if necessary.
Various types of variances can be understood with the help of Exhibit 10.1
Exhibit 10.1: A diagrammatic presentation of variances and their Inter-
relationships.
10.11 KEYWORDS
Direct Labour Cost Variance: It is the difference between the direct wages
specified or the activity achieved and the actual wages paid.
Direct Labour Efficiency Variance: It is that portion of direct labour cost variance
which is due to the difference between the standard labour hours specified for the
activity achieved and the actual labour hours expended.
91
Cost Management Direct Labour Rate Variance: It is that portion of direct Labour Cost Variance
which is due to the difference between the standard rate of wage specified and actual
rate paid.
Direct Material Cost Variance: It is the difference between the standard cost of
direct materials specified for the output achieved and the actual cost of direct material
used.
Direct Material Price Variance : It is that portion of the direct material cost
variance which is due to difference between the standard price specified and actual
price paid.
Direct Material Usage Variance: It is that portion of the direct material cost
variance which is due to difference between the standard quantity specified (for the
output achieved) and the actual quantity used.
Fixed Overhead Cost Variance: It is the difference between recovered fixed
overheads (i.e. standard fixed overheads for actual output) and the actual fixed
overheads.
Fixed Overhead Expenditure Variance: It is the variance due to the difference
between budgeted fixed overheads and the actual fixed overheads incurred.
Fixed Overhead Volume Variance: It is the variance due to the difference between
recovered overheads (i.e. standard overheads for actual output) and the budgeted
overheads.
Over head Cost Variance: It is the difference between recovered overheads (i.e.
standard overheads for actual output) and the actual overheads.
Sales Price Variance: It is the variance on account of difference between actual
selling price and standard selling price for actual quantum of sales.
Sales Value Variance: It is the difference between the budgeted sales and the actual
sales.
Sales Volume Variance: It is the variance on account of difference between
budgeted and actual quantity of goods sold at standard price.
Variance: It is the difference between the standard/budgeted performance and the
actual performance.
Variable Overhead Cost Variance: It is the difference between recovered variable
overheads (i.e. standard variable overheads for actual output) and the actual variable
overheads.

1 What is a Variance? Why are the variances computed?
2 How can the Variance be controlled?
3 List some possible causes, separately for “material price variance” and
“material usage variance"
4 What is Direct Labour Efficiency (Time) Variance? What the managers or
supervisors can (or should) do to ensure that their is no such unfavourable
Variance?
5 Distinguish between Variable Overhead Cost Variance and Fixed Overhead
Cost Variance. Why such variances are caused?
6 Discuss the importance of variance analysis in operational and management
control. How does this technique help in, what is popularly known as
management by exception’?
92
7 State whether each of the following statements is “True or False” : Variance Analysis
a) A cost variance is said to be favourable if the
standard cost is more than the actual cost. True False
b) Material usage variance is that portion of material
cost variance which arises due to the difference
between standard quantity for the output achieved
and the actual quantity. True False
c) Labour efficiency variance is the difference

between standard hours for the actual output and
the actual hours. True False
d) Direct labour rate variance is the difference
between the standard direct wages specified for
the activity achieved and the actual direct wages
paid. True False
e) Standard sales and budgeted sales are synonymous

terms. True False
f) Recovered overheads and absorbed overheads
mean one and the same thing. True False
g) Fixed overhead cost variance is the aggregate of

the expenditure variance and the volume variance. True False
h) The selling department is responsible for factory
overhead volume variance. True False
8 Fill in the blanks:

a) Variance analysis involves………….…..and ……………... of variance.
b) Variance is the difference between standard performance and the
…………………… performance.
c) Material cost variance is sub-divided into ………………….. variance
and ………………….. Variance.
d) Overhead cost variance can be classified into …………..………..
overhead cost variance and …………..….. overhead cost variance.
e) Sales value variance is the difference between …...…………… sales and
………………….… sales.
9 From the following particulars, compute Direct Material Variances:
Quantity of direct materials, consumed 2,500 kgs.
Actual rate of material purchased Rs. 3 per kg.
Standard quantity of materials required per tonne of output 30 kg.
Standard rate of material Rs. 2.50 per kg.
Output during the period 80 tonnes.
10 XYZ Ltd., which has opted standard costing, furnishes you the following
information:
Standard:
Material for 700 units of Finished products 1,000 Kgs.
Price of materials Re. 1 per kg.
Actual:
Output 2,10,000 units
Opening Stock Nil
93
Cost Management Purchases 3,00,000 kg.
For Rs. 2,70,000
Closing stock 20,000 kgs.
You are require to calculate
(a) Direct Material Usage Variance, (b) Direct Material Price Variance and
(c) Direct Material Cost Variance.
11 In a production department of a factory there are 80 workers and the average arte
of wages per worker is Re. 1 per hour. Standard working hours per week are 45
and the standard performance is six units per hour.
12 The following information is gathered from the labour records of Bajaj Electrical
for January 2003.
Pay roll allocation for direct labour Rs. 40,000
Time card analysis shows that 8,000 hours were worked on production lines.
Production reports for the period showed that 2,000 units have been completed,
each unit requiring standard labour time of 3 hours and a standard labour rate f
Rs. 4 per hour.
Calculate the labour variances.
13 Basu Industries turns out only one article the prime cost standards for which have
been established as follows
Total
Materials – 5lbs. @ Rs. 4.20 Rs. 21
Labour – 2 hours @ Rs. 3 Rs. 6
The production schedule for the month of July, 2003 required completion of 5,000 pieces.
However, 5,120 pieces were actually completed. Purchases for the month of July 2003
amounted to 30,000 lbs. of material at the total invoice price Rs. 1,35,000.
Production records for the moth of July 2003 showed the following actual results:
Material used 25,700 lbs.
Direct labour – 15,150 hours Rs. 48,480
Calculate the appropriate material and labour variances.
14 From the following data, calculate overhead variance:
Fixed overhead budget for November Rs. 50,000
Variable overhead budget for November Rs. 1,00,000
Budgeted production for the month 25,000 units
Actual production for the month 27,000 units
Actual Fixed overhead incurred Rs. 60,000
Actual variable overhead incurred Rs. 1,20,000
15 The budgeted and actual sales of Vikas Ltd. Manufacturing and marketing a
single product are furnished below:
Budgeted Sales 10,000 units at Rs. 10 per unit
5,000 units at Rs. 8 per unit
Actual Sales 8,000 units at Rs. per unit
94
Calculate (a) Sales Value Variance Variance Analysis
(b) Sales Price Variance and
(c) Sales Volume Variance
10.1 DMCV = Rs. 76,000 (F)
DMPV = Rs.60,000 (F)
DMUV = Rs. 16,000 (F)
10.2 DLCV = Department A Rs. 4,000 (A)
Department B 3,000 (F) 1,000 (A)
DLRV = Department A 4,000 (A)
Department B 3,000 (A) 7,000 (A)
DLEV = Department A Nil
Department B 6,000 (F) 6,000 (F)
10.3 OCV = Rs. 2,000 (F)
VOCV = 1,200 (F)
FOCV = 800 (F)
10.4 FOCV = Rs. 1,280 (A)
FOEXPV = 8,000 (A)
FOVV = Rs. 6,720 (F)
Notes:
FOCV = Recovered Fixed Overheads – Actual Fixed Overheads
= 1,26,720 – 1,28,000
= 1,280 (A)
Recovered Fixed Overheads have been calculated as under:
Man hours per day 6,400
Multiplied by output per man hour in units X 0.9
Total units produced per day
Multiplied by No. of working days 5,760
Total units produced in the month X 22
Multiplied by standard overhead 1,26,720
Cost per unit i.e., Rs. 1,20,000 divided by
1,20,000 (6,000 X 1 X 20) X1
Rs. 1,26,720
FOEXPV = Budgeted Fixed Overheads – Actual Fixed Overheads

= 1,20,000 – 1,28,000
= 8,000 (A)
FOVV = Recovered Fixed Overheads – Budgeted Overheads
= 1,26,720 – 1,20,000
= 6,720 (F)
10.5 Sales Variance
Sales value variance Rs. 3,000 (A)
Sales Price variance Rs. 1,000 (A)
Sales volume variance Rs. 2,000 (A)
Budgeted Sales Rs. 1,46,000
Less sales price variance (A) -1,000
Less sales volume variance (A) -2,000
Actual sales 1,43,000
Profit variance 500 (A)
Price variance 1,000 (A)
Volume variance 1,000 (A)
Overall cost variance 500 (A) 95
Cost Management
Statement of Reconciliation of Actual Profit with Budgeted Profit
Budgeted Profit = Rs. 60,000
Less unfavourable variances:
Due to Price Rs. 1,000*
Due to cost 500* 1,500
Add favourable variances due 58,500

to volume*** 1,000
Actual Profit 59,500
* Sales Price Variance is Rs. 1,000 as earlier shown.

** Variance in profit due to cost is: (Standard cost –Actual cost) X Actual
Quantity.
Applying the formula –
A (12-13) X 4,000 = 4,000 (A)
B (10-9) X 3,500 = 3,500 (F)
500 (A)
*** Variance in profit due to volume is (Standard Quantity – Actual Quantity) X

Standard Profit
Applying formula –
A (3,000 – 4,000 X 10 = 10,000 (F)
B (10-9) X 3,500 X 6 = 9,000 (A)
1,000 (F)
10.6 a) Labour cost increased because a higher wage was paid. Hence
unfavourable Direct Labour Rate Variance (DLRV).
b) Material was wasted. More material was used than allowed by the
standard. Hence unfavorable Direct Material Usage Variance
(DMUV).
c) Factory office costs are a part of manufacturing overhead. As such it is
a favourable Overhead Cost Variance (OCV).
d) Because the price change was anticipated and was already included for
calculating standard material cost, it does not result in a variance from
standard. Hence, no variance.
e) The substitution resulted in a higher price for material used
though the quantity was not affected. Hence unfavourable Direct
Material Price Variance (DMPV).
f) Whereas the standard time per leg is four minutes, the new
worker took seven minutes. Hence unfavourable Direct Labour
Efficiency variance (DLEV).
g) In this situation the actual fixed overhead costs and the budgeted costs
were the same though the production level was higher by 22 per cent.
The recovery for fixed overhead in made on per unit basis. This will
result in favourable Fixed Overhead Volume Variance (FOVV).
7 (a) True; (b) True; (c) True; (d) True; (e) False (f) True; (g) True;
(h) True; (i) False.
96
8 (a) calculation, interpretation; (b) actual; (c) price, quantity; (d) fixed, Variance Analysis
variable; (e) budgeted, actual.
9 DMCV Rs. 1,500 (A); DMPV Rs. 1,250 (A); DMUV Rs. 250 (A)
10 (a) Rs. 20,000 (F); (b) Rs. 28,000 (F); (c) Rs. 48,000 (F)
11 Labour Rate Variance Rs. 360 (F)

(Hint: Standard wages Rs. 14,400; Actual wages Rs. 14,040
No note is to be taken of idle time).

12 Rate Variance Rs. 8,000 (A); Efficiency Variance Rs. 8,000 (A); Cost
Variance Rs. 16,000 (A);
13 DMCV Rs. 8,130 (A); DMPV = Rs. 7,710 (A); DMUV Rs. 420 (A)
DLCV Rs. 2,400 (A); DLRV = Rs. 3,030 (A); DLEV Rs. 630 (F)
14 Volume Variance Rs. 4,000 (F); Expenditure Variance

Rs. 10,000 (A); Fixed Overhead Cost Variance Rs. 6,000 (A); Variable Over-
head cost variance Rs. 12,000 (A)
15 (a) Rs. 36,000 (F); (b) Rs. 6,000 (F), (c) Rs. 30,000 (F)

Bhatta Chary S.K., Dearden John 2002, Costing for Management, Vikas Publishing
House, New Delhi (Chapter 7)
Khan M.Y. and Jain P.K., 2002, Management Accounting (Chapter 17), Tata
McGraw Hill : New Delhi
Daff, Trevor. 1986, Cost and management Accounting, Woodhead Fulkner
(Chapter 8).
Davidson, S. and R.L. Weil. 1977, Handbook of Modern Accounting, McGraw-hill
(Chapter 13).
Glautier, M.W.E. and B. Underdown. 1982, Accounting Theory & practice, ELBS
(English Language Book Society) (Chapter 37).
Douch N., Birnberg J.G. and Demiski, Joel. 1982, Cost Accounting. Harcourt Brace
Jovanovich: New York (Chapter 11).
Maheshwari, S.N. 1987, Management Accounting and Financial Control, 5th edition,
Mahavir Book Depot: Delhi (Section C, Chapter 3).
97
Understanding and Classifying
UNIT 7 UNDERSTANDING AND Costs
CLASSIFYING COSTS
Objectives
The Objectives of this unit are:
• to familiarise you with the process of determination of costs, particularly in a

manufacturing concern
• to explain how the costing techniques are useful in the process of managerial
decision-making.
Structure
7.1 Introduction
7.2 Cost Accounting
7.3 Costs
7.4 Elements of Cost
7.5 Components of Total Cost
7.6 Cost Sheet
7.7 Classification of Costs
7.8 Some other Concepts of Costs
7.9 Summary
7.10 Key Words
7.1 INTRODUCTION
You will recall that units 1 and 2 of this Course gave you detailed outline about the
conceptual frame work of accounting and the role the accountant is required to play
in the present commercial and industrial set-up. You have seen that he is more of an
adviser to the management. He functions as the channel through which accounting
information flows to the management efficiently and effectively. He gathers informa-
tion, breaks it down, sifts it and organises it into meaningful categories. He separates
relevant information from irrelevant and then ranks the former according to the
degree of importance to management. He also compares the actual performance with
the planned one and reports and interprets the results of operations to all levels of
management and to the owners of the business.
In performing the above multiple duties, the accountant has to make use of different
management accounting techniques. Cost techniques have a precedence over other
techniques since accounting treatment of costs is often both complex and financially
significant. For example, if a firm proposes to increase its output by 10%, is it
reasonable to expect total cost increase by less than 10%, exactly 10% or more than
10%? Such questions are concerned with the cost behaviour, i.e., the way costs
change with the level of activity.
Answers to these questions are pertinent for the management accountant or financial
analyst, since they are basic for the firm's projections and profits which ultimately 5
Cost Management become the basis for all financial decision. It is, therefore, necessary for a manage-
ment accountant or financial analyst to have a reasonably good working knowledge
about basic cost concepts and patterns of cost behaviour. All these come within the
range of cost accounting.
7.2 COST ACCOUNTING
In the initial stages cost accounting was merely considered to be a technique for
ascertainment of costs of products or services on the basis of historical data. In course
of time it was realised, due to competitive nature of the market, that ascertainment of
cost' was not so important as controlling costs was. Hence, cost accounting is consid-
ered more as a technique for `cost control' rather than as a technique merely for cost
ascertainment. Due to technological developments in all fields, `cost reduction' has
now come within the ambit of cost accounting. Cost accounting is thus concerned
with:
• Ascertaining the costs.
• Controlling the costs.
• Reducing the costsa
7.3 COSTS
Cost Accountant is concerned with costs and hence it will be of relevance to us to

understand the meaning of the term `Cost' in a proper perspective.
In general, cost means the amount of expenditure (actual or notional) incurred on, or
attributable to a thing. For example, if you have purchased a book for Rs. 150, it can
be said that the cost of the book to you is Rs.150. Similarly, if furniture manufacturer
makes a table by paying Rs.500 for timber, Rs 20.0 as carpenter's wages and Rs.100
as rent of the works, it can be said that the table cost him Rs.800. It may be noted,
however, that the term cost cannot be exactly defined. Its interpretation depends on:
a) the nature of the business or industry; and
b) the context in which it is used.
In a business where selling and distribution expenses are quite nominal, the cost of
the article may be calculated without considering the selling and distribution
overheads. In a business where the nature of the product requires heavy selling and
distribution expenses, the calculation of cost without taking into account selling and
distribution expenses may prove very costly to the business. Further the costs may
pertain to factory, office or other establishment aspects of operations. For example,
prime cost , includes expenditure on direct materials, direct labour and direct
expenses. Money spent on materials is termed as cost of materials, that spent on
labour as cost of labour and so on. Thus, the use of the term `cost' without
background information may be quite misleading.
It may also be noted that there is no such things as an exact cost or a true cost
because no figure of cost is true in all circumstances and for all purposes. Many items
of cost of production are handled in an optional manner which may give different
costs for the same product or job without going against the accepted principles of
cost accounting Depreciation is one such item. Its amount varies in accordance with
6 the method of depreciation being used. However, endeavour should be made to
obtain as far as possible the accurate cost of a product or service.
Understanding and Classifying
7.4 ELEMENTS OF COST Costs
In order to understand the correct interpretation of the term cost, it will be appropriate
for us to learn about the basic elements of cost. There are broadly three elements of
cost.
Material
The substance from which the product is made is known as material. It may be in a
raw or a manufactured state. It can be direct as well as indirect.
Direct Materials: All material which becomes an integral part of the finished
product and which can be conveniently assigned to specific physical units is termed
as `Direct Material'. The following are some of the examples of direct material:
• All material or components specifically purchased, produced or requisitioned

from stores.
• Primary packing material (e.g., carton, wrapping, cardboard, boxes, etc.)
• Partly produced or purchased components.
Indirect Material: All material which is used for purposes ancillary to the business
and which cannot conveniently be assigned to specific physical units, is termed as
ìndirect material'. Consumable stores, oil and waste, printing and stationary material,
etc., are a few examples of indirect material.
Labour
For conversion of materials into finished goods, human effort is needed, such human.
effort is called labour. Labour can be direct as well as indirect.
Direct Labour: Labour which takes an active and direct part in the production of a
particular commodity is called direct labour. Direct labour costs are, therefore,
specifically and conveniently traceable to specific products.
Indirect Labour: Labour employed for the purpose of carrying but tasks incidental
to goods produced or services provided is indirect labour. Such labour does not alter
the construction, composition or condition of the product. It cannot be practically
traced to specific units of output. Wages of store-keepers, foremen, time-keepers,
directors' fees, salaries of salesmen, etca, are all examples of indirect labour costs.
Expenses
Expenses may be direct or indirect.
Direct Expenses: These are expenses which can be directly, conveniently and
wholly allocated to specific cost centres or cost units. Examples of such expenses are:
hire of some special machinery required for a particular contract, cost of defective
work incurred in connection with a particular job or contract etc.
Indirect Expenses: These are expenses which cannot be directly, conveniently and
wholly allocated to cost centres or cost units. Example of such expenses are rent,
lighting, insurance charges; etc.
7
Cost Management
Chart 7.1: Element of Cost
Overheads
The term overhead includes indirect material, indirect labour and indirect expenses.
Thus, all indirect costs are overheads.
A manufacturing organisation can broadly be divided into three divisions:
• Factory or Works, where production is done.
• Office and administration, where routine as well as policy matters are

decided.
• Selling and distribution, where products are sold and finally despatched to
the customers.
Overheads may be incurred in the factory or office or selling and distribution

divisions. Thus, overheads may be of three types.
Factory Overheads: They include;
• Indirect material used in the factory such as lubricants,-oil, consumable

stores, etc.
• Indirect labour such as gate-keeper's salary, time-keeper's salary, manager's

salary, etc.
• Indirect expenses such as factory rent, factory insurance, factory lighting, etc.
Office and Administration Overheads: They include:
• Indirect material used in the office such as printing and stationery material,
rooms and dusters, etc.
• Indirect labour such as salaries payable to office manager, office accountant,

clerks, etc.
• Indirect expenses such as rent, insurance, lighting of the office.
Selling and Distribution Overheads: They include:
• Indirect material used such as packing material, printing and stationery

material, etc:
8 • Indirect labour such as salaries of salesmen and sales manager, etc.
• Indirect expenses such as rent, insurance, advertising expenses, etc.

The above classification of overheads can be shown by means of Chart 7.2 Understanding and Classifying
Costs
Chart 7.2: Classification of Overheads Overheads
7.5 COMPONENTS OF TOTAL COST

Prime cost: It consists of costs of direct material, direct labour, and direct expenses.
It is also known as basic, first or flat cost.
Factory Cost: It comprises prime cost and, in addition, works or factory overheads
which include costs of indirect material, indirect labour and indirect factory expenses.
This cost is also known as works cost, production or manufacturing cost.
Office Cost: It comprises of factory cost and office and administration overheads.
This is also termed as total cost of production.
Total Cost: It comprises of cost of production and selling and distribution overheads.
It is also termed as Cost of Sales. '
Various components of the total cost can be depicted by means of Chart 7.3.
Chart 7.3 : Components of Total Cost

Direct material
Direct labour Prime Cost or Direct cost or First cost or
Flat Cost
Direct expenses Works or Factory cost or Production cost or
Manufacturing cost
Prime cost plus Office cost or Total cost of production
Works overheads Cost of Sales or Total Cost
Works cost plus Office and
Administration overheads
Office cost plus Selling and
Distribution overheads
It may be noted that some accountants do not use the term office cost at all. They
prefer to use the term total cost after adding office and administration overheads and
selling and distribution overheads to works cost. However, while framing Chart 7.3
we have presumed that office and administration overheads exclusively relate to
production. The selling and distribution overheads are inclusive of any office and 9
administration overheads which may have been incurred in respect of sales.
Cost Management
7.6 COST SHEET
The elements/ components of total cost can be presented in the form of a statement,
popularly known as `Cost Sheet'. The cost sheet may be prepared separately for each
cost center. It may have columns to show total cost, cost per unit, together with the
relevant figures of the previous period.
The techniques of preparing a cost sheet can be understood with the help of an Illus-
tration.
Illustration 7.1
Let us prepare a cost sheet for a company showing different components of cost for
2003 from the following details
2003 from the following details. Rs Rs:
Raw Materials Consumed 80,000
Wages paid to labourers 20,000
Directly chargeable expenses 4,000
Oil & Waste 200,
Wages of Foremen 2,000
Storekeeper's Wages 1,000
Electric Power 400
Lighting : Factory 1,000
Office 400 1,400
Rent : Factory 4,000
Office 2,000 6,000
Repairs and Renewals: 1,000
Factory Plant
Machinery 2,000
Office premises 400 3,400
Depreciation : Office premises . 1,000
Plant and Machinery 400 1,400
Consumable stores 2,000
Manager's Salary 4,000
Director's Fees 1,000
Office Printing & Stationery 400
Telephone Charges 100
Postage and Telegrams 200
Sales men's Commission and Salary 1,000
Traveling expenses 400
Advertising 1,000
Warehouse charges 400
Carriage outwards 300
Cost Sheet for January, 2003

Rs. Rs. Rs.
Direct Material: Raw materials consumed 80,000
Direct Labour: Wages paid to laborers 20,000
Direct Expenses: Directly chargeable 4,000
10 expenses
PRIME COST 1,04,000
Add: Factory Overheads: Understanding and Classifying
Indirect Materials: Costs
Consumable stores 2,000
Oil & Waste 200
Indirect Labour: 2,200

Wages of foremen 2,000
Storekeeper Wages 1,000 3,000
Indirect Expenses:
Electric Power 400
Factory lighting 1,000
Factory rent 4,000
Repairs and Renewals:
Plant 1,000
Machinery 2,000
3,000
Depreciation:
Plant and machinery 400 8,800
Factory or Works Cost 14,000
1,18,000
Add: Office or Administrative Overheads :
Indirect material:
Office Printing and Stationery 400
Indirect labour:
Manager's salary 4,000
Director's fees 1,000 5,000
Indirect expenses:
Office lighting 400
Office rent 2,000
Repairs and Renewals premises 400
Depreciation on premises 1,000
Telephone charges 100
Postage and Telegrams 200 4,100
9,500
1,27,500
TOTAL COST OF PRODUCTION
Add: Selling and Distribution overheads:

Indirect labour:
Salesmen's Commission and 1,000
salary
Indirect expenses: 400

Travelling expenses 1,000
Advertising 400
Warehouse charges 300 2,100 3,100
Carriage outward
1,30,600 11
COST OF SALES
Complete the following Cost sheet
Cost Sheet for June 2003
Opening stock of raw material 10,000
Add purchases ……..
Less: Closing stock of raw material 50,000
Raw material consumed 12,000
Direct wages ……… ……….
Other Direct expenses 30,000
2,000
……….
a) Prime Cost 6,000 ………

Add: Factory overhead: ………
Indirect material
Indirect labour
Indirect expenses 1,000
9,000
b) Factory or Works Cost 17,000
Add: Office or administration
Overheads
c) Cost of Production 14,000

Add: Opening stock of finished goods
Less: Closing stock of finished goods 15,000
Selling and Distribution overheads 8,000
d) Cost of goods sold 1,03,000
Sale of finished goods 1,33,000

Profit for the month ……….
7.7 CLASSIFICATION OF COSTS
Costs can be classified into different categories depending upon the purpose for
which information is required. The costs can broadly be classified into Fixed,
Variable, Semi-variable and Step Costs.
Fixed Costs: These are the costs which remain constant irrespective of the quantum
of output within and up to the capacity that has been built up. Examples of such costs
are: rent, insurance charges, management salary, etc.
Fixed costs remain constant per unit of time. As a result, they decrease per unit with
every increase in output and vice versa. For example, if Rs.6,000 have been paid as
rent for a factory building with an output of 1,000 units, the cost of rent per unit is
Rs.6. In case the output increases to 1,200 units, the cost of rent per unit will decrease
to Rs.5. In case output is reduced to 800 units, the cost of rent per unit will increase
to Rs.7.50.
Fixed costs sometimes are also referred to as period costs. They can further be
divided into (i) committed fixed cost (ii) discretionary fixed costs.
Committed Fixed Costs Consists largely of those fixed costs that arise from the
possesssion of plant, equipment and a basic organisational structure. For example,
once a building is constructed and plant is installed, nothing much can be done to
reduce the costs such as depreciation, property taxes, insurance and salaries of the
key personnel, etc., without impairing the organisation's competence to meet the
long-term goals.
Discretionary Fixed Costs are those which are set at fixed amount for specific time
periods by the management in the budgeting process. These cost directly reflect top
management policies and have no particular relationship with volume of output.
These costs can therefore be reduced or eliminated entirely, if the circumstances so
12
require. Examples of such costs are: research and development costs, advertising and
sales promotion costs, donations, management consulting fees, etc. These costs are
also termed as managed or programmed costs.
Figure 7.1 shows the behaviour of fixed cost graphically. Understanding and Classifying
Costs
Figure 7.1 : Fixed Cost behaviour
3
Cost in thousand rupees
2
Fixed Cost line
1
0 1 2 3 4
Production in thousand units
Variable Costs: These are the costs which vary in direct proportion to output. They
increase or decrease in the same proportion in which the output increases or
decreases. The example of such costs are direct material, direct labour, power, etc.
Variable costs may be said to be constant per unit of output. For example, if a factory
incurs Rs. 1,000 on raw material for an output of 1,000 units, the cost of raw material
per unit would amount to Real. In case the output increases to 2,000 units, the cost of
raw material would proportionately increase to Rs. 2,000 (i.e Re. 1 x 2,000).
Similarly if the output decreases to 800 units, the cost of raw material would also
decrease to Rs 800 (i.e Re.1 x 800)
Variable costs are also referred to as product costs.
Figure 7.2 gives graphical presentation of variable costs
Figure 7.1 : Variable Cost Behaviour
Variable Costs
3
0 1 2 3 4
Semi-variable Costs: These are the costs which do vary but not in direct proportion
to output. They are made up of both fixed and variable cost elements such as depre-
13
ciation, repairs, light, heat, telephone, etc.
Cost Management Semi –variable costs are shown graphically in Figure 7.3
Figure 7.3: Semi-Variable Cost Behaviour

Semi-variable cost line
2
0 1 2 3 4
Identification of fixed and variable elements of semi-variable costs is important for
the management for planning their business activities. Different methods are
available for this purpose which will be discussed in the next unit.
Step Costs: Fixed cost in general remain fixed over a range of activity and then jump
to a new level as activity changes. For example, a foreman can supervise a given
number of workers. Beyond this number, it is necessary to hire a second foreman,
then a third and so on. Similarly, the rental cost of delivery vehicles also follows the
same pattern.
The general characteristic of fixed cost rising in steps is depicted in Figure 7.4
Figure 7.4: Fixed Costs rising in Steps
3
0 1 2 3 4
14
Illustration 7.2 Understanding and Classifying
Costs
A company has provided the following information to you in respect of 10,000 units
of output. Let us calculate the total cost for 12,000 units of output and the cost per
unit with the following information:
Variable cost Rs.50,000
Fixed Cost Rs.30,000
Semi-variable Cost (50% fixed) Rs.80,000
STATEMENT OF COST
Output 12,000 units
Rs. Rs.
60,000
Variable Cost @ Rs.5 30,000
Fixed cost
Semi-variable cost: 40,000
Fixed 48,000 88,000
Variable cost @ Rs.4
Total cost 1,78,000
Cost per unit 1,78,000 Rs.14.83

=
12,000
Direct and Indirect Cost
Direct Costs: These are costs which can be directly, conveniently and wholly traced
to a product , service or job. Example of such costs are: direct material, direct labour
and direct expenses.
Indirect Costs: These are costs which cannot be directly, conveniently and wholly
identified with a specific product, service or job. They include all overhead costs
such as salaries of time keepers, stores keepers, foreman , printing and stationery
costs, etc.
Indirect or overhead cost are apportioned to different jobs, products or services on a

reasonable basis. For example, the indirect factory labour cost may be apportioned
over different jobs according to their direct labour cost. Similarly, the selling
overheads can be charged to different products according to their sales values.
It may be noted that the more the share of the direct cost in relation to the total cost of
the product, the greater is the exactness in costing. The reason for this is that indirect
costs are allocated (or apportioned) on an estimated basis.
Activity 7.2
In terms of your own organisation give five examples of each of the following:
a) Direct Costs
b) Indirect Costs
c) Fixed Costs
d) Variables costs
e) Semi-Variables Costs
…………………………………………………………………………………………
…………………………………………………………………………………………
………………………………………………………………………………………… 15
…………………………………………………………………………………………
………………………………………………………………………………………….
Cost Management
7.8 SOME OTHER CONCEPTS OF COSTS
Shut Down and Sunk Costs
Shut Down Costs: These represent the fixed costs which have to be incurred even
during the period when a factory is shut down on account of some temporary difficul-
ties, viz., shortage of raw materials, non-availability of requisite labour force etc.
During this period, though no work is done, the fixed costs, such as rent, insurance,
depreciation, maintenance, etc. for the entire plant are still to be incurred. Such costs
of the idle plant are known as shut down costs.
Sunk Costs: These are historical or past costs, that is, costs which have been
incurred as a result of a decision-made in the past. Such costs cannot be reversed or
revised by subsequent decisions. Investments in plant and machinery, building, etc.
are some prominent example of such costs. Sunk costs are considered not relevant for
decisions concerning the increase in the present profit levels. Let us consider an
example.
Goa Steel Ltd, purchased a machine for Rs.60,000. The machine has an operating life
of five years without any scrap value. Soon after making the investment the manage-
ment felt that the machine should not have been purchased as it was incapable of .
yielding the operating advantage originally contemplated. Originally, it was expected
to result in savings in operating cost of Rs.40,000 over a period of ten years. On the
other hand, the machine can be sold immediately for sum of Rs. 42, 000.
In taking the decision whether the machine should be sold or it should be used, the
relevant amounts to be compared are Rs. 40,000 in cost savings over ten years and
Rsa 42,000 that can be realised in case it is immediately disposed offa The amount of
Rs. 60,000 invested in the asset is not relevant since it is the same in both cases. This
amount is sunk cost. Therefore, Goa Steels should sell the machinery for Rs. 42,000
since it will result in a gain of Rs. 2,000 as. compared to keeping and using it.
Controllable and Uncontrollable Costs
Controllable Costs: These are costs which can be influenced by the action of a
specified member of an organisation. For example, the foreman of a production
department can control the utilisation of power or raw materials in his department, .
These are, therefore, controllable costs as far as he is concerned.
Uncontrollable Costs: These are costs which cannot be influenced by the action of a
specified member of an undertaking. For example, the foreman of a production
department can control the wastage of power in his department, but he cannot control
the power which is being wasted in the power house itself resulting in higher cost per
unit of power to him. Similarly, he cannot control the increase in the cost of materials
consumed in his department, if the purchase department which is the supplying
department, buys the materials at higher prices due to its own inefficiency. Such costs
are controllable at a particular level of management while they are uncontrollable at
some other level of management.
The difference between controllable and uncontrollable costs is of particular signifi-

cance to the management. The executive concerned should be held responsible only
for those costs which are within his control and not for costs which are beyond his,
control.
Imputed or Hypothetical Costs: These are costs which do not involve cash outlay.
They are not included in cost accounts but are important for making management
16 decisions. For example, interest on capital is ignored in cost accounting though it is
considered in financial accounting. If two projects require unequal outlays of cash, the
management must take into consideration interest on capital to judge the relative Understanding and Classifying
profitability of the projects. Costs
Differential, Incremental or Decremental Costs: The difference in total costs

between two alternatives is termed as differential cost. In case the choice of an
alternative results in increase in the total costs, such increased costs are known as
incremental costs. If the choice results in decrease in total costs, the resulting
decrease is known as decremental costs. While assessing the profitability of a
proposed change, the incremental costs are matched with incremental revenuesa The
following illustration will demonstrate the concept of incremental costs.
Illustration 7.3
A company is presently selling, 1000 'unit @, Rs. 10 per unit. The variable cost per
unit is Rs 5 and the total fixed costs are Rs.1,000. The company receives an order for
supply of 200 units @ Rs.8 per unit. The execution of this export order will increase
fixed cost by Rs.200.
The cost and sales data under the existing and proposed situation can be put as under:
Existing Proposed Incremental
situation situation Cost Revenu
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 10,000 11,600 1,600
Less: Variable costs 5 000 6 000
Less : Fixed costs 4,000 9,000 4,200 10,200 1,200
Profit 1,000 1,400 400
Under the existing situation, there is a profit of Rs.1,000. If the alternative proposal.
is considered, it would result in incremental revenue of Rs.1,600 against the
incremental cost of Rs. I ;200. Hence the incremental profit will be Rs.400.
Out-of-Pocket Costs: Out-of-pocket cost means the present or future cash expendi-
ture regarding a certain decision which may vary, depending upon the nature of the
decision made. For example, a company has its own trucks for transporting raw
materials and finished products from one place to another. It seeks to replace these
trucks by employing public carriers of goods. In making this decision, of course , the
depreciation of the trucks is not to be considered, but the management must take into
account the present expenditure on fuel, salary to drivers and maintenance which
have to be incurred in cash. Such costs for arriving at a decision are termed as out-of-
pocket costs.
Opportunity Costs: Opportunity cost refers to the advantage, in measurable terms;

which has been foregone on account of not using the facilities in the manner
originally planned. For example, if an owned building is proposed to be utilised for
housing a new project plant, the likely revenue which the building could fetch, if
rented out, is the opportunity cost which should be taken into account while
evaluating the profit-ability of the project.
Suppose you have sizeable deposit in a bank which is fetching you a return of 10%
per annum. When your deposit is nearing maturity (but can be renewed), a friend of
yours approaches you with a business proposal which is likely to earn for you a
return of 18% (after tax). After careful consideration of the factors relating to risk and
return, you decide to go in for the proposal. It is obvious that you have to give tip the
existing alternative in view of the limited funds that you have. Thus you will no
longer have the bank deposit. The sacrifice in the form of 10% interest on your
deposit in the bank that you have to 'forego if you go in for business proposal is the 17
opportunity cost for the new alternative.
Cost Management Traceable, Untraceable and Joint Costs
Traceable Cost: These are costs which can be easily identified or traced to specific
products, services or units of the company such as raw material and labour. etc.
Untraceable Cost: These are cost which cannot be identified with a department,
process or product Such costs are also termed as common costs, as they are incurred
collectively for a number of products or cost centres e.g., overheads incurred for the
factory as a whole. As such they are apportioned among various products or cost.
centres using suitable criterion.
Joint Costs: Whenever two or more products are produced out of one and the same
raw material or process, the cost of material purchased and the processing costs are
called joint costs. Take the example of an oil refinery where a range of products such
as bitumen, petrol, kerosene, diesel, etc., are derived in the process of refining crude
oil. All these products have joint cost comprising the cost of crude and the cost
incurred in the course of refining. These joint costs are then apportioned to various
products on some basis.
Conversion Cost: The cost of transforming direct materials into finished products,
exclusive of direct material cost, is known as conversion cost. It is usually taken as
the aggregate of the cost of direct labour, direct expenses and factory overheads.
The above classification concepts of cost help the management in the decision
making process. For example, segregation of cost into fixed and variable elements
will help the management in analysing the total cost. Similarly, segregation of cost
into controllable and uncontrollable categories will help the management in fixing
responsibilities of d different executives for unfavourable cost variances. Numerous
other examples can be given highlighting the usefulness of the above classification of
costs.
Activity 7.3
Classify each of the following as direct or indirect cost (D or I) and as fixed or

variable cost (F or V). You will have two answers, D or I and F or V, for each of the
following items:
7.9 SUMMARY
In order to maximise a firm's wealth, ascertaining and controlling of cost is necessary.
18
Cost control involves controlling different elements of costs, viz. material, labour and
expenses. Each of these elements of costs can further be classified into direct and
indirect. The term overhead is used for all indirect costs. Costs can be classified into Understanding and Classifying
different categories, such as direct and indirect costs, fixed, variable and semi- Costs
variable costs; controllable and uncontrollable costs; differential incremental or
decremental costs, out -of-pocket costs and opportunity costs, etc. Each classification
of costs has its own significance in the managerial decision-making process.
7.10 KEY WORDS

Cost: The amount of expenditure (actual or notional) incurred on or attributable to a
given thing.
Conversion Cost: The Cost of converting direct materials into finished products, i.e,
direct wages, direct expenses and factory overheads.
Controllable Cost: Costs chargeable to a job or cost center which can be influenced
by the actions of the persons in whom the control of such a center is vested.
Differential Cost: The difference in total cost between two alternatives.
Fixed Cost: The cost which remains fixed irrespective of the quantum of output over
a certain capacity of the organisation.
Opportunity Cost: The value of the benefit sacrificed in favour of choosing a

particular alternative or action.
Uncontrollable Cost: The costs chargeable to a job or cost center which cannot be
influenced by the action of the person in whom the control of the center vests.
Variable Cost: The cost which tends to vary in direct proportion to changes in the
volume of output or turnover.

1. What do you understand by cost accounting? State its objectives.
2. What do you understand by cost? Explain its different elements.
3. All controllable costs are direct costs, not all direct costs are controllable.
Explain with the help of suitable examples.
4. "Fixed costs are variable per unit, while variable costs are fixed per units".
Comment.
5. How would you differentiate between `Direct cost' and `Variable Costs'?
Give suitable illustrations.
6. State whether each of the following statements is `True' or `False'.
19
Cost Management 7. Select the most appropriate answer for each of the following cases:
i) Cost accounting mainly helps the management in: (a) earning extra
profit: (b) providing information to management for decision-making;
and (c) fixing prices of the products.
ii) Variable cost per unit: (a) remains fixed; (b) fluctuates with the volume
of production; and (c) varies in sympathy with the volume of sales.
iii) Fixed cost per unit increases when: (a) production volume decreases;
(b) production volume increases; and (c) variable cost per unit decreases
iv) Opportunity cost helps in: (a) ascertaining of cost (b) controlling cost;
and (c) making managerial decisions.
v) Conversion cost is the sum total of: (a) direct material cost and direct
wages cost (b) direct wages, direct expenses and factory overheads, and
(c) indirect wages and factory overheads.
8. Prepare a cost sheet from the following details:

Raw Materials :
Opening stock 20,000
Purchases 1,00,000
Closing 40,000
Direct wages 40,000
Chargeable Expenses 8,000
Machine hours worked 16,000
Machine hour rate Rs. 2
Office overheads 10% of works cost
Selling Overheads Rs. 1.50 per unit
Cash discount allowed 1,000
Interest on capital 2,000
Units produced 4,000
Units sold 3,600 @ Rs. 50 each
(Hint: Cash discount and interest on capital are to be excluded from costs).
9. Calculate (a) Value of raw material consumed, (b) Total cost of production,
(c) Cost of production of goods sold, and (d) The amount of profit from the
following particulars:
Rs.
Opening Stock:
Raw materials 5,000
Finished goods 4,000
Closing stock
Raw materials 4,000
Finished goods 5,000
Raw materials purchased 40,000
Octroi paid on raw materials 4,000
Carriage inward 6,000
Direct wages paid 20,000
Direct expenses 2,000
Rent, rats and taxes 5,000
Power 2,000
Factory heating and lighting 2,000
Factory insurance 1,000
20
Experimental expenses 500 Understanding and Classifying
Office management salaries 4,000 Costs
Office printing and stationary 2,000
Salary of salesman 600
Advertising 300
Carriage outwards 100
Sales 1,00,000
Answers to Activity 7.3
a) I V
b) D V
c) D V
d) I V
e) I F
f) I F
g) I F
h) D V
i) I V
j) D V
k) D V
l) D V
Answers to Self-assessment Questions/ Exercises
6. (i) F; (ii) F; (iii) F; (iv) T; (v) F.
7 (i) b; (ii) a; (iii) a; (iv) c; (v) b.
8. Prime Cost Rs. 1,28,000; Works cost Rs. 1,60,000
Cost of production Rs. 1,76,000; Cost of sales Rs. 1,63,800; Profit Rs.
16,200
9 (a) Rs.51,000; (b) Rs. 89,500; (c) Rs. 89,500 and (d) Rs. 10,500

Horngren, C.T.; Datar Srikant M and Foster George M, 2002, Cost Accounting : A
Managerial Emphasis, Prentice Hall of India: New Delhi ( Chapters 2 and 9 )
Bhattacharyya, S.K., Dearden John, 2002, Costing for Management (Part I), Vikas
Publishing House : New Delhi
Dopuch, N Birnberg, J.G. and Demiski , Joel, 1982, .Cost Accounting , (2nd Ed.)
Harcourt Brace Javanovich: New York. ( Chapter 2)
Glautier, M.W.E. and B. Underdown, 1982, Accounting Theory and Practice,

ELBS, London: Bombay ( Chapter 27)
Maheshwari, S. N. 1987, Management Accounting and Financial Control,

5th Edition, Mahavir Book Depot, Delhi ( Section A, Chapter 3).
21
Cost Management
UNIT 8 ABSORPTION AND MARGINAL
COSTING
Objectives
The aims of this unit are:
• to familiarise you with the techniques of Absorption Costing and Marginal

Costing
• to explain the basic features and in that process bring out explicitly the
differences between the two techniques
• to develop an appreciation that Marginal Costing has an edge over

Absorption Costing as far as managerial decision making is concerned
Structure
8.1 Introduction
8.2 Absorption Costing
8.3 Marginal Costing
8.4 Absorption Costing and Marginal Costing : Differences
8.5 Marginal Cost
8.6 Segregation of Semi-variable Costs
8.7 Contribution
8.8 Break-even Analysis
8.9 Utility of Marginal Costing
8.10 Limitations of Marginal Costing
8.11 Summary
8.12 Key Words
8.13 Self-assessment Questions/ Exercises
8.1 INTRODUCTION
In the preceding unit, we familiarised you with the different elements of cost i.e.
materials, labour and expenses. These elements of cost can broadly be put into two
categories: Fixed and variable costs. Fixed costs are those which do not vary but
remain constant within a given period of time in spite of fluctuations in production.
The examples of fixed costs are: rent, insurance charges, management salaries, etc.
On the other hand, variable costs are those which vary in direct proportion to any
change in the volume of output. The costs of direct material, direct wages etc, can be
put into this category. The cost of a product or process can be ascertained ( using the
different elements of cost) by any of the following two techniques:
• Absorption Costing
• Marginal Costing
22
Absorption and Marginal
8.2 ABSORPTION COSTING Costing
Absorption Costing technique is also termed as Traditional or Full Cost Method.

According to this method, the cost of a product is determined after considering both
fixed and variable costs. The variable costs, such as those of direct materials, direct
labour, etc. are directly charged to the products, while the fixed costs are apportioned
on a suitable basis over different products manufactured during a period. Thus, in
case of Absorption Costing all costs are identified with the manufactured products.
This will be clear with the help of the following illustration.
Illustration 8.1
Tripura Ltd. is manufacturing three products : A, B and C. The costs of manufacture
are as follows:
A B C
Rs. Rs. Rs.

Direct Labour 2 3 4
Selling Price 10 15 20
Output 1,000 units 1,000 units 1,000 units'
The total overheads are Rs. 12,000 out of which Rs. 9,000 are fixed and the rest are
variable. It is decided to apportion these costs over different products in the ratio of
output. We would prepare a statement showing the cost and profit of each product
according to Absorption Costing.
Statement Showing Costs and Profit

(According to Absorption Costing Technique)
A B C
Per Total Per Total per Total
Unit Unit Unit Rs.
Rs. Rs. Rs. Rs. Rs.
Direct Materials 3 3,000 4 4,000 5 5,000
Direct Labour 2 2,000 3 3,000 4 4,000
Overheads:
Fixed 3 3,000 3 3,000 3 3,000
Variable 1 1000 1 1,000 1 1,000
Total Cost 9 9,000 11 11,000 13 13,000
Profit 1 1,000 4 4,000 7 7,000
Selling Price 10 10,000 15 15,000 20 20,000
Total profit Rs. 1,000+ Rs. 4,000 + Rs. 7,000= Rs. 12,000
This system of costing has a number of disadvantages:

• It assumes prices are simply a function of costs.
• It does not take account of demand.
• It includes past costs which may not be relevant to the pricing decision at
hand.
• It does not provide information which aids decision-making in a rapidly
changing market environment
As a result of these disadvantages, fallacious conclusions may be derived as shown 23
Cost Management
by the following illustration.
Illustration 8.2
With the data given in Illustration 8.1, we would calculate the amount of profit or
loss made by Tripura Ltd. in the first two years of its existence, presuming that:
i) In the. first year, it manufactures 1,000 units of each of the products A, B and
C but fails to effect any sales.
ii) In the second year , it does not produce anything but sells the entire stock
carried forward from the first year.
The profit or loss for the first two years can be ascertained by preparing the Profit
and Loss Account for each of these years
Tripura Ltd.
Profit & Loss Account for the 1st year
Rs. Rs. Rs.
Direct Material Sales -
A 3,000 Closing Stock 33,000
B 4,000
C 5,000
______ 12,000
Direct Labour
A 2,000
B 3,000
C 4,000
______ 9,000
Overheads:
Variable
A 1,000
B 1,000
C 1,000 3,000
Fixed ____ 9,000 12,000
33,000 33,000
Tripura Ltd.
Profit & Loss Account for the 2nd year
Rs. Rs.
Opening Stock 33,000 Sales
Fixed Overheads 9,000
Profit 3,000 A 10,000
B 15,000
C 20,000 45,000
45,000 45,000
The above Profit and Loss Accounts show that in the first year in spite of the fact that
the company does not make any sales, there is no loss what so ever; while in the
second year, it makes a profit of Rs.3,000. As a matter of fact, the company losses
Rs, 9,000 on account of non-recovery of fixed cost in the first year. The Profit and
Loss Account does not show any loss because these fixed costs have been included in
24 the closing inventory values and thus carried forward to the next year. As a result, the
Profit and Loss Account for the second year has to bear Rs.18,000 on account of
fixed costs (i.e. Rs. 9,000 for the first year + Rs. 9,000 for the second year). The real
profit in the second year should have been Rs.12,000 and not Rs. 3,000. This will be Absorption and Marginal
elaborated a little later. Costing
Thus, the technique of Absorption Costing may lead to rather odd results particularly
for seasonal businesses in which the stock levels fluctuate widely from one period to
another. Their profits for the two periods will be influenced by the transfer of
overheads in and out of stock, showing falling profits when the sales are high and
increasing profits when the sales are low.
The technique of Absorption Costing may also lead to the rejection of profitable
business. The total unit cost will tend to be regarded as the lowest possible selling
price. An order at a price which is less than the total unit cost may be refused, though
this order may actually be profitable, as shown in Illustration 8.3.
Illustration 8.3
You are the Managing Director of Usha Automobiles Ltd. and have received a
special offer for the supply of 200 components at Rs. 60 a piece from a motorbike
manufacturer. Your company has a capacity to produce 1,000 components. You are
at present, working at 80 per cent capacity. The present selling price per component is
Rs.100. The cost details, as supplied by your Cost Accountant, are as follows:
Variable cost per unit Rs. 40
Fixed overheads cost per unit
(Total Fixed overheads Rs. 24,000) Rs. 30
Total Cost per unit Rs. 70
Your Cost Accountant advises you to reject the order since you will be getting less
than the total cost of the component. How would you react?
The advice given by the Cost Accountant is not correct. Since he has based his
decision on Absorption Costing, he is advising against accepting the special offer. As
a matter of fact, the acceptance of the special order may result in extra profit to the
company, as shown below:
Statement of Profit
Sales Total
Sales in Units 800 200 1000
Sales in Rs. 80,000 12,000 92,000
(800 x 100) (200 x 60)
Total Cost:
Fixed (Rs) 24,000 - 24,000

56,000 8,000 64,000
Profit (Rs) 24,000 4,000 28,000
Thus, if the offer is accepted, the profit will increase from Rs. 24,000 to Rs. 28,000.
It is, therefore, advisable to accept the offer rather than reject it.
8.3 MARGINAL COSTING
The technique of Marginal Costing is a definite improvement over the technique of

Absorption Costing. According to this technique, only the variable costs are consid-
ered in calculating the cost of the product, while fixed costs are charged against the 25
Cost Management
revenue of the period. The revenue arising from the excess of sales over variable
costs is technically known as Contribution under Marginal Costing.
The following illustration will help you in understanding the technique.
Illustration 8.4
From the data given in Illustration 8.1, Let us prepare a statement of cost and
profit according to Marginal Costing Technique.
Statement of Cost and Profit
(According to Marginal Costing Technique)
Product A Product B Product C
Per Total Per Total Per Total

Unit Unit Unit
Direct Material 3 3,000 4 4,000 5 5,000

Direct Labour 2 2,000 3 3,000 4 4,000
Variable overheads 1 1,000 1 1,000 1 1,000
Total Marginal Cost 6 6,000 8 8,000 10 10,000
Contribution 4 4,000 7 7,000 10 10,000
Selling Price 10 10,000 15 15,000 20 20,000
Thus, the total contribution from the three products, A, B and C is Rs. 21,000. The
profit will now be computed as follows:
profit will now be computed as follows:
Total Contribution Rs. 21,000
Fixed Costs 9,000
Profit
12,000
Marginal Costing helps us in managerial decision-making as can be seen from the
following illustrations:
Illustration 8.5
With the data given in Illustration 8.2, let us calculate the amount of profit or loss by
preparing a Profit and Loss Account according to Marginal Costing technique.
Profit and Loss Account for the 1st year
Rs. Rs.
Direct Material 3,000 Sales --------
A 4,000 Closing Stock 24,000
B 5,000 12,000 Loss 9,000
C
Direct Labour
A
B
2,000
C
3,000
Variable overheads
4,000 9,000
Fixed overheads
3,000
9,000
33,000 33,000
Profit and Loss Account for the 2nd year
Rs. Rs.
Opening Stock 24,000 Sales
26
Fixed overheads 9,000 A 10,000
Profit 12,000 B 15,000 Absorption and Marginal
Costing
C 20,000 45,000
45,000 45,000
The above statement shows that the company suffers a loss of Rs. 9,000 in the first
year because of non-recovery of fixed overheads, while in the second year it makes a
profit of Rs. 12,000. It may be seen from the two years ` Profit and Loss Accounts
that the fixed cost of one year has not been carried forward to the next year, Thus, the
profit and Loss Account gives a correct picture
8.4 ABSORPTION COSTING AND MARGINAL

COSTING : DIFFERENCES
The difference between Absorption Costing and Marginal Costing is based on the
recovery of fixed overheads. The difference in valuation of inventory under the two
techniques is a consequence of such treatment. However, for the sake of clarity, we are
analysing the difference from both angles, viz. recovery of overheads and valuation of
stock.
Recovery of overheads
In case of Absorption Costing, both fixed and variable overheads are charged to
production. On the other hand, in Marginal Costing only variable overheads are
charged to production while fixed overheads are transferred in full to the profit and
loss account. Thus, in case of marginal Costing, there is under- recovery of overheads
since only variable overheads are charged to production.
Valuation of Stocks
In Absorption Costing stocks of work -in-progress and finished goods are valued at
works cost and total cost of production respectively. The works cost or cost of pro-
duction is so defined as to include the amount of fixed overheads also. In marginal
Costing, only variable costs are considered while computing the value of work-in
progress or finished goods. Thus, the closing stock in Marginal Costing is under-
valued as compared to Absorption Costing. But this does not result in carrying over
of fixed overheads of one period to another, as it happens in Absorption Costing.
The above points of difference will become clear with the help of the following
illustration.
Illustration 8.6
Taking the figures given in Illustration 8.1, let us compute the amount of profit under
Marginal and Traditional Costing systems, in case units sold of products A, B and C
are 900 each.
Statement of Profit
(Absorption Costing Systems)
A B C
Rs. Rs. Rs.
Direct Material 3,000 4,000 5,000
Direct Labour 2,000 3,000 4,000
Overheads : Variable 1,000 1,000 1,000
Total Marginal Cost 6,000 8,000 10,000

Add: Fixed overheads 3,000 3,000 3,000
Total Cost of Production 9,000 11,000 13,000

Less: Closing Stock 900 1,100 1,300 27
Cost Management Cost of goods sold 8,100 9,900 11,700
Profit 900 3,600 6,300
Sales 9,000 13,500 18,000

Thus, total profit under Absorption Costing is:
Rs.
Product A 900
Product B 3,600
Product C 6,300
10,800
Statement of Profit
(Marginal Costing)
A B C
Rs. Rs. Rs.
Total Marginal Cost 6,000 8,000 10,000
Less: Closing Stock 600 800 1,000
Cost of goods sold 5,400 7,200 9,000
Contribution 3,600 6,300 9,000
(Sales - Marginal Cost of Production)
Sales 9,000 13,500 18,000
Thus, total profit under Marginal Costing will be:

Rs
Product A 3,600
Product B 6,300
Product C 9,000
Total Contribution 18,900
Less: Fixed cost 9,000
Profit Rs. 9,900
The profit under Traditional Costing system is Rs. 10,800 while it is Rs. 9,900
under Marginal Costing system. This is on account of the difference in valuation
of closing stock. The closing stock under Traditional Costing system includes
fixed cost of Rs. 900.
That is why the profit under Traditional Costing System is higher by Rs. 900
compared to Marginal Costing system.
Illustration 8.7
From the following cost, production and sales data of Competent Motors Ltd.,
prepare comparative income statement for three years under (i) absorption costing
method, and (ii) marginal costing method. Indicate the unit cost for each year
under each method. Also evaluate the closing stocks. The company produces a
single article for sale.
Particulars Year
2001 2002 2003
Selling price per unit 20 20 20
Variable manufacturing cost per unit 10 10 10
28 Total fixed manufacturing cost 5,000 5,000 5,000
Opening stock 500
Units produced 1,000 1,500 2,000 Absorption and Marginal
Costing
Units sold 1,000 1,000 1,500
Closing stock 500 1,000
Comparative Income Statement
(Absorption Costing System)
2001 2002 2003

Unit Unit Unit Rs.
Rs. Rs. Rs. Rs. Rs.
Variable cost 10 10,000 10 15,000 10.00 20,000
Fixed cost 5 5,000 3.33 5,000 2.50 5,000

Total cost of production 15 15,000 13.33 20,000 12.50 25,000
Add: Opening stock - - 6,665
15 15,000 13.33 20,000 12.50 31,665
Less : Closing Stock - 6,665 12,500
Cost of production of goods sold
15 15,000 13.33 13,335 12.50 19,165
Profit 5 5,000 6.67 6,665 7.50 10,835
Sales 20 20,000 20.00 20,000 20.00 30,000
Comparative Income Statement

(Marginal Costing System)
2001 2002 2003
Unit Rs. Unit Rs. Unit Rs.
Rs. Rs. Rs.
Variable cost 10 10,000 10 15,000 10 20,000
Add: Opening stock --- --- --- --- --- 5,000
Less: Closing stock 10 10,000 10 15,000 10 25,000

--- --- --- 5,000 --- 10,000
Cost of production of 10 10,000 10 10,000 10 15,000
goods sold
Sales 20 20,000 20 20,000 --- 30,000
Contribution 10 10,000 10 10,000 15,000
Less: Fixed cost 5,000 5,000 5,000
Profit 5,000 5,000 10,000

From the above illustrations the following general rules can be made out:
• The profit under Traditional Costing System and the Marginal Costing
System will be the same in case there are no opening and closing stocks.
• In case, there is closing stock (and no opening stock), the profit under
Traditional Costing system will be more as compared to Marginal Costing
System.
• In case, there is opening stock (and no closing stock), the profit under
Marginal Costing system will be more than the profit under Traditional
Costing System.
• If the quantity of closing stock is more than the quantity of the opening stock
(presuming that both opening and closing stocks are valued at uniform
prices), profit under Traditional Costing System will be more as compared to
profit under Marginal Costing System and vice versa.
Activity 8.1
Prepare a Comparative Inventory and Income Measurement Statement for a firm for
years II and III under Absorption and Marginal costing. The statement for the 1st
29
Cost Management
years is given. You may assume the following for your calculations :
a) Sales annually remain constant at 36,000 units at Rs. 10 per unit.
b) Variable overhead is Re. I Per unit, and fixed overheads is Rs. 20,000 per
annum.
c) Production in Year I is 40,000 units, Year II is 50,000 units and Year III is
25,000 units.
d) Direct materials and labour costs amount to Rs. 6 per unit.
You can further assume that overheads absorption rate and actual overhead costs
are the same. From (b) and (c) you will see that the fixed overheads absorption rate
is Re. .50, .40, .80, per unit in the three successive years.
Comparative Inventory and Income Measurement
(In thousand rupees)
Year I Units Per Absorption Marginal
(‘000) Unit
Rs.
Sales 36 10 360 360

Cost of Goods Produced
Direct Material and 40 6 240 240
Labour
Variable Overhead 40 1 40 40
Fixed Overheads 40 .5 20 300 --- 280
Closing Stock
Direct Materials and 4 6 24 24
Labour
Variable Overhead 4 1 4 4
Fixed Overheads 4 .5 2 30 270 --- 28 252
Fixed Overheads
108
Profit 20
90 88
Year II Units Per Absorption Marginal

(‘000) Unit
Rs.
Sales
Opening Stock
Direct Material and
Labour
Variable Overhead
Fixed Overheads
Closing Stock
Direct Materials and
Labour
Variable Overhead
Fixed Overheads
Fixed Overheads
Profit
Year III Units Per Absorption Marginal

(‘000) Unit
Rs.
Sales
Opening Stock
Direct Material and
Labour
30 Variable Overhead
Fixed Overheads
Closing Stock Absorption and Marginal
Direct Materials and Costing
Labour
Variable Overhead
Fixed Overheads
Fixed Overheads
Profit
8.5 MARGINAL COST

The technique of marginal costing is concerned with marginal cost. It is, therefore,
necessary for you to understand correctly the term `Marginal Cost'. The Institute of
Cost and Management Accountants, London, has defined Marginal Cost as "the
amount at any given volume of output by which aggregate costs are changed if the
volume of output is increased by one unit". On analysing this definition we can
conclude that the term "Marginal Cost" refers to increase or decrease in the amount
of cost on account of increase or decrease of production by a single unit. The unit
may be a single article or a batch of similar articles. This will be clear from the
following example.
A factory produces 500 tricycles per annum. The variable cost per tricycle is Rs. 100.
The fixed expenses are Rs. 10,000 per annum.
Thus, the cost sheet of tricycles will appear as follows:
Rs.
Variable Cost (500 x Rs. 100) 50,000
Fixed cost 10,000
60,000
If production is increased by one unit, i.e. it becomes 501 tricycles per annum, the
cost sheet will then appear as follows:
Rs.
Variable Cost (501 x Rs. 100) 50,100
Fixed cost 10,000
60,100
Marginal cost per unit is, therefore, Rs 100
Marginal cost ordinarily is equal to the increase in total variable cost because within
the existing production capacity an increase of one unit in production will cause an
increase in variable cost only. The variable cost consists of direct materials, direct
labour, variable direct expenses and variable overheads. The term àll variable
overheads' includes variable overheads plus the variable portion contained in semi-
variable overheads. This portion has to be segregated from the total semi-variable
overheads according to the methods to be discussed later.
The accountant's concept of marginal cost is different from the economist's concept
of marginal cost. According to economists, the cost of producing one additional unit
of output is the marginal cost of production. This shall include an element of fixed
cost also. Thus, fixed cost is taken into consideration according to the economist's
concepts of marginal cost, but not according to the accountant's concept. Moreover,
with additional production the economist's marginal cost per unit may not be
uniform since the law of diminishing (or increasing) returns may be applicable, while
31
the accountant's marginal cost is taken as constant per unit of output with additional
Cost Management
production.
Illustration 8.8
Following information related to a factory which manufactures fans:

Production Direct Direct Other Variable Fixed Total
in units Material Labour Costs Costs Cost
Rs. Rs, Rs. Rs. Rs.
500 1,000 750 500 1,000 3,250
1,000 2,000 1,500 1,000 1,000 5,500
1,500 3,000 2,250 1,500 1,000 7,750
2,000 4,000 3,000 2,000 1,000 10,000
2,500 5,000 3,750 2,500 1,000 12,250
Let us see the effect of increase in output on per unit cost of production through a
graph and calculate the marginal cost of production.
Production Total Variable Fixed Cost Total Cost
units Cost per unit per unit per unit
Rs. Rs. Rs.
500 4.50 2.00 6.50
1,000 4.50 1.00 5.50
1,500 4.50 0.67 5.17
2,000 4.50 0.50 5.00
2,500 4.50 0.40 4.90
Graph Depicting Total Cost per Unit at Varying Levels of Output
The above graph shows that with an increase in production the total cost per unit is
decreasing. This happens because the fixed overheads which are constant at all levels
of output are spread over successively larger outputs. Hence cost of output per unit
goes on decreasing with every increase in volume of output. It will be seen that while
the marginal cost of production per unit remains constant (at Rs. 4. 50), the fixed cost
per unit decreases from Rs. 2 to 0.40. This phenomenon will have considerable effect
in motivating the firm in its decision to increase production, as in the present
illustration.
Marginal cost under the present illustration can be calculate with the help of the
following formula:
Marginal Cost = Direct Material Cost + Direct Labour Cost + Other Variable Costs
32 or
Total Cost - Fixed Cost Absorption and Marginal
Costing
When the production is 500 units, the marginal cost of production shall be equal to
Rs. 1,000 +Rs. 750 + Rs. 500, i.e, Rs. 2,250 (or Rs. 3,250 - Rs. 1,000). Marginal cost
at other levels of output can be figured out in a similar fashion.
8.6 SEGREGATION OF SEMI-VARIABLE COSTS

As explained earlier, Marginal Costing Method requires segregation of all costs into
two parts-fixed and variable. This means that the semi-variable costs will have to be
segregated into fixed and variable elements.
This may be done by any of the following methods:
• Levels of output compared to levels of expenses method,
• High-low method,
• Degree of variability Method,
• Scattergraph method,
• Least squares method.
Each of the above methods has been discussed in detail with the help of the following
illustration:
Illustration 8.9
Production Units Semi-variable expenses
July 2002 100 300
August 2002 60 264
September 2002 160 400
October 2002 120 340
November 2002 200 460
December 2002 140 380
During the month of January, 2003 the production is 80 units only. Let us calculate
the amount of fixed, variable and total semi-variable expenses for the month.
Levels of Output to Levels of Expenses Method
According to this method, the difference in output at two different points of time is
compared with the corresponding difference in expenses. Since the fixed portion of
expenses remains constant, any increase or decrease in total semi-variable expenses
must be attributed to the variable portion. The variable cost per unit can be derived
by dividing the difference in (total) semi-variable expenses with the difference in the
level of output at two points of time.
Taking the figures for the month of September and November of the illustration
given above, we can calculate fixed and variable components of semi-variable costs:
Month Production Semi-variable Fixed Variable
units expenses (Rs.) (Rs.) (Rs.)
September 160 400 160* 240
November 200 460 160** 300

33
Cost Management Difference 40 Rs.60
The variable element included in semi-variable expenses is:
* Variable overheads for September= 160 x Rs. 1.50 = Rs, 240

Fixed overheads for September = Rs. 400 - Rs. 240 = Rs. 160
** Overheads (into fixed and variable components) for November have been computed
in a. similar manner.
Semi-variable Overheads for January: Rs.
Variable overheads for January 80 x Rs. 1.50 = 120
Fixed overheads 160
280
High-Low Method
This method is similar to previous method except that only the highest and the lowest
levels of output rate are considered out of various levels. This method is also known
as the Range Method.
The highest production in the illustration is in the month of November while the
lowest is in the month of August. The figures for these two months, therefore, have
been considered.
Month Production Semi-variable Fixed Variable
units expenses (Rs.) (Rs.) (Rs.)
August 60 264 180** 84*
November 200 460 .180** 280
Difference 140 196
Variable element: 196/140 i.e., Re 1.40 per unit.,
* Variable overheads for August = 60 x Rs. 1.4 = Rs. 84
Fixed overheads for August = Rs. 264 - 84 = Rs. 180
** Similarly, the fixed and variable overheads for November have been ascertained.
Semi Variable overheads for January: Rs.
Variable overheads for January: 80 x Rs. 1.40 112
Fixed overheads 180
292
The High - Low Method takes into consideration two sets of data instead of all the
data. The two sets of data are the high cost point and the low cost point relating to a.
specific measure of output such as number of units produced (as in our Illustration),
labour hours, machine hours etc.
As the results in High-Low method are based on observation of extreme data, the
results may not be very accurate. Because of relying only on the extreme points, the
basis computed for segregation of fixed and variable costs may not be representative
34 of normal situation. As such the High-Low method is generally not recommended.
Though a crude alternative to more elaborate Least Squares, this method can give
fairly acceptable results if the high and low points are chosen with careful consider- Absorption and Marginal
ation of the data. Costing
Degree of Variability Method
In this method, degree of variability is estimated for each item of semi-variable

expenses. Some semi-variable items may have 40% variability while others may
have 60% variability. The method is simple to understand. However, determining the
degree of variability may be quite difficult.
Assuming the degree of variability is 60% in semi-variable expenses and taking the
month of October as a basis, the analysis can be done as under:
Variable element = (60% of Rs. 340) i.e. Rs. 204
Fixed element = Rs. 340-204 = 136
On the above basis, the variable expenses for 80 units (the production of January 2003)
will be as follows:
Hence, the total semi-variable expenses for January, 2003 are Rs. 136 + Rs. 136 = Rs.
272.
Scattergraph Method
In this method the given data are plotted on graph paper and line of best fit is drawn.
The method is explained below:
• The volume of production is plotted on the horizontal axis and the costs are
plotted on the vertical axis.
• Corresponding costs of each volume of production are then plotted on the
paper, thus several point are shown on it.
• A straight line of best fit is then drawn through the points plotted. This is the
total cost line. The point where this line intersects the vertical axis is taken to
be the amount of fixed element.
• A line parallel to the horizontal axis is drawn from the point where the line of
best fit intersects the vertical axis. This is the fixed cost line.
• The variable cost at any level can be known by noting the difference between
fixed cost and total cost lines.
35
Cost Management
An observation of the graph tells us that fixed expenses are Rs. 170 approximately.
For the month of January 2003, the semi-variable expenses are Rs. 290 (which can be
ascertained from the line of best fit in the graph at the level of 40 units). As such, the
variable expenses will be Rs. 120 (Rs. 290-170).
Method of least squares
This method is based on the mathematical technique of fitting an equation with the help
of a number of observations. The linear equation, i.e, a straight line equation, can be
assumed as:
An equation of second order, i.e, a curvilinear equation can be drawn as
y = a + bx + cx2 and the various sub-equations to solve it (i.e., to find out the values of
constants a, b and c, shall be:
A linear equation can be obtained with the help of the following values, thus:
Months Production Expenses
(units) Rs.
x y x2 xy
July 2002 100 300 10,000 30,000
August 2002 60 264 3,600 15,840
September 2002 160 400 25,600 64,000
October 2002 120 340 14,400 40,800
November2002 200 460 40,000 92,000
December 2002 140 380 19,600 53,200
Total ∑x = 780 ∑y = 2,144 ∑x2 = 1,13,200 ∑xy = 2,95,840
Assuming the equation as y = a + bx, we have to find the values of constants a and b
with the help of above figures. The other two equations are:
36
Costing
8.7 CONTRIBUTION
It has already been stated earlier in the unit that the difference between selling price
and variable cost (i.e. the marginal cost) is known as `Contribution' or `Gross Mar-
gin' In other words, contribution is the sum of fixed costs and the amount of profit. It
can be expressed by the following formula.
Contribution = Selling Price-Variable Cost

or = Fixed Cost + Profit
From the above, we can conclude that profit cannot result unless contribution exceeds
fixed costs. In other words, the point of no profit no loss' will be at a level where
contribution is equal to fixed costs. Let us take an example.
Variable cost Rs. 5,000
Fixed cost Rs 2,000
Selling Price Rs. 8,000
Contribution = Selling Price – Variable cost
= Rs. 8,000 – Rs. 5,000
= Rs. 3,000
Profit = Contribution – Fixed cost
= Rs. 3,000 – Rs. 2,000
Rs. 1,000
As contribution exceeds fixed cost there is a profit of Rs. 1,000. If fixed cost is
assumed at Rs. 4,000, the position will change as under:
Contribution – Fixed Cost = Profit (Loss)
Rs. 3,000 – Rs. 4,000 = (Rs. 1,000)
The sum of Rs. 1,000 represents the extent of loss since the fixed costs are more than 37
Cost Management
contribution. At the level of fixed cost of Rs. 3,000, there shall be no profit and no
loss. The concept of Break-even Analysis emerges out of this basic fact.
8.8 BREAK-EVEN ANALYSIS

The term 'Break-even Analysis refers to a system of determination of that level of
activity where total cost equals total selling price. However, in the broader sense, it
refers to that system of analysis which determines the probable profit at any level of
activity. The relationship between cost of production, volume of production, profit
and sales value is established by break-even analysis. The analysis is also known as
`Cost-Volume-Profit analysis.
Break-even analysis is useful for a manager in the following ways:
• It helps him in forecasting the profit fairly accurately.
• It is helpful in setting up flexible budgets, since on the basis of Cost-Volume
Profit relationship, one can ascertain the costs, sales and profits at different
levels of activity.
• It assists in performance evaluation for purposes of management control.
• It helps in formulating price policy by projecting the effect which different
price structures will have on costs and profits.
• It helps in determining the amount of overhead cost to be charged at various
levels of operations, since overhead rates are generally pre-determined on the
basis of a selected volume of production.
Thus, cost-volume-profit analysis is an important medium through which one can
have an insight into effects on profit due to variations in costs (both fixed and
variable and sales (both volume and value). This enables us to take appropriate
decisions. This aspect will be discussed in detail in the next unit of this course.
However, it will be expedient for us to understand at this stage the meaning of and
the technique of determining the break-even point.
Break-even Point
It refers to that level of activity where the income of the business exactly equals its
expenditure. In other words, it is a `no profit, no loss' point. If production is increased
beyond this level, profit shall accrue to the business and if it is decreased below this
level, loss shall be suffered.
At the break-even point the profit is zero. In case the volume of output of sales is to be
computed for à desired profit'. The amount of `desired profit' should be added to
38 fixed costs in the formulae given above. For example.
Costing
Illustration 8.10
A factory manufacturing fans has the capacity to produce 250 fans per annum. The
marginal (variable) cost of a fan is Rs. 400 which is sold for Rs. 500. Fixed
overheads are Rs. 12,000 per annum. Let us calculate the break-even points for
output and sales and show what profit will result if output is 90% of capacity?
Contribution per fan is Rs. 500 - Rs. 400 Rs. 100.
Break-even Point for Output
Break-even Point for Sales
39
Cost Management
Activity 8.2
Consider any profit-oriented organisation. Talk to a well informed functionary of

Accounting and Finance Department of such an organisation regarding its break-even
point. At what percentage of the capacity the organisation is having its break-even
point presently? Analyse in terms of the break-even point it had 3-5 years ago. Has
break-even point moved downward or upward? Why?
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8.9 UTILITY OF MARGINAL COSTING

40 The technique of Marginal Costing is of immense use to the management in taking
various decisions, as explained below:
Helps in determining the volume of production: Marginal Costing helps in deter- Absorption and Marginal
mining the level of output which is most profitable for a running concern. The Costing
production capacity, therefore, can be utilised to the maximum possible extent. It
helps in determining the most profitable relationship between cost, price and volume
in the business which helps the management in fixing best selling price for its
products. Thus, maximisation of profit can be achieved. This has been explained in
greater detail in a separate unit.
Helps in selecting production lines. The technique of Marginal Costing helps in

determining the most profitable production line by comparing the profitability of
different products. Certain products or activities may turn out to be unprofitable with
the passage of time. Production of such products can be discontinued while production
of those products which are more profitable can be taken up. It can help in the intro-
duction of new products and work as a good guide for deciding the optimum mix of
products keeping in mind the available capacity and resources.
Helps in deciding whether to produce or procure: The decision whether a particular

product should be manufactured in the factory or procured from outside source can
be taken by comparing price at which it can be had from outside. In case the procure-
ment price is lower than the margin cost of production, it will be advisable to procure
the product from outside rather than manufacture it in the factory.
Helps in deciding method of manufacturing: In case a product can be manufactured

by two or more methods, ascertaining the marginal cost of manufacturing the product
by each method will be helpful in deciding as to which method should be adopted.
Helps in deciding whether to shut down or continue: Marginal Costing, particulaly

in periods of trade depression, helps in deciding whether the production in the
plant should he suspended temporarily. or continued in spite of low demand for the
firm's products. This can be understood with the help of following illustration.
Illustration 8.11
A company has a manufacturing capacity of 1,000 units per month. The cost details
are as under:
Direct Material Rs. 3 per unit.
Direct labour Rs. 2 per unit.
Variable overheads Rs. 1 per unit.
Fixed overheads Rs. 2,000 per month.
The Company has been selling its products at Rs. 10 per unit.
Due to depression in the market, the product can now be sold only at Rs. 7 per unit.
The depression is expected to continue for a period of three months. The accountant
advises you to discontinue production since the selling price is less than the total cost
of the product. What would be your reaction?
The accountant of the company seems to have calculated the total cost per unit
according to Absorption Costing technique as under:
Rs.
Direct material 3
Direct labour 2
Variable overheads 1
Fixed overheads 2
(2,000/1000)
Total cost 8
As the cost per unit is Rs. 8 compared to the expected selling price of Rs. 7, the
accountant obviously has advised the management to suspend the production till the
41
Cost Management
situation returns to normal.
However, the decision to suspend production even in this unusual situation is not in
the interest of the company. The fact of the matter is that in spite of suspending
production, the company will still have to incur fixed cost of Rs. 2,000 per month. If
the company continues to manufacture and sell the product, it will be in a position to
reduce its loss to Rs. 1,000 per month, as shown below:
Rs. Rs.
Selling price per unit 7
Less: Variable Cost 3
Direct material
Direct labour 2
Variable overheads 1 6
Contribution 1
The total contribution on 1,000 units will amount to Rs. 1,000 and this will go to
some extent in recovering the fixed cost per month of Rs. 2,000. As such the net loss
will be limited to Rs. 1,000 only as compared to Rs. 2,000, if production is sus-
pended.
8.10 LIMITATIONS OF MARGINAL COSTING

Marginal Costing technique has some limitations as explained below:
Difficulty in classification of costs between fixed and variable elements: It is a

tough job to analyse costs under `fixed' and `variable' elements. The nature of costs in
several cases may not be very clear. Moreover, some items of costs may be partly
fixed and partly variable. Splitting of such costs into fixed and variable components
may have to be based on assumptions. Besides, some overheads may have no relation
either with the volume of output or with the time factor. As such, they cannot logically be
categorised either as fixed or variable. The decisions of the management regarding
bonus to workers, facilities to administrative staff, etc. are some such examples.
Difficult application: Marginal Costing technique is difficult to apply in many firms.

Its scope is highly circumscribed where job costing is the need.
Notwithstanding the above-mentioned limitations of marginal costing it is regarded as a

highly useful technique for analysis of several business decisions.
8.11 SUMMARY
Marginal Costing and Absorption Costing are the two techniques which can be used for
ascertaining the cost of a product, job or a process. Absorption Costing is also termed
as Traditional or full Cost method. According to this technique, the cost of a product is
determined after considering both fixed and variable costs. in other words, all costs are
identified with or absorbed into the manufactured products. Marginal Costing is a
technique where only the variable costs are considered while computing the cost of
products. The fixed costs are met against the total contribution of all the products taken
together.
Marginal Costing is regarded as superior to traditional costing so far as managerial

decision-making is concerned. It identifies only such costs with the jobs or products
which directly vary with the level of output. The uncertainty and irrationality associated
with apportionment of fixed cost in traditional costing is thus avoided.
42 The technique of Marginal costing greatly helps the management in taking appropriate
managerial decisions, viz., dropping a product line, making or buying a component,
shut-down or continuation of operations in periods of trade depression, fixation of Absorption and Marginal
minimum selling price of a product, etc. Costing
Marginal Costing involves computation of marginal cost. The term marginal cost is
synonymous with the term `variable cost'. It comprises of direct material, direct labour,
variable direct expenses and variable overheads.
The semi-variable overheads are also segregated into fixed and variable categories
according to some suitable method. Such segregation of costs into fixed and variable
categories helps also in determining the break-even or no profit no loss point. A firm
will start making profits only after it reaches the break even level. The sooner it reaches
this level, the better it will be. Hence, the break-even level of activity is also of
considerable significance to management.
Marginal Costing technique has some limitations. The categorisation of costs into fixed
and variable elements is a difficult and tedious task. However, in spite of these
limitations, marginal costing is regarded as a highly useful technique of analysis for
several business decisions.
8.12 KEY WORDS
Absorption Costing: A technique where all costs, fixed as well as variable, are allotted
to cost units.
Break-even Point : It refers to the level of activity where the income of the business
exactly equals its expenditure. It is also termed as `no profit, no loss' point.
Contribution It refers to the excess of selling price over variable cost.
Marginal Cost The variable cost of one more unit of a product or service, i.e. a cost
which would be avoided if the unit was not produced or service not provided.
Marginal Costing: A technique whereby marginal cost of a product is ascertained.

Only variable costs are charged to production. Fixed costs are charged against the
contribution of the period. It is also termed as `variable costing'.

1. Explain briefly the technique of Marginal Costing. In what ways you
consider this technique useful in Management Accounting?
2. a) Explain and bring out in a comparative form the means of income
determination under marginal and traditional costing systems.
b) Explain the different methods for segregating semi-variable overheads.
3. What benefits are gained from Marginal Costing? Are there any pitfalls in its
application?
4. State whether each of the following statements is True or False:
a) Fixed costs are included in the valuation of work-in-
True False
progress and finished goods stocks under marginal
costing.
b) The valuation of stock is higher in absorption True False
costing as compared to marginal costing.
c) Semi-variable costs form a part of product cost in
marginal costing. True False
d) Absorption costing is not as suitable for decision-
making as marginal costing is. True False 43
Cost Management
5. From the following choose the most appropriate answer:
i) Contribution margin is also known as
(a) Marginal Income; (b) Gross Profit; (c) Net Income.
ii) Period cost means:
(a) Variable cost; (b) Fixed Cost; (c) Prime cost.
iii) If fixed cost is Rs. 10,000 and P/V ratio is 50%, the break-even point
will be: (a) Rs. 20,000 (b) Rs. 40,000 (c) Rs. 50,000 (d) None of
these.
iv) If Profit-Volume Ratio is 40% and sales value Rs. 10,000, the
variable costs will be:
(a) Rs. 4,000 (b) Rs. 40,000 (c) Rs. 10,000 (d) None of these.
v) If sales are Rs. 2 lakhs, fixed cost Rs. 30,000, P/V ratio 40%, the
amount of profit will be:
(a) Rs. 50,000 (b) Rs. 80,000 (c) 12,000.
6. Fill in the blanks:
a) The technique of Marginal Costing is based on classification of costs
into…………………………….costs.
b) Contribution is the difference between sales and ………………..
c) In marginal costing stock of finished goods is valued
at…………cost.
d) Both fixed and variable costs are charged to products
under…………………..…costing.
e) Profit-Volume ratio shows the relationship
between………………….…and…………….………
f) At break-even point, total cost is equal to……………………….
g) At break-even point, the contribution will be equal to …………..
7. Hansa Ltd. produces a standard type of article. The results of the last four
quarters of the year 2003 are as follows:
Quarters Output (Units)
I 200
II 300
III 400
IV 600
The cost of direct material is Rs.60 and direct labour is Rs. 40 per unit.
Variable expenses are Rs. 20 per unit. Fixed expenses are Rs. 1,20,000 per
annum. Find out cost per unit of each quarter.
8. From the following data, prepare statements of cost according to both

absorption costing and marginal costing technique:
Sales Product X Products Y Product Z
Rs. 15,000 Rs. 30,000 Rs. 40,000
Direct Material 6,000 12,500 18,000
Direct Labour 4,000 5,000 7,000
Factory overheads: 3,000 4,000 3,000
Fixed
Variable 1,000 1,500 2,500
Administrative overheads 500 1,000 1,000
Fixed
Selling Overheads 1,000 1,000 1,500
44 Fixed
Variable 500 1,500 1,500
9. Production costs of Ambitious Enterprises Limited are as follows: Absorption and Marginal
Costing
Levels of Activity
60% 70% 80%
Output (in Units) 2,400 2,800 3,200
Cost (in Rs)
Direct Materials 24,000 28,000 32,000
Direct Labour 7,200 8,400 9,600
Factory overheads 12,800 13,600 14,400
Works Cost
44,000 50,000 56,000
The management is considering a proposal to increase production to 90% level

of activity. The proposal is not expected to involve any increase in fixed
factory overheads.
You are required to prepare a statement showing the prime cost, total marginal
cost and total factory cost at 90% level of activity.
(Hint: Fixed Overheads Rs. 8,000)
10. The following figures relate to the repairs and maintenance costs incurred in
a machine shop and the corresponding machine hours for a period of six
months:
Month Machine hours Repairs & Maintenance
January 2,000 3,000
February 2,200 3,200
March 1,700 2,700
April 2,400 3,400
May 1,800 2,800
June 1,900 2,900
Total 12,000 18,000
You are required to segregate the repairs & maintenance cost into fixed and
variable elements.
11. The following data are obtained from the records of a company:
First year Second year
Sales Rs. 1,60,000 Rs. 1,80,000
Profit 20,000 28,000
Calculate the break-even point.
12. From the following data, calculate:
i) Break-even point expressed in rupee sales.
ii) Number of units that must be sold to earn a profit of Rs. 1,00,000
per year.
Selling price Rs. 20 per unit
Variable manufacturing costs Rs. 10 per unit
Variable selling costs Rs. 5 per unit
Fixed Factory overheads Rs. 5,00,000 per year
Fixed selling costs Rs. 2,00,000 per year
13. Ahmed Khan sells a popular brand of men's sports shirts at an average price
of Rs.28 each. He purchases the shirt from a supplier at a unit cost Rs.18.
The costs of operating his shop are all fixed costs and amount to Rs.54,000
a year. He pays commission to his salesmen at the rate of Re. 1 on each
shirt sold. 45
Cost Management
Required: i) How many shirts must be sold in a year to break-even?
ii) Compute the sales revenue at the break-even.
iii) Compute the monthly sales revenue required to earn a net
profit before tax of Rs.45,000 a year.
Answer to Activity 8.1
Year II Year III
Absorption Marginal Absorption Marginal
Costing Costing Costing Costing
Inventory 133.20 126 54.60 49
Profit 93.20 88 86.40 88
While Profit under Marginal Costing is the same for all the three years, it is different
under Absorption costing. Why? Please read the text and attempt the answer:

4. (a) False; (b) True; (C) False; (d) True
5. (i) a (Marginal Income); (ii) b (Fixed Cost) (iii) a (Rs.20,000); (iv) d
(Rs.6,000) (v) a (Rs. 50,000)
6. (a) Fixed and variable; (b) variable costs; (c) marginal; (d) absorption; (e)
contribution, sales, (f) total sales; (g) fixed costs
7 (i) Rs.270, (ii) Rs.220, (iii) Rs.195.0, (iv) Rs.170.0
8. Absorption Costing Profit: Product X Rs(-) 1,000, Product Y Rs.3,500;
Product Z Rs.5,500; Marginal Costing Contribution: Product X Rs. 3,500
Product Y Rs.9,500, Products Z Rs. 11,000
9. Prime cost Rs. 46,800; Marginal Cost Rs. 54,000; Works Cost Rs.
62,000
10. Fixed Cost Rs.1,000
11. Rs. 1,10,000
12. (1) Rs. 28,00,000; (ii) 1,60,000 units,
13. (i) 6,000 shirts (ii) Rs. 1,68,000 (iii) Rs. 25,667

Horngren, C.T., Datar, S.M. & Foster, G.M., 2002, Cost Accounting: A
Managerial Emphasis 1 1 ed., Publishers: Pearson Education
Tulsain, P.C., 2000, Practical Costing, Vikas Publishing 1-louse: New Delhi
(Chapter 1 1)
Anthony, Robert N. and James S., Reeche, 1987, Accounting Principles, Irwin:
New York, (Chapter 15-17)
Moore, Carl L. and Robert K Jaedicke, 1976, Managerial Accounting. South

Wester' Publishing Co., (Chapter 12& 13)
Glautier, M.W.E. and B. Underdown, 1982, Accounting Theory and Practice,

ELBS: London, (Chapter 33)
Maheshwari, S.N. 1937, Management Accounting and Financial Control (5th

ed.) Mahavir Book Depot (Section C, Chapter 4).
Audio Programme
46 Emerging Horizons in Accounting and Finance - Part VI: Cost Audit in India
Cost-Volume-Profit Analysis
UNIT 9 COST-VOLUME-PROFIT ANALYSIS
Objectives
The aims of this unit are to:
• acquaint you with the nature of Cost-Volume-Profit analysis
• illustrate the factors which affect Cost-Volume-Profit relationships
• examine the role of break-even analysis by elaborating the Cost-Volume-
Profit framework.
• discuss the applications of Cost-Volume-Profit relationships in specific
decisions
Structure
9.1 Introduction
9.2 What is Cost-Volume-Profit Analysis?
9.3 Interplay and Impact of Factors on Profit
9.4 Profit Graph
9.5 Cost Segregation
9.6 Marginal Cost and Contribution
9.7 Summary
9.8 Key Works
9.1 INTRODUCTION
Managers have to take frequent decision which involve considerations of selling
prices, variable costs, and fixed costs. Many of these decisions are a part of their
planning responsibilities and have, as such, to be based on predictions about costs
and revenues. Almost every question that is posed has a `cost-profit' aspect. you may
react to what Horngren (1985, p43 ) states about cost-volume-profit relationships:
"Cost -volume-profit analysis is a subject inherently appealing to most students of
management because it gives a sweeping overview of the planning process and
because it provides a concrete example of the importance of understanding cost
behaviour-the response of costs to a wide variety of influences."
Probably, you belong to the category of management students identified by
Horngren. If you have a propensity to know about the planning process and the cost
behaviour, you are sure to get at once interested in the study of cost-volume-profit
relationship.
9.2 WHAT IS CVP ANALYSIS?

The Cost -Volume-Profit (CVP) analysis is an attempt to measure the effect of
changes in volume, cost, price and products-mix on profits. You will appreciate that
while these variables are inter-related, each one of them, in turn, is affected by a
number of internal and external factors. For instance, costs vary due to choice of
plant, scale of operations, technology, efficiency of work-force and management
efficiency. Etc 47
Cost Management Also, cost of inputs bought externally is affected by market forces. While many wide-
ranging factors influence costs and profits, the largest single variable affecting them
in the short-run is the volume of output. Hence, the CVP relationship acquires a vital
significance for the manager facing a wide spectrum of short-run decisions like: what
are the most profitable and what are the least profitable products? How does a reduc-
tion in selling prices affect profits? How does volume or product-mix affect product
costs and profits? What will be the break-even point if volume and costs change?
How an increase in wages and /or other operating expenses will affect profit? What
will be the effect of plant expansion on costs, profit and volume of sales? Answers to
all such questions will have to be formulated in a cost-benefit framework and CVP
analysis will offer the technique for doing it.
You may, in fact, perceive CVP analysis as one ofthe decision-models which
managers employ to choose among alternative courses of action. The basic
(simplified) CVP model may be outlined as follows:
You may now be getting ready to comprehend the CVP concept. You will observe
that profits are a function of the interplay of costs, prices, and each one of them is
relevant to profit planning. In fact, variance between actual and budgeted profit arises
due to one or more of the following factors: selling price, volume of sales, variable
costs, and fixed costs.
You will also appreciate that these four factors which cause deviations in planned
profits, differ from each other in terms of controllability by management. It is
obvious that selling prices largely depend upon external farces. Costs, of course, are
more controllable. But they pose a problem of measurement. This is more so when a
firm manufactures two or more products. Nevertheless, a knowledge of fixed and
variable costs is essential if costs are to be controlled. Consider a tenuous cost -
volume-profit transit.
"Sales price change Æ volume change Æ unit cost change Æ profit structure change"
You may try an answer to the question: How will costs change in the foregoing
situation? Would you succeed? Probably, not quite so at this stage! But the CVP
decision model will of course have an answer within its own assumptive framework
9.3 INTERPLAY AND IMPACT OF FACTORS ON

PROFIT
We have said above that costs and volume do influence profit. You wilhat observe
more objectively the extent and nature of this impact with the help of an illustration.
It is proposed to evaluate the effect of
• Price changes on net profit,
• volume changes on net profit,
• price and volume changes on net profit,
• an increase or decrease in variable costs on net profit,
• an increase or decrease in fixed costs on net profit,
• all four factors viz., price, volume, variable costs, and fixed costs on net
profit.
48
Illustration 9.1 Cost-Volume-Profit Analysis
The following assumptions are made in the illustration: normal sales volume is
2,00,000 units at a selling price of Rs. 2 per unit; capital investment is Rs. 2,00,000
and management expects to earn a fair return on it: fixed costs are Rs. 1,60,000;
variable expenses are Re. 1 per unit.
Solutions for the three situations are tabulated separately. The control column of each
table shows, normal volume' and a decrease in volume/price by 10% and 20% is
shown on the left, while an increase in volume/price by the same percentages is
shown on the right of the `central column', calculations show not only net profit or
loss for each set of conditions but also the net profit per unit, the percentage return of
investment, and the break-even point.
Influence of price changes on Net Profit.
Table 9.1
Particulars Decrease in price Normal Increase in Price

20% 10% Volume 10% 20%
Units 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Sale (Rs.) 3,20,000 3,60,000 4,00,000 4,40,000 4,80,000
Variable cost (Rs) 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Marginal Income (Rs.) 1,20,000 1,60,000 2,00,000 2,40,000 2,80,000
Fixed costs (Rs.) ' 1,60,000 1,60,000 1,60,000 1,60,000 1,60,000
Net Profit (Net Loss) Rs (40,000) 0 40,000 80,000 1,20,000
Net Profit ( Net loss) (.20) - .20 .40 .60
per unit ( Rs.) - 200 % 100% + 100% + 200 %
% change in profit
Return on investment -20% 0% 20% 40% 60%
Break-even point rupee 4,26,667 3,60,000 3,20,000 2,93,333 2,74,286
sales
You may note the following from the above situation: (a) a 10% decrease in price
reduces profit to zero, while a 10% increase in price increases profit by 100%.
(b) with lower selling prices and a constant volume, the break-even point increases.
This happens because a reduction in sales revenue on account of decrease in sales
price reduces the marginal income (contribution). A much greater number of units
have to be sold in order to recover the fixed costs.
Influence of volume changes on Net Profit.
Table 9.2
Particulars Decrease in volume Normal Increase in Volume

20% 10% Volume 10% 20%
Units 1,60,000 1,80,000 2,00,000 2,20,000 2,40,000
Sales (Rs.) 3,20,000 3,60,000 4,00,000 4,40,000 4,80,000
Variable cost (Rs.) 1,60,000 1,80,000 2,00,000 2,20,000 2,40,000
Marginal income (Rs.) 1,60,000 1,80,000 2,00,000 2,20,000 2,40,000
Fixed costs (Rs) 1,60,000 1,60,000 1,60,000 1,60,000 1,60,000
Net Profit (Rs.) - 20,000 40,000 60,000 80,000
Net Profit per unit (Rs.) -100% .11 .20 .273 .33
% change in profit 0% -50% - +50% +100%
Break-even point (Rs.) 3,20,000 3,20,000 3,20,000 3,20,000 3,20,000
in sales 49
Cost Management You may note here the following: (a) a 20% decrease in volume reduces sales to the
break-even point which remains constant because variable costs change in proportion
to sales. (b) a 20% increase in volume improves profit by 100% . A similar increase
in price (viz., by 20%) increases profit by 200% (see above).
Influence of changes in prices and volume on Net Profit.
Table 9.3
Particulars Increase in price Decrease in Price
20% 10% 10% 20%
and and
Decrease in VolumeNormal Increase in Volume
20% 10% Volume 10% 20%
Units 1,60,000 1,80,0002,00,000 2,20,000 2,40,000
Sales (Rs) 3,84,000 3,96,0004,00,000 3,96,000 3,84,000
Variable costs (Rs.) 1,60,000 1,80,0002,00,000 2,20,000 2,40,000
Marginal income (Rs) 2,24,000 2,16,0002,00,000 1,76,000 1,44,000
Fixed costs (Rs.) 1,60,000 1,60,0001,60,000 1,60,000 1,60,000
Net profit/(Net loss) Rs 64,000 56,000 40,000 16,000 (16,000)
Net profit per unit Rs. .40 .31 .20 .0727 (.066)
% change in profit +60% +40% - -60% -140%
Return on investment 32% 28% 20% 8% 8 % loss
Break-even point (Rs.) 2,74,286 2,93,3333,20,000 3,60,000 4,26,667
Please note in this situation that (a) the prices increase, as assumed would result in
higher profits, even if it is accompanied by a decrease in volume of the same order.
The reverse, however, is true of a price decrease accompanied by a volume increase,.
(b) that the break-even point would be at its lowest when prices are increased and
volume decreased because higher rupee volume with lower unit volume reduces the
variable cost ratio.
Activity 9.1
You may continue your computations for the remaining three situations referred to at
the beginning of this section and list your conclusions. The break-even point may be
calculated with the help of the following formula:
You will observe from the conclusions derived from the above exercises that such
operations would be found quite useful in all such cases where irrational tendencies
for price-cutting or for achieving high sales volume exist.
Please note the following in our discussion so far with a view to develop under-
standing for subsequent sections
1. CVP analysis explores the fundamental relationships between cost -volume-

profiit variables. You will observe that changes in volume influence cost and
profit and, while this process gets underway, a stage is reached when cost is
equated with revenue at acertain level of output or at a certain volume of
sales. This is recognised as `break-even point.' You must understand that
‘break-even point’,
is a point which is incidental to CVP analysis and, therefore, attempts to

define CVP analysis as break-even analysis, should be considered only
50 restrictive. It must be admitted that break-even analysis does become an
integral part of CVP analysis but the two are not co-terminus.
2. You will grasp the CVP fundamentals along the following routes Cost-Volume-Profit Analysis
a) First, the profit -volume relationship will be analysed and the basic
framework of `Profit Graph' will be presented.
b) The assumptions underlying the construction and analysis of a `Profit

Graph' will be postulated and the concept of " Planned range of
activity' will be discussed.
c) A crucial step in the understanding of CVP analysis would be a

segregation of costs into fixed and variable components. Procedures
for doing this would be briefly examined.
d) The concepts of `marginal cost' and `contribution' will be introduced

and this will lead to `break-even analysis ' and `margin of safety'.
e) After a look at the conventional break-even chart the use of such

charts for various purposes will be demonstrated.
f) Finally, CVP analysis will be presented in mathematical

formulations. With this, you should be in a position to understand
practical applications of CVP analysis for business decisions. You
will be expected to do assignments on these aspects.
9.4 PROFIT GRAPH

A business Firm usually pursues a profit objective. In a way, it plans for maximising
its profit. Both the operations plan and the over-all plan of the firm are couched in
terms of this `profit objective; and their primary variables are cost, volume, and profit
forecast for the planning period (or horizon). The critical variable is usually the
`volume of sales forecast' around which costs and profit estimates are built.
A question often faced in the planning stage itself is: what will happen to profit if the
forecast level of sales changes? Such a question will not always be irrelevant because
conditions change so rapidly. A manager seeking an appropriate answer to this
question would obviously want to get some guidance. The profit graph which shows
the relationship between profit and volume (P/V relationship) helps to provide the
questioning manager a possible answer.
You will recall from the calculations presented in the previous section about gauging
the impact of changes in price, volume, etc., on profit that a term called 'marginal
income' was calculated ( please see item number 4 in each of the Tables 9.1, 9.2 and
9.3). Please note that, `marginal income' is the difference between sales and variable
expenses and represents total contribution to fixed expenses and profit. This term
may be understood in another way as well. If variable expenses are expressed as a per
cent of sales we get the variable cost ratio. Then, total contribution or marginal
income is equal to "1-variable cost ratio". In all the three situations given in Section
9.3, the variable cost ratio for the normal volume of sales is 50% or .50. Total
contribution or marginal income would , therefore, be 1-.50 = .50 or 50%. Another
term for `marginal income' is P/V ratio or the profit -volume ratio. You must note
that the P/V ratio is not obtained by dividing sales volume by profit but by
deducting the variable cost ratio from unity (1)
51
Cost Management
Figure 9.1: Profit Graph

With the basic purpose of the profit graph and some of its vital variables having been
clarified, you may now move on to a hypothetical profit graph with a view to
comprehending relationships involved .Figure 9.1 provides this graph. We may
explain the construction of the graph to you and will then specify the assumptions
behind this graph in the following section. OX on the X-axis provides sales volume,
and OY on the Y -axis plots profit above 0 and loss below O.OFC measures the fixed
cost. The line FCP joins two points viz. FC the fixed cost and P the profit expected to
be released as the profit-volume plan. The area encompassed by XBE is the margin
of safety while the point BE is the break-even point. BEPX is the profit area and the
line FCBEP is the total contribution or the PV line. If the sales volume does not
materialise at point X, as per the plan, and drops to X' the profit zone will shrink to a
new profit area BEX'. Further declines in sales volume will be absorbed by the
margin of safety after which losses will begin showing up. All these points will come
up for further clarification in subsequent sections.
Activity 9.2
1 The cost -Volume-Profit analysis is another name given to Yes No
break-even analysis [ ] [ ]
2 CVP relationships aid in planning [ ] [ ]
3 CVP analysis is on a profit-volume graph; hence cost is an irrelevant variable.
[ ] [ ]
4 Profit responses to price increases are greater than to price reductions.
[ ] [ ]
5 P/V ratio is obtained by dividing sales volume by profit.
[ ] [ ]
6 Lower selling prices will push up the break-even point if: [ ] [ ]
a) Volume remains constant
b) profit targets are raised
c) plant capacity is expanded
d) new products are added
52
e) none of the above.
7 The margin of safety is the difference between [ ] [ ] Cost-Volume-Profit Analysis
a) planned sales and actual sales
b) planned sales and break -even sales
c) planned profit and realised profit
d) planned profit and fixed profit
8 If sales volume of a firm is Rs. 10 lakhs, variable costs are Rs. 6 lakhs, profit is
Rs. 2 lakhs, the P/V ratio will be [ ] [ ]
a) 20 per cent
b) 33 per cent
c) 40 per cent
d) 60 per cent
e) none of these
9 The proposition that the break-even point would be at its lowest when prices
are increased and volume decreased is [ ] [ ]
a) generally true
b) seldom true
c) true in the case of a multi-product firm only
d) never true
e) none of these
10 To be able to control, costs must be segregated into fixed and variable.
[ ] [ ]
Assumptions in Profit Graph
You have seen the Profit Graph and have got your first exposure to it. May be, few
doubts have started bothering you. Your queries may take the following form: "How
will the total contribution line emerge as straight line if variable costs per Unit do not
remain constant, or if efficiency of operations improves within the planned range of
activities, and so on?" You are probably right in thinking so.
We have already stated that the CVP is a decision-model and, as with most such
models, there are some simplifying assumptions which undoubtedly make the
underlying analysis a bit unreal but nevertheless easier to comprehend.
You may consider the following assumptions in particular:
a) Variable costs are a constant cost per unit of volume. This will mean that the
variable cost rate is constant even if the total variable costs will increase in
direct proportion to increase in output volume or sales quantum.
b) Total fixed costs remain constant throughout this planned range of activity.
c) Efficiency of operations remains unchanged throughout the planned range of
activity..
d) All costs and particularly, the semi-variable and mixed costs can be separated
into fixed and variable elements.
e) Selling prices per unit of sale remain constant
f) Sales-mix for a multi-product firm remains constant.
g) Volume is the only relevant factor affecting cost.
h) Factor prices e.g. material prices, wage rates etc., remain unchanged.
i) Costs and revenue are being compared on a single activity base e.g., sales
value of output or units produced. Further, stock levels will not vary
significantly in the period covered by the plan.
j) Variations in opening and closing inventories are insignificant. The
important implications are: there is a relevant range of activity over which 53
cost behaviour is linear; all prices remain unchanged; and costs can be
classified into fixed and variable costs.
You have studied cost behaviour patterns in the unit on Ùnderstanding and Classify-
ing Costs'. This behaviour is relevant to CVP analysis as you must have noted. If it is
taken that the set assumptions about cost behaviour are nowhere near the real life
situation, the whole exercise is reduced to a hypothetical pictorial presentation. With
this backdrop, examine the truth of the following statement:
The idea of a relevant range to justify linear rather than non-linear cost patterns may
not be correct but "a linear expression of total cost may often be a reasonable reflec-
tion of reality". (Middleton, 1980)
(Hint: It is plain that the accountant's assumptions are unrealistic. But he does not
seem to be very much in error; firstly, because obtaining more accurate cost functions
is both difficult and expensive. Often, the cost of obtaining more accurate data would
exceed the value of any additional information that may be gained from such accurate
data: secondly, because most decisions that managers take are within the relevant
range of volume where the linearity assumption may not appear unreasonable).
9.5 COST SEGREGATION

Some broad guidelines may be suggested to divide costs into two dominant groups
viz., fixed and variable. They are listed below:
a) Costs which remain invariant to volume of activity would be considered
fixed. In fact, no costs are fixed forever. The concept is relative to the
planning horizon (usually a short-run one) and to the relevant range of
activity.
b) Costs which vary in direct proportion to volume of activity will be classified
as variable costs.
c) Costs which otherwise belong to a mixed category, i.e., which neither belong
neatly to category (a) nor to category (b) above, would, in fact, be
apportioned to one of the two categories viz., fixed or variable.
If a mixed cost varies in some (not direct) proportion to output or volume of activity,
it will be classed as variable cost. If a mixed cost, on the other hand, is predominantly
fixed, it would be classed as a fixed cost.
Activity 9.4
Give some examples (other than you gave in Unit 7) of each of the cost categories
stated in this Section.
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Methods to segregate costs
In the previous unit, various methods of segregating semi-variable costs into fixed
and variable elements were discussed. Here, we repeat two statistical techniques
54 which may be employed to separate fixed costs and variables costs.
• Least squares Cost-Volume-Profit Analysis
• Scatter Diagram
We illustrate these methods.
Illustration 1
Least Squares: Power charges are a semi-variable or a mixed cost of Aravali Ltd. It
is proposed to segregate them into fixed and variable components, using the method
of least squares.
Monthly data regarding direct labour hours and electricity charges are given below:
Month Direct Labour Electricity
hours (000) Charges
Rs.
January 34 640
February 30 620
March 34 620
April 39 590
May 42 500
June 32 530
July 26 500
August 26 500
September 31 530
October 35 550
November -43 530
December 48 680
Total: 420 6,840
The following calculations are made for the variable rate and the fixed element of
electricity charges:
∑ xy
Variable rate:
∑x 2
Fixed element : Y = a+bx

Where Y is the dependent variable, x is the independent variable, (i.e., direct labour
hours in the example), a is the constant i.e, the fixed cost element to be solved, and b
is the slope of the regression line i.e., the variable cost per unit.
Calculation of Fixed and Variable Elements
Month Direct Deviation Electricity Deviation
labour from mean Expenses From mean
Flours x=35 Y y=570 x2 xy
X (`000)
January 34 640 +70 1 -70
February 30 -5 620 +50 25 -250
March 34 -1 620 +50 1 -50
April 39 +4 590 +50 16 +80
May 42 +7 500 -70 49 -490
June 32 -3 530 -40 9 +120
July 26 -9 500 -70 81 +630
August 26 -9 500 -70 81 +630
September 31 -4 530 -40 16 +160
October 35 0 550 -20 0 0
November 43 +8 580 +10 64 +80
December 48 +13 680 +110 169 +1430 55
∑ x2=512 ∑ xy =2,270
Cost Management
∑ xy
Variable electricity rate b =
∑x 2
2270
= = 4.4 paise per thousand labour hours
512
= 44 Paise per 100 labour hours
or .0044 per labour hour.
Fixed element of electricity charges à' can be found out by substituting values in the
equation, a + bx, where
Y=570
X = 35,000 labour hours
we get : Rs. 570 = a + .0044 (35000)
Rs. 570 = a + Rs. 154
Rs. 570 – Rs: 154 = a
Rs. 416 = a (the fixed element)
Scatter Diagram: The regression equation calculated above may be fitted by free
hand on a diagram where direct labour hours are plotted on the X-axis and electricity
charges are plotted on the Y-axis. There will be 12 points scattered within the
quadrant space of the graph. A line may be made to pass through these points so that
there is roughly an equal member of points above and below the line. The vertical
intercept of the regression line thus drawn (i.e., the point at which the line intersects
the Y-axis ) will measure the fixed element of the electricity charges.
The slope of the regression line may be found to ascertain the variable rate per 100
labour hours. Alternatively, the fixed expense as given by the vertical intercept may
be multiplied by 12 to get the annual fixed expenses on electricity. This may be
deducted from the total electricity charges of Rs.6,840. The balance may be divided
by the total annual labour hours viz. 4,20,000 hr., and that quotient would be the
approximate rate per labour hour.
Activity 9.5
You may draw the scatter diagram using the data given in the example and follow the
procedure outlined above. Then, determine the fixed and variable elements of
electricity charges. Verify your results with the results computed above.
………………………………………………………………………………………….
………………………………………………………………………………………….
………………………………………………………………………………………….
………………………………………………………………………………………….
9.6 MARGINAL COST AND CONTRIBUTION

Once the fixed and variable costs are segregated it becomes possible to calculate the
total contribution as well as total contribution per unit. You will recall that total
contribution is equal to the difference between sales and variable ( marginal) costs.
Total contribution per unit is expressed in per unit terms by dividing both sales and
variable costs by the total number of units and deducting per unit variable cost from
per unit selling price. Total contribution may be directly divided by total number of
units to obtain similar results.
You should remember that total contribution is the contribution of sales revenue to
fixed cost recovery and profit after meeting the total variable costs.
56
You may also recapitulate that total contribution may also be expressed as a percent- Cost-Volume-Profit Analysis
age in which case it is recognised as P/V ratio. This is ‘1-variable cost’ ratio. And
variable cost ratio is sales divided by total variable cost.
You must understand now the basic thrust of the Profit Graph presented in an earlier
section. So far, you must be wondering how the contribution line was plotted on that
graph. Now, probably, it is easier to comprehend. The contribution line is, in fact,
obtained by plotting contribution per unit figures against different levels of sales
values.
You may switch back to the Profit Graph and have a closer look at the contribution
line. This line originates from the loss zone and raises up to the break-even point BE
on the sales volume line. You may interpret this part of the contribution line up to BE
i. e. the break-even point as indicative of the recovery of fixed costs only. It is only
after this point that the contribution line combines itself with the X-axis and the right
Y-axis to form a triangle PXBE which has been marked as the profit area.
Break-even Point
We had earlier stated that the break-even point is not all that is contained in the CVP
analysis. It is only incidental to such an analysis. You have already seen that the
break-even point is just one point on the whole journey of the contribution line as it
transits from the fixed cost point F to the profit point P via the sales revenue line viz,
the X-axis . The horizontal intercept of the contribution line at BE is the break-even
point. At this point, total costs and total revenues are held in equilibrium and a no-
profit no loss position emerges.
Margin of Safety
The Profit Graph, while revealing the estimated profit or loss at different levels of
activity also suggests the magnitude by which the planned activity level can fall
before a loss is experienced. This is known as the Margin of Safety and is obtained
by deducting the break-even sales from the planned sales.
A graphical glimpse into cost-volume -profit structures: Two cases of companies

A and B are presented. You may examine the sales and total cost lines and offer your
comments. You should note the differences between these graphs and the profit graph
presented earlier.
57
Cost Management A major difference between companies. A and B is in terms of the location and slope
of their respective total cost line. Company A has a high ratio of fixed cost to total
cost because the vertical intercept of its total cost line is very high. In contrast,
company B's vertical intercept is quite low and it has accordingly a low ratio of fixed
costs to total costs. The following results follow:
a) Once the break-even point is reached for company A, large profits are made
quickly as volume rises. The profit growth for company is slower after this
break-even point.
b) Company B, however, has larger Margin of Safety than company A and can,
therefore, sustain difficult business spells without immediately cutting down
on its level of activity. Company A cannot hazard a similar course and may
have to shut down much earlier.
Break-even Chart
You will appreciate the break-even analysis is a transitional stage of CVP analysis.
Many authors in fact, discuss the interchangeability of these two because the
derivation of break-even analysis from CVP analysis is very subtle.
The break-even chart also emerges from the Profit Graph, but the contribution line is
replaced by the total cost. The new relationships which must receive attention in the
wake of this major change, viz., replacement of the contribution line by the total cost
line are presented in the two graphs below:
Figure 9.4 provides an idea of a conventional break-even chart. Figure 9.5, however,
depicts a situation where sales revenue may have declined as a result of lowering
selling prices to liquidate a higher volume of goods and the company moves into a
situation where loss is incurred. The point of maximum profit is also shown on the
graph.
58
Purpose of Break-even Charts Cost-Volume-Profit Analysis
The figures presented in this sub-section provide a glimpse of the uses to which
break-even analysis can be put to. The objective is to offer a visual comprehension of
a few illustrative situations. This will hopefully make the mathematical section more
comprehensible.
59
Study Figures 9.6 through 9.11 and note your comments on important conclusions
that you would arrive at from each Figure.
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CVP and Break-even Analysis : A resume
This concluding section of the unit presents CVP relationship and break-even
application in the form of mathematical formulations.
The following abbreviations are used:
FC = Fixed Cost
C = Contribution
P = Profit
S = Sales
P/V ratio = profit-volume ratio
BE point = Break-even point
MS = Margin of Safety
VC = Total Variable Cost
1 FC = C- P or alternatively (P/V ratio x S) P
2 C = FC + P or alternatively P/V ratio x S
Illustration 9.2
The following data relates to a firm for an accounting period:
Rs.
Sales 20,000
60 Variable cost 12,000
Contribution 8,000 Cost-Volume-Profit Analysis
8, 000
Fixed cost 6,000 P/V ratio = = 40%
20, 000
Profit 2,000
Units manufactured and sold 10,000
The following changes have been planned:
a) Fixed cost increases to Rs. 7,000
b) Selling price per unit reduced to Rs. 1.50
c) Rs. 2,000 minimum additional profit is required for additional fixed cost of Rs.
1,000.
d) Extra profit is also required and this is put at Rs. 1,000.
3, 000
The new P/V ratio is =20%
15, 000
Applications of CVP Formulae:
A Determination of the level of sales (Rs.)
a) To achieve a given profit when fixed cost and P/V ratio are known:
b) To maintain the current profit after an increase in fixed cost when the new
fixed cost and original P/V ratio are know:
61
Cost Management
62
9.7 SUMMARY Cost-Volume-Profit Analysis
Cost volume profit analysis provides a framework within which the impact of volume
changes in the short-run may be examined on profit. Cost behaviour is added as a
dimension and corresponding changes in profit, break-even point, and margin of
safety are observed.
Break-even analysis is an integral part of CVP analysis, even though the former is
just incidental to the latter.
CVP analysis is used as a tool of planning. A profit plan is essentially to be based on

it. A number of managerial decisions are often premised on this vital tool of analysis.
Examples of such decision are: distribution channels, outside contracting, sales
promotion expenditures, and pricing strategies.
The conventional break-even chart is based on a number of assumption, the most

relevant being the 'planned range of activity', The `short-run,, and `linearity of cost
functions'.
Many useful conclusions can be drawn from CVP and break-even analysis. Notice,
for example, the following:
a) A firm with a high proportion of fixed cost to total cost is accompanied by a

high break-even point, and carries a potential for substantial profits once the
break-even point is reached.
b) A company with a low proportion of fixed cost to total cost, on the other
hand, commands greater flexibility in terms of profitable operation.
c) An increase in sales prices lowers the break-event point and increases the
margin of safety.
d) An increase in costs pushes up the break-event point and lowers the margin
of profit.
9.8 KEY WORDS

CVP analysis is a technique of analysis to study the effects of costs and volume
variations on profit.
Break-even point is a level of sales (volume or value) where total costs and total
revenues are equal.
Margin of safety is the excess of sales, budgeted or actual, over the break-even sales
volume. It shows the amount by which sales may decrease before losses occur.
Margin of safety ratio is a relative expression of margin of safety and is obtained by

dividing the sales with actuahat (or budgeted) sales.
Unit contribution line is the relationship between contribution (i.e., sales minus
variable costs) per unit and different sales levels shown on a profit graph.
Profit Graph is a depiction of the unit contribution hatine on a graph with sales on
the horizontal scale and profit/fixed cost/ loss on the vertical scale.
PV ratio is the percentage of contribution to sales.
Variable cost ratio is the percentage of variable costs to sales value.
Mixed costs are costs which carry both fixed and variable element. These are also
63
known as semi-variable costs.
Cost Management 9.9 SELF-ASSESSMENT QUESTIONS/EXERCISES
1 What is CVP analysis? Does it differ from break-even analysis?
2 How do you compute the break-even point?
3 Though the break-even chart and profit graph intend to show the same
information, they seem to differ from each other'. Examine and explain the
statement
4 ‘This break-even approach is great stuff. All you need to do is worry about
variable costs. The fixed costs will take care of themselves.’ Discuss.
5 What is meant by margin of safety? How is it determined?
6 You are asked to employ break-even analysis for suggesting likely profits
and losses at different levels of sales activity. Do you think your report
would be invalidated by certain factors? Give your answer with examples.
7 Please state whether the following statements are true or false:( T/F)
a) Mixed costs are used independent of fixed and variable costs in cost-
volume profit analysis
b) The variable cost ratio is 1-P/V ratio.
c) The higher the break-even point the lower the fixed costs.
d) An increase in total costs unaccompanied by a change in sales reduce
the margin of safety.
e) Semi- variable costs cannot be separated into fixed and variable
elements.
f) Break-even analysis is invalid for a multi-product firm.
8 Increase in capacity reduces the margin of safety if
a) total costs remain unchanged.
b) fixed costs at new capacity are increased.
c) fixed costs increase and sales grow.
d) variable costs per unit increase.
9 If sales and fixed costs remain unchanged, contribution will remain
unchanged only when.
a) revised profit increases
b) margin of safety is increased
c) fixed costs increase
d) total variable costs remain constant
e) none of the above
10 An increase in variable costs
a) reduces the contribution
b) increases the P/V ratio
c) increases the margin of safety
d) increases the new profit
e) none of above
11 An increase in sales price
a) does not affect the break-even point
b) lowers the break-even point
c) increases the break-even point
d) lowers the new profit
64
e) none of the above
12 Budget sales of a firm are Rs. 1 crore, fixed expenses are Rs. 10 lakhs, and Cost-Volume-Profit Analysis
variable expenses are Rs. 50 lakhs. The expected profit in the event of 10 %
increase in total contribution margin and constant sales would be 1
1
a) Rs. 40,00,000
b) Rs, 60,00,000
c) Rs. 45,00,000
d) Rs. 55,00,000
e) None of the above
13 If the ratio of variable costs to sales of a firm is 30% and its fixed expenses
are Rs. 63,000, the break-even point would be
a) Rs. 90,000
b) Rs. 18,900
c) Rs. 71,100
d) Rs. 81,900
14 Total fixed costs of firm are Rs. 9,000 total variable costs are Rs, 15,000 total
sales are Rs. 30,000 and units sold are 10,000. The margin of safety is
a) 5,000 units
b) 8,000 units
c) 4,000 units
d) 6,500 units
e) None of the above.
15. If the variable cost per unit is Rs.10, fixed costs are Rs. 1,00,000 and selling
price per unit is Rs.20 and if the break-even point is lowered to 8000 units,
the selling price would be
a) Rs.25.00
b) Rs.30.00
c) Rs.27.50
d) Rs.22.50
16. Where total costs are Rs.60,000, fixed costs are Rs. Rs.30,000 and sales are
Rs.1,00,000 the break-even point in Rs. would be
a) Rs.50,450
b) Rs. 42,857
c) Rs.45,332
d) Rs.60,000
e) None of the above.
17. A company manufactures and sells four types of products under brand names
A, B, C and D. The sales mix in terms of value is 33 3 %, 413 %, 16 3 %o
and 8 3 % for A, B, C and D respectively. The total budgeted sales are Rs.
60,000 per month.
Operating costs are:
Product A 60% of selling price
Product B 68% selling price
Product C 80% of selling price
65
Product D 40% of selling price
Fixed costs amount to Rs.14,700 per month
Cost Management You are required to
a) calculate the break even point for the products on an overall basis, and
b) calculate the new break even point if the sales mix undergoes the following
change:
Products Sales mix
A 25%
B 40%
C 30%
D 5%
c) describe and explain the main factor which contributes to a shift in the break-
even point in the new position.
18. Janata Ltd. reported poor profits for the previous year. This point came up to
discussion at a management meeting convened to discuss profitability in the
following year. Bhasker Mitter, the Sales Manager, has attended the said
meeting. He stressed his belief that greater volume in terms of sales was the
answer to the problem of the company. An increase in volume in the
previous year had not materialised. In fact, the sales value was the same as
the year before with no major volume change, and yet the profit had dropped.
Bhaske Mitter mentioned that products 423 had not sold in the current year
as well as it did in the previous year. Acharya, the factory manager,
expressed the hope that Bhasker Mitter would achieve a higher sales level
next year because he had taken delivery of a costly and new pieces of plant
and machinery and this should an increased rate of production.
Purnendu Kumar, the Managing Director, presented the following chart

submitted by his accountant, Naveen Sethi, in his efforts to discuss a plan for
the future:
Naveen Sethi explained the chart and then the meeting adjourned for lunch:
66
You are required to Cost-Volume-Profit Analysis
a) Describe the cost-volume -profit relationships implied in the statements of

Analysis Bhasker Mitter and Acharya.
b) Give a possible explanation of the chart prepared by Naveen Sethi.
Answers and Approaches to Activities
Activity 9.1
Conclusions
a) 20% increase in variable costs raises break even point to the present normal
sales volume leaving no profit at all.
b) 20% decrease in variable cost doubles profit per unit, lowers the break even
point to almost Rs.1,50,000 below the normal sales volume, and yields 100%
more profit.
Influence of change in fixed costs:
Conclusions
a) A 20% increase in fixed costs still preserves the profit but a 20% decrease
lowers the break-even point to the lowest of any situation so far.
b) Decrease in fixed costs does not yield the same profit as does the decrease in
variable costs.
67
Cost Management Conclusions
a) Break-even point is quickly reached when prices are reduced, costs increased
and yet volume remains insufficient to overcome changes.
b) Increase in price accompanied by a decrease in volume coupled with a cost
reduction programme will lead to most satisfactory results.
Activity 9.2
1. No 2. Yes 3. No 4. Yes 5. No 6. (a) 7. (b) 8. (c) 9. (a) 10. Yes
Solution:
Activity 9.4
Fixed Costs: Rent, rates and taxes
Executive salaries
Insurance
Audit fees
Insurance
Variable Costs Direct materials
Direct labour
Power and fuel
Discount on sales
Salesman’s commission
Semi-variable costs: Maintenance and supervision
Telephone
Inventory carrying costs
Publicity and Advertising
Transport and vehicles
Activity 9.6
Figure 9.6: Rise in sales level, increase in profit, break-even point lowered, and
margin of safety increased.
Figure 9.7: Variable cost rises, total cost rises, revised profit declines, break-
even point rises, margin of safety is lowered.
Figure 9.8: Fixed cost rises ( please note that the vertical intercept of the total
cost line shifts upwards in contrast with Figure 9.7 where the revised
total cost line commences form the same point as the original total
cos line), total costs rise, revised profit declines, break-even point
rises, am margin of safety is reduced.
Figure 9:9: Capacity expansion increases both profits and fixed costs. The break
even point is increased and the safety margin is decreased.
Figure 9.10: Shows how the profit zone beyond the break-even point is
appropriate among suppliers of capital. It also shows the profits
retained in business.
Figure 9.11: Note the steepness of the slope of individual product contribution
lines. This indicates relative profitability. The figure is a profit graph
with average and individual product contribution lines. The break-
even point and margin of safety can be determined. They are not
68 marked on the graph.
Answers to Self-assessment Questions/Exercises Cost-Volume-Profit Analysis
7. (a) False (b) True (c) False (d) True (e) False (f) False 8. (c) 9. (d) 10. (a)
11. (b)
69
Cost Management
17 Solution
(a) Calculation of Break -even point
Product A B C D TOTAL
1
Sales mix 33 /3% 412/3% 162/3% 8'/3% 100%
Sales (Rs.) 20,000 25,000 10,000 5,000 60,000
Variable cost (Rs.) 12,000 17,000 8,000 2,000 39,000
Contribution 8,000 8,000 2,000 3,000 21,000
Fixed costs - - - - 14,700
Profit - - - - 6,300
b) Effect of change in sales mix
70
Cost-Volume-Profit Analysis
18.(a) The CVP relationships implied in the statements are as follows:

Bhasker Mitter:
Greater volume in terms of sales was the answer to the problem of the company’
High volume would aim at lowering the total unit cost per product. A low
contribution per unit with high fixed costs would require high volume to obtain a
reasonable profit. A low volume with high fixed costs would be serious for company
profitability.
" The sales value was the same as the year before with no major volume change yet
the profit had dropped ...... product 423 had not sold in the current year as well as in
the previous year'. This result appears to be due to a change in the mix of sales with
greater volume of less profitable products than product 423 making up the total
volume of sales in units:
Acharya:
'Delivery of an expensive raw piece of plant and machinery and this should mean an
increased production rate'. This machinery will increase fixed costs. Although the
increased production rate will reduce unit cost, the profit implied in the increased
contribution per unit is dependent on the increased volume . Higher fixed costs will
have reduced the margin of safety.
b) A possible explanation of the chart supplied by Naveen Sethi is as follows:
Plan A gives the highest costs with the resultant highest break-even point
and the lowest margin of safety. Variable costs and revenue are indicated as a
constant per unit. Fixed costs are indicated as a constant amount for the range
of activity shown.
Plan B gives a lower level of fixed costs than plan A and this lowers the
break-even point with a corresponding increase in the margin of safety.
Plan C gives increased profit for the same level of fixed costs as plan 13,
thus lowering the break-even point further and giving the highest margin of
safety.
The increased profit may be explained by a reduction of variable costs or a
possibly improved mix of sales, or perhaps both.

Horngren, C.T. Datar, Srikant M, Foster. George M, 2002, Cost Accounting : A
Managerial Emphasis (11th ed) : Prentice Hall of India : New Delhi
Khan M.Y. and Jain P.K., 2000, Management Accounting (Chapter 14), Tata
McGraw Hill
Glautier, M.W.E. and B, Uunderdown , 1982, Accounting Theory and Practice,
ELBS. Bombay (Chapter 32)
Dopuch, N Birnbirg J.G. and Joel Demiski, 1974, Cost Accounting Harcourt Brace
Javanovich: New York (Chapter4) 71
Video Programme
Accounting in Decision Making
Financial Management :
An Introduction
UNIT 11 FINANCIAL MANAGEMENT :
AN INTRODUCTION
Objectives
The objectives of this unit are to familiarise you:

• with the scope and functions of financial management
• with the objectives of the business firm
• to the major decisions of the finance function and
• with the structure and organisation of finance department.
Structure
11.1 Introduction
11.2 Scope of Financial Management
11.3 Finance Functions
11.4 Objectives of the Firm
11.5 Risk-Return Trade-off
11.6 Conflict of Goals: Management vs. Owners
11.7 Financial Goals and Firm's Objectives
11.8 Organisation of Finance Function
11.9 Finance and Related Disciplines
11.10 Summary
11.11 Key Words
11.12 Self Assessment Questions
11.1 INTRODUCTION
After getting a fairly good idea about accounting, lets, now move on to what
Financial Management is?
Financial management is a managerial activity concerned with planning and

controlling of the firm's financial resources to generate returns on its invested funds.
The raising and using of capital for generating funds and paying returns to the suppli-
ers of capital is the finance function of a firm. Thus the funds raised by the company
will be invested in the best investment opportunities, with an expectation of future
benefits. As every business activity either directly or indirectly involves the acquisi-
tion and use of funds, there is an inseparable relationship between the finance and
other functions like production, marketing etc. However, the raising of funds and
using of money may not necessarily limit the general running of the business. A firm
in a tight financial position will give more priority to financial considerations to devise
its marketing and production strategies in tune with its financial constraints. On the
contrary, management of a business firm, with plentiful supply of funds, will be more
flexible in formulating its production and marketing policies. In fact, the financial
policies will be devised to fit the production and marketing decisions under such a
situation. Thus although it may be difficult to separate the finance function from the
other functions of the business, the finance function can be broadly discussed as: 5
Financial and i. Managerial functions
Investment Analysis
ii. Routine functions
The managerial functions require greater planning, control and execution of financial
activities. Whereas, the routine functions need a greater managerial talent to carry
them out. The routine functions are mainly clerical and incidental to the effective
handling of the managerial functions. Some of the important routine functions are:
i. Supervision of cash receipts and payments and safeguarding of cash;

ii. Custody and safeguarding of securities, insurance policies and other valuable
papers;
iii. Taking care of the methodological procedures of new outside financing;
iv. Preparation of the reports arid keeping of the records.
These routine functions are carried out by the people at the supervisory levels. About
three to four decades ago, the scope of finance function was limited to routine activi-
ties and the involvement of the financial executive in the managerial finance
activities is a very recent origin.
11.2 SCOPE OF FINANCIAL MANAGEMENT
The scope and functions of financial management are divided into two broad catego-
ries:
a. Traditional approach
b. Modern approach
Traditional Approach
The traditional approach to the scope of financial management refers to its subject
matter in the academic literature in the initial stages of its evolution as a separate
branch of study. According to this approach, the scope of financial management is
confined to the raising of funds. Hence, the scope of finance was treated by the
traditional approach in the narrow sense of procurement of funds by corporate
enterprise to meet their financial needs. Since the main emphasis of finance function
at that period was on the procurement of funds, the subject was called corporation
finance till the mid-1950's and covered discussion on the financial instruments,
institutions and practices through which funds are obtained. Further, as the problem
of raising funds is more intensely felt at certain episodic events such as merger,
liquidation, consolidation, reorganisation and so on. These are the broad features of
the subject matter of corporation finance, which has no concern with the decisions of
allocating firm's funds. But the scope of finance function in the traditional approach
has now been discarded as it suffers from serious criticisms. Again, the limitations of
this approach fall into the following categories.
i. The emphasis in the traditional approach is on the procurement of funds by the

corporate enterprises, which was woven around the viewpoint of the suppliers of
funds such as investors, financial institutions, investment bankers, etc, i.e.
outsiders. It implies that the traditional approach was the outsider-looking-in
approach. Another limitation was that internal financial decision-making was
completely ignored in this approach.
ii. The second criticism leveled against this traditional approach was that the scope
of financial management was confined only to the episodic events such as
mergers, acquisitions, reorganizations, consolation, etc. The scope of finance
6 function in this approach was confined to a description of these infrequent
happenings in the life of an enterprise. Thus, it places over emphasis on the An Introduction
topics of securities and its markets, without paying any attention on the day to
day financial aspects.
iii. Another serious lacuna in the traditional approach was that the focus was on the
long-term financial problems thus ignoring the importance of the working capital
management. Thus, this approach has failed to consider the routine managerial
problems relating to finance of the firm.
During the initial stages of development, financial management was dominated by the
traditional approach as is evident from the finance books of early days. The tradi-
tional approach was found in the first manifestation by Green's book written in 1897,
Meades on Corporation Finance, in 1910; Doing's on Corporate Promotion and
Reorganisation, in 1914, etc.
As stated earlier, in this traditional approach all these writings emphasized the finan-
cial problems from the outsiders' point of view instead of looking into the problems
from managements, point of view. It over emphasized long-term financing lacked in
analytical content and placed heavy emphasis on descriptive material. Thus, the
traditional approach omits the discussion on the important aspects like cost of the
capital, optimum capital structure, valuation of firm, etc. In the absence of these
crucial aspects in the finance function, the traditional approach implied a very narrow
scope of financial management. The modern or new approach provides a solution to
all these aspects of financial management.
Modern Approach
After the 1950's, a number of economic and environmental factors, such as the
technological innovations, industrialization, intense competition, interference of
government, growth of population, necessitated efficient and effective utilisation of
financial resources. In this context, the optimum allocation of the firm's resources is
the order of the day to the management. Then the emphasis shifted from episodic
financing to the managerial financial problems, from raising of funds to efficient and
effective use of funds. Thus, the broader view of the modern approach of the finance
function is the wise use of funds. Since the financial decisions have a great impact on
all other business activities, the financial manager should be concerned about deter-
mining the size and nature of the technology, setting the direction and growth of the
business, shaping the profitability, amount of risk taking, selecting the asset mix,
determination of optimum capital structure, etc. The new approach is thus an analyti-
cal way of viewing the financial problems of a firm. According to the new approach,
the financial management is concerned with the solution of the major areas relating
to the financial operations of a firm, viz., investment, and financing and dividend
decisions. The modern financial manager has to take financial decisions in the most
rational way. These decisions have to be made in such a way that the funds of the
firm are used optimally. These decisions are referred to as managerial finance
functions since they require special care with extraordinary administrative ability,
management skills and decision - making techniques, etc.
11.3 FINANCE FUNCTIONS

Finance functions can be divided into three major decisions, which the firm must
make, namely the investment decision, the finance decision, and the dividend decision.
Each of these decisions must be considered in relation to the objective of the firm: an
optimal combination of the three decisions will maximize the value of the share to its
shareholders. Since, these decisions are interrelated, we must consider their joint
impact on the market price of the firm's stock. Now, in the following pages we will
briefly discuss each of these decisions.
7
Financial and A. Investment Decision
Investment Analysis
The investment decision is the most important one among the three decisions. It
relates to the selection of assets in which funds are invested by the firm. The assets,
which can be acquired, fall into two broad groups:
i. Long-term assets which will yield a return over a period of time in future,
ii. Short-term I current assets which are convertible into cash in the normal
course of business usually within a year.
Accordingly, the asset selection decision of a firm is of two types. The first of these
involving the first category of assets is popularly known as capital budgeting. The
other one, which refers to short-term assets, is designated as liquidity decision.
i. Capital budgeting decision
It is the most crucial financial decision of a firm which relates to the selection of an
investment proposal whose benefits are likely to arise in future over the life-time of
the project. The first aspect of the capital budgeting decision is the choice of the
investment out of the available alternatives. The selection will be always based on
the relative benefits and returns associated with it. Therefore, the measurement of
the worth of the investment proposal is a major element in the capital budgeting
decision. Another aspect of the capital budgeting decision is the analysis of risk and
uncertainty. As, the benefits from the proposed investment relate to the future period,
their accrual is uncertain. Thus, an element of risk in the sense of uncertainty of
future benefits is involved in this exercise. Therefore, the return from the proposed
investment should be evaluated in relation to the risk associated with it. Finally,
this return should be judged with a certain norm, which is referred by several
names such as cut-off rate, required rate, hurdle rate, minimum rate of return, etc.
The correct standard to use for this purpose is the company's cost of capital, which
is another important aspect of the capital budgeting decision.
ii. Liquidity decision
The liquidity decision is concerned with the management of the current assets, which
is a pre-requisite to long-term success of any business firm. The main objective of
the current assets: management is the trade - off between profitability and liquidity.
There is a conflict between these two concepts. If a firm does not have adequate
working capital, it may become illiquid and consequently fail to meet its current
obligations thus inviting the risk of bankruptcy. On the contrary, if the current
assets are too large, the profitability is adversely affected. Hence, the key strategy
and the main consideration in ensuring a trade-off between profitability and
liquidity is the major objective of the liquidity decision. Besides, the funds should
be invested optimally in the individual current assets to avoid inadequacy or
excessive locking up of funds in these assets. Thus, the liquidity decision should
obtain the basic two ingredients, i.e. overview of working capital management and
the efficient allocation of funds on the individual current assets.
B. Financing Decision
The second major decision of the firm is the financing decision for determining the
best financing mix of the firm.
After determining the asset-mix, the financial manager must decide the mode of
raising the funds to meet the firm's investment requirements. The major issue in this
8 decision is to determine the proportion of equity and debt capital. Since the involve-
ment of debt capital affects the return and risk of shareholders, the financial manager
should get the optimal capital structure to maximise the shareholders' return with
minimum risk, in other words the cost of capital is the lowest and the market value of An Introduction
the share is the highest at that combination of debt and equity. Thus, the financing
decision covers two inter-related aspects: (i) capital structure theory, and (ii) capital
structure decision.
C. Dividend Decision
The third important decision of a firm is its dividend policy. The financial manager
must decide whether the firm should distribute all profits or retain it in the firm or
distribute part and retain the balance. The dividend decision should be taken in terms
of its impact on the shareholders' wealth. The optimum dividend policy is one, which
maximizes the market value of share. Thus, if the shareholders are not indifferent to
the firm's dividend policy, the financial manager must determine the optimum divi-
dend-payout ratio. Another important aspect of the dividend decision is the factors
determining dividend policy of the firm in practice.
To summarise, the financial management involves the solution o f the three decisions
of the firm according to the modern approach. The traditional approach with a very
narrow perception was devoid of an integrated conceptual and analytical framework.
In contrast the modern approach has broadened the scope of financial management to
ensure the optimum decisions by fulfilling the objectives of the business firm.
11.4 OBJECTIVES OF THE FIRM

It is clear from the above discussion that the modern approach to financial manage-
ment is to give answers for three questions: where to invest and in what amounts how
to raise and in what amount, and when to pay dividends. These aspects relate to the
firm's investment, financing and dividend policies. In order to meet them rationally,
the firm must have an objective. It is generally agreed that the financial objective of
the firm should be the maximisation of owners' economic welfare. However, there is
a disagreement as to how the economic welfare of the owners can be maximised. The
two well known and widely discussed criteria in this respect are:
a. Profit maximisation, and
b. Wealth maximisation
A. Profit Maximisation
According to this concept, actions that increase the firm's profit are undertaken while
those that decrease profit are avoided. The profit can be maximised either by increas-
ing output for a given set of scarce input or by reducing the cost of production for a
given output. The modern economics states that the profit maximisation is nothing
but a criterion for economic efficiency as profits provide a yardstick by which eco-
nomic performances can be judged under condition of perfect competition. Besides,
under perfect competition, profit maximisation behaviour by firms leads to an
efficient allocation of resources with maximum social welfare. Since, the capital is a
scarce material, the financial manager should use these capital funds in the most
efficient manner for achieving the profit maximisation. It is, therefore, argued that
profitability maximisation should serve as the basic criterion for the ultimate
financial management decisions.
The profit maximisation criterion has, however, been questioned and criticised on the
following grounds:
i. its vagueness
ii. it ignores the timing of benefits 9
iii. it ignores risk

Financial and One practical difficulty with profit maximisation criterion is that the term profit is
Investment Analysis vague and ambiguous as it is amenable to different interpretations, like, profit before
tax or after tax, total profit or rate of return, etc. If profit maximisation is taken to be the
objective, the problem arises, which of these variants of profit to be maximised?
Hence, a vague concept of profit cannot form the basis of operation for financial
management.
A more important technical objection to profit maximisation is that it ignores the

differences in the time pattern of the cash inflows from investment proposals. In other
words, it does not recognise the distinction between the returns in different periods of
time and treat them at a par which is not true in real world as the benefits in earlier
years should be valued more than the benefits received in the subsequent years.
Another limitation of profit maximisation as an operational objective is that it ignores

the quality aspect of benefits associated with a financial course of action. The quality
here refers to the degree of certainty with which benefits can be obtained. As a matter
of fact, the more certain the expected return, the higher the quality of the benefits.
Conversely, the more uncertain the expected returns, the lower the quality of
benefits, which implies risk to the investors. Generally, the investors want to avoid or
at least to minimise the risk. Hence, the concept of profit maximisation is unsuitable
as an operational criterion for financial management, as it only considers the size of
benefits but gives no weight to the degree of uncertainty of future benefits.
Therefore, from the above discussion, it clear that the profit maximisation concept is
inappropriate to a firm from the point of view of financial decisions, i.e. investment,
finance and dividend policies. It is not only vague and ambiguous but also it does not
recognise the two basic aspects, i.e., risk and time value of money. The most appro-
priate operational decision criteria should consist of the following aspects:
i. it must be precise and exact;
ii. it should consider both quality and quantity dimension of the receipts;
iii. it should be based on the bigger the better principle; and
iv. it should recognise the, time value of money.
An alternative to profit maximisation, which solves these issues is the wealth

maximisation objective.
B. Wealth Maximisation
The most widely accepted objective of the firm is to maximise the value of the firm for
its owners. The wealth maximisation goal states that the management should seek to
maximise the present value of the expected returns of the firm. The present value of
future benefits is calculated by using its discount rate (cost of capital) that reflects both
time and risk. The discount rate (capitalisation rate) that is applied is, therefore, the rate
that reflects the time and risk preferences of the suppliers of capital.
The next feature of wealth maximisation criterion is that it takes; both the quantity and
quality dimensions of benefits along with the time value of money. Other things being
equal, income with certainty are valued more than the uncertain ones. Similarly, the
benefits received in earlier period should be valued more than the benefits received in
later period, in this criterion. Thus, the objective of wealth maximisation has a number
of distinct merits.
It is quite clear that the wealth maximisation is, no doubt, superior to the profit
10 maximisation objective. The wealth maximisation objective involves a comparison of
present value of future benefits to the cash outflow. If the activity results in positive
net present value, i.e. the present value of future stream of cash flows exceeds the An Introduction
present value of outflows, reflecting both time and risk, it can be said to create wealth
and such actions should be undertaken. Conversely, actions with value less than its
cost reduce the wealth of the firm and should be rejected. In case of mutually exclu-
sive projects, when only one is to be chosen, the alternative with the greatest net
present value should be selected.
According to Ezra Solomon's symbols and methods, the net present wealth can be
ascertained as under:
i. W=V–C where W = Net Present Wealth
V = Gross Present Wealth
C = Investment / Capital Outflow
ii. V=E/K
Where E = Size of future stream of benefits
K = Capitalisation rate / discount factor reflecting both risk and

timing of benefits attached to E.
iii. E=G- (M+I+T)
Where G = average expected future cash inflows (earnings before interest,

taxes and dividends);
M = average annual re-investment required to maintain G at the

projected level expected flows of annual payments on account of
interest, dividend and charges
T = expected annual outflows on account of taxes
According to the modern approach the objective of the financial management is to

maximise the wealth of the firm.
The objective of wealth maximisation can also be explicitly defined by short-cut

method symbolically as under:
When A1, A2, .... An represent the stream of benefits (cash inflows) expected to occur
on the investment project;
Co is the cost of the project
k is the discount factor / capitalisation rate to calculate the present value of expected
cash flows; and,
W is the net wealth of the firm (the difference between the present value of stream of
expected benefits and the present value of cash outflow).
It is abundantly clear from the above discussion that the wealth maximization
criterion recognizes the time value of money and also tackles the risk, which is
ascertained by the uncertainty of the expected benefits. That is why, it is rightly said 11
that maximization of wealth is more useful than minimization of profits as a
statement of the objective of most business firms.
Financial and
Investment Analysis
11.5 RISK-RETURN TRADE-OFF
The financial decisions of the firm are interrelated as they jointly affect the market
value of the shares by influencing return and risk. This relationship between return
and risk can be expressed as:
Return = Risk-free rate + Risk premium

Here the risk free rate is a compensation for time and risk premium for risk coverage.
In order to maximise the market value of the firm's shares, a proper balance between
return and risk should be maintained. Such a balance is called as risk-return trade-off.
It is the overview of the functions of financial management, which is depicted, in the
following figure:
Figure 11.1: An overview of financial management
11.6 CONFLICT OF GOALS: MANAGEMENT VS

OWNERS
In the joint stock company form of organisations, the decision-making lies in the hands
of its management. While taking the decisions, the management need not necessarily
act in the best interest of the shareholders and may pursue their own personal
welfare, job security, etc. In other words, there may be a divergence between the
shareholders' wealth maximization goal and the actual goals pursued by the
management of the business firm. The main reason, which has been attributed for
this, is the separation of ownership and control (management) in these organisations.
But in practice, the possibility of pursuing exclusively the managernents personal
welfare is considered remote because the continuous supervision by the owners,
employees, creditors, customers, government will restrict management's freedom to
act for their own interests. Every group connected with the company will evaluate the
management performance from their point of view. The survival of the management
will be threatened if their objectives remain unfulfilled. The wealth maximization
criterion may be generally in accordance with the interests of the parties who are
related to the organisation. However, situations arise where a conflict may occur
between the shareholders' and managements goals, that is the management may play
safe and create satisfactory wealth for the shareholders which may not be the
maximum one. Such type of attitude of management towards the shareholders goal
will frustrate the objective of shareholders wealth maximization.
11.7 FINANCIAL GOALS AND FIRM'S OBJECTIVES

In the shareholders' wealth maximisation criterion a question may arise: Is wealth
12 maximisation the objective of the firm? Does a firm exist with the sole objective of
serving the interests of owners? The business firms do not exist with the main
objective of maximising the welfare of shareholders. The survival and the future
growth of the firm always depends on how it satisfies its customers through the An Introduction
quality of goods and services. Further, the firms in practice set their vision or mission
concerned with technology, leadership, market share, image, welfare of employees,
etc. Hence, the firm designs its strategy around such basic objectives in the areas of
technology, production, purchase, marketing, finance, etc. For this, the firm takes its
decisions, which are consistent with its strategies. Therefore, the wealth
maximisation objective is the second level criterion, which ensures to meet the
minimum standard of the economic performance. As a matter of fact, the
management is not only the agent of owners, but also trustee for the owners. Hence,
it is the responsibility of the management to harmonise the interests of owners with
that of creditors, employees, government, society, etc.
11.8 ORGANISATION OF FINANCE FUNCTION

Since the finance function is a major functional area, the ultimate responsibility for
carrying out the financial management functions lies with the top management: Board
of directors / Managing director / chief executive / committee of the Board. However,
the exact nature of the organisation of the finance function differs from firm to firm
depending upon the factors such as size of the firm, nature of the business, ability of
the financial executive, financial philosophy, etc. similarly, the designation of the chief
executive of the finance department also differs widely in case of different firms. In
some cases, they are known as finance managers while in others as vice-president
(Finance), or Director (Finance), or Financial controller, etc.
Figure 11.2 : Organisation for finance function
Figure 11.3: Organisation for finance function in a multi-divisional 13

Indian company
Financial and Under the chief executive, there are controllers, treasurers, who will be looking after
Investment Analysis the sub functions viz., accounting and control; and financing activities in the firm.
The functions of treasurer includes obtaining finance; maintaining relations with
investors, banks, etc., short-term financing, cash management, credit administration
while the controller is related to the functions like financial accounting; internal
audit; taxation, management accounting a n d control, budgeting, planning and
control, economic appraisal, etc. Figure 11.2 shows that the finance function is one of
the major functional areas, and the financial manager / director is under the control of
the board of directors.
11.9 FINANCE AND RELATED DISCIPLINES

There is an inseparable relationship between finance o n the one hand and other
related disciplines and subjects on the other. It draws heavily on related disciplines
and fields of study. The most important of these are accounting and economics, but
the subjects like marketing, production, quantitative methods, etc. also have an
impact on the finance field. In the following sections these disciplines are noted.
FINANCE AND ACCOUNTING
The relationship between finance and accounting, has two dimensions:

i. They are closely related to the extent that accounting is an important input in
financial decision making;
ii. There are certain differences between them.
Accounting is a necessary input into the finance function. It generates information
through the financial statements. The data contained in these statements assists the
financial managers in assessing the past performance and future directions of the firm
and in meeting certain legal obligations. Thus, accounting and finance are function-
ally inseparable.
The key differences between finance and accounting are relating to the treatment of
funds and decision-making, which are discussed as under:
a. Treatment of funds:
The measurement of funds in accounting is based on the accrual concept. For
instance, revenue is recognised at the point of sale and not on collection of credit.
Similarly, expenses are recognised when they are incurred but not at the time of
actual payment of these expenses. Where as in case of finance the treatment of funds is
based on cashflows. That means here the revenue is recognised only when actually
received - or actually paid in cash.
b. Decision Making:
The purpose of accounting is collection and presentation of financial data. The
financial manager uses these data for financial decision-making. It does not mean
that accountants never make decisions or financial managers never prepare data. But
the primary focus of the function of accountants is collection and presentation of data
while the financial manager's major responsibility relates to financial planning, con
trolling and decision-making. Thus, the role of finance begins, where the accounting
ends.
ECONOMICS AND FINANCE
The development of the theory of finance began in the 1920s as an offshoot of the
study of the theory of the firm in economic theory. The financial manager uses
microeconomics when developing decision models that are likely to lead to the most
14 efficient and successful modes of operation within the firm. Further, the marginal
cost and revenue concepts are used in making the investment decisions, managing
working capital, etc in the finance field.
11.10 SUMMARY An Introduction
In this unit we have tried to introduce you to an overview of financial management

emphasizing its importance in a firm. We also discussed how the traditional concept
of ‘Corporation Finance’ which considers only the provision of funds required by the
business firm was replaced by the modern concept which treats finance as an integral
part of the overall management rather than mere raising of funds and the scope of
finance. Then the shift of the emphasis to the managerial problems from raising of
funds to efficient and effective use of funds. The objectives of profit maximisation,
wealth maximisation and their importance has been discussed. Finally, we had
covered about the organisation of finance function and related disciplines of finance.
11.11 KEY WORDS

Financial Management: It is an activity concerned with planning and controlling of
the firm's financial resources to generate returns on its invested funds to achieve the
objectives of the firm.
Profit Maximisation: It is one of the objectives of the firm to earn higher returns on
its resources, which means higher dividends to the investors. It is nothing but a crite-
rion for economic efficiency as profits provide a yardstick by which economic
performances can be judged under condition of perfect competition.
Wealth Maximisation: It is the most widely accepted objective of the firm for its
owners, which states that the management should seek to maximise the present value
of the expected returns of the firm.
11.12 SELF ASSESSMENT QUESTIONS

1. Write in brief about Financial Management and discuss the scope and functions
of Financial Management.
2. Distinguish between Profit Maximisation and Wealth Maximisation objectives
of the firm?
3 In what ways is the role of a finance manager different from that of an
accountant?
4. What are the important decisions of finance functions? Explain their
importance and relevance in Financial Management.
5. Discuss the different approaches to Financial Management.
6. What is the nature of the risk-return trade off faced in financial decision
making?
7. Discuss the problems of a finance manager in the management of finance
functions in the Indian context?

Pander, I.M. 2002. Financial Management (8th ed.), Vikas Publishing House : New
Delhi
Brigham, F. Eugene and Houston F. Joel, 1999, Fundamentals of Financial

Management, (2nd ed.), Harcourt Brace College Publishers : Florida (Chapter 1)
Soloman, Ezra and Pringle John, 1993. An Introduction to Financial Management,

Prentice Hall of India Private Ltd.: New Delhi 15
Financial and
Investment Analysis UNIT 12 RATIO ANALYSIS
Objectives
The main objectives of the unit are to:
• provide a board classification of ratios
• identify ratios which are appropriate for control of activities
• attempt a system of ratios which responds to the needs of control by management
Structure
12.1 Introduction
12.2 Classification
12.3 The Norms for Evaluation
12.4 Computation and Purpose
12.5 Managerial Uses of the Primary Ratio
12.6 Summary
12.7 Key Words
12.8 Self Assessment Questions/Exercises
12.1 INTRODUCTION
You have already been exposed to the Ìntroduction and analysis' of financial
statements in Units 4-6 of this course. By now you might have acquired some
familiarity with financial ratios that provide basic relationships about several aspects
of a business. You may have observed that the Financial media (magazines like
Fortune India, Business India Business World, and dailies like Economic Times,
Financial Express and Business Standard, among many others) presents many of
these ratios to analyse the strengths and weaknesses of individual business firms.
Further, the Bombay Stock Exchange makes one of the most exhaustive efforts in the
country to analyse financial data of a large number of companies through a set of 21
ratios. An internationally cited use of ratios comes in the ranking of the 500 largest
corporations by a financial bi-monthly, viz., Fortune International. This exercise is
based on five basic parameters viz., Sales, Assets, Net Income, Stockholders Equity,
and Number of employees. The nine rating measures derived from these parameters
are: sales change, profits change, net income as a percent of sales, net income as a
per cent of stockholders equity, 10-year growth in earning per share, total return to
investors (latest year and 10-year average), assets per employee, and sales per
employee.
This is not an exhaustive list and you may come across many more sources of
published ratios including the individual companies, many of which now provide
summarised financial information and ratios for the past five or ten years. The point
is that users of ratios are vast, ratios that emerge from financial data are numerous
and uses to which these ratios can be put are many.
16
Ratio Analysis
12.2 CLASSIFICATION
Financial ratios have been classified in a variety of ways. You may find the following
broad bases having been employed in current literature:
Primacy Criterion: This distinguishes a measure, which could be considered useful

for all kinds and sizes of business enterprises, from many other measures which are
not so universal in usage. The first one has been called the Primary Ratio (viz., the
Return on Investment or the ROI) and the other category called Secondary measures
includes all other ratios. Such measures will essentially vary among firms, and they
will select only such of those measures as are relevant for their needs. The British
Institute of Management uses this classification for inter-firm comparisons.
Ratios tagged to needs of interest groups: The major interest groups identified for
this purpose are:
a) Management
b) Owners
c) Lenders
This classification assumes that. ‘management group’ is different from ‘owner
group’.
Management and operational control: Cost of goods sold and gross margin
analysis, profit (net income) analysis, operating expense analysis, contribution
analysis and analysis of working capital.
Owner's viewpoint Net profit to net worth, net profit available (to, equity share-
holders) to equity share capital, earnings per share, cash flow per share and dividends
per share.
Lenders' evaluation: Current Assets to Current Liabilities, Quick Assets (i.e.,

current assets minus inventories) to Current Liabilities, Total Debt to Total Assets,
Long-term Debt to Net Assets, Total Debt to Net Worth, Long-term Debt to Net
Worth, Long-term Debt to Net Assets and Net Profit before Interest and Taxes (i.e.,
NBIT) to Interest.
Fundamental classification Ratios under this classification are grouped according to

a basic function relevant to financial analysis. Four such functional groups have been
generally recognised.
a) Liquidity Ratios are ratios which measure a firm's ability to meet its matur-
ing short-term obligations. The most common ratio indicating the extent of
liquidity or lack of it are current ratio and quick ratio.
b) Leverage Ratios are ratios ' which measure the extent to which a firm has
been financed by debt. Suppliers of debt capital would look to equity as
margin of safety, but owners would borrow to maintain control with limited
investment. And if they are able to earn on' borrowed funds more than the
interest that has to be paid, the return to owners is magnified. (This aspect
has been elaborated and illustrated in the next Unit of Financial and
Operating Leverage). Example include debt to total assets, times interest
earned, and charge coverage ratios.
c) Activity Ratios are ratios which measure the effectiveness with which a firm
is using its resources. Example include Inventory. turnover. Average collec-
tion period, Fixed assets turnover, and Total assets turnover.
d) Profitable Ratios are ratios which measure management's overall effective-

ness as shown by the returns generated on sales and investment. Examples
17
Financial and could be profit (net or gross) margin. Net Profit to total assets or ROI, Net
Investment Analysis profit after taxes to Net worth.
One more class of ratios is sometimes added to the four groups specified above. This
is called the `Market Value `group of ratios, which relate investors' expectations
about the company's future to its present performance and financial conditions.
Examples would cover Price-earnings (PE) and Market/book-value ratios.
The fundamental classification is probably the most extensively used mode of

presenting financial statement analysis.
Activity 12.1
Table 12.1 on next page lists 21 ratios being computed by the Bombay Stock
Exchange. Tick the board class to which each of the 21 ratios belongs to in the blank
columns of the Table.
You must have begun grouping the ratios on the basis of what you have learnt about
them. However, we would help you in this exercise. The very first ratio and for that
matter the first three ratios are figured on net worth which is a parameter of great
interest to proprietors. Nevertheless, the ratios do not reflect either of the four
fundamental ratios viz., liquidity, leverage, profitability and activity. Also, they are
not primary since they do not measure final profitability of capital (or investment)
committed to the firm. Hence, ratios 1 to 3 are secondary and owner-oriented. Of
course, they do reveal one fundamental aspect viz., stability. The Bombay Stock
Exchange classifies these ratios under the board group of ‘Stability ratios’.
This exercise of classification has given you an idea about ratios, which are relevant
for controlling business activities, and the ratio in which top management would be
particularly interested. Obviously, they are activity ratios which we have classified as
`management-oriented' ratios. The primary ratio, which is of universal relevance to
top management, will be specifically explained regarding its rationale and con-
struction in this unit.
You have noticed that the basic flow of activities of a business firm follows a certain
sequence:
Investment decision → financing of investment → acquisition of resources

deployment of resources → disposal of output → reinvestment of surplus.
This sequence needs some explanation. A typical business firm would take a decision
to invest after an analysis of the projected inflows and outflows of the project. This
will be followed by a plan to finance the project, which may be debt finance and / or
proprietors' own funds. Finance will then be utilized to build facilities and
commercial output will be obtained as per the project schedule (assuming there are
no over-runs and delays) Sales revenue will follow the disposal of the output and
after meeting all costs and expenses (including tax and finance charges), a decision
will be taken to compensate the owners (dividend decision) and reinvest the balance,
if any.
You will appreciate that the cycle of business activities commences with the deploy-
ment of recourses and terminate in the disposal of output. A business would like to
have as many such cycles as possible during a time period, say a year. Apart from
increasing the number of such cycles during a time period the management would be
interested to reduce costs and expenses to the minimum at each stage of the cycle.
Accounting ratios, which belong to the category of “management-oriented activity
ratios”, enable business firms to exercise control over operations. The next section of
this unit focuses attention on these ratios.
18
Ratio Analysis
Table 12.1 : Table listing 21 ratios being computed by the Bombay Stock Exchange
Broad Classes of Ratios
Ratios Primacy Interest Groups Fundamental
Primary Secondary Management Owner Lender Liquidity Leverage Profitability Activity
1 Net worth to Total
2 Net block to Net worth
3 Total liabilities to Net worth
4 Current Assets to Current liabilities
5 Quick Assets to Current liabilities Net
6 Sales to Total assets
7 Net Sales to Net worth + Debentures
8 Net Sales to Plant & Machinery at Cost
9 Sundry Debtors to Average Daily Sales
10 Net profit to Total Capital Employed
11 Net Profit + Debenture Interest to Net worth +
Debentures
12 Net profit to Total Assets
13 Depreciation Reserve to Gross Block
14 Depreciation Provision to Net Block Tax
15 Tax Provision to Pre-tax profit
16 Preference Capital + Debentures to Equity
Capital
17 Debentures to Net worth + Debentures
18 Preference Capital to Net worth + Debentures
19 Equity Capital + Reserve to Net worth +
Debentures
20 Times Debenture Interest covered
21 Times Preference Dividends covered
19
Financial and
Investment Analysis
12.3 THE NORMS FOR EVALUATION
You may just be wondering as to how we control activities through ratios. The
answer is not difficult to seek. Ratios that we have identified for control of activities
measures relationships between key elements at any point of time. Such a measure is
then compared with some `norm' and the causes for deviation investigated. An
action-plan is then prepared and implemented to remove the cause(s). For example,
Nagpur Textile Mills Ltd. reports 89 days of inventories held on an average against
net sales during the year 2002. Now, how do we judge if the figure of `89 days' is just
about okay for a firm like “Nagpur Textile Mills Ltd.”? The following appear to be
the ways for evaluating this figure:
a) Against a trend over time: The following data may be observed for Nagpur
Textile Mill:
Year Average No. of days of inventory*
1998 90
1999 118
2000 115
2001 107
2002 98
b) Against an average of some past period: The relevant data for Nagpur
Textile Mill may be evaluated on the basis of the mean of average number of
days viz., (90 +118 + 115 + 107 + 89)/5 = 519/5 = 104 days approximately.
c) Against an industry average: A certain number of firms chosen (randomly

or otherwise) from textile industry, to which Nagpur Textile Mill Ltd.
belongs, may be used to compute the industry average as a norm. Thus; data
relating to average number of days of inventory of, say, 20 textile units of the
size and type of Nagpur Textile Mills Ltd. may be averaged for a particular
year for which Nagpur Textile's ratio is being evaluated. Period averages for
firms may also be used to obtain a grand mean for evaluation.
d) Against an average of a cross-section sample: The Reserve Bank of India

publishes financial statistics of joint companies. Their sample for the period
1998-99 to 2000-01 included 1927 public limited companies (with paid up
capital of Rs 100 crores and above). Year-wise averages for corporate sector
as a whole are available. In a similar manner, the ICICI publishes elaborate
data on financial performance of companies assisted by them. The latest
study pertains to the year 1984-85 and included 417 companies in different
industry groups. This sample covers around 50 per cent of the total private
corporate sector in terms of paid-up capital. Year-wise average for industry
groupings are available.
20
Activity 12.2 Ratio Analysis
The Study of Financial Performance presents the following data with regard to
inventory turnover of 43 textile companies.
Inventory as % of sales
Year 34 composite 9 spinning Total 43
mills mils mils
1997-98 24.8 25.1 24.8
1998-99 26.5 24.2 26.3
1999-2000 26.4 24.2 26.1
2000-2001 26.0 22.9 25.6
2001-2002 24.4 23.7 24.3
Comment on the suitability of the given data to evaluate the inventory position of
Nagpur Textile Mills Ltd. in the year 2002.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
………………………………………………………………………………………….
12.4 COMPUTATION AND PURPOSE

A summary of management - oriented activity ratio are given below. This describes
the ratios and also their main purposes.
Activity Ratios (Secondary Group)

Ratio Computation Purpose(s)
Method
I Cost of Goods Sold and Gross Margin Analysis
1. Cost of Goods Cost of Goods Provide an idea of “gross margin”
sold sold/ Net Sales which in turn would depend on
2. Gross Margin Net Sales - Cost relationship between prices,
of goods sold/net volumes and costs
sales
II Profit Analysis
3. Net Margin Net Profit / Net Reflects management's ability to
Sales operate business to recoup all
costs & expenses (including
depreciation, interest and taxes)
and also to provide a compensation
to owners
4. Operating Margin Net operating Provides a view of operating
Income before effectiveness
Interest and
Taxes/Net Sales
5. Post-tax Margin Net Profit after Shows after-tax margin to both
tax but before owners and lenders.
Interest*/ Net
Sales
* The numerator of post-tax margin may be obtained by adding back to net

profit the after-tax cost of interest on debt which is pre-tax interest times 21
(1-tax rate)
Financial and
Investment Analysis
Ratio Computation Method Purpose(s)
III Expense Analysis
6 Operating Ratio Operating expenses / Reflects the incidence of
Net sales operating expenses (which are
defined variously for different
costing systems)
IV Contribution Analysis
7 Total contribution Net sales - directly Indicates the total margin
variable costs / Net provided by operations towards
Sales fixed costs and profits of the
period
V Management of Capital
8 Gross Assets Net Sales/ Total assets Effectiveness of the use of all
assets viz., current and non-
current.
9 Net Assets Net Sales / Total assets - Effectiveness of assets

turnover current liabilities employed on the assumption
that current liabilities are
available to the business as a
matter of course, and will
effectively reduce the assets
required to be employed
10 Inventory turnover Net Sales or Cost of Shows the number of times
Goods Sold / Average inventory replenishment is
Inventories required during an accounting
period to achieve a given level of
sales
11 Receivables Net Sales / average Amount of trade credit allowed
turnover receivables and revolved during a year to
achieve a level of sales.
12 Average collection Average Receivables Evaluates the effectiveness of

X 365
period Net Sales the credit period granted to
customers.
Activity 12.3
State whether the following statements are True or False :

True False
a) Cost of goods sold + Gross Margin = Net Sales
b) Net margin is the only measure of profitability of a True False

manufacturing firm
c) Net operating Income (NOI) is the same as Earnings
before Interest and Taxes (EDIT) True False
d) The numerator of the ratio called “Post-tax margin” is
obtained as follows Net profit after interest, depreciation True False
and taxes + Interest (1-tax rate)
e) In calculating the operating ratio, all firms employ a
standard definition of operating expenses. True False
f) The ratio called “total contribution” can also be
calculated as follows : Fixed costs/Net sales - Variable
costs True False
g) Net assets turnover is calculated b y Net sales/ True False

Net Fixed Assets + Net Current Assets + Other assets
22 h) In computing the inventory turnover ratio, cost of goods True False
sold is a better numerator than net sales
i) The ratio called “Average collection period” evaluates True False Ratio Analysis
all aspects for credit policy
j) Net sales are gross sales as reduced by returns, rebates and excise duty True False
You have been through a review of the select ratios, which focus managerial
attention on some of the critical aspects of a firm's activities. You may acquire a
greater degree of confidence in the use of the ratios summarised above if you review
their construction process also. What, therefore, follows is an example relating to a
company from the paper industry. You have to calculate the twelve ratios tabulated in
this section of the unit.
Activity 12.4
Compute the twelve activity ratios for the three years with the help of the following
information, which has been extracted from the annual accounts of Mahud Paper
Industries Ltd. Also offer you comments. On the basis of the limited information
available with you what areas would you identify for control?
Year ending on 31st March
20012002 2003 2004
(Amount in Rs. Crores)
Balance Sheet (Select items)
1. Current Assets 38.28 39.74 52.23
2 Of which Inventories 17.89 21.70 22.33 26.37
2A Of which S. Debtors 6.91 10.17 10.49 10.93
3 Net Fixed Assets 47.68 47.18 50.08
4 Total Assets 90.26 91.21 106.60
5. Current Liabilities 41.95 43.87 45.02
Profit & Loss Statement (Select Items)
6 Net Sales 95.09 113.60 155.29

7. Cost of goods sold 80.88 93.12 130.65
8. Directly variable expenses (Wages, salaries and

direct manufacturing expenses) 61.79 73.20 101.41
9. Interest 4.81 4.54 5.44
10. Operating Profit (after depreciation and interest) .17 .39 2.60
11 Non-operating profit 4.34 2.49 3.27

12. Pre-tax-profit 4.51 2.88 5.87
13. Provision for taxes .80
14. Net Profit 4.51 2.88 5.07
12.5 MANAGERIAL USES OF THE PRIMARY RATIO

The return on investment has been aptly regarded as a primary ratio because it
specifies the relative net profit earned on the capital employed. This is one single
measure where the final outcome of all business activities gets recorded. It provides
not only a vehicle for measuring relative business efficiency but also focuses
attention on whether an adequate return has been earned in accordance with the
expectations of the investors on the capital contributed by them.
In many cases it becomes necessary to disaggregate an organisation into divisions
and the return on divisional investment can be employed to gauge the divisional 23
performance
Financial and However, it may be stated that the concept of ROI (Return on Investment) is not free
Investment Analysis from ambiguity. This is primarily due to the fact that numerator and denominator of
this ratio i. e. “return” and “capital” are subject to differing interpretations. As
standard definitions of these two basic terms do not exist as yet, the firms define the
terms according to their own thinking. While some firms may define “investment”
quite broadly, others may define it narrowly. As a consequence of this, variations of
ROI are found in “practice”, e.g.; ROA (i.e. Return on Assets).
You will appreciate these variations better as you go along with the discussion, and
the illustrations regarding the analysis of ROI.
You may note that the use of ROI which in fact is a combination of some other ratios
was pioneered by Du pont. That is why it is sometimes known as the Du point system
of Financial control.
The Du pont chart is presented in Figure 12.1 and it may be of interest to you to note
the manner in which the various key elements converge into a single measure viz:,
the Return on Investment: The right block charts out the investment made in various
assets and the left block depicts the earnings and costs flowing in and out of the
utilisation of these assets. Both the net income and total assets are then related to
sales to finally yield the single measure, which peaks the pyramid viz., the ROI.
You will notice that Cash, Accounts Receivable, Marketable Securities and Inven-
tories shown on the right block at the bottom are added up as current assets, which
then are added (leftward) to fixed, assets. This aggregates into total assets, which are
then divided (rightward) into sales to produce a ratio shown as Total Asset Utilisation
or Total Assets Turnover. A similar kind of measure based on income emerges from
the left block. The bottom four boxes at left sum up Interest Taxes, Depreciation and
other operating costs into Total Costs which are then deducted (rightward) from Sales
to yield Net Income: The Net Income is divided (leftward) into sales to generate, a
ratio known as the Net Margin. The two penultimate measures viz., Total Asset
Utilisation and Net Margin are then
24
multiplied together to figure out the Return on Investment at the top box of the chart. Ratio Analysis
The return on investment may be expressed as a relationship in the following

formula:
ROI = Total Asset Turnover X Net Margin
You may further notice that total assets may be financed partly by owners' funds
(known as equity) and partly by borrowed funds (recognised as debt). Given the
proportion of assets financed by equity, an appropriate measure of Return on Equity
(ROE) may also be derived from the ROI. This will be given by
ROE = ROI/Proportion of Total Assets financed by Equity
The term Total Assets / Equity may be recognised as Equity Multiplier and then ROE
will be equal to ROI times the Equity Multiplier.
Versions of ROI
A large number of variations of ROT are found in practice, depending upon how
“Investment” and “Return” are defined “Investment” may be defined to include any
of the following:
1. Gross capital employed Net fixed assets + total current assets + other
assets
2. Net capital employed Net fixed assets + net current assets + other
assets
3. Proprietors' net capital Total assets - (Current liabilities + long-term
employed borrowing + any other outside funds)
4. Average capital employed Opening + closing balances of capital, reserves,
accumulated depreciation and borrowings/2
Similarly, ‘Return’ may be defined to included any of the following:
1 Gross profit
2 Profits before depreciation, interest and taxes (PBDIT)
3 Profits before depreciation, interest and taxes (excluding capital and
extraordinary nary profits): PBDIT
4 Profits before tax (PBT)
5 Profits before tax (excluding capital and extraordinary profits): PBT*
The following versions of ROI are used in practice :
1. Gross Return on Investment = Gross Profit/Total Net Assets
2. Net Return on Investment = Net Profit/Total Net Assets
3. Return on Capital Employed = Profit before tax + Interest/Net Worth
(ROCE) + Interest bearing debt.
4. ROI (based on PBDIT) = PBDIT as per cent of average capital 25
Employed
Financial and 5. ROI (based on PBT) = PBT average of capital and
Investment Analysis
as per cent of reserves.
Activity 12.5
The following particulars have been selectively taken from the annual accounts of
Kavali Woolen Mills Ltd., for the years 2001, 2002 and 2003.
Particulars Years ending on March 31st
2001 2002 2003
Income Statement
1. Operating profit 18.75 22.78 28.48
2. Interest 6.74 8.90 10.78
3. Gross Profits (1- 2) 12.01 13.88 17.70
4. Depreciation 7.66 8.84 8.84
5. Profit before tax (PBT) : (3 - 4) 4.35 5.04 8.86
6. Tax 0.05 .01 .01
7. Net Profit (5 - 6) 4.30 5.03 8:76
Balance Sheet
1 Fixed Assets (gross) 94.61 112.28 162.16
2. Accumulated Depreciation 26.90 34.34 38.26
3 Net fixed assets (1 - 2 + capital work in 75.16 107.23 127.66
progress)
4 Investments 8.48 10.12 12.29
5 Current Assets 42.61 59.97 75.17
6 Current Liabilities and Provisions 30.95 36.53 56.30
7 Net Current Assets (5 - 6) 11.66 23.44 18.87
8 Total Net Assets (3 + 4 + 7) Financed by 95.30 140.79 158.82
9 Net worth 33.97 39.41 53.16
10 Borrowings 61.33 101,38 105.66
of which long-term 39.27 71.09 63.61
a) Compute Gross Return on Investment, Net Return on Investment, and Return
on Capital Employed for the three years. What are your conclusions?
b) Also derive the Return on Equity from the ROI (i.e., Net return on Total Net,
Assets).
Illustration 12.1
EVERLIGHT COMPANY LIMITED
Comparative Balance Sheet
December 31, Year 1 and Year 2
December 31st
Year 1 Year
Assets Rs. Rs.
Cash 1,000 1,200
Bank 6,000 7,500
Accounts Receivable 12,600 14,800
Inventory 18,400 20,500
Repayments 800 850
26 Land and Building 20,000 24,000
Plant and Machinery 30,000 32,000 Ratio Analysis
88,800 1,00,850
Liabilities and Shareholders'
Equity 4,000 7,850
Bills Payable
Accounts Payable 6,400 6,000
Other Current Liabilities 2,000 2,200
Debentures (10%) 20,000 18,000
Preference Shares (12%) 10,000 10,000
Ordinary Shares. Rs. 10 each 40,000 50,000
Retained Earnings 6,400 6,800
88,800 1,00,850
Income and Retained Earnings Statement of the Year Ended December 31, Year 2
Sales Revenue Rs. 60,000

Less Expenses: Rs. 28,000
Cost of Goods Sold
Selling 8,000
Administrative 6,000
Interest 2,000
Income Tax 6,400
Total Expenses 50,400
Net Income 9,600
Less Dividend : 1,200
Preferred
Ordinary 8,000
9,200
Increase in Retained Earning for Year 2 400
Retained Earnings, December 31, Year 1 6,400
Retained Earnings, December 31, Year 2 6,800
With the above information, let us compute the following ratios
a) Rate of Return on Assets
b) Profit Margin (before interest and related tax effect)
c) Cost of Goods Sold to Sales Percentage
d) Selling Expenses to Sales Percentage
e) Operating Expense Ratio
f) Total Assets Turnover
g) Accounts Receivable Turnover
h) Inventory Turnover
i) Rate of Return on Ordinary Share Equity
j) Current Ratio
k) Quick Ratio
l) Long-Term Debt Ratio
m) Debt Equity Ratio 27
n) Times interest Charges Earned
Financial and o) Earnings per (Ordinary) Share
Investment Analysis
p) Price Earning Ratio
q) Book Value per Ordinary Share
The income tax rate is 40 per cent. The market price of an ordinary share at the end
of Year 2 was Rs. 14.80.
Let us take all these ratios one by one.
a) Rate of Return on Assets.

Rs. 9,600 + (1- .40) (Rs. 2, 000) = 11.39 per cent
=
.5 (Rs. 88,800 + Rs.1,00,850)
b) Profit Margin Ratio
Rs. 9,600 + (1-40) (Rs. 2,000) = 18 per cent
=
Rs. 60,000
c) Cost of Goods Sold to Sales Percentage
Rs. 28,000 = 46.67 per cent
=
Rs. 60,000
d) Selling expenses to Sales Percentage
Rs. 8,000 = 13.33 per cent
=
Rs. 60,000
e) Operating Expense Ratio
Rs. 8,000+ Rs. 6,000 = 23.33 per cent
=
Rs. 60,000
f) Total Asset Turnover
Rs. 60,000 = .63 times per year
=
.5 (Rs. 88,800 + Rs.1,00,850)
g) Accounts Receivable Turnover
Rs. 60,000 = 4.3 8 times per year
=
.5 (Rs. 12,600 + Rs. 1,4,800)
h) Inventory Turnover Ratio
Rs.28,000 = 1.44 times per year
=
.5 (Rs. 18,400 + Rs. 20,500)
i) Rate of Return or Ordinary Share Equity
Rs. 9,600 - Rs. 1,200 x 100 = 16.28 per cent
=
.5 (Rs. 46,400 + Rs. 56,800)
j) Current Ratio
December 31, Year 1 : Rs.38,800 = 3.13:1
Rs.12,400
28
December 31, Year 2 : Rs. 44,850 = 2.79 : 1 Ratio Analysis
Rs.16,050
k) Quick Ratio :
December 31, Year 1 : Rs.19,600 = 1.56 :1

Rs.12,400
December 31, Year 2: Rs.23500 = 1.46 :1
Rs.16,050
l) Long-term Debt Ratio
December 31, Year 1: Rs.20,000 = 24.86 per cent

Rs. 80,400
December 31, Year 2: Rs. 18,000 = 21.23 per cent
Rs. 84,800
m) Debt Equity Ratio
December31, Year 1 : Rs.20,000 = 43.1

Rs.46,400
December 31, Year 2 : Rs.18,000 = 31.69
Rs. 56,800
(Equity may or may not include retained earnings. Here, retained earnings
have been included)
n) Times Interest Charges Earned
Rs. 9,600 + Rs. 6,400 + Rs: 2,000 = 9 times

Rs: 2,000
o) Earnings per Ordinary Share (EPS)
December 31 Year 2:
Rs. 8,40 0 = Rs.1.87
=
.5 (4000 + 5000)
p) Price-Earnings Ratio
December 31, Year 2:

14.80 = 7.91 times
=
1.87
q) Book Value per Ordinary Share
December 31, Year 1 : = Rs. 46,400 = Rs.11.60

4,000
December 31, Year 2 : = Rs. 56,800 = Rs.11.36
5,000
29
Financial and Illustration 12.2
Investment Analysis
The information contained in Tables 12.1 to 12.4 relate to a company for the year
2002 and 2003, we shall attempt a comprehensive analysis.
Table 12.1
Megapolitan Company Ltd.
Condensed Balance Sheet for the years ending
December 31, 2003 and December 31, 2002
Increase or (Decrease) Percentage of
total Assets
2003 2002 Rs. % 2003 2002
Rs. Rs.
ASSETS
Current Assets 1,95,000 1,44,000 51,000 35.4 41.1 33.5
Plant and equipment (net) 2,50,000 2,33,500 16,500 7.1 52.6 54.3
Other Assets 30,000 52,500 (22,500) (42.9) 6.3 12.2
Total 4,75,000 4,30,000 45,000 10.5 100.0 100.0
LIABILITIES & CAPITAL
Liabilities:
Current liabilities 56,000 47,000 9,000 (19.1) 11.8 10.9
12% Debentures 1,00,000 1,25,000 (25,000) (20.0) 21.1 29.1
Total 1,56,000 1,72,000 16,000 (9.3) 32.9 40.0
Shareholder's equity
9% preference shares 50,000 50,000 10.5 11.6
(Rs. 100 each)
Equity shares (Rs. 10 each) 1,25,000 1,00,000 25,000 25.0 26.3 23.2
Premium on issue of shares 35,000 20,000 15,000 75.0 7.4 4.7

Retained earnings 1,09,000 88,000 21,000 23.9 22.9 20.5
Total shareholders equity 3,19,000 2,58,000 61,000 23.6 67.1 60.0
Total 4,75,000 4,30,000 45,000 10.5 100.0 100.0
Table 12.2
Income statement for the years ended December 31, 2003 and December 31, 2002
Increase or (Decrease) Percentage of net

Sales
2003 2002 Rs. % 2003 2002
Rs. Rs.
Net sales 4,50,000 3,75,000 75,000 20.2 100.0 100.0

Cost of goods sold 2,65,000 2,10,000 55,000 26.2 58.9 56.0
Gross profit on sales 1,85,000 1,65,000 20,000 12.1 41.1 44.0
Operating expenses:
Selling 58,500 37,500 21,000 56.0 13.0 10.0
Administrative 63,000 47,500 15,500 32.6 14.0 12.7
Total 1,21,500 85,000 36,500 42.9 27.0 22.7
Operating income 63,500 80,000 (16,500) (20.6) 14.1 21.3
30 Interest expense 12,000 15,000 3,000 (20.0) 2.7 4.0
Income before income 51,500 65,000 (13,500) (20.8) 11.4 17.3 Ratio Analysis
taxes
Income taxes 14,000 20,000 6,000 (30.0) 3.1 5.3
Net Income 37,500 45,000 (7,500) (16.7) 8.3 12.0
Table 12.3
Statement of Retained Earnings
for the years ended December 31, 2003 and December 31, 2002
Increase or (Decrease)
2003 2002 Rs. %
Rs. Rs. Rs.
Retained earnings, beginning of year 88,000 57,500 30,500 53.
Net Income 37,500 45,000 (7,500) (16.7)
1,25,500 1,02,500 23,000 22.
Less : Dividends on equity shares 12,000 10,000 2,000 20.
Dividends on preference shares 4,500 4,500
16,500 14,500 2,000 13.
Retained earnings, end of year 1,09,000 88,000 21,000 23.
Table 12.4
Schedule of Working Capital
as at December 31, 2003 and December 31, 2002
Increase or Percentage of
(Decrease) total current items
2003 2002 Rs. % 2003 2002
Current Assets: Rs. Rs.
Cash 19,000 20,000 (1,000) (5.0) 9.7 13.9
Receivables (net) 58,500 43,000 15,500 36.0 30.0 29.9
Inventories 90,000 60,000 30,000 50.0 46.2 41.6
Prepaid expenses 27,500 21,000 6,500 31.0 14.1 14.6
Total current assets 1,95,000 1,44,000 51,000 35.4 100.0 100.0
Current liabilities
Bills Payable 7,300 5,000 2,300 46.0 13.1 10.7
Accounts payable 33,000 15,000 18,000 120.0 58.9 31.9
Accrued liabilities 15,700 27,000 (11,300) (41.9) 28.0 57.4
Total current liabilities 56,000 47,000 9,000 19.1 100.0 100.0
Working capital 1,39,000 97,000 42,000 43.3
Using the information in the above Tables let us consider analyses that would be of
particular interest to:
• Equity shareholders
• Long-term creditors
• Short-term creditors
Equity shareholders : Equity shareholders, present and potential, look primarily to

the company's record of earnings. They are therefore interested in relationships such
as earnings per share (EPS) and dividends per share. Earnings per share are computed
by dividing the income available for equity shareholders by the number of equity
shares outstanding during the year. Any preference dividend must be subtracted from 31
the net income to ascertain the income available to equity shareholders.
Financial and 2003 2002
Investment Analysis Rs. Rs.
Net Income 37,500 45,000
Less Preference dividend 4,500 4,500
Income available to equity shareholders 33,000 40,500
Equity shares outstanding during the year 12,500 10,000

Earnings per (Equity) share 2.64 4.05
While dividend may be of prime importance to some equity shareholders, it may not
be so for other shareholders. Some shareholders may be interested in receiving a
regular cash income, while others may be more interested in securing capital gains
through rising market prices. In comparing the merits of alternative investment
opportunities, we should therefore relate earnings and dividends per share to the
market, value of shares. Dividends per share divided by market price per share would
give yield rate on equity shares. Dividend yield is of particular importance to those
investors whose objective is to maximise the dividend income from their
investments.
Earnings performance of equity shares is often expressed as price earning ratio by

dividing the market price per share by the annual earnings per share. Thus a share
selling for Rs. 40 and having earnings of Rs. 5 per share in the year just ended may
be stated to have a price-earning ratio of 8 times.
Assuming that the 2,500 additional equity shares issued by the company on January
1, 2003 received the full dividend of 96 paise in 2003, and further assuming the price
of the equity shares at December 31, 2002 and December 31, 2003 as given in Table
12.5, earnings per share and dividend yield may be summarised as follows.
Table 12.5
Earnings and dividends per equity share
Date Assumed Earnings Price- Dividend Dividends
Market per share earnings per share yield %
value per ratio
share
Rs. Rs.
Dec. 31, 2002 18 4.05 4.44 1.00 5.56
Dec. 31, 2003 14 2.64 5.30 0.96 6.86
The decline in market value during 2003 presumably reflects the decrease in earnings
per share. The investors evaluating these shares on December 31, 2003 would
consider whether a price earning ratio of 5.30 and the dividend yield of 6.86 repre-
sented a satisfactory situation in the light of alternative investment opportunities. We
can also calculate the book value per share.
Table 12.6
Book value per equity share
.
2003 2002
Rs. Rs.
Total shareholder's equity 3,19,000 2,58,000
Less: Preference shareholders equity 50,000 50,000
Equity of ordinary shareholders 2,69,000 2,08,000
Number of shares outstanding 12,500 10,000
Book value per equity share 21.52 20.8
32
Book value indicates the net assets represented by each equity shares. This informa- Ratio Analysis
tion is helpful in estimating a reasonable price for company shares, especially for
small companies whose shares are not publicly traded. However, the market price of
the shares of a company may significantly differ from its book value depending upon
its future prospects with regard to earnings.
Long-term Creditors: Long-term lenders (or creditors) are primarily interested in
two factors:
1. The firm’s ability to meet its interest requirements.
2. The firm’s ability to repay the principal of the debt when it falls due.
From the viewpoint of long-term creditors, one of the best indicators of the safety of
their investments may be the fact that, over the life of the debt, the company has
sufficient income to cover its interest requirements by a wide margin. A failure to
cover interest requirements may have serious repercussions on the stability and
solvency of the firm. A common measure of the debt safety is the ratio of income
available for the payment of interest to annual interest expenses, called number of
time interest earned. This computation for Megapolitan Company would be as
follows:
Number of Times Interest Earned
2003 2002
Rs. Rs.
Operating income (before interest and income taxes) a) 63,500 80,000
Annual interest expense b) 12,000 15,000

Times interest earned (a - b) 5.29 5.33
Long-term creditors are interested in the amount of debt outstanding in relation to the
amount of capital contributed by shareholders. The debt ratio is computed by
dividing long-term debt by shareholders equity as shown below:
Debt Ratio
2003 2002
Rs. Rs.
Long-term/debt a) 1,00,000 1,25,000
Shareholders equity b) 3,19,000 2,58,000
Debt ratio (a - b) 31.35 48.45
From creditors’ point of view, the lower the debt ratio (or higher the equity ratio) the
better it is. The lower debt means the shareholders have contributed a bulk of funds
to the business, and therefore the margin of protection to creditors against shrinkage
of assets is high.
Short-term Creditors: Bankers and other short-term creditors have an interest
similar to those of the equity shareholders and debenture holders who are interested
in the profitability and long-term stability of the business. Their primary interest,
however, is in the current position of the firm, i.e. its ability to generate sufficient
funds (working capital) to meet current operating needs and to pay current debts
promptly.
The amount of working capital is measured by the excess of current assets over
current liabilities. What is important to short-term creditors is not merely the amount
of working capital available but more so-is its quality. The main factors affecting the
quality of working capital are (i) the nature of the current assets comprising the
working capital, and (ii) the length of time required to convert these assets into cash.
In this context we can calculate the following ratios:
1 Inventory turnover ratio 33
2 Account receivable turnover ratio
Financial and Activity 12.6
Investment Analysis
In illustration 12.2 we analysed the financial statements (or information) from the
point of view of three groups of people and calculated certain ratios. But these ratios
by no means were all inclusive. Certain other ratios, useful for these groups of
people, can also be computed. For example, some other ratios useful for equity
shareholders (present and prospective) are: Return on investment (ROI), Leverage
ratio, and Equity ratio.
In the context of illustration 12.2:
a) Calculate and interprete all such ratios; and
b) Calculate and interprete some ratios for groups of people other than the three
above who might be interested in the company, e.g., preference shareholders
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12.6 SUMMARY
A large number of financial ratios are in use. They fulfill a wide variety of objectives
and functions. Managers evaluate performance and exercise control, investors match
their expectations, and lenders undertake credit approvals with their help.
Control of business activity is crucial for efficiency. Managerial action follows

meaningful information flows. Ratios provide a relevant basis, but all ratios may not
serve the objective of control. A profit performance measure, which is widely
prevalent, is the Return of Investment, which is considered a primary yardstick for
the measurement of operational efficiency. A decomposition of this measure into its
key elements as depicted in the Du pont Chart may underline areas, which need
managerial control for achieving the basic goal of maximizing the return on capital
employed in the enterprise
A series of secondary ratios has also been found useful in controlling business
activities. Since production and sales are the key parameters in an efficient conduct
of business activities, most of these ratios are related in some manner to sales and
output. The focus is on revenues and costs and also on the intensity of activity as
measured by the various turnover ratios. Going deeper into the conduct of business
transactions, a larger number of relationships would be uncovered e.g. stores control,
material usage control, labour hours control, machine maintenance quality control,
operating cycle control and so on. But the focus in this unit has been on control of
activities through ratios emerging from informations externally presented.
12.7 KEY WORDS

Primary Ratio is of primary concern for management because it provides an overall
measure of business efficiency and is measured by the much controversial but
nevertheless much widely employed Return on Capital Employed.
PBDIT or Profits before depreciation, interest and taxes. This amounts to gross cash
flow.
34
Liquidity Ratios measure the short-term solvency of the firm.
Leverage Ratios measure the long-term solvency of the firm and also provide an Ratio Analysis
idea of the equity cushion for long-term indebtedness.
Activity or Turnover Ratios measure the intensity with which resources of the firm
are being utilised.
Average Capital Employed is one-half of the sum total of opening and closing
balances of capital, reserves, accumulated depreciation and long-term debt.
Net Total Assets are obtained by deducting current liabilities from total assets.
Equity Multiplier is used to derive the Return on Equity from the Return on
Investment, and is computed by dividing Equity into total assets.
Ratio Norm is obtained for different kinds of ratios either as an average over time of
the same firm, or an industry average or an average of a cross-section of firms, and is
used to evaluate performance and for control purposes.
Average Collection period is obtained by dividing average accounts receivables
with net credit sales and multiplying the resultant with 365 days of the year. It
suggests the average credit period actually granted during a year.
12.8 SELF-ASSESSMENT QUESTIONS/ EXERCISES

1. List the fundamental accounting ratios. Why are they called ‘fundamental’?
2. What are `Stability' ratios?. Can they be classed as ‘fundamental ratios’?
3. Enumerate ratios that are appropriate for controlling business activities. What
common criterion/criteria bring them together into one category?
4. Which of the control ratios are more important in your view? Why?
5. Point out the major limitation of Return on Capital Employed as a basis for
comparing one firm with another.
6. What is Return on Equity? Why do we measure it?
7. The ratios measuring management's overall effectiveness as shown by the
return generated on sales and investment are
a) Leverage ratios
b) Profitability ratios
c) Activity ratios
d) Liquidity ratios
8. According to the Du pont analysis, firms dealing with relatively perishable
commodities would be expected to have.
a) High profit margins and high turnover
b) Low profit margins and low turnover
c) High profit margins and low turnover
d) Low profit margins and high turnover
9. Inventory turnover is defined as_________divided by inventories.
a) Cost of goods sold
b) Accounts receivable
c) Gross profit
d) Net operating income
10. The primary purpose of the current ratios is to measure a firm's
35
a) Use of debt
b) Profitability
Financial and c) Effectiveness
Investment Analysis
d) Liquidity
e) None of these
11. The Du pont System is designed to help pinpoint the trouble if a firm has
relatively low rate of return on equity. It focuses on the total asset turnover
ratio, the profit margin, and the equity/asset ratio True False
12. Because inventories are less liquid than other current assets, the quick ratio is
regarded as being a more stringent test of liquidity than die current ratio. .
True False
13. Other things being constant, (assuming an initial current ratio greater than
1.00) which of the following will not affect the current ratio?
a) Fixed assets are sold for cash
b) Long-term debt is issued to pay off current indebtedness
c) Accounts receivables are colleted
d) Cash is used to pay off accounts payable
e) A bank loan is obtained
14. The average collection period is found by dividing ________ with _________
and then dividing average sales per day into accounts _________. The average
collection period is the length of time that a firm must wait after making a sale
before it receives_________.
15. Individual ratios are of little value in analysing a company's financial
condition. More important is the_________ of a ratio over time, and a
comparison of the company's ratios to_________ ratios.
16. Prabhat Industries profit margin is 6 per cent, its total assets turnover ratio is 2
times, and its equity/total assets ratio is 40%. The company's rate of return on
equity is
(a) 5% (b) 7.5% (c) 12% (d) 30% (e) 20%
17. If the net profit margin for a firm is 20%, and the ROI is 10%, the total assets
turnover ratio must be
(a) 1 (b) 2 (c) .5 (d) .2 (e) Not possible
to compute.
18. Determine the sales of a firm with the financial data given below:
Current ratio 2.7
Quick ratio 1.8
Current liabilities Rs. 6,00,000
Inventory turnover 4 times
a) Rs. 34,00,000
b) Rs.19,60,000
c) Rs. 21,60,000
d) Rs.14,20,000
e) Rs.16,40,000
19. Complete the balance sheet and sales data by filling in the blanks using the
following financial data:
Debt/Net worth 50%
Acid Test ratio 1.4
Total Assets turnover 1.6 times
Days sales outstanding 40 days
in accounts receivable
Gross profit margin 25%
Inventory turnover 5 times
36
Balance Sheet Rs. Ratio Analysis
Rs. Cash
Equity Share Capital 25,000 Accounts Receivable
General Reserve 26,000 Inventories
Accounts Payable Plant & Equipment
Total assets
Total capital and liabilites Sales
Cost of goods sold
20. Weldone Co. and Goodluck Co, trade in the same industry but in different
geographical locations. The following data are taken from the 2002 annual
accounts.
Weldone Rs. Goodluck Rs.
Turnover 40,000 60,000
Total operating expenses 36,000 55,000
Average total assets during 2002 30,000 25,000
Attempt the following (ignore taxation):
a) Calculate the rate of return on total assets (profit as a percentage of total assets)
for each company.
b) Analyse the rates of return in part (a) into the net profit percentage and the ratio
of turnover to total assets.
c) Comment on the relative performance of the two companies in so far as the

information permits. Indicate what additional information you would require to
decide which company is the better proposition from the viewpoint of:
i) potential shareholder; and
ii) potential loan creditors
21. Abrasives Ltd., has the following turnover ratios presented along with the
corresponding industry averages:
Ratio description Abrasive's ratio Industry average
Sales / Inventory 530/101 = 5 times 10 tithes
Sales / Receivables 530/44 = 12 times 15 times
Sales / Fixed assets 530/98 = 5.4 times 6 times
Sales / Total assets 530/300 = 1.77 times 3 times
Financial analysis of the company is presented on the next page in the form of a Du
Pont Chart. Study the chart, along with the four turnover ratios and industry averages,
and comment on the major weaknesses of the company where managerial attention
must be focused for future control.
37
Financial and
Investment Analysis
Answers or Approaches to Activities
Activity 12.1
Ratio Nos. Broad Class
1 to 3 Secondary, Owners
4&5 Secondary, Lenders,, Liquidity
6 to 9 Secondary, Management, Activity
10 to 12 Primary, Management, Profitability, Owners
13 to 15 Secondary, Management, Profitability (Appropriation)
16 to 21 Secondary, Lenders, Leverage
Activity 12.2
a) Nagpur Textile Mills data relating to average number of days of inventory will
have to be converted into inventory ratio as follows:
38
Assuming the numerator to be 365 days, the inventory turnover ratios for the five Ratio Analysis
years will be:
Year Inventory turnover ratios
1998 100 365 / 90 =24.66
1999 100 365/118 =32.33
2000 100 365 / 115 = 31.51
2001 100 x 365/107 = 2932
2002 100 x 365 / 89 = 24.39
b) Nagpur Textile's is a composite mill. It may, therefore, be appropriate to

compare the inventory ratios for five years with the annual averages of compos-
ite mills for five years. It is manifest that Nagpur Textile's inventory turnover
ratio is higher than the industry average for the years 1999-2001.
c) The trend for the last four years since 1999 is for the ratio to decline.
Activity 12.3
a) True
b) False
c) True
d) True
e) False
f) False
g) True
h) True because inventory which is the denominator of the ratio is also carried
generally at cost in a world of rising prices.
i) False because it reflects only the average credit period and does not state
anything about discounts and credit standards.
j) True
Activity 12.4
Ratio Information Computed ratio for
inputs the year
2001 2002 2003
1. Cost of goods sold (7) (6) 85.06 81.97 84.13
2. Gross margin (6) - (7) (6) 14.94 18.03 15.87
3. Net margin (14) (6) 4.74 2.54 3.26
4. Operating margin (10) + (9) (6) 5.24 4.34 5.18
5. Post-tax margin (14)+ (9) x (13)/(12) 6 9.80 6.53 6.30
6. Operating Ratio (6) - (10) (6) 99.82 99.66 98.33
7: Total Contribution (6) - (8) (6) 35.02 35.56 34.70
8. Gross Assets Turnover (6) (4) 1.05 1.25 1.45
9. Net Assets Turnover (6) (4) - (5) 1.97 2.36 2.52
10. Inventory Turnover (7) (2) 4.09 5.16 6.38
11. Receivables Turnover (6) (2A) 11.13 11.03 14.50
12. Average Collection (2A) (6) / 365 32.78 33.10 25.17
Period (Days)
39
Financial and
Investment Analysis
Activity 12.5
a) Gross Return on Investment 2001 2002 2003
Net Return on Investment 12.61 9.86 11.14
Return on Capital employed 4.51 3.57 5.81
11.63 9.90 12.61
b) You may first proceed to find out the Equity multiplier viz., Total Net
Assets/Equity for each of the three years, and then multiply the R0I by this
multiplier. Equity multipliers for the three years are as follows:
Years Equity multiplier
2001 95.30/33.97 = 2.81
2002 140.79/39.41 = 3.57
2003 158.82/53.16 = 2.99
Return on Equity 12.67 12.75 17.37

Answers to Self-Assessment Questions/ Exercises
7 (b)
8 (d)
9 (a)
10 (d)
11 (True)
12 (True)
13 (c)
14 annual sales; 360; receivable; cost;
15 Trend; industry average;
16 (d)
17 (c)
18 (c)
19 Accounts payable = Rs. 25,500; Total Capital and Liabilities as well as Total
Assets = Rs. 76,500; Cash = Rs. 22,100; Accounts Receivable = Rs. 13,600;
Inventories = Rs. 24,480; Cost of goods sold = Rs. 91,800; Plant & Equipment
= Rs. 16,320; and Sales = 1,22,400.
20. Weldone Co. Goodluck Co.
a) Rate of return on total assets 13.3% 20%
b) Net profit percentage 10% 8.3%
Asset turnover 1.33 times 2.4 times
c) The three ratios provide an estimate of a company's overall performance. They
are inter-related: =
From the viewpoint of potential investors - shareholders and loan creditors - the
overall performance is important. In what way the profit between the two types of
finance (loan and equity) is apportioned is also of equal importance. They will
therefore need information about capital leverage i.e. the relation-ship between equity
40 and loan capital and the relationship between profits and interest payments.
The potential loan creditor will also require information about security that the. Ratio Analysis
company can provide.
The potential shareholders are also interested in future dividends as well as current
yields. They will need information about the share prices and earnings per share so
that they could make relevant comparison against similar other investment in terms
of PEE ratio and yield.
21 a) Profit margin not too bad ; assets turnover quite low. Action
required.
b) Inventory per unit of sales higher that other firms. Action required.
Implications and impact of suggested action (like funds released in
the wake of inventory reduction utilized in liquidating debt and
reducing interest burden with improved profit prospects) should be
highlighted.
c) Excess capacity situation may exist, though not with definitiveness

Fraser, M. Lyn and Aileen Ormiston, 04/10/2003, Understanding Financial
Statements (Chapter 5) : Prentice Hall.
Khan, M.Y. and Jain, P.K., 2000. Management Accounting (Chapter 4), Tata
McGraw-Hill : New Delhi.
Brigham F. Eugene and Houston F. Joel, 1999, Fundamentals of Financial

Management, 2nd ed. (Chapter 3), Harcourt Brace and Company : Florida.
Fanning, David and M. Pendlebury, 1984, Company Accounts: A Guide, Allen &
Unwin : London.
Bhatia, Manohar L., 1986, Profit Centres: Concepts, Practices and Perspectives,
Somaiya Publications, Bombay (pp, 166-170)
Hingorani N.L. and A.R. Ramanathan, 1986. Management Accounting (Chapter 7)

Sultan Chand: Delhi.
AUDIO PROGRAMME
Role and Regulation of Stock Markets
41
41
Financial and
Investment Analysis UNIT 13 LEVERAGE ANALYSIS
Objectives
This unit will enable you to:
• acquire an understanding of leverage ratios
• examine the consequences of financial leverage for a business firm
• trace relationship between financial and operating leverages, and
• assess the risk implications of financial leverage.
Structure
13.1 Introduction
13.2 Concept of Financial Leverage
13.3 Measures of Financial Leverage
13.4 Effects of Financial Leverage
13.5 Operating Leverage
13.6 Combined Leverage
13.7 Financial Leverage and Risk
13.8 Summary
13.9 Key Words
13.10 Self-assessment Questions / Exercises
13.11 Further readings
13.1 INTRODUCTION
You have familiarised yourself with the various kinds of financial ratios-both
separately and in their broad groupings. Unit 12 on Financial Ratios introduced the
four fundamental bases for ratios viz., liquidity, leverage, activity, and profit-
ability. The ratios discussed in that unit were picked up on the basis of their
relevance in controlling business activities. Accordingly, the liquidity and leverage
ratios were not covered.
Even though a firm's management would always be interested in maintaining a

satisfactory level of liquidity and solvency, it is the lender or the banker who would
insist upon certain norms and would monitor movements in these ratios.
Leverage ratios, which reflect the solvency status of a firm , are covered here in
detail. You will get an idea about the basic concept of leverage and will be exposed
to the role and effects of financial leverage.
We had covered another leverage concept in the unit titled ‘Cost-Volume-Profit

Analysis’, you will recall the `break-even analysis' that was explained and illustrated
in that unit. We derive from that discussion the term operating leverage and examine
its importance. Our discussion will also help you to link-up the two concepts of
leverage viz., financial leverage and operating leverage.
42
Leverage Analysis
13.2 CONCEPT OF FINANCIAL LEVERAGE
Consider for a moment the common use of the terms `level' and ` leverage'. Webster's
dictionary defines them as follows:
‘Lever’ is an inducing or compelling force.
‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it also
means èffectiveness' or `power'
The common interpretation of leverage is derived from the use or manipulation of a

tool or device termed as lever, which provides a substantive clue to the meaning and
nature, of financial leverage. Could you guess it?
Your reply we guess, may well be in the negative.
Now, suppose we suggest that our lever is the use of debt or borrowed funds in
financing the acquisition of assets. Would you get somewhere near the concept of the
term financial leverage?
Probably, you need a little explanation. We will do that. You have to look at the
following simple (and hypothetical) facts about the GTB (Gain Through Borrowing)
Limited.
The GTB Limited wanted to purchase fixed assets worth Rs. 80 lakhs for the
execution of a project, which was to be financed by raising share capital of Rs. 30
lakhs and term loans of Rs. 50 lakhs. The company was required to earn a minimum
return of 20% on its share capital. Other companies of this type were earning this
much and unless GTB Limited provided at least this return, no investor would be
attracted to buy its shares. The GTB Limited pays tax at 40% and is not required to
pay any tax on the interest charges on term-loans.
You may do your own calculations for the two situations. We now pose a question to
you: What happens to the company's net return (after interest and taxes) on equity if
(a) the whole of Rs. 80 lakhs is financed by selling share capital, and (b) the scheme
of financing as envisaged in the problem is implemented? You may assume GTB's
earning power to be 40% (before taxes and interest) on total assets of Rs. 80 lakhs.
We present for your verification a solution below:

Table 3.1
Effect of Financial Leverage
Rs. 80 lakh as Rs. 30 lakh of

Share capital share capital plus
50 lakh
(Rs. Lakh) (Rs. Lakh)
Earnings on assets of Rs. 80 lakh @ 40% 32.0 32.00
Less interest : 18% on Rs. 50 lakh ----- 9.00
Earnings after interest 32.00 23.00
Taxes @ 40% I2.8 9.20
Earnings after taxes 19.2 13.80
Earnings after interest and taxes as a % 24% 46%
of share capital
If your solution tallies with ours, you may be wondering at the results. The net
return on equity is 24% when no debt is used but it is 46% when debt is used. There
is a considerable increase in the net return. It is conceivable that a similar outcome
may be nowhere near in some other situations even if debt is employed. At this 43
juncture, we would premise that the use of debt funds in a profit-making and
Financial and tax-paying business improves the net equity returns. The effect which the use of
Investment Analysis debt funds produces on returns is called financial leverage.
You would have noted in the above example that the increase of net equity returns
from 24% to 46% has occurred at a certain level of debt viz., when the debt is Rs. 50
lakh against an equity of Rs. 30 lakh (i.e., when the debt - equity ratio is 5:3 or
167%) or when the debt is of Rs. 50 lakh against total assets of Rs. 80 lakh (i.e.,
when the debt- assets ratio is 5:8 or 62.5%). The sub-section below examines these
and other measures of financial leverage. But before we proceed, let us sum up the
concept of financial leverage as follows:
Financial leverage refers to a firm's use of fixed-charge securities like deben-

tures and preference shares (though the latter is not always included in debt) in
its plan of financing the assets
Activity 13.1
13.3 MEASURES OF FINANCIAL LEVERAGE
The amount of debt which a firm employs or proposes to employ can be expressed in
relation to total assets or total equity. Equity will include paid-up capital and reserves
and total assets will be taken at net value . Even though, both equity shares and assets
can be measured at market values, the present discussion will use only book values.
Market values are difficult to obtain, fluctuate widely and are not available for new
undertakings which also make use of the concept of financial leverage in planning
their sources of finance.
We will illustrate two ratios viz., Debt-equity and Debt-assets ratios both of which
are computed from Balance Sheet data and are inter-related. You may note that this
section measures the use of financial leverage and not its effects. The latter is
measured through Degree of Financial leverage, which is discussed in a later section.
We shall explain the concept of financial leverage with the help of an example.
Bharat Engines Limited, plans to acquire total assets amounting to Rs. I crore. The
company has only two sources of finance viz.; debt and equity. The Finance Director
wants to know the changes that will take place in the Debt-equity and Debt-assets
ratios for various debt levels i.e., (a) Zero (b) Rs. 10 lakh (c) Rs. 20 lakh (d) Rs. 30
lakh (e) Rs. 50 lakh (f) Rs. 80 lakh (g) Rs. 1 crore. The table 13.2 provides the
required calculations:
44
Table 13.2 Leverage Analysis
Debt-assets and Debt-equity Ratios
(Total investment in assets = Rs 100 lakh)
Debt Equity Debt-assets Debt-equity
Rs. Lakh Rs. Lakh Ratio Ratio
Zero 100 Zero Zero
10 90 10% 11.1%
20 80 20% 25%
30 70 30% 43%
50 50 50% I00%
80 20 80% 400%
100 Zero 100% ∞
Please study the last two columns of the above table. The following analysis reflects
the basic properties of the two ratios and indicate their inter-relationship:
a) The Debt-assets ratio rises at a constant rate and reaches a maximum of 100%
The Debt-equity ratio grows exponentially and reaches infinity (∞)
b) The two ratios are mathematically related and can be derived from each other.
The following relationships may be used for such derivations:
Debt - assets Ratio (D/A) = D/E Ratio ….(1)

1 + D / E Ratio
Debt - equity Ratio (DIE) = D/ A Ratio ….(2)
1-D/A Ratio
The use of these formulas for deriving one ratio from the other can be demonstrated
at any debt level. For example, at a debt level of Rs. 80 lakh, the Debt-assets ratio is
80%. The DIE ratio can be derived by using formula-(2) above:
D/E Ratio = 80 = 80 = 4.00 or 400%

1- 80 20
Similarly, with a given DIE ratio of 400% or 4:00, the D/A ratio can be derived by
using formula (1) above :
D/A Ratio = 4.00 = 4.00 = 80 or 80%

1+4.00 5,00
Both D/A and D/E ratios are used to measure the amount of financial leverage. You
may note that the D/E ratio overstates the amount of financial leverage for all levels
of debt and becomes indeterminate when debt employed is one hundred per cent. It
may, therefore be technically more feasible to employ the Debt-asset ratio as
indicator of the use of financial leverage.
You may come across some ratios in contemporary literature which attempt to
measure the use of financial leverage. They are:
Debt
a)
Total Value of the Firm (at market Price)
Return on Equity
b)
ReturnonTotalCapital
45
Investment Analysis
Answer the following :
a) Amount of leverage and degree of leverage are the same Yes No
b) Debt-equity ratio overstates the use of leverage Yes No
c) A firm (to be established) can use market values Yes No
for its leverage ratios
d) The D/E ratio is infinite at 100% debt Yes No
e) D/A and D/E ratios can be derived from each other Yes No
f) When the D/E ratio is 200%, D/A ratio would be Yes No
(i) 80% (ii) 100% (iii) 67% (iv) 45% (v) None of these
13.4 EFFECTS OF FINANCIAL LEVERAGE

The example in Table 13.I introduced you to a possible effect of financial leverage
on return on equity. You must have noted one important consideration in the use of
borrowed funds, that is, the improvement in net equity returns which such a move
brings about.
In fact, the effect of financial leverage is also measured through another variable viz.,
earnings per share (EPS). This is done in the case of joint stock companies which
have raised their proprietary capital by selling units of such capital known as equity
shares. Earnings per share are obtained by dividing earnings (after interest and taxes)
by total equity. You may note that if a company has preference shares also on its
capital structure, net equity earnings will be arrived at after deducting interest, taxes
and preference dividends. Capital structure refers to the permanent long-term
financing of a company represented by a mix of long-term debt, preference shares,
and net-worth (which included paid-up capital, reserves and surpluses). When the
sum total of capital structure components is added to short-term debt, it is known as
Financial structure. Financial Leverage and its effects are a crucial consideration in
planning and designing capital structures.
We may reiterate that the effects of financial leverage are. not always clear and
identical in various states of profitability and debt proportions. It may be necessary to
explore these effects before a particular long-term finance-mix is recommended for
implementation. We shall illustrate the effects of financial leverage by extending the
example taken in the previous section. Bharat Engines is considering four alternative
debt ratios (i.e. D/A ratios): 0%, 20%, 50% and 80%. The corresponding D/E ratios
are: 0%, 25%, 100% and 400%.
The equity capital of the company is divided into shares of Rs. 10 each which can be
sold in the market at their face value only.
The firm estimates a net profit (before tax) of 25% on total assets of Rs. 1 core if
business conditions are favourable, a net profit (before tax) of 50% on total assets if
conditions are highly favourable, and net loss (before tax) of 25% if conditions are
unfavorable. Bharat Engines is assessed to income tax at 40%. In the event of loss,
the company could assume a tax credit at this rate.
The average interest rate on borrowings by the company is estimated at 15%.
Table 13.3 provides an analysis of the effects of all four alternative debt levels on the
return on equity as well as on the earnings per share.
46
Table 13.3 Leverage Analysis
Financial Leverage, Equity Returns & EPS

Total Investment Rs. 1 Crore
Alternative Estimates of Earnings Before Interest
& Taxes (EBIT) (in Rs. Lakhs) as of Total Assets
Capital Structure (-25%)+25% +50%
I : Debt = Zero, Equity = Rs. 1 Crore

EBIT (-25.00) 25.00 50.00
Less interest (at 15%) zero zero zero
Earnings (before tax) (-25.00) 25.00 50.00
Less tax at 40% 10.00 10.00 20.00
Net Income (after tax) (-15.00) 15.00 30.00
Return on Equity (-15%) 15% 30%
Earnings per share (in Rs. 10,00,000 shares of (-1.50) 1.50 3.00
Rs. 10 each)
II : Debt = Rs. 20 lakh, Equity = Rs. 80 lakh
EBIT (-25.00) 25.00 50.00
Less interest (at 15%) 3.00 3.00 3.00
Earnings before tax (-28.00) 22.00 47.00
Less tax at 40% 11.20 8.80 18.80
Net income (-16.80) 13.20 28.20
Return on equity of Rs. 80 lakh (-21%)16.5%35.25%
Earnings per share (Rs. 8,00,000 shares of
Rs. 10 each) (2.1) 1.65 35.25
III : Debt = Rs. 50 lakh, Equity = Rs. 50 lakh

EBIT (-25.00) 25.00 50.00
Less interest (at 15%) 7.50 7.50 7.50
Less tax at 40% 3,00 7.00 17.00
Net income (19.50) 10.50 25.50
Return on equity of Rs. 50 lakh (-39%) 21% 51%
Earnings per share (Rs. 5,00,000 shares of
Rs. 10 each) (-3.9) 2.1 5.1
IV : Debt = Rs. 80 lakh, Equity = Rs. 20 lakh
EBIT (-25.00) 25.00 50.00
Less interest (15%) 12.00 12.00 12.00
Less tax at 40% 14.80 5.20 15.20
Net income (-22.20) 7.80 22.80
Return on Equity of Rs. 20 lakh (-111%) 39% 114%
Earnings per share (Rs. 2,00,000 shares
of Rs. 10 each) (-11.1) 3.9 11.40
You may now have a closer look at the effects of leverage. Please note that the
analysis presented in Table 13.3 above assumes:
a) an average tax rate of 40% or a tax credit at the same rate in a year of loss
b) four different levels of debt
c) three different states of economy viz., bad, good, and very good
d) the fact that equity shares of the company can be sold only at par i.e., at Rs. 10 per
share.
47
Financial and We offer the following comments on Table 13.3 for further study and analysis by
Investment Analysis you:
a) At zero debt level (viz., capital structure I), the after-tax return on total assets is
60% of the before tax return because the tax rate is 40%. Also, the after-tax
return on total assets is equal to the after-tax return on equity.
b) Financial leverage in general is favourable when the return on assets exceeds
the cost of debt. This is true of all the four capital structures when the return
levels are 25% and 50%.
c) When the return on assets is high, both the net return on equity and earnings
per share increase with a rise in the debt ratio. You may notice that when the
return on assets is the highest at 50% (last column of Table 13.3), the return on
equity increases from 30% at zero debt to 114% at 80% debt level. The corre-
sponding increase in EPS is from Rs. 3.00 to Rs. 11.40.
d) The amount of interest affects the relationship of after-tax return on assets and
return on equity at different levels of leverage. The numerators of both the
ratios bear the following relationship:
EBIT (I- t) = Net Income + (1- t) Interest charges---------3

Where t = tax rate
You may note that the term to the left of the equation is the numerator of return on
assets and the term to the right is the numerator of return on equity. You may
verify this relationship at any debt level. For example, take capital structure - II
in Table 13.3 at an EBIT level of Rs. 25 lakh and substitute relevant values in
equation (3). You will get :
25,00,000 (1 - .40) = 13,20,000 + (1 - .40) 3,00,000 Rs. 15,00,000
= Rs. 15,00,000
e) It is significant that while higher amounts of leverage improve equity returns
and earnings per share, they produce a higher degree of volatility also in such
returns. Table 13.4 below summarizes the minimum, maximum and the range
of equity returns at different debt levels on the basis of the data furnished in
Table 13.3.
Table 13.4
Financial Leverage and Equity Returns
Amount of Financial Leverage Return on Equity (ROE)
(Debt-assets Ratio) Minimum Maximum Range
0% -15% 30% 45%

20% -21% 35.25% 56.25%
50% -39% 51% 90%
80% -111% 114% 225%
You may observe that the Return on Equity (ROE) varies within a range of 45%
when the debt ratio is zero, but the range increases to 225% when the debt ratio rises
to 80%. This increased volatility will also be found to be true if you measure the
equity return by net income or earnings per share. From this analysis we may,
conclude: Financial leverage magnifies the volatility of return whether measured
by net income or return on equity or earnings per share.
It would, thus, be seen that financial leverage is a double-edged sword. It magnifies

returns and also increases their volatility. Increased volatility implies greater risk in
48 the wake of a riding interest burden, which, if not met, may lead to bankruptcy. In
the perception of equity shareholders as well as lenders, the riskiness of the firm
may increase. This aspect of financial leverage is covered in the last section o f Leverage Analysis
this unit.
Activity 13.3
Use the data given in Table 13.3 and draw a graph showing the position of the four
capital structures. The X-axis should represent EBIT as a percent of total assets and
the Y-axis the per cent return on equity. What conclusions do you draw from the
graphs? Are they consistent with the analysis of Table 13.3 given above?
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13.5 OPERATING LEVERAGE

We have stated and seen in the preceding section that Financial Leverage magnifies
the risk of bankruptcy viz. the financial risk. Now, we have another concept of
leverage, which has a close relationship with business risk. This is operating
leverage. In fact, operating leverage affects business risk, which may be viewed as
the uncertainty inherent in estimates of future operating income.
A little recapitulation from our discussion of break-even analysis (Unit 9) will help
us to understand the concept of operating leverage. You may note that the operating
leverage refers to the degree to which a firm has built in fixed costs due to its
particular or unique production process.
In a large number of situations, a firm would be in a position to exercise a degree of

control on the choice of its technology and the related production processes. The
production processes which are accompanied' by high fixed costs but low variable
costs are generally the highly mechanised and automated processes. With such
processes, the degree of operating leverage is generally high, the break-even point is
relatively higher, and thus changes in the sales level have a magnified 49
Financial and (or “leveraged” ) effect on profits. Notice that as the operating leverage (i.e., fixed
Investment Analysis costs), goes higher, so does the break-even sales volume. Hence greater is the impact
on profits of a given change in sales volume. Also notice that Financial Leverage
adds another element of fixed expenses i.e., fixed financial charges, and serves to
further magnify the impact of total leverage on profits.
Operating Leverage : We present the following hypothetical volume - costs - profit

profile of three firms A, B and C.
Table 13.5
Operating Leverage
Rs. in lakh
Units Sales @ Firm A Firm B Firm C
sold Rs. 10/ per
unit Cost Profit Cost Profit Cost Profit
30,000 3.00 3.60 -.60 4.50 -1.505.70 -2.70

40,000 4.00 4.30 -.30 5.00 -1.006.10 -2.I0
50,000 5.00 5.00 0.00 5.50 -.506.50 -1.50
60,000 6.00 5.70 .30 6,00 0.006.90 -.90
70,000 7.00 6.40 .60 6.50 .507.30 -.30
80,000 8.00 7.10 .90 7:00 1.007.70 .30
90,000 9.00 7.80 1.20 7.50 1.508.10 .90
1,00,000 10.00 8.50 1.50 8.00 2.008.50 1.50
Fixed Costs: Rs. 1.5 lakh Rs. 3.0 lakh Rs. 4.5 lakh
Variable cost per unit: Rs. 7.00 Rs. 5.00 Rs. 4.00
You may have noticed the characteristics of the three firms from Table 13.5. They
are
a) Sales volume in units, selling price per unit, and sales value realisation are
identical for all the three firms.
b) Fixed costs are the lowest for firm A, medium for B, and highest for C. Firm A
has the least automated plant, lowest depreciation charges, low fixed costs, and
a higher per unit variable cost. Firm B has a moderately automated plant. Firm
C has the most highly automated plant which needs very little labour per unit
of output. Its variable costs rise slowly and its overhead burden is relatively
higher. Firm C has the lowest variable cost per unit at Rs. 4.00.
50
Activity 13.4 Leverage Analysis
Look at Figures 13.1, 13.2 and 13.3. Comment upon the main features of each firm's
volume cost relationships.
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Degree of operating leverage : Degree of operating leverage measures the effect of
change in volume on net operating income or earnings before interest and taxes. This
may be obtained by using the following formula:
Degree of operating leverage
% change in net operating income

( DOL) =
% change in units sold or sales
Degree of operating leverage will be calculated for a firm when it moves over from
one level of sales (volume or value) to another. For example, the degree of leverage
for firm B in Table 13.5, when it shifts from a volume of 80,000 units to 90,000
units, would be as below: -
( DOL) =
Where ∆ NOI is the change in Net Operating Income
NOI is net operating income or earnings before interest and taxes
∆ Q is the change in quantity or volume, and
Q is quantity or volume
Thus, DOL for firm B for a change in output from 80,000 units to 90,000 units would
be:
1,50, 000 − 1, 00, 000 /1, 00, 000 50, 000 /1, 00, 000
= =
(90, 000 − 80, 00) / 80, 000 10, 000 / 80, 000
50%
=
12.5%
=4
To be able to understand the implications of DOL, you may compare Firm A (least
operating leverage) with Firm C (highest operating leverage) at any two given levels
of output, say for a change in output from 80,000 units to 90,000 units i.e. an
increase of 12.5%.
.30 / .90
DOLA at 80,000 units = = 2.67
10,000 / 80,000
.60 / .30
DOLC at 80,000 units = = 16.00 51
10,000 / 80,000
Financial and You may now notice the manner in which profits change in response to change in
Investment Analysis volume. Thus, for 12.5% increase in output, profits will increase by 26.7% for Firm
A (which is low-leveraged firm) and by I60% for Firm C (which is high leveraged
firm). You will find fluctuations in profits to be more steep for firms which are
highly leveraged. Thus, the higher the degree of operating leverage the greater
will be the fluctuations in profits in response to changes in volume. And this
relationship works both ways i.e. when volume increases as well as when it declines.
The degree of leverage has implications for a number of business and financial
policy areas. The following examples based on the DOL of Firm C illustrate some of
these areas :
a. The high degree of operating leverage for Firm C suggests that volume may be
increased to gain' a steep rise in profits. If Firm C could increase its volume
from 1,00,000 units to 2,00,000 units by reducing the selling price to Rs. 9.00
per unit, the net operating income with this price revision would be:
NOI = PQ -VQ-F Where P is price per unit, y is variable cost per unit,
Q is volume in units and F is total fixed cost.
= Rs. 9 X 2,00,000 - Rs. 4 X 2,00,000 - Rs. 4.5 lakhs
= Rs. 18 lakhs - Rs, 8 lakhs - Rs. 4.5 lakhs
= Rs. 5.5 lakhs
You may note that Firm C is able to increase its profits from Rs.. 1.50 lakhs at
a volume of 1,00,000 units to Rs. 5.50 lakhs at a volume of 2,00,000 units.
Thus, a doubling of output (by a 10% reduction in sales price from Rs. 10 to
Rs. 9) results in profits becoming about 3.6 times. Firm C with a high degree of
operating leverage may, therefore, adopt an aggressive price policy.
b. A high degree of operating leverage also suggests that profits will swing widely
as volume fluctuates: If, Firm C belongs to an industry where sales are greatly
affected by changes in the overall level of the economy resulting in wild
fluctuation of profits, the degree of financial leverage appropriate to Firm C
will be lower than the one for a firm which belongs to an industry not so
sensitive to changes in the economy.
13.6 COMBINED LEVERAGE

The degree of operating leverage may be combined with the degree of financial
leverage. In fact, degree of operating leverage (DOL) is viewed as the first-stage
leverage and degree of financial leverage (DFL) as the second-stage leverage. Since
financial leverage measures the effect of changes in EBIT on earnings avail-able to
equity shareholders, it may be calculated by using the following formula:
% change in Net Income

Degree of financial leverage =
% change in EBIT
The use of this formula may be illustrated before demonstrating the implications of
combining DOL and DFL. The data of Table 13.3 for the leverage factors of 20%
debt and 80% debt may be utilised to show the effect of an increase of EBIT from
Rs. 25 lakhs to Rs. 50 lakhs. The following calculations may be noticed:
DFL (80%) the degree of financial leverage at 80% debt.
DFL (20%) the degree of financial leverage at 20% debt.

52
(22.80 - 7.80) / 7.80 Leverage Analysis
DFL (80%) =
(50.00 - 25.00) / 25.00
(15.00 - 7.80) 2.92
= = = 2.92
25.00 / 25.00 1.00
(28.20 - 13.20) / 13.20 15.00 / 13.20
DFL (20%) = = = = 1.14
(50.00 - 25.00) / 25.00 25.00 / 25.00
The Figures 2.92 and 1.14 can be easily understood. The former implies that when
the debt ratio (or the leverage factor) is 80%, a 10% increase in EBIT produces a
29.2% (10 x 2.92) increase in net income available to equity shareholders. At a
leverage factor of 20%, a 10% increase in EBIT brings about only an 11.4% (I 0 x
1.14) increase in net income or earnings available to equity shareholders. You may
conclude that a high degree of leverage brings about a higher magnification of
equity earnings.
In the absence of debt, the degree of financial leverage (DFL) will be 1.00 (i.e.
unity). The use of debt will lead to DFL above 1.00 or 100%. The DFL may be
viewed as a multiplication factor, and when this multiplication factor is 1.00, there is
no magnification in net income or return on equity, or in earnings per share.
A combination of operating and financial leverage measures the degree of

magnification in Net Income (NI), Return on Equity (ROE), and Earnings per Share
(BPS) for a given increase in sales. When the use of operating and financial
leverage is considerable, small changes in sales will produce wide fluctuations in
NI, ROE and EPS.
The Degree of Combined Leverage (DCL) may be measured by using the following
formula:
DCL = DOL X DFL
% change in Net Income EBIT % change in net income

DCL = ×
(% change in sales) (% change in EBIT)
% change in net Income

=
% change in sales
You may note that a number of combinations of DOL and DFL may produce the
same DCL. And if management has a target DCL, changes in DOL or DFL may be
made to attain the targeted DCL. For instance, if the firm has a high degree of
operating leverage clue to the nature of its operations, the degree of financial
leverage may be suitably lowered so as not to lower the targeted combined leverage
and vice versa.
13.7 FINANCIAL LEVERAGE AND RISK
We posed the question of risk at the beginning of this unit. You would have noted
from our discussion so far that the concepts of operating, financial, and combined
leverage have been examined to assess the quantum or risk (business, financial and
combined), which the firm faces as a result of decisions to change the various
degrees of leverage. In fact, the extent to which the various measures of net income
fluctuate, for given variations in sales or EBIT, has a direct bearing on many business
and financial policies. 53
Financial and There are several statistical measures, which help us to quantify risk. We propose to
Investment Analysis calculate one such measure known as coefficient of variation by using data in Table
13.3 and the additional data given in Table 13.6 below:
Table 13.6
Cost Structure of Bharat Engines Ltd.
Rs. in lakhs
Sales (units) 1875 8125 11250
Sales @ Rs. 1,000 per unit 18.75 81.25 112.50

Fixed operating cost 40.00 40.00 40.00
Variable operating costs (20% of sales in Rs) 3.75 16.25 22.50
Earnings before interest and taxes (EBIT) -25.00 25.00 50.00
Pre-tax return on total assets (%) -25.00 25.00 50.00
The total cost can be estimated as follows:
Total Cost = Fixed operating costs + Variables operating costs per unit (Sales)
= 40 lakhs + 0.20 (sales)
In order to obtain a measure of coefficient of variation, the first step is the

assignment of probabilities to the possible levels of sales that the management has
forecast. Probability in brief is the chance of some event occurring. If it is absolutely
definite, it is 1, otherwise probability is always a fraction of unity (1).
The state of the economy is beyond the control of management, but corporate
policies are within its control and can be reasonably forecast.
The state of the economy may range from `very poor' to `very good' and may
accordingly be incorporated in the management's attitudes of pessimism or optimism.
Assume that the management of Bharat Engines Ltd., has assigned the following
probabilities based on the aforesaid consideration:
Table 13.7
Estimated Probabilities
Stage of Expected sales Probability of
economy (Rs. lakh) expected sales
A 18.75 .2
B 81.25 .5
C 112.50 .3
Note : All probabilities must add up to 1.00
54
Now we use information from Tables I3.3, 13.6 and 13.7 and present computations Leverage Analysis
of coefficient of variations in Table 13.8 below:
You may study Table 13.8 and its results carefully. The four sections of the table
depict the four capital structures viz., zero debt, 20% debt, 50% debt and 80% debt.
You may notice that as the leverage factor (viz., Debt ratio) rises, the coefficient of
variation also goes up. Thus, for zero debt, the Cv is 1.163 and for 80% debt it shoots
up to 3.919. On the basis of the data furnished and probability information generated,
it may be concluded that the business risk (which is the sum of operating risk and
financial risk) rises with financial risk in the case of Bharat Engines Ltd.
55
Financial and Calculations similar to those given in Table 13.7 can be performed for determining
Investment Analysis the risk character of the firm in response to amounts of financial leverage stipulated.
This analysis helps to plan capital structure.
13.8 SUMMARY
Concepts of financial and operating leverages are important for evaluating business
and financial risk of a firm. Operating leverage refers to the use of fixed costs in
operations and it is related to the firm's production processes. The greater the operat-
ing leverage the higher is the risk in operations. At the same time, a high degree of
operating leverage causes profits to rise rapidly after the break-even point is reached.
Financial leverage refers to the use of debt in financing non-current assets. If the
return on assets exceeds the cost of debt, the leverage is successful i.e., it improves
returns on equity. While this being so, a high financial leverage magnifies financial
risk. At some degree of financial leverage the cost of debt rises because of increased
risk with the higher fixed charges. When this happens, riskiness of the firm also
increases in the eyes of equity investors who start expecting a higher return to
compensate for the increased risk burden.
Financial leverage and operating leverage are related with each other. Both have
similar effects on profits. A greater use of either i.e., operating or financial leverage
leads to following results:
a) The break-even point is raised
b) The impact of change in the level of sales on profits is magnified.
Operating and financial leverages have reinforcing effects. Operating, or first-stage

leverage affects earnings before interest and taxes (i.e., net operating income) while
financial, or second-stage leverage affects earnings after interest and taxes (i.e., net
income available to equity shareholders).
Operating and financial leverages are measured in relative terms to assess their
impact on profitability of a firm. These measures are given by the degrees of
operating and financial leverage. A combined degree of financial and operating
leverage can also be calculated to evaluate effects of changes in sales on net-income
or earnings per share.
Financial leverage and risk are related variables and the statistical measures known
as coefficient of variation can be computed to estimate the risk of the firm at
different levels of leverage or debt ratio.
13.9 KEY WORDS

Financial Leverage refers to the use of debt in the financing of a firm. It denotes the
presence of fixed-return securities in the capital structure of the firm.
Operating Leverage is the use of fixed costs in operations. A high operating

leverage factor indicates the presence of automated production processes.
Leverage Factor refers to the ratio of long-term debt to total assets.
Capital Structure is the long-term financing plan of a firm. It covers debentures,

preference shares, other fixed-return securities, long-term loans, equity shares, and
reserves and surplus.
Financial Structure is the total financing plan of a firm, which, besides all compo-
nents of capital structure, also includes short-term debt.
56
Degree of Operating Leverage is the percentage change in net operating income in Leverage Analysis
response to a percentage change in sales (volume or value).
Degree of Financial Leverage is the percentage change in net income available to
equity investors in relation to changes in earnings before interest and taxes.
Degree of Combined Leverage is the percentage in net income after interest and
taxes in response to percentage variations in sales (volume or value).
Risk includes both operating risk (as given by the degree of operating leverage) and
financial risk (as reflected by the degree of financial leverage) and is evaluated by a
statistical measure known as coefficient of variation.

1. Is the use of financial leverage justifiable from a socio-economic standpoint?
Explain by listing some advantages and disadvantages.
2. How does the use of financial leverage affects the break-even point? Illustrate.
3. In what way is financial leverage related, to operating leverage? Discuss with an

example.
4. `Risk increases proportionately with financial leverage'. Refute this statement

with reasons.
5. Òther things remaining the same , firms with relatively stable sales are able to
incur relatively high debt ratios.; Do you agree With the statement?
6. Why is EBIT (Earnings before Interest and Taxes or Net Operating Income)
generally Considered to be independent of financial leverage?: Why should
EBIT actually be influenced by financial leverage at high debt' levels?
7. State whether the following are True or False :

a) Financial leverage affects both net income and True False
BBIT, while operating leverage affect only BBIT
b) Two firms with identical financial and operating
leverage may have different degrees of business True False
risk as measured by the coefficient of variation of'
their respective ROE.
c) Business risk refers primarily to uncertainty
about future EBIT, While financial risk refers to
the added uncertainty about future net income that True False
is caused by the use of debt
8. Other things being constant,' if Firm A has more Operating leverage than Firm
B, then a given percentage decline in sales will cause a larger percentage decline
for Firm A than for Firm B in
a) EBIT
b) Net Income
c) Both (a) and (b)
d) Neither (a) nor (b)
e) None of these
9. One of the components of a firm's financial structure that is not a component of
its capital structure is:
a) debentures
57
b) reserves
Financial and c) convertible preference
Investment Analysis
d) shares
e) short-term debt
f) equity shares
10 . Financial leverage is different from operating leverage in that it is concerned
with
a) capital structure
b) uncertainty of markets
c) inefficient financial mangers
d) uncertain estimates of EBIT
e) None of these
11. In general, financial leverage is favourable whenever the return on assets
exceeds the
a) cost of equity share capital
b) total cost of capital
c) net return after taxes
d) cost of debt
e) none of these
12. Highly leveraged companies are most likely to be found in industries where
sales are
a) increasing around a trend line
b) relatively unstable
c) relatively stable
d) expected to decline
e) relatively uncertain with high margins
13. Fill in the blanks
a) Firms that have a high ratio of fixed costs to variable costs are said to
operate with a high degree of …………………….
b) Other things being constant firms with a ……………… degree of
operating leverage are better able to employ more………………. in
their capital structures.
c) Debt has a ………..over equity in that ……………is a deductible expense
while …………is not.
14. A firm has a debt ratio of 75% , and it has total assets of Rs. 20 crores. Before
the creditors are unprotected these assets may drop to a value of
a) Rs. 10 crores
b) Rs. 5 crores
c) Rs. 20 crores
d) Rs. 15 crores
e) none of these.
15. The debt ratio of Firms A and B are 60% and 30%, respectively. Both firms
have assets totalling Rs. 50 crores and both have a cost of debt of 8 per cent.
Firm A earns 12 per cent before interest and taxes on its total assets. Assume a
50 per cent tax rate and answer the following questions:
58
a) What does A earn on equity after interest and taxes?
b) If B is to earn the same rate on equity after taxes as A. What must it earn Leverage Analysis
before interest and taxes on its assets?
(A) (B)
i) 15 % 7%
ii) 9% 15%
iii) 7% 12%
iv) 9% 12%
v) 7% 15%
16. Triveni Dyes Ltd. desires to increase its assets by 50% to execute large
government contracts it has received, the expansion could be financed by
issuing additional equity shares at a net price of Rs. 45 per share (the price
earnings ratio being 20). Alternatively, debt at a cost of 10% could be
increased with a price earnings ratio of 15. The balance sheet is given
below:
Current Balance Sheet of Triveni Dyes Ltd.
Rs. Rs.
Debt (8%) 20,000 Total assets 90,000
Equity shares of Rs. 10 each 60,000
Reserves 10,000
Total claims Rs. 90,000 Total assets Rs. 90,000

Assume that the gross profit margin is 12% of estimated sales of Rs. 4,00,000 and
that the tax rate is 35%. What are the expected market prices, after expansion, under
the two alternatives?
Debt Equity Shares
a) Rs. 13.150 Rs. 20.20
b) Rs. 29.30 Rs. 41.70
c) Rs. 52.35 Rs. 66.20
d) Rs. 68.10 Rs. 86.20
e) Rs. 86,50 Rs. 99.20
17. Chakradhar Seshan has developed a revolutionary new computerized

method of preparing tax returns for individuals. He has a choice of
computers on which to install his new process. Under Plan L he would
lease a computer for Rs. 5 lakhs per year and process returns with a
variable cost of Rs. 2 per, return. Under plan S he would lease a smaller,
less efficient computer for Rs. one lakh per year, but processing costs
under plan B will be Rs, 12 per return. Under either process; Seshan would
charge Rs. 22 per return processed.
A. Answer the following questions:
i) Which plan has a higher degree of operating leverage
ii) Construct break-even charts of the two plans.
iii) At what volume of tax returns would Seshan have the same
operating profit under either plan?
59
iv) Based on this information only, which plan is more risky?
Financial and B. Assume that Seshan decides to use the large computer described under plan
Investment Analysis L. Seshan now needs Rs. 20 lakhs to build facilities, obtain working capital,
and start operations. He has some money of his own with which he would
buy stock and the balance of the required funds can be obtained in the form
of debt or equity. If Seshan borrows part of the money, his interest charges
will depend upon the amount borrowed according to the following schedule:
Percentage of debt a Interest rate o

upper end of Class- total amount
interval in capital borrowed
structure
Amount borrowed
Up to Rs. 2 Lakhs 10% 9.00%
More than Rs. 2lakhs and up to Rs. 4 lakhs 20% 9.50%
More than Rs. 4 lakhs and up to Rs. 6 lakhs 30% 10.00%
More than Rs. 8 lakhs up to 10 lakhs 50% 19.00%
Assume further that the equity shares can be sold at Rs, 20 per share regardless of the
amount of debt the company uses. This will be the case at the time of initial offering
of shares. Then, after the company begins operations, the price of its shares will be
determined as a multiple of earnings per share. This multiple, viz., price-earnings
(P/E) ratio will depend upon the capital structure as follows:
Debt-Assets Ratio P/E Ratio
0 to 9.99% 12.5
10.00 to 19.99% 12.0
20.00 to 29.99% 11.5
30 00 to 39 99% 10 0
40 00 to 49 99% 80
50.00 to 59.99% 6.0
60.00 to 69.99% 5.0
If the company processes 50,000 returns annually and that its effective tax is 40%,
calculate the company's EPS at different debt-assets ratios.
Activity 13.1
1. (a) No (b) No (c) No (d) Yes (e) Yes (f) No
Activity 13.2
2. (a) No (b) Yes (c) No (d) Yes (e) Yes (f)
D/E ratio 2.0 2.00

(iii) D/A ratio = = = = = 67%
60 1+D/E ratio 1+2.00 3.00
Activity 13.3 Leverage Analysis
Return on Equity
Figure : Financial Leverage and Variation in. Equity Returns Conclusions

a) With zero debt, the ratio of ROE to Return on Total Assets (ROTA) as
depicted by AA is a relatively flat line.
b) With 80% debt, the ratio of ROE to ROTA as , shown by DD becomes.. very
steep.
This implies that as the debt-assets ratio rises, the ratio of ROE to ROTA becomes
steeper:
Thus, greater financial leverage produces greater volatility in the return on equity.
Conclusions are consistent with the analysis of Table 13.3.
4 Firm A has the lowest level of fixed costs and Firm C the highest.
Firm A has a steep total cost curve because the variable cost per unit is high and the
low fixed costs of not permitting a net reduction in total costs.
Total cost curve of Firm C is relatively flat. The high fixed cost component ' enables
the firm to try variable costs, particularly the labour costs.
The location of Break-even Points (BEP) is interesting. The BEP for Firm A is at the
lowest level of sales of the three firms. For firm C, it is at the highest level of sales.
Firm, C which has a BEP at a higher volume is able to record a higher rate of
increase in profits once it reaches the BEP, compared to the other two firms. At a
high volume of operations, Firm. C begins to command a substantial cost superiority
compared to the other two firms and more particularly Firm A. This result is now
obvious at a
61
Financial and level of 1 lakh units. But if volume of sales rises to 2 lakh units, the per unit costs for
Investment Analysis the three firms would be as under:
Firm Fixed cost Variable Total cost Units of Per unit
cost for 2 sales cost
lakh units
(Rs.lakh) (Rs.lakh) (Rs.lakh)
A 1.50 14.00 15.50 2,00,000 7.75
B 3.00 10.00 13.00 2,00,000 6.50
C 4.50 8.00 12.50 2,00,000 6.25
Firm C can use the cost advantage at higher levels of sales in competitive markets.
This will be particularly relevant for export sales.
Answers or approaches to Self-assessment Questions / Exercises Hints for some

selected questions:
1 Advantages
a) It provides a method for some investors to hold securities with fixed and prior
claims.
b) It may encourage real investment.
c) Financial leverage tends to stabilise economic functions by promoting contra

cyclical investment: Debt is costly during booms and firms avoid it after a stage.
Investment is reduced and a boom is not fed further. Similarly, debt is cheaper
during depressions and it may result in higher investment, which pushes the
economy out of unstable, to more stable conditions.
Disadvantages
A major disadvantage is that heavy fixed charges may cause forced liquidation of
firms during business downswings and may aggravate the severity of business
depressions.
If risk is defined as coefficient of variation, it is not possible to generalise the

relationship with absolute certainty. With increased financial leverage, risk could rise
proportionately, more than proportionately or, less than proportionately.
The example in the test of the unit demonstrates a case where risk or the Cv rises less
than proportionately with the debt ratio. With some other set of data, a linear
relationship could be established, or a relationship where risk increases at a decreas-
ing rate with the debt ratio could be found. Note that in all these cases risk does
increase to some extent.
5. If sales tend to fluctuate widely, then cash flows and the ability to service
fixed charges will also vary. Consequently, the possibility that the firm is
unable to meet its fixed obligations increases. For this reason, firms in
unstable industries tend to minimise their use of debt.
6. Financial leverage has no effect on EBIT; it only affects equity earnings or

net income, given EBIT. The EBIT is influenced by operating leverage.
7. (a) False (b) True (c) True 8 (c) 9 (d) 10 (a) I1 (d) 12 (c)
62 13 (a) Operating leverage (b) low; debt (c) tax; interest; dividends.
14 (b) Leverage Analysis
Total assets Rs. 20 crores.
Less : Debt
(.75 of Rs. 20 crores) = Rs. I5 crores
Equity = Rs. 5 crores
Rs. 5 crores representing owner's equity is the amount that assets could drop to
before creditors would begin to lose protection.
15 (ii)
Firm A Firm B
Debt 60 % Rs. 30 crores 30% Rs. 15 crores
Equity 40% Rs. 20 crores 70% Rs. 35 crores
Total Assets 100% Rs. 50 crores 100% Rs. 50 crores
Firm A earns .12 x Rs. 50 crores = Rs. 6.00 crores
Less : Interest .08 x Rs. 30 crores = Rs. 2.40 crores
Taxable income = Rs. 3.60 crores
Less : taxes = Rs. 1.80 crores
Net income = Rs. I.80 crores
Rate of return on equity = Rs. 1.8 crores/ Rs. 20 crores = 9 %
Firm B's net income .09 x Rs. 35 crores = Rs. 3.15crores
Add : B's taxes = Rs. 3.15 crores
Taxable income = Rs. 6.30 crores
Add debt interest .08 x Rs. 15 crores = Rs. 1.20 crores
EBIT = Rs. 7.50 crores
Rate of return on assets = Rs. 7,5 crores/Rs. 50 crores = 15 %
16 (d) EBIT = Gross profit margin X Sales.
= 12 x Rs. 4,00,000 = Rs. 48,000
EBIT Debt Equity

Rs. 48,000 Rs. 48,000
Interest expenses:
(Rs. 1600 + .10 x Rs. 45,000) -6,100 -1,600
Taxable Income Rs. 41,900 Rs. 46,400
Tax % 35% Rs.14,665 16,240
Rs. 27,235 Rs. 30,160
Earning per share 27,235 6;000 30,160 7,000
= Rs. 4.54 = Rs. 4.31
Price Earning (P/E) ratios 15 20
63
Expected Market price (EPS x PE ratio) Rs. 68.10 Rs. 86.20
Financial and 17. A. i) Plan A has greater operating leverage owing to higher fixed costs
Investment Analysis
ii) Break-even charts for Plan A and Plan B.3
iii) Profit under Plan A = (Price - VC) Units – FC
= (Rs. 22 - Rs.2) (x) - 5,00,000
where x is the indifference number of units
Profit under Plan B = (Rs. 22-Rs. I2) (x) - Rs. 1,00,000
Set the equation for profits under the two plans equal to one another and solve for x:
(Rs. 22 - Rs. 2) (x) - Rs. 5,00,000 = (Rs. 22 Rs. 12) (x) - Rs. 1,00,000
Rs. 20 x Rs. 5,00,000 = Rs. 10x - Rs. 1,00,000
10x = Rs. 4,00,000
x = Rs. 40,000 returns processes.
Thus, if fewer than 30,000 returns are processed, Plan B is better but if more than
40,000 returns are handled, Plan A is more profitable.
iv) Plan A is more risky because if sales fall below 25,000 units, losses will be
incurred. The break-even of Plan B is only 10,000 forms.
B. The following steps are suggested for the solution:
i) Calcalation of EBIT = Rs. 11,00,000
Sales in Rs. = (50,000) (Rs. 22) 5,00,000
Less : Fixed costs = 1,00,000
Variable costs =(50,000) (Rs. 2) =
64 EBIT = Rs. 5,00,000

ii) Calculation of EPS at each Debt-assets ratio using the formula: EPS = (EBIT- Leverage Analysis
I) (1-t)/ No. of equity shares outstanding
Where
I = Interest Charges = (Rupees of debt) (interest rate at each D/A ratio).
No. of shares outstanding = (Assets - Debt)/Initial price per share.
= (Rs. 20,00,000 - debt) Rs. 20.00
The calculations made are:
iii) Calculation of Sheshan Ltd's expected equity share price at different debt-
assets ratios
iv) Amount of debt which Seshan should use:
The debt ratio at which share price is maximised will give the desired debt
level. This is. 20% or Rs. 4,00,000 of debt. Note that the EPS, is also not the
maximum at this debt level. For this to happen, the debt ratio must be 40% and
the corresponding debt level must be Rs. 8,00,000

Van Horne, James C. 2002. Financial Management Policy, 12th edition, Prentice-
Hall of India : New Delhi. (Chapter 10&12).
Keown, Arthur J. (with Scott, Martin, and Petty). 10/14/2002, Foundation of
Finance: The Logic and practice of Financial Management Prentice-Hall of India:
New Delhi.
Khan, M.Y. and P.K. Jain. 1985. Financial Management, Tata McGraw-Hill: New 65
Delhi. (Chapter 10).
Financial and
Investment Analysis
UNIT 14 BUDGETING AND
BUDGETARY CONTROL
Objectives
The objectives of this unit are to familiarize you with:
• the basic aspects of financial planning and the role of budgeting
• various types of budgets
• some new ideas and development in the area of budgeting.
Structure
14.1 Introduction
14.2 Financial Planning
14.3 What is a Budget?
14.4 Budgetary Control
14.5 Classification of Budgets
14.6 Control Ratios
14.7 Performance Budgeting
14.8 Zero base Budgeting
14.9 Summary
14.10 Key Words
14.1 INTRODUCTION
At the beginning of the course, we have emphasized the need for managers to be
forward-looking. For you, therefore, reviewing the past information alone is not
enough since your job involves not only predicting but also shaping the future of
your enterprises. This requires proper planning about all activities of the business.
Finance being the life blood of a business, financial planning is of utmost
significance to a businessman. A budget is an important tool for financial planning
and control.
However, before we come to the intricacies of budgeting, it will be useful for you to
understand the meaning and implications of financial planning.
14.2 FINANCIAL PLANNING

Financial planning is concerned with raising of funds and their effective utilisation
with a view to maximise the wealth of the company. It includes the determination of:
• the amount of funds needed for implementing various business plans
• the pattern of financing i.e. the form and proportion of various corporate
securities , such as shares, debentures, bonds, bank loans to be issued or raised
66 • the timing of floatation of various corporate securities
In spite of a good financial plan, the desired results may not be achieved if there is no Budgeting and
effective control to ensure its implementation. The budget represents a set of Budgetary Control
yardsticks or guidelines for use in controlling internal operations of an organisation.
The management, through budget, can evaluate the performance of every level of the
organisation. The discrepancy between plan performance and actual performance is
highlighted through budgets. The organisation may have to change the course of its
operations in a particular area or revise its plans keeping in view the changing
conditions.
It will, therefore, be useful for you to understand the complete budgeting process. In
this unit, we shall explain what budget is and what budgetary control means. Besides
the importance of budgeting as a management tool, the techniques of preparing
various types of budgets will also be discussed.
14.3 WHAT IS A BUDGET?

A budget is a plan expressed in quantitative, usually monetary terms, covering a
specific period of time, usually one year. In other words, a budget is a systematic
plan for the utilisation of manpower and material resources. In a business
organisation a budget represents an estimate of future costs and revenues. Budgets
may be divided into two basic classes : Capital Budgets and Operating Budgets.
Capital budgets are directed towards proposed expenditure for new projects and often
require special financing (this topic is discussed in the next unit). The operating
budgets are directed towards achieving short term operational goals of the
organisation, for instance, production or profit goals in a business firm. Operating
budgets may be sub-divided into various departmental or functional budgets. The
main characteristics of a budget are:
a) It is prepared in advance and is derived from the long term strategy of the
organisation
b) It relates to future period for which objectives or goals have already been laid
down
c) It is expressed in quantitative from, physical or monetary units, or both.
Different types of budgets are prepared for different purposes e.g. Sales Budget.
Production Budget, Administrative Expense Budgets, Raw-material Budget, etc. All
these sectional budgets are afterwards integrated into a master budget which
represents an overall plan of the organisation. A budget helps its in the following
ways:
a) It brings about efficiency and improvement in the working of the organisation.
b) It is a way of communicating the plans to various units of the organisation. By

establishing the divisional, departmental, sectional budgets, exact
responsibilities are assigned. It thus minimizes the possibilities of buck-passing
if the budget figures are not met.
c) It is a way of motivating managers to achieve the goals set for the units.
d) It serves as a benchmark for controlling on-going operations.
e) It helps in developing a team spirit where participation in budgeting is

encouraged.
f) It helps in reducing wastage's and losses by revealing them in time for

corrective action.
g) It serves as a basis for evaluating the performance of managers.

67
h) It serves as a means of educating the managers.
Financial and
Investment Analysis
14.4 BUDGETARY CONTROL
No system of planning can be successful without having an effective and efficient
system of control. Budgeting is closely connected with control. The exercise of
control in the organisation with the help of budgets is known as budgetary control.
The process of budgetary control includes
(i) preparation of various budgets
(ii) continuous comparison of actual performance with budgetary performance
and
(iii) revision of budgets in the light of changed circumstances.
A system of budgetary control should not become rigid. There should be enough
scope for flexibility to provide for individual initiative and drive. Budgetary control
is an important device for making the organisation more efficient on all fronts. It is
an important tool for controlling costs and achieving the overall objectives.
Installing A Budgetary Control System
Having understood the meaning and significance of budgetary control in an

organisation, it will be useful for you to know how a budgetary control system can be
installed in the organisation. This requires first of all, finding answers to the
following questions in the context of an organisation:
• What is likely to happen?

• What can be made to happen?
• What are the objectives to be achieved?
• What are the constraints and to what extent their effects can be minimised?
Having found answers to the above questions, the following steps may be taken for
installing an effective system of budgetary control in an organisation.
Organisation for Budgeting
The setting up of a definite plan of organisation is the first step towards installing
budgetary control system in an organisation. A, Budget Manual should be prepared
giving details of the powers, duties, responsibilities and areas of operation of each
executive in the organisation.
Responsibility for Budgeting

The responsibility for preparation and implementation of the budgets may be fixed as
under:
Budget Controller
Although the Chief Executive is finally responsible for the budget programme, it is
better if a large part of the supervisory responsibility is delegated to an official
designated as Budget Controller or Budget Director. Such a person should have
knowledge of the technical details of the business and should report directly to the
President of the Chief Executive of the organisation.
Budget Committee
The Budget Controller is assisted in his work by the Budget Committee. The
Committee may consist of Heads of various departments, viz., Production, Sales
Finance, Personnel, Purchase, etc. with the Budget Controller as its Chairman. It is
generally the responsibility of the Budget Committee to submit, discuss and finally
68 approve the budget figures. Each head of the department should have his own Sub-
committee with executives working under him as its members.
Fixation of the Budget Period Budgeting and
Budgetary Control
`Budget period' means the period for which a budget is prepared and employed. the
budget period depends upon the nature of the business and the control techniques.
For example, a seasonal industry will budget for each season, while an industry
requiring long periods to complete work will budget for four, five or even larger
number of years. However, it is necessary for control purposes to prepare budgets
both for long as well as short periods.
Budget Procedures
Having established the budget organisation and fixed the budget period, the actual
work or budgetary control can be taken upon the following pattern:
Key Factor
It is also termed as limiting factor. The extent of influence of this factor must first be
assessed in order to ensure that the budget targets are met. It would be desirable to
prepare first the budget relating to this particular factor, and then prepare the other
budgets. We are giving below an illustrative list of key factors in certain industries.
Industry Key factor
Motor Car Sales demand
Aluminium Power
Petroleum Refinery Supply of crude oil
Electro-optics Skilled technicians
Hydel power generation Monsoon
The key factors should be correctly identified and examined. The key factors need
not be of a permanent nature. In the long run, the management may overcome the key
factors by introducing new products, by changing material mix or by working
overtime or extra shifts etc.
Making a Forecast
A forecast is an estimate of the future financial conditions or operating results. Any

estimation is based on consideration of probabilities. An estimate differs from a
budget in that the latter embodies an operating plan of an organisation.
A budget envisages a commitment to certain objectives or targets, which the manage-

ment seeks to attain on the basis of the forecasts prepared. A forecast on the other
hand is an estimate based on probabilities of an event. A forecast may be prepared in
financial or physical terms for sales, production cost, or other resources required for
business. Instead of just one forecast a number of alternative forecasts may be
considered with a view to obtaining the most realistic, overall plan.
Preparing Budgets
After the forecasts have been finalised the preparation of budgets follows. The
budget activity starts with the preparation of the sales budget. Then production
budget is prepared on the basis of sales budget and the production capacity avail-
able. Financial budget (i.e. cash or working capital budget) will be prepared on the
basis of sales forecast and production budget. All these budgets are combined and
coordinated into a master budget. The budgets may be revised in the course of the
financial period if it becomes necessary to do so, in view of the unexpected develop- 69
ments, which have already taken place or are likely to take place.
Financial and Choice Between Fixed and Flexible Budgets
Investment Analysis
A budget may be fixed or flexible. A fixed budget is based on a fixed volume of
activity. It may lose its effectiveness in planning and controlling if the actual capacity
utilisation is different from what was planned for any particular unit or time e.g. a
month or a quarter, The flexible budget is more useful for changing levels of activity
as it considers fixed and variable costs separately. Fixed costs, as you are aware,
remain unchanged over a certain range of output. Such costs change when there is a
change in capacity level. The variable costs change in direct pro-portion to output. If '
flexible budgeting approach is adopted, the budget controller can analyse the
variance between actual costs and budgeted costs depending upon the actual level of
activity attained during a period of time. This will be explained in detail a little later.
Activity 14.1
Arrange a meeting with one of the officials concerned with budgetary control and
administration in your organisation and discuss the following points:
a) The nature and the exact nomenclature of the budgetary control system.
b) The time for which the system has been in operation.
c) The objectives and scope activities) of the system.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………….……………………………………………………………
14.5 CLASSIFICATION OF BUDGETS

Budgets can be classified into different categories on the basis of Time, Function, or
Flexibility. The different budgets covered under each category are shown in the
following chart:
Chart : Classification of Budgets
70
Let us discuss some of the budgets covered in the above classification.
Rolling Budget Budgeting and
Budgetary Control
Some organisations follow the practice of preparing a rolling or progressive budget.
In such organisations, a budget for a year in advance will always be there
immediately after a month, or a quarter, passes, as the case may be, a new budget is
prepared for twelve months. The figures for the month/quarter, which has rolled
down, are dropped and the figures for the next month/quarter are added. For example,
if a budget has been prepared for the year 2003, after the expiry of the first quarter
ending 31st March 2003, a new budget for the full year ending 31st March, 2004 will
be prepared by dropping the figures for the quarter which has rolled (i.e. quarter
ending 31st March 2003) and adding the figures for the new quarter ending 31st
march 2004. The figures for the remaining three quarters ending 31st December 2004
may also be revised, if necessary. This process will continue whenever a quarter ends
and a new quarter begins.
Sales Budget
Sales Budget generally forms the fundamental basis on which all other budgets are
built. The budget is based on projected sales to be achieved in a budget period . The
Sales Manager is directly responsible for the preparation and execution of this
budget. He usually takes into consideration the following organisational and
environmental factors while preparing the sales budget:
Organisational factors Environmental Factors
Past sales figures and trends General trade prospects
Salesmen's estimates Seasonal fluctuations
Plant capacity Potential market
Orders on hand Degree of competition
Proposed expansion or Government controls, rules
and regulations relating to the
discontinuation of products industry Political situation
Availability of material or supplies
and its impact on market
Financial aspect
Cost of distribution of goods
It is desirable to break up the entire sales budget on the basis of different products,
time periods and sales areas or territories.
Illustration 14.1
Andhra Vinyl Ltd. has three sales division at Madras, Bangalore and Hyderabad. It
sells two products - I and II. The budgeted sales for the year ending 31st December
2002 at each place are given below:
Madras Product I 50,000 units @ Rs. 16 each
Product II 35,000 units @, Rs. 10 each
Bangalore Product II 55,000 units @ Rs. 10 each
Hyderabad Product I 75,000 units @ Rs. 16 each
The actual sales during the same period were:
Madras Product I 62,500 units @ Rs.16 each
Product II 37,500 units @ Rs. 10 each
Bangalore Product II 62,500 baits @ Rs. 10 each
Hyderabad Product I 77,500 units @ Rs. 16 each
From the reports of the sales department it was estimated that the sales budget for the
year ending 31st December 2003 would be higher than 2002, budget in the following
respects:
Madras Product I 4,000 units
Product II 2,500 units
Bangalore Product II 6,500 units 71
Hyderabad Product I 5,000 units
Financial and Intensive sales campaign in Bangalore and Hyderabad is likely to result in additional
Investment Analysis sales of 12,500 units of products I in Bangalore and 9,000 units of Products II in
Hyderabad. Let us prepare a sales budget for the period ending 31st December, 2003.
Production Budget
This budget provides an estimate of the total volume of production distributed

product-wise with the scheduling of operations by days, weeks and months, and a
forecast of the inventory of finished products. Generally, the production budget is
based on the sales budget. The responsibility for the overall production budget lies
with Works Manager and that of departmental production budgets with departmental
works managers.
Production budget may be expressed in physical or financial terms or both in relation

to production. The production budgets attempt to answer questions like: (i) What is .
to be produced? (ii) When it is to be produced? (iii) How it is to be produced? (iv)
Where it is to be produced? The production budget envisages the production
programme for achieving the sales target. It serves as a basis for preparation of
related cost budgets, e.g., materials cost budget, labour cost budget, etc. It also
facilitates the preparation of a cash budget. The production budget is prepared after
taking into consideration several factors like: (I) Inventory policies, (ii) Sales
requirements, (iii) Production stability, (iv) Plant capacity, (v) Availability of
materials and labour, (iv) Time taken in production process, etc.
Activity 14.2
From the following details of Mysore Cement Works Limited, complete the
production budget for the three-month period ending March 31, 2003 (Production
budget for product P has already been worked (out).
72
Type of Estimated stock Estimated sales Desired closing Budgeting and
Budgetary Control
Product on Jan. 1, 2003 during Jan-March stock on
2003 March 31, 2003
(Units) (Units) (Units)
P 1,000 5,000 1,500
Q 1,500 7500 2,500
R 2.000 6.500 1,500
S 1,500 6.000 1,000
Production Costs Budgets
Basically, there are three elements of cods, namely direct material direct labour and
overheads. Separate budgets for each of these elements have to be prepared.
The direct materials' budget has two components, (i) materials requirement, bud-get,
and (ii) materials procurement or purchase budget. The former deals with the total
quantity of materials required during the budget period, while the later deals with the
materials to be acquired from the Market during the budget period. Materials to be
acquired are estimated after taking into account the losing rind the opening
inventories and the materials for which orders have already been placed.
Illustration 1.4.2
The Sales Director of Andhra Paraffin Company expects to sell 25,000 units of a
particular product next year, The Production director consulted the store-keeper who
gave the necessary details as follows: 73
Financial and Two kind of raw materials, P and Q are required for manufacturing the product. Each
Investment Analysis unit of the product requires 2 units of P and 3 units of Q. The estimated opening
balance at the commencement of the next year are:
Finished products : 5,000 units
Raw material P : 6,000 units
Raw material Q : 7,500 units
The desirable closing balance at the end of the next year are:
Finished : 7,000 units
Raw material P : 6,500 units
Raw material Q : 8,000 Units
Let us prepare a statement showing material purchase budget for the next year.
units to be produced = Sales + Desired closing Stock - Opening Stock
= 25,000 + 7,000 - 5000 = 27,000 units.
Materials Purchase or Procurement Budget

Finished product Materials in units
units
P Q
Production budget 27,000 54,000 81,000
Estimated Opening Balance +5,000 -6,000 -7,500
32,000 48,000 73,500
Estimated Closing Balance -7,000 +6,500 +8,000
Estimated Sales of Product 25,500
Estimated Purchase of Materials 54,500 81,500
Direct Labour Budget : Direct labour budget, like direct materials budget, may be
divided into two categories, (i) direct labour requirement budget and (ii) direct labour
procurement budget. The former deals with the total direct labour requirement in
terms of quantity or/and value, while the latter states the additional direct workers to
be recruited.
Activity 14.3
The production budget of a factory shows that 1,000 units of a product are to be
manufactured during the next month consisting of 25 working days. Each unit is
expected to take two hours and each worker is required to work for 8 hours a day.
Calculate (a) the number of workers required to complete the job, (b) the number of
additional workers to be recruited in case the factory has already 8 workers, and likes
to keep two workers in reserve for possible absenteeism, and (c) the Labour Budget if
the wages of existing and the new workers are Rs. 500 and Rs. 600 p.m. respectively.
Part (a) has already been worked out.
74
Budgeting and
Budgetary Control
Overhead Budget The overheads may relate to factory, general administration

selling and distribution function. Separate budgets may, therefore, be prepared for
factory overheads, administrative overheads and selling and distribution overheads.
Factory Overheads Budget: Factory or manufacturing overheads include the cost of

indirect material, indirect labour and indirect expenses.. Manufacturing overheads
may be classified into (i) Fixed Overheads i.e. which tend to remain constant
irrespective of change in the volume of output, (ii) Variable Overheads i.e. which
tend to vary with the output, and (iii) Semi-variable Overheads i.e. which are partly
variable and partly fixed. The manufacturing overheads budget will provide an
estimate of these overheads to be incurred during the budget period.
Fixed manufacturing overheads can be estimated on the basis of the past information
and knowledge of any changes which may occur during the ensuing budget period.
Variable overheads are estimated after considering the scheduled production and
operating conditions in the budget period.
Illustration 14.3
From the following average figures of pervious quarters, let us prepare manufactur-
ing overhead budget for the quarter ending March 31, 2003. The budgeted output
during this quarter is 8,000 units.
The figures for the previous quarter are:
Fixed overtheads Rs. 40,000
Variable overheads 20,000 (@ Rs. 5 per unit)
Semi-variable 20,000 (40% fixed and 60% varying @ Rs. 3 per

unit)
75
Financial and Manufacturing Overheads Budget
Investment Analysis
For the Quarter ending 31st March 2003
(Output 8,000 units)

Fixed overheads 40,000
Variable overheads @ Rs. 5 per unit 40,000

Semi-variable overheads 8,000
Fixed
Variable (@Rs. 3 per unit) 24,000 32,000
Total Overheads 1,12,000
Administrative Overheads Budget: This budget covers the administrative expenses
including the salaries of administrative and managerial staff. A careful analysis of the
needs of all administrative departments of the enterprise is necessary. The minimum
requirements for the efficient operation of each department can be estimated on the
basis of costs for the previous years, and after a study of the plans and responsibilities
of each administrative department for the budget period. The budget for the entire
administrative function is obtained by integrating the separate budgets of all
administrative departments.
Selling and Distribution Overheads Budget: This budget includes all expenses
relating to selling advertising delivery of goods to customers, etc. It is better if such
costs are analysed according to products, types of customers, territories and the sales
departments. The responsibility for the preparation of this budget rests with the
executives of the sales department. There must be a relationship of selling expenses
with the volume of sales expected and an effort should be made to control the costs
of distribution. The preparation of the budget would depend on analysis of the market
situation by the management, advertising policies, research programmes, and the
fixed and variable elements.
Illustration 14.4
Let us prepare a Sales Overheads Budget for the quarter ending 31st March, 2003
from the estimates given below:
Rs.
Advertisement 12,500
Salaries of the sales department 25,000
Expenses of sales department 7,500
Counter salesmen salaries and allowances 30,000
Commission to counter salesmen is payable at 1 % of sales executed by them.
Travelling salesmen are entitled to a commission at 10% on sales effected through

them and a further 5 % towards expenses.
Sales Sales at Sales by Traveling Total estimated
Territories Counters salesmen sales

A Rs. 4,00,000 50,000 4,50,000
B 6 00 000 75 000 6 75 000
C 7,00,000 1,00,000 8,00,000
76
Budgeting and
Budgetary Control
Cash Budget
Planning cash and controlling its use are important tasks. If the future cash flows are
not properly anticipated, it is likely that idle cash balances may be created which may
result into unnecessary losses. It may also result in cash deficits and consequent
problems. The financial manager should, therefore, plan the needs and uses. Budget
is a useful device for this purpose.
The cash budget is a summary of the firm's expected cash inflows and outflows over
a particular period of time. In other words, cash budget involves a projection of
future cash receipts and cash disbursements over various time intervals.
A cash budget helps the management in:
• determining the future cash needs of the firm

• planning for financing of those needs
• exercising control over cash and liquidity of the firm
The overall objective of a cash budget is to enable the firm to meet all its
commitments in time and at the same time prevent accumulation at any time of
unnecessary large cash balances with it.
Lets recapitulate what we have already discussed in Unit 6 about cash inflows and
cash outflows, which constitute the components of a cash budget. In both these
components there are two types of flows, viz. operating cash flows and financial cash
flows. Some common elements of each are as follows:
Cash Inflows - a) Operating : cash sales, receivable collections.
b) Financial : interest receipts, sale of marketable
securities, issue of new securities.
Cash Outflow - a) Operating : wage payments, payments of bills
and accounts payable, and capital expenditure
Payable.
b) Financial: dividend payments, interest payments,
redemption of securities, loan repayments,
77
purchase of marketable securities, tax payments.
Financial and Sales Work Sheet
Investment Analysis
Sales bring in a major part of cash inflows. All sales may not be against cash; credit
sales are quite common. Each business establishment has its own credit policy for
promoting sales. Even when care is taken to ensure that credit sales do not exceed the
permitted percentage of total sales and that debtors do not default in paying bills in
time, it is a common experience that the total amount of sales is recovered over a
period of time.
Let us take an example. In a business, 10 per cent of the sales value in a month is
realised in cash during the same month; 50 per cent is received in the next month;
and the remaining 40 per cent in the month after that. We can find out the estimated
cash inflow due to sales for every month with the help of the data on past and future
sales.
Sales Work Sheet
January to March 2003
Nov. Dec. Jan. Feb. March
2002 2002 2003 2003 2003
Past Sales 960 900
Estimated future sales - - 900 1,000 1,000
Estimated Cash Receipts from sales:
10% of current month's sales 90 100 100
50% of last month's sales 450 450 500
40% of previous to last Month's sale 384 360 360
Total Cash Collections from receivables 924 910 960
The total cash collections from receivables will be transferred to the cash budget
proforma.
In a similar manner, a Purchase Work Sheet can also be prepared to find out the
estimated total cash disbursements for purchases. For example, 50 per cent of current
month's purchases may be paid for in the current month, 40 per cent in the next
month and the remaining 10 per cent in the month after that.
A proforma Cash Budget with hypothetical figures in presented below

Proforma for Cash Budget
(in Rs.)
Months
Estimated Cash Inflows: Jan. Feb. March
Cash Sales 9.60
(including collections of current and
previous month's sales)
Others 1.90
Total 11.50
Cash Outflow
Bills for Purchases 6.83
Factory Expenses 3.49
Head Office Expenses 1.54
Interest 1.21
Others 0.40
Total 13.47
Excess Inflow during the-month (1-2) 1.97
Opening Cash Balance 2.32
Closing Cash Balance (4+3) 0.35
Minimum Cash Balance Needed 2.00
78 Estimated Cash Surplus (5-6) - or Deficit (6-5) 1.65
Illustration 14.5 Budgeting and
Budgetary Control
You are appointed as the Finance Manager of Orissa Polymers Limited. Prepare a
cash budget for six months of 2003 with the help of the following information:
a) Sales on credit cost of material and wages are budgeted as follows (figures
for November and December of the previous year are the actual figures for
those months).
Months Credit sales Cost of material Wages
Nov. 30,000 5,000 10,000
Dec. 32,000 6,000 12,000
Jan. 28,000 5,000 10,000
Feb. 31,000 7,000 11,000
March 34,000 8,000 12,000
April 29,000 5,000 9,000
May 30,000 6,000 11,000
June 36,000 7,000 12,000
b) Fixed overheads amount to Rs. 10,000 per month.
c) Preference dividend of Rs. 8,000 for the half year will be due in June.
d) Income tax amount of Rs. 10,000 is payable in January.
e) Progress payment under a building contract are due as follows:
March 31 Rs. 12,000
May 31 Rs. 15,000
f) Goods are sold on terms: Net cash in the following month. Experience indicates
that 80% of debtors pay within the period of credit and the remainder do not
pay until the following month.
g) Cost of material is payable in the month following the month in which the cost
is incurred. Half of the purchases are subjected to a 2% discount and the
remaining is payable net.
h) The company pays all its accounts promptly.
79
Financial and Purchase Budget
Investment Analysis
January February March
Desired ending inventory (at cost price) 90,000 97,500 1,12,500
Add Cost of goods (Current Month) 37,500 45,000 45,000

Total requirement 1,27,500 1,42,500 1.57,500
Less beginning inventory (60.000) (90,000) (97,500)
Purchases 67,500 52,500 60,000
It will be seen that deficiency of cash occurs in the months of January, March, May
and June, mainly because some unusual payments like preference dividend, advance
income tax and progress payments under building contract are to be made in those
months. With the help of the cash budget, the company will be able to plan its short-
term financing. One of the courses is to obtain the overdraft facilities from its
bankers.
The net cash position in a particular period may show deficit. Hence, arrangements
should be made in advance to fill this gap by borrowing or by other means. In case
there is a surplus balance, the desirability of investing it in government or other
short-term securities should be examined. Any surplus should be invested in safe
securities, provided the surplus is fairly considerable and the period of investment is
short so as to ensure quick conversion of securities in cash without loss of value.
Activity 14.4
Arrange a meeting with an accounting executive of your organisation and ascertain if

cash budgeting is being practised? Obtain a proforma of cash budget for your record.
What are the major sources of cash inflows and the main uses of cash outflows? In
what way our organisation manages any deficit or surplus of cash revealed by the
cash budget?
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Master Budget
The Master or final budget is a summary budget, which incorporates all functional
budgets in a capsule form. It sets out the plan of operations for all departments in
considerable detail for the budget period. The budget may take the form of a Profit
and Loss Account and a Balance Sheet as at the end of the budget period.
The Master budget requires the approval of the Budget Committee before it is put into
operation. It may happen, sometimes, that a number of master budgets have to be
prepared before the final one is agreed upon. The budget generally contains details
regarding sales (net), production costs, cash position, and key account balances (e.g.
debtors, fixed assets, bills payable, etc.). It also shows the gross and net profits and
the important accounting ratios.
Fixed and Flexible Budgets
Fixed Budget:
A fixed budget is designed to remain unchanged irrespective of the level of activity.

This budget is prepared on the basis of a standard or fixed level of activity. Since the
80 budget does not change with the change of level of activity, it becomes an unrealistic
yardstick in case the level of activity (volume of production
or sales) actually attained does not conform to the one assumed for budgeting Budgeting and
purposes. The management will not be in a position to assess the performance of Budgetary Control
different heads on the basis of budgets prepared by them, because they can serve as
yardsticks only when the actual level of activity corresponds to the budgeted level of
activity. On account of the limitations of fixed budgeting and its inability to provide
for automatic adjustments when the volume changes. Firms whose sales and
production, cannot be accurately estimated have given up the practice of fixed
budgeting
The Master Budget may have the following format:
Exhibit 14.1: Budget Format
Flexible Budget: The Flexible Budget is designed to change in accordance with the
level of activity attained. Thus, when a budget is prepared in such a manner that the
budgeted cost for any level of activity is available, it is termed as flexible budget.
Such a budget is prepared after considering the fixed and variable elements of cost
and the changes that may be expected for each item at various levels of operations.
Flexible budgeting is desirable in the following cases:
• Where, because of the nature of business, sales are unpredictable, e.g. in

luxury or semi-luxury trades.
81
Financial and • Where the venture is new and, therefore, it is difficult to foresee the demand
Investment Analysis e.g., novelties and fashion products.
• Where business is subject to the vagaries of nature, such as soft drinks.
• Where progress depends on adequate supply of labour and the business is in an

area, which is suffering from shortage of labour.
14.6 CONTROL RATIOS
Budget is a part of the planning process. After the various budgets, including the
master budget, have been prepared, you may like to compare actual performance with
the budgeted performance. This can be done by using three important ratios as shown
below:
The above ratios are expressed in terms of percentages. If the ratio works out to 100
per cent or more, the trend is taken as favourable. If the ratio is less than 100 per
cent, the indication is taken as unfavourable. We shall discuss these ratios in some
details.
Activity Ratio : Activity Ratio is a measure of the level of activity attained over a
period of time. It is obtained by expressing the number of standard hours equivalent
to the work produced as a percentage of the budgeted hours.
Standard hours for actual production

Activity Ratio = ×100
Budgeted hours
Capacity Ratio : This ratio indicates whether and to what extent budgeted hours of
activity are actually utilised. It shows the relationship between the actual number of
working hours and the maximum possible number of working hours in a budgeted
period.
Actual hours worked

Capacity Ratio = × 100
Budgeted hours
Efficiency Ratio : This ratio indicates the degree of efficiency attained in produc-
tion. It is obtained by expressing the standard hours equivalent to the work produced
as a percentage of the actual hours spent in producing that work
Standard hours for actual production

Efficiency Ratio = × 100
Actual hours worked
Activity 14.5
Calculate : Efficiency, Activity and Capacity ratios and comment on the results
obtained for a factory which produces two units of a commodity in one standard
hour. Actual production during a particular year is 34,000 units and the budgeted
82 production for the year is 40,000 units. Actual hours operated are 16,000 (Some clues
have been provided).
Two units are produced in one standard hour. Hence, for actual production of 34,000 Budgeting and
units, standard hours required will be 17,000 (i.e 34,000/2). Budgetary Control
For budgeted production of 40,000 units, budgeted hours will be 20,000 (i.e.
40,000/2)
Efficiency Ratio:
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Activity Ratio:
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Capacity Ratio:
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Activity 14.6
In Activity 14.1 you had described the system of budgetary control in your
organisation. Keeping in view the objectives of the system, you now critically
evaluate the system in terms of its achievements, and / or failures. What do you think
are the causes for failure (total or partial)? Reflect on improving the system.
Achievements:
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Failures:
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Causes for failure:
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Financial and Ideas for improvement:
Investment Analysis
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14.7 PERFORMANCE BUDGETING

As explained in the preceding pages, budgeting is nothing but the technique of ex
pressing, largely in financial terms, the management's plans for operating and financ-
ing the enterprise during specific periods of time. Any system of budgeting, in order
to be successful, must provide for performance appraisal, as well as follow up
measures.
The traditional (also known as line-item or object-account) budget in government

enumerates estimated expenditures by type (and quantity) for a specified period of
time, usually one year. The expenditure is classified by object; the personnel are
listed by type of position; the budget is divided into sections according to
organisational units, department sections; and the types of expenditure are listed by
category. The primary purpose of traditional budget particularly in government
administration is to ensure financial control and meet the requirements of legal
accountability, that is, to ensure that appropriation, sanction or allotment limits for
different items are not related to the intended or planned outputs (or achievements).
The necessity for linking the expenditures (or inputs in financial terms) to outputs (in
physical terms), facilitating the evaluation of outcomes (or result of activities) cannot
be overemphasized.
Performance budgeting (or programme budgeting) has been designed to correct the
shortcomings of traditional budgeting by emphasizing management's considerations/
approaches. Both the financial and physical aspects are incorporated into the budget.
A performance budget presents the operations of an organisation in terms of
functions, programmes, activities, and projects.
In performance budgeting (PB), precise detainment of job to be performed or

services to be rendered is done. Secondly, the budget is prepared in terms of
functional categories and their sub-division into programmes, activities, and projects.
Thirdly, the budget becomes a comprehensive document. Since the financial and
physical results are interwoven, it facilitates management control.
The Main objectives of PB are: (i) to coordinate the physical and financial aspects;
(ii) to improve the budget formulation, review and decision-making at all levels of
management (iii) to facilitate better appreciation and review by controlling authori-
ties (legislature, Board of Trustees or Governors, etc) as the presentation is more
purposeful and intelligible; (iv) to make more effective performance audit possible;
and (v) to measure progress towards long-term objectives which are envisaged in a
development plan.
Performance budgeting involves evaluation of the performance of the organisation in

the context of both specific, as well as, overall objectives of the organisation. It
presupposes a crystal clear perception of organisational objectives in general, and
short-term business objectives as stipulated in the budget, in particular by each
employee of the organisation, irrespective of his level. It thus, provides a definite
84 direction to each employee and also a control mechanism to higher management.
Performance budgeting requires preparation of periodic performance reports. Such Budgeting and
reports compare budget and actual data, and show variances. Their preparation is Budgetary Control
greatly facilitated if the authority and responsibility for the incurrence of each cost
element is clearly defined within the firm's organisational structure. In addition, the
accounting system should be sufficiently detailed and coordinated to provide neces-
sary data for reports designed for the particular use of the individuals or cost centres
having primary responsibility for specific cost.
The responsibility for preparing the performance budget of each department lies on
the respective Department Head. Each Department Head will be supplied with a copy
of the section of the master budget appropriate to his sphere. For example, the chief
buyer will be supplied with the copy of the materials purchase budget so that he may
arrange for purchase of necessary materials. Periodic reports from various sections of
a department will be received by the departmental head that will submit a summary
report about his department to the budget committee. The report may be daily,
weekly or monthly, depending upon the size of business and the budget period. These
reports will be in the form of comparison of budgeted and actual figures, both
periodic and cumulative. The purpose of preparing these reports is to promptly
inform about the deviations in actual and budgeted activity to the person who has the
necessary authority and responsibility to take necessary action to correct the
deviations from the budget.
14.8 ZERO BASE BUDGETING
Earlier we have explained the formulation. of different types of budgets. If the

approach adopted in the formulation and preparation of budgets is based on current
level of operations or activities, including current level of expenditure and revenue,
such budgeting is known as traditional budgeting .This type of budgeting process
generally assumes that the allocation of financial resources in the past were correct
and will continue to hold good for the future as well. In most cases, an addition is
made to the current figures of cost to allow for expected (or even unexpected) in-
creases. Consequently, the budget generally takes an upward direction year after
year, inspite of generally declining efficiency. Such a system of budgeting cannot be
expected to promote operational efficiency. It may, on the other hand, create several
problems for top management. Some of these problems are:
• Programmes and activities involving wasteful expenditure are not identified,

resulting in avoidable financial and other costs.
• Inefficiencies of a prior year are carried forward in determining subsequent

years' levels of performance.
• Managers are not encouraged to identify and evaluate alternative means of

accomplishing the same objective.
• Decision-making is irrational in the absence of rigorous analysis of all proposed

costs and benefits.
• Managers tend to inflate their budget requests resulting in more demand for
funds than their availability. This results in recycling the entire budgeting
process.
Thus, the traditional budgeting technique may be quite meaningless in the present
context when management must review or re-evaluate every task with a view to
utilize the scarce resources in a better manner or to improve performance. The
technique of zero base budgeting provides a solution for overcoming the limitations
of traditional budgeting by enabling top management to focus on priorities, key areas
and alternatives of action throughout the organisation. 85
Financial and The technique of zero base budgeting suggests that an organisation should not only
Investment Analysis make decisions about the proposed new programmes, but should also review the
appropriateness of the existing programmes from time to time. Such a review
should particularly be done of such responsibility centres where there is relatively
high proportion of discretionary costs. Costs of this type depend on the discretion or
policies of the responsibility centre or top managers. These costs have no direct
relation to volume of activity. Hence, management discretion typically determines
the amount budgeted. Some examples are: expenditure on research and development,
personnel administration, legal advisory services.
Zero base budgeting, as the term suggests, examines or reviews a programme or

function or responsibility from ‘scratch’. The reviewer proceeds on the assumption
that nothing is to be allowed. The manager proposing the activity has, therefore, to
justify that the activity is essential and the various amounts asked for are reasonable
taking into account the outputs or results or volume of activity envisaged.. No
activity or expense is allowed simply because it was being allowed or done in the
past. Thus according to this technique each programme, whether new or existing,
must be justified in its entirety each time a new budget is formulated. It involves:
• dealing with particularly all elements of mangers' budget requests

• critical examination of ongoing activities along with the newly proposed
activities
• providing each manger a range of choice in setting priorities in respect of

different activities and in allocating resources.
Process of Zero Base Budgeting
The following steps are involved in Zero base budgeting:
Determining the objectives of budgeting: The objective may be 'to effect cost
reduction in staff overheads or it may be to drop, after careful analysis, projects
which do not fit into achievement of the organisations objectives etc.
Deciding on scope of application: The extent to which zero base budgeting is to be

introduced has to be decided, i.e. whether it will be introduced in all areas of the
organisation's activities or only in a few selected areas on trial basis.
Developing decision units Decision units for which cost-benefit analysis is proposed
have to be developed so as to arrive at decisions whether they should be allowed to
continue or to be dropped. Each decision unit, as far as possible should be
independent of other units so that it can be dropped if the cost analysis proves to be
unfavourable for it.
Developing decision packages : A decision package for each unit should be devel-
oped. While developing a decision package, answers to the following questions
would be desirable:
• Is it necessary to perform a particular activity at all? If the answer is in the

negative, there is no need to proceed further.
• How much has been the actual cost of the activity and what has been the actual
benefit both in tangible as well as intangible forms?
• What should be the estimated cost of the level of activity and the estimated
benefit from such activity?
• Should the activity be performed in the way in which it is being performed, and
what should be the cost?
86 • If the project or activity is dropped, can the unit be replaced by an outside
agency?
After completing decision packages for each unit, the units are ranked according to Budgeting and
the findings of cost-benefit analysis. Essential projects are identified and given the Budgetary Control
highest ranks. The last stage is that of implementing the decision taken in the light of
the study made. It involves the selection and acceptance of those projects which have
a positive cost-benefit analysis or which are capable of meeting the objectives of the
organisation.
The above analysis shows that zero base budgeting is in a way an extension of the
method of cost-benefit analysis to the area of the corporate budgeting.
Advantages of Zero Base Budgeting
Let us summarise the advantages of zero base budgeting:
• It provides the organisation with systematic way to evaluate different

operations and programmes undertaken. It enables management to allocate
resources according to priority of the programmes.
• It ensures that each and every programme undertaken by managers is really

essential for the organisation, and is being performed in the best possible way.
• It enables the management to approve departmental budgets on the basis of

cost-benefit analysis. No arbitrary cuts or increase in budget estimates are
made.
• It links budgets with the corporate objectives. Nothing will be allowed simply
because it was being done in the past. An activity may be shelved if it does not
help in achieving the goals of the enterprises.
• It helps in identifying areas of wasteful expenditure and, if desired, it can also

be used for suggesting alternative courses of action.
• It facilitates the introduction and implementation of the system of `management

by objectives'. Thus it can be used not only for fulfillment of the objectives of
traditional budgeting, but also for a variety of other purposes.
It is contended that zero base budgeting is time consuming. Of course, it is true, but it
happens only in the initial stages when decision units have to be identified and
decision packages have to be developed or completed. Once this is done, and the
methodology is clear, zero base budgeting is likely to take less time than the
traditional budgeting. In any case, till such time the organisation is properly
acclimatized to the technique of zero base budgeting, it may be done in a way that all
responsibility centres are covered at least once in three or four years.
Zero base budgeting as a concept has become quite popular these days. The
technique was first used by the U.S. Department of Agriculture in 1962. Texas
Instruments, a multinational company, pioneered its use in the private sector. Today,
a number of major companies such as Zerox, BASF, International Harvester and
Easter Airlines in the United State are using the system.
Some departments of the Government of India have recently introduced zero base
budgeting with a view to making the system of budgetary control more effective.
87
Investment Analysis
Discuss again with an official concerned with the budgetary control system in your
organisation in the light of new developments that have taken place in the field of
budgeting. Has your organisation adopted any of the features of the new
developments of innovations, such as Performance Budgeting, Zero Base Budgeting,
etc.? List some of the important steps taken in the recent past.
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14.9 SUMMARY
Since finance is regarded as the life blood of business, financial planning is of utmost
significance to management. A budget is a quantitative expression, usually in
financial terms , of the future plans of an organisation. It includes projections
regarding the levels of activity, expenses and revenues. A budget is an important tool
of financial planning. It helps in uncovering inefficiencies in operations, in
minimising wasteful expenditure and in bringing out weaknesses in the organisation
structure.
The responsibility for preparing the budget rests on the Budget Controller, who is
assisted in his work by a Budget Committee. The Budget Committee may consist of
heads of various departments, viz., Sales, Production, Personnel, Purchase, and Fi-
nance etc. Each head of the department is made responsible for preparing and execut-
ing the budget of his department. In a business organisation, preparation of any
budget is preceded by a sales forecast. Production budget is prepared after consid-
ering the forecasts embodied in the sales budget and the available productive capacity
etc. Production budget includes the preparation of various cost budgets associated
with production process. Budgets pertaining to different functions or units are then
combined and coordinated into one Master Budget.
The budget may be revised from time to time if the changed conditions or new
developments so warrant. A budget may be fixed or flexible. A fixed budget is based
on fixed volume of activity. If actual capacity utilisation is likely to vary from period
to period, flexible budgets are more desirable. A flexible budget is thus prepared for
changing levels of activity. It considers fixed and variable costs separately and is
therefore more useful to a business where the level of activity cannot be exactly
predicted.
In a system of budgetary control, control ratios may be computed and used in order to
compare the actual performance with the budgeted performance. These ratios are:
activity ratio, capacity ratio and efficiency ratio. In case the ratio is hundred percent
88 or more, it is considered favourable. If it is less than hundred percent, it is taken as
unfavourable.
The traditional budgeting technique which takes the current level of operations as the Budgeting and
basis for estimating the future level of operations is slowly going out of date. It is Budgetary Control
being increasingly realised that the traditional technique has serious shortcomings in
view of the constantly changing conditions of today. The management is expected to
review and re-evaluate the tasks in view of the increasing pressures of environment.
The concept of `zero base budgeting' is being considered as a suitable alternative to
replacing the traditional method.' `Zero base Budgeting' technique suggests that an
organisation should not only make decisions about the proposed new programmes,
but should also, from time to time, review the appropriateness of the existing
programmes. Nothing is allowed simply because it w as being allowed in the past.
Each programme, whether new or existing has to be justified in its entirety each time
a new budget is formulated.
The concept of `Zero base Budgeting' has been accepted for adoption in the
departments of the Central Government, and some State Governments.
14.10 KEY WORDS

Budget : A statement in financial terms, prepared prior to a defined period of time,
showing the strategy to be pursued during that period for the purpose of attaining a
given objective.
Budgeting: Art of building budgets.
Budgetary Control: The establishment of budgets relating to the responsibilities of

executives to the requirements of a policy, and the continuous comparison of actual
with budgeted results, either to secure by individual action the objective of that
policy or to provide a basis for its revision.
Budget Manual: A document, which sets out, inter alia, the responsibilities of the
persons engaged in the routine of and the forms and records required for budgetary
control.
Master Budget: Summary budget, incorporating all component functional, budgets,

which are finally approved, adopted and employed.
Fixed Budget: A budget designed to remain unchanged irrespective of the level of

activity actually attained.
Flexible Budget: A budget designed to change in accordance with the level of

activity actually attained.
Performance Budget: A budget, which specifies the outputs or results to be

achieved along with the inputs or expenditure to be incurred during the budget
period.
Zero Based Budgeting: An operating planning and budgeting process which

required each manager to justify his entire budget in detail from scratch.
Decision Unit: A significant programme, individual department or unit or level of an

organisation that can be analysed from the standpoint of decisions and funding.
Decision Package: A programme with goals, activities, and resources along with a
document that identifies and describes the programme in terms of its (i) goals, (ii)
activities by means of which goals are to be achieved, (iii) benefits to be expected
(iv) alternatives to the programme, (v) consequences of not approving the programme
and , (vi) financial and manpower resources required.
89
Financial and
Investment Analysis
14.11 SELF-ASSESSMENT QUESTIONS / EXERCISES
1. What do you understand by 'Budgeting'? Mention the types of budgets that the
management of a big industrial concern would normally prepare.
2. What is Budget? What is sought to be achieved by Budgetary Control?
3. What is the significance of' Budgetary Control' in modern business?
4. Outline a plan for Sales Budget and Purchase Budget. What considerations are
necessary in the preparation of such budgets?
5. Distinguish between Master budget and Financial Budget. How does

management make use of Master Budget
6. What is a `Flexible Budget' and how it is different from ` Fixed Budget'?
7. Explain the methods of forecasting cash requirements.
8. Sate whether each of the following statements is True of False
9. Fill in the blanks:

a) A system by which budgets are used as a means of planning and
controlling all aspects of a business …………..
b) is a budget designed to furnish budgeted costs for any level of activity
actually attained.
c} is a summary of all functional budgets in a capsule form.
d) Budgetary control helps management to ...................................................
e) Budget is an expression of a business plan in financial
terms…………………….
f) …………………shows the anticipated sources and utilisation of cash.
g) ....................................determines the priorities of functional budgets.
h) A document which sets out the responsibilities of the persons engaged in
the routine of and the forms and records required for budgetary control is
90 called ……………………..
i) Cash budget is a ……………….budget. Budgeting and
Budgetary Control
j) ……………………..is a budget which states the 'additional workers to be
engaged in the factory.
k) A budget which consolidates the organisation's overall plan is
called…………..
l) Capacity Ratio x Efficiency Rate = ……………………………………..
m) It is essential to determine the proper……………and to have well defined
……………… .
10. Choose the correct answer :
i) Sales budget is a :
(a) functional budget, (b) master budget, (c) expenditure budget.
ii) In the case of plant the limiting factor may be :
(a) insufficient capacity, (b) shortage of experienced salesmen,
(c) general shortage of power.
iii) The difference between fixed and variable cost has a special significance in the
preparations of :
(a) flexible budget, (b) master budget, (c) cash budget.
iv) The budget that is prepared first of all is :
(a) cash budget, (b) master budget, (c) budget for the key factor.
v) In case of materials, the key factor may be :
(a) insufficient advertising, (b) restrictions imposed by quota, (c) low market
demand
vi) The budget which commonly takes the form of budgeted Profit and Loss
Account and Balance Sheet is:
(a) cash budget, (b) master budget, (c) flexible budget.
11. Prepare a materials budget of Bihar Udyog Ltd, based on the following
information. The production orders of the products show the following
consumption
i) Consumption for a batch of 1,000 units of
Material No. Rate per kg. Product P kg Product Q kg
1 Rs. 60 50 80
2 60 10 5
3 10 - 30
4 50 6 10
5 25 4 4
Total 70 129
ii) Production (units)
Product P 12,000 units
Product Q 11,000 units
12. Draw a Material Procurement Budget (Quantitative) from the following
information:
Estimated sale of a product is 20,000 units. Each unit of the product requires 3 units
of material X and 5 units of Material Y. 91
Financial and Estimated opening balance at the commencement of the next year:
Investment Analysis
Finished Product 2,500 kgs.
Material X 6,000 units
Material Y 10,000 units
Material on order:
The desirable closing balances at
the end of the next year:
Finished Product 3,500 units
Material on order:
Q13. Kashmir Valley Ltd. has submitted the following information :
2002 Sales Purchase Wages Other

Expenses
January 40,000 20,000 7,500 2,000
February 50,000 30,000 10,000 2,500

March 60,000 40,000 12,000 3,0'00
April 70,000 40,000 12,500 2,000
May 50,000 30,000 12,000 2,500
June 30,000 20,000 7,500 2,250
July 35,000 15,000 9,000 2,750
August 40,000 15,000 9,000 2,500
September 30,000 20,000 8,000 2,000
October 50,000 25,000 11,000 3,000
November 60,000 30,000 12,000 3,500
December 65,000 35,000 12,500 4,250
The company is engaged in the manufacture of furniture. It recently purchased

machinery worth Rs. 50,000 on 1st April, 2003 on deferred payment basis with
interest at 12% per annum with the stipulation that the principal is repayable in four
quarterly equal installments beginning from April, 2003 and thereafter interest to be
paid as at the end of each quarter, i.e. in July, October and January. The company has
been carrying deposits of Rs. 50,000 at 16% interest, payable on the last day of June
every year.
About 40% sales are made on cash basis. A credit period of two months is allowed
for sales on credit. Closing cash balance as on 31st March 2003 is projected at Rs.
5,250.
Cash discount of 5 % is available if creditors are paid within one month, but not later.
The company has been advised by its consultant to maintain minimum cash balance
of Rs. 2,500 for day-to-day cash requirements.
As the Financial Controller of Kashmir Valley Ltd., please prepare a cash budget for
92 the quarter April to June 2003.
14. Production cost of a factory for a year is as follows: Budgeting and
Budgetary Control
Direct Wages Rs. 80,000
Direct Materials 1,20,000
Production overheads, fixed 40,000
Production overheads, variable 60,000
During the forthcoming year, it is anticipated that:
a) Average rate for direct labour remuneration will fall from Rs. 3 per hour to Rs.
2.50 per hour;
b) Production efficiency will remain unchanged; and
c) Direct labour hours will increase by 33 1/3 %
The purchase price per unit of direct materials and of the other materials and services
which comprise overheads will remain unchanged.
Draw up a budget and compute a factory overhead rate, the overheads being absorbed
on a direct wage basis.
15. ABC Co. wishes to arrange overdraft facilities with its bankers during the
period April to June when it will be manufacturing mostly for stock. Prepare a
Cash Budget including the extent of bank facilities the company will require at
the end of each month for the above period from the following data.
a) Sales Purchases Wages
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000

April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,25,000 2,68,000 15,000
b) 50 per cent of credit sales is realised in the month following the sale and the
remaining 50 per cent in the following second month. Creditors are paid in the
month following the month of purchase.
c) Cash at bank on the 1st April (estimated) is Rs. 25,000.
16. Jammu Manufacturing Company Ltd. is to start production on 1st January

2004. The Prime cost of a unit is expected to be Rs. 400 out of which Rs. 160
is for materials and Rs.240 for labour. In addition, variable expenses per unit
are expected to be Rs. 80 and fixed expenses per month Rs.3,00,000. Payment
for materials is to be made in the month following the purchase. One third of
sales will be for cash and the rest on credit for settlement in the following
month. Expenses are payable in the month in which they are incurred. The
selling price is fixed at Rs.800 per unit. The number of units manufactured and
sold are expected to be as under:
January 9,000 April 20,000

February 12,000 May 21,000
March 18,000 June 24,000
Draw a cash budget showing requirements of cash from month to month.
93
Financial and 17. The Sudershan Chemicals Ltd., operates a system of flexible budgetary control.
Investment Analysis A flexible budget is required to show levels of activity at 70%, 80% and 90%
The following is a summary of the relevant information:
a) Sales based on normal level of activity of 70 % (3,50,000) units at Rs. 200

each. If output is increased to 80% and 90% , selling prices are to be reduced
by 2.5 % and 5 % of the original selling price respectively in order to reach a
wider market.
b) Variable costs are Rs. 100 per unit (70 % is the cost of raw material). In case
output reaches 80 % level of activity or above the effective purchase of raw
material will be reduced by 5%
c) Variable overheads: Salesman's commission is 2 % of sale value.
d) Semi-variable overheads (total) at 3,50,000 units are Rs. 1,20,00,000. They are
expected to increase by 5 % if output reaches a level of activity of 80 % and by
a further 10% if it reaches the 90 % level.
e) Total fixed overheads are Rs. 2,00,000 which is likely to remain unchanged up
to 100% capacity.
18. Calculate: (a) Efficiency Ratio (b) Activity Ratio (c) Capacity Ratio from the
following figures:
Budgeted production 880 units
Standard hours per unit 10
Actual production 750 units
Actual working hours 6,000
Answers to Self-assessment Exercises
8 (a) F, (b) F, (c) T, (d) F, (e) T, (f) F, (g) T, (h) F, (i) F.

9. a) is called budgetary control
b) Flexible Budget
c) Master Budget
d) plan and control
e) for some specific future period
f) Cash budget
g) Principal budget factor
h) is termed Budget Manual
i) Short-term
j) Labour Procurement Budget
k) Master Budget
1) Activity Ratio
m) Budget Period, Responsibility Centre.
10. (i) a; (ii) a; (iii) a; (iv)c; (v) b; (vi) b;
Material No 1 2 3 4 5
Qty. 1,480 175 330 182 92
(Kg.)
Amount 88,800 10,500 3,300 9,100 2,300
(Rs.)
12. Units to be procured X: 65,000; Y: 1,07,000
13. Closing balance April May June

94
Rs. 2,250 Rs. 2,500 Rs. 2,500
14. Cost of production Rs. 3,08,889, Production overhead rate 112.5 %. Budgeting and
Budgetary Control
15. Closing balance April May June
(Overdraft) (Rs. 56,000) (47,000) (1,67,000)
17. Budgeted Profit: 70 % : Rs. 214 lakhs. 80 % : Rs. 250.4 lakhs, 90 % : Rs.
269.65 lakhs.
18. (a) 125%; (b) 85.23%; (c) 68.18%.

Arthus, J. Keown, .1. William Petty, John D. Martin, David, F. Scott, 10-14-2002,
Foundation of Finance : The Logic and Practice of Financial Management,
Prentice Hall : New Delhi (Chapter 14)
Horngren Charles T. Sundem Gary L. Stratton William, O. Introduction to Manage-

ment Accounting, 11 th ed (Part 2); Prentice Hall of India : New Delhi
McAlpine, T.S. 1976. The Basic Arts of Budgeting, Business Books (Chapter 2, 6, 7,
and 9).
Moor, Carl L. and Robert K. Jaedicke. 1976. Managerial Accounting, South Western
Publishing Co., (Chapter 17 and 18).
Chandra, Prasanna, 1985. .Managers' Guide to Finance and Accormting, Tata

McGraw-Hill: Delhi (Chapter 8 & 24).
Prem Chand. 1969. Perjbrniance Budgeting, Academic Books: New Delhi. Pyhrr,
Peter A 1973. Zero Base Budgeting, John Wiley & Sons: New York.
Maheshwari, S.N. 1987. Management Accounting and Financial Control, Sultan

Chand: New Delhi.(Section C, Chapter 1).
AUDIO/VIDEO PROGRAMME
Audio
Emerging Horizons in Accounting & Finance - Part I: Zero Base Budgeting
Video
Management Control Systems: Part I & II
95
Financial and
Investment Analysis UNIT 15 INVESTMENT
APPRAISAL METHODS
Objectives
The objectives of this unit are to:
• develop an appreciation for the need for proper investment appraisal
• familiarise you with various methods of appraising capital projects, including

their relative merits and demerits
• introduce some other concepts relevant in investment appraisal.
Structure
15.1 Introduction
15.2 Types of Investment Proposals
15.3 Need for Appraisal
15.4 Project Report
15.5 Methods of Appraisal
15.6 Depreciation, Tax and Inflows
15.7 Cost of Capital
15.8 Limitations of Investment Appraisal Techniques
15.9 Summary
15.10 Key Words
15.11 Self Assessment Questions/Exercises
15.1 INTRODUCTION
One of the aspects of financial management is proper decision-making in respect of
investment of funds. Successful operation of any business depends upon the
investment of resources in such a way as to bring in benefits or best possible returns
from any investment. An investment can be simply defined as expenditure in cash or
its equivalent during one or more time periods in anticipation of enjoying a net
inflow of cash or its equivalent in some future time period or periods.
An appraisal of any investment proposal is necessary to ensure that the investment of

resources will bring in desired benefits in future. If the financial resources were in
abundance, it would be possible to accept several investment proposals, which satisfy
the norms of approval or acceptability. Since resources are limited, a choice has to be
made among the various investment proposals by evaluating their comparative merit.
This would facilitate the identification of relatively superior proposals keeping in
mind the limited available resources. It is apparent that some techniques should be
followed for making appraisal of investment proposals. In this unit we shall describe
the various appraisal methods and acquaint you with their relative merits so that you
could identify the appropriate method for appraising investment proposals in
96 different situations.
Investment Appraisal
15.2 TYPES OF INVESTMENT PROPOSALS Methods
According to the terminology used in financial management the terms ìnvestment

decision', ìnvestment projects' and 'investment proposal' are generally associated
with application of long-term resources. What is a `long terra'? There is no hard and
fast rule to define it, but by common practice and in accordance with the financing
policies, practices and regulations of the financial institutions and banks a period of
ten years and above is generally treated as long term.
Thus all proposals or projects involving investment of funds for a period often years
or more will fall in the category of investment proposals. Long-term investment of
funds may be generally needed for the following purposes.
• Expansion of operation
• Diversification in operations
• Replacement/Modernisation of plant and machinery
• Research and Development
Expansion
A manufacturing unit, for example, is presently producing one-lakh units per year. If
it intends to double the production this will obviously increase the need for funds.
The variable cost in aggregate will increase. Accordingly, the current assets will
increase. Thus the financial resources required for working capital will have to be
increased. In case the production carried so far was less than the capacity, no
additional investment of funds is needed for long term. In case the existing
infrastructure-plant, machinery and other permanent or fixed assets-is inadequate, the
proposal for doubling the production will involve additional investment of funds for
long term. It must, however, be noted that the financial needs for such a project will
include not only expenditure on fixed assets but also an increase in working capital.
Diversification
The management of an enterprise such as the Indian Tobacco Company (ITC), as it

happened, decided to diversify its production into other lines by adding to its original
business a new area of hoteliering. Philips, famous for radio and electric bulbs etc.,
diversified into production of other electrical appliances and television sets. This
process of diversification would involve use of large financial resources for long-
term investment.
Replacement
Machines used in production may either wear out or may be rendered obsolete on
account of new technology. The productive capacity of he enterprise and its competi-
tive ability may be adversely affected. Some funds maybe needed for modernisation
of a certain class of machines or for renovation of the entire plant or building etc. To
make them more efficient and productive. Modernisation and renovation will be a
substitute for total replacement. Funds will obviously be invested for long-term.
Where renovation/modernisation is not desirable or feasible, funds (obviously larger
amounts) will be needed for replacement.
Research and Development
There has been a growing realisation that the efficiency of production and the total
operations can be improved by application of new and more sophisticated techniques
of production and management. New technology can be borrowed or developed.
There is a greater realisation that investment of funds (obviously long term and large 97
amounts) in constant research is very useful. productive and ultimately profitable
though there may be no immediate benefits or returns from such investments.
Financial and
Activity 15.1
Investment Analysis
Try to look for the expenditure of capital nature incurred by your organisation over
the last 3-5 years. What necessitated this expenditure? Identify the nature of this
expenditure in terms of the purposes mentioned in the above section. You may like to
talk to a knowledgeable person in your organisation regarding the basis of the
decision and the factors that went into it.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
………………………………………………………………………………………….
1.5.3 NEED FOR APPRAISAL

You must have observed that the investment proposals: (i) involve large amount of
funds (ii) involve greater amount of risk on account of unforeseen situation and (iii)
often mean irreversibility once the investment decision is made. In view of these the
task of appraising investment proposals is very important in financial management.
15.4 PROJECT REPORT

Preparation of a project report is a complicated process. It includes not only the
projections of financial data related to outflow and inflow of cash, but also a meticu-
lous exercise to assess the following aspects:
• Potentiality for the marketing of the project
• Technical feasibility of the project
• Availability of managerial skills
• Environmental impact
• Financial viability
In this unit we are mainly concerned with only the financial aspects for the appraisal
of an investment proposal.
Relevant Data
The following need to be considered before appraisal is taken up:
• The amount and timing of initial investment outlays
• The amount and timing of subsequent investment outlays
• The economic life of the project
• Salvage value at the end of the project
• The amount and timing of cash inflows
1. Initial Investment Outlays
98 This covers the total cash required to implement the proposal. It includes expenditure
on design, survey, consultancy fees and the working capital costs, such as costs of
maintaining stocks, contingency reserves to cover the cost of supporting additional Methods
debtors. Benefit of credit from suppliers will have the effect of reducing the quantum
of additional working capital required.
2. Subsequent Investment Outlays
The cost of maintenance, replacement and updating exercises are to be treated as

outflows during the period in which they are expected to be incurred.
3. Economic Life of a Project
The economic life of a project is to be distinguished from the life of an individual

asset. A building may have a life of sixty years, plant may have a life of fifteen years
and some equipment may have a life of five years only. The economic life of the
project is determined by the duration of the èarnings flow' generated by the project.
The economic life may end:
a) When the cost of replacement or renovation becomes uneconomical in relation

to the likely benefits;
b) When the viability of the project is adversely affected due to obsolescence,
c) When rising maintenance costs exceed the estimated disposal value; and
d) When the development of new technology necessitates new investment.
4. Salvage Value
Some equipments may have some value for the enterprise at the end of the life of the
project or there may be an anticipated sale value of the equipment. Such amount is to
be treated as an inflow at the end of the life of the project.
5. Operating Cash Flows
Three main areas are to be considered here:
a) Sales revenue: It is a function of sales volume and unit selling price. Any
miscalculation of sales revenue may have a crucial impact on appraisal of an
investment proposal. In assessing any investment opportunity, the additional or
incremental revenues generated by it need to be considered. Investment may also be
undertaken to reduce operating costs. For instance, an existing plant and machinery
or equipment may be replaced by a newer model, which is more economical to
operate. The new piece of equipment may either be more efficient (or more
productive) or it may require relatively less consumption of electricity or
maintenance costs, etc. It has to be noted that the ultimate impact of cost-saving
equipment is the same as that of the new equipment for building up additional
capacity, that is , the overall revenue is increased.
b) Production costs: A distinction between fixed and variable costs will be very
meaningful to anticipate the likely behaviour of costs. Only incremental costs have to
be considered.
c) Other direct costs: These costs will cover selling and promotion costs and
additional rent, etc. The net inflow/outflow of cash can be worked out by allocating
the aforesaid items period-wise. It may appear to you that in order to make an
appraisal regarding the financial viability of an investment proposal, or to make a
choice between two proposals, it will be enough to find out the net cash flow, that is
the difference between total outflow (amount to be invested) and the inflow (net of 99
Sales Revenue Expenditure + Salvage Value).
Financial and
See for example the following situation:
Investment Analysis
Illustration 15.1
Year Net Cash Flows (Rs. 000)
A B
0 40 -360
1 150 200
2. 200 '300
3 220 400
4 230 450
5 370 600
Total 1210 1590
The preceding illustration tells us only that proposal B generates a total cash flow of
Rs. 15,90,000 whereas proposal A brings in only Rs. 12,10,000. This alone does not
help us in arriving at any appropriate decision, unless we know the total investment
needed for each of them the time value of money and the desired acceptable rate of
return on investment. Hence it will be useful to examine a few methods of assessing
the return on investment.
15.5 METHODS OF APPRAISAL
The main methods used for evaluating investment proposals are:
• Pay Back Period
• Accounting Rate of Return
Discounted Cash Flow
• Net Present Value
• Internal Rate of Return
• Profitability Index
Pay Back Period
In simple terms it means the total period within which the total amount invested will
be recovered throughout net cash flow (after tax). Suppose a sum of Rs. 5 lakh has to
be invested in a project whose expected net cash flows are as follows:
Illustration 15.2
Incremental Cash Flow (Rs. 000)
Year Annual Annual Cumulative
(-) 500 (-) 500

1 185 (-) 315
2 125 (-) 190
3 140 (-) 50
100 4 170 (-) 120
5 180 300
It is apparent that the total money invested is Rs. 5 lakh which is shown as a negative Methods
cash flow. This could be recovered during the fourth year. To be exact, the payback
period is 3.29 years (i.e., three years and three and a half months approx.), as
calculated below:
B
P=E+
C
where P stands for payback period
E stands for number of years immediately preceding the year of final

recovery
B stands for the balance amount still to the recovered
C stands for cash flow during the year of final recovery
Anybody can say that shorter the period the better it is. Early and certain results are
better than more uncertain long-term estimates.
The Payback method is simple to calculate.
The greatest weakness of this method is that it ignores the timing and amount of all
cash inflows. It does not take any cognizance of the cash flows after the payback
period. Thus, this method is not appropriate either for absolute or comparative
appraisal. Let us observe the following example of two projects.
Illustration 15.3
(Rs. 000)
Project A Project B
Years Cash Cumulative Cash Cumulative
Flow Cash Flow Flow Cash Flow
0 (-) 700 (-) 700 (-) 700 (-) 700
1 100 (-) 600 400 (-) 300
2 200 (-) 400 300 (-) 0
3 300 (-) 100 200 (-) 200
4 400 300 100 300
5 500 800 -
Payback period 3.25 years 2 years
In both cases the investment is Rs. 7 lakhs, which is shown as negative cash flow in
zero year. It is apparent that the payback period is shorter for project B and as such. it
may be preferred. Project A, being a slow starter in cash flows, is likely to be
rejected. As we noted earlier, this method ignores the total benefits or cash inflows
generated by projects. In this particular illustration, Project A generates cash flows
for a period longer than B. Project B brings in returns for a lesser number of years
and that too at a decreasing rate. The payback method thus concentrates only on the
liquidity aspect and ignores the overall profitability of the project. It would be better
not to depend solely on this method because it is simple. As this method does have
some utility it need not be rejected totally but may be assigned the status of a
secondary or subsidiary criterion. In this context, a maximum period of payback may
be laid down and a project exceeding this period may not be entertained.
Accounting Rate of Return
This method of working out the rate of return on investment is based on the financial 101
accounting practices of the company for working out the annual profits. The net
annual profits are derived after deducting depreciation and taxes. The average of
Financial and
annual profits thus derived is worked out on the basis of the period (number of years)
Investment Analysis of the life of the project.
Illustration 15.4
(Amount in Rupees)
Years Cash Flow Depreciation Interest

(after tax)
1 13,000 6,000 400
2 11,000 6,000 .400
3 9,000 6,000 400
4 '6,400 6,000 400
5 6,000 6,000 400
Total 45,800 30,000 2,000
The investment is Rs. 30,000. Accounting rate of return will be equal to the average
of net cash flow (after depreciation, taxes, and interest) as a percentage of investment
1
(45,800-30,000-2,000) ×
5 = 9.2 Per cent
30, 000
In the above illustration the calculation of the return is based on the original (initial)
investment in the project, which is Rs. 30,000. Since the investment in this
Illustration is a depreciable asset and is estimated to have five years of useful life
with no salvage value, it could be argued that the investment base for calculating
ARR ought to be average investment which would be one-half of initial investment,
in this case Rs. 30,000/2 = 15,000. The ARR based on average investment would be:
1
(45,800-30,000-2,000) ×
5 = 18.4 Per cent
15, 000
It will be seen that where there is no salvage value and the average investment is one-
half the original investment, the rate of return will be double the rate calculated on
the original investment.
In the calculation of ARR, working capital is usually not considered. Any additional
working capital needed, however, should betaken into account in calculating the fund
requirements of new investment. This method like the Payback Method ignores the
time value of cash flows since it does not give any recognition to the timing (1st year,
2 nd year and so on) of the generation of income. The timing of cash flow is an impor-
tant variable in investment decision-making. Higher earnings in earlier years and
lower earnings in later years cannot be taken at par with lower earnings in earlier
years and greater earnings in later years. The ARR method thus suffers from a
serious drawback by neglecting the quality or pattern of benefits and by ignoring the
time value of money. Further, it does not take into account the scrap value of asset
(or project) at the end of its useful life. Finally, the calculation of profit is subject to
varying practices. The attempts at window dressing and manipulation of accounting
data have a distorting influence on the calculation of profit and consequently on the
102 ARR. All these factors make ARR a less reliable method.
Discounted Cash Flow (DCF) Methods
This concept is based on the premise of the `time value of money'. The flow income
is spread over a few years. The real value of a rupee in your hand today is much more
than that of a rupee which you will earn after a year. Why is it so? It is the value of
time. The future income, therefore, has to be discounted in order to be associated
with the current outflow of funds in the investment. Two methods of appraisal of
investment project are based on this concept. These are Net Present Value method
and Internal Rate of Return method.
Net Present Value Method
Calculation of the net present value of future income can be related to the
understanding of the compounded rate of interest or the general formula of
compounding. Sup-pose a sum of Rs. 100 (P) is invested for a period of one year at a
rate of interest (r) of 10 per cent per annum. The investment at the end of one year
will be equal to (you can refer to Table 3 given at the end of this block):
n
 r 
P 1+ 
 100 
n
 10 
= 100 1+ 
 100 
n =1
 11 
= 100+ 
 100 
= 110
It can also be stated that Rs. 110 in one year's time is worth only Rs. 100 today.
Applying the compounding formula over the number of years to work out the present
value (PV) of a future flow of income the formula will be reconstructed as
P
PV =
(1+r) n
100
Where P is the amount to be received in future (number of years = n) and r is the

annual rate of interest. Suppose we want to know the PV of cash flow of Rs. 500 to
be received at the end of five years discounted at 10% rate of interest. The PV will
be:
P = 500
n=5
= Rs. 310.5
 (r = 10) 
1+ 
 100 
Rather than spending your time on calculations, see Table 1 (given at the end of this
block) showing the discount factor for 10% over a period of 5 years in respect of the
present value of one rupee. It is 0.621. By multiplying it with the expected future
income of Rs. 500 the PV of this income will be 500 x 0.621= Rs. 310.5 If a person
were to receive a series of equal amounts over a period of 103
Financial and
five years, say Rs. 1,000 every year, the present value of these receipts can be
Investment Analysis calculated as given below
Years Amount Present Present

Rs. Value Factor Value Rs.
1 1,000 .909 909
2 1,000 .826 826
3 1,000 .751 751
4 1,000 .683 683
5 1,000 .621 621
3790
The process of reducing future values according to the factors shown to determine
the present value is called discounting. When the annual cash flows to be received
over a period of time are equal in amount, as in the above case, a simple method of
determining the present value is available through Table 2. Taking the above
example, you could look in the 10 per cent column at the line for 5 years in Table 2
and find a factor of 3.790. Multiplying it by Rs. 1,000, you would find the present
value to be the same i.e. Rs. 3,790 as determined by the longer method using Table I.
Table 2. Contains factors which represent the present value of Rupee one received
annually for the given number of years (this form of cash flows is commonly known
as an annuity).
You will realise that by discounting the expected annual returns for each year the
project has been covered and not a few years' return as covered under Payback
Method. By adding the PV of the annual inflow of cash for each year of the expected
life of the project we come to know the PV of the aggregate of the inflows. This can
easily be compared with the cash outflow needed today for investment. The
investment proposal can be acceptable if the aggregate PV of cash inflow is more
than the current outflow. The decision to accept or reject the proposal or to accept the
superior one (with higher PV against the same investment) out of two or more
proposals can be taken more rationally with the Discounted Cash Flow - Net Present
Value Method. We may illustrate the method by comparing two projects.
Illustration 15.5
Project Initial Net Cash Income (before depreciation but after Tax)
(Rs. in Thousand)
Year
Rs. 1 2 3 4 5 8
A 20,000 4 4 4 8 2 - - -
B 20,000 8 6 2 2 2 2' 2 2
If the present value of the stream of net cash income exceeds the capital outlay, the
firm can be assured of a surplus. When alternative projects are being considered, that
project which has positive (or highest) net present value will be selected.
104
Project A Project B Methods
Year Net Cash Discount PV Net Cash Discount PV Rs.

Income Factor* Income Factor*
Rs. Rs. Rs.
1 4000 0.935 3,740 8000 0.935 7,480
2 4000 0.873 3,492 6000 0.873 5,238
3 4000 0.816 3,264 2000 0.816 1.632
4 8000 0.763 6,104 2000 0.763 1.526
5 2000 0.713 1,426 2000 0.713 1.426
6 - - - 2000 0.666 1.332
7 - - - 2000 0.623 1.246
8 - - - 2000 0.582 1.164
Total Present Value 18,026 21,044
Initial Cost 20,000 20,000
Net Present Value (1,974) 1,044
* Refer to Table 1 (at the end of the book)
One important point should not escape your notice. In working out the NPV we used
a discounting rate (in our Illustrations the rates were 10 per cent and 7 per cent),
which is also known as the `cutoff' rate or `hurdle' rate or `required rate of return'.
The discounting rate is particularly needed when more than one-investment proposals
is to be appraised and the funds available for investment are not sufficient to
accommodate all the proposals. Is the discounting rate chosen arbitrarily or is there
any basis for its selection? Should it be the rate at which the firm would borrow or
lend money, or should it be the current rate of return on capital employed? A
business enterprise may set a target rate of return for appraising investment, which
ordinarily would not be less than the cost (or interest rate) of funds needed for
investment. It may however be stated that monetary interest rates do not reflect the
additional risks which may be borne by the business. Logically speaking, therefore,
the firm should select that rate of interest, which most adequately represents the risk
of the project, i.e. a rate that is presumably close to, if not exactly equal to, the
overall rate of return on capital employed. We shall further deal with this subject
under `Cost of Capital' a little later. Apart from recognising the time value of money
the NPV method considers total benefits of a proposed project over its life. This
method is particularly useful for the selection of mutually exclusive projects. The
method is in line with the objective of financial management i.e. maximization of the
wealth of shareholders. The acceptance of the proposals with positive net present
values are expected to have a positive impact on the market prices of shares.
Compared to pay back or ARR methods, NPV method is difficult to calculate and
understand. What discounting rate is to be used in calculating present values may be
difficult to decide. The selection of a particular discounting rate has a crucial effect
on the desirability of a project. With a change in rate, a desirable project may turn
into an undesirable one and vice-versa. As will be observed in a subsequent section,
105
cost of capital is generally adopted as the basis for the discount rate. Further, NPV is
an absolute measure. For projects involving different outlays the NPV method may
not give dependable results. It may also not give satisfactory results where the
Financial and
projects under competition have different lives. Other things being equal, a project
Investment Analysis with shorter pay back would be preferable.
Activity 15.2
a) How much money would you have to deposit in a savings account today in
order to have Rs. 4,000 in that account at the end of five years if the bank
pays a 5 per cent return calculated half-yearly? How much would you have to
deposit if you wanted to have Rs.10,000 after five years.
b) How much money would you have in a Fixed Deposit Account after seven
years if you deposit Rs. 1,000 today and the bank pays, an 11 per cent rate
annually? How much would you have after seven years if you deposit
Rs.4,500 today?
c) Suppose you have won a prize in a lottery, you have the opportunity to pick
one of the two prizes?
Prize A: Rs. 50,000 a year for the next ten years, paid on December 3 1 of each year.
Prize B: Rs. 2,50,000 cash paid today, ‘January 1
Assuming both prizes are tax-free and that you can earn an interest of 6 per cent per
annum on your money (also tax-free), which prize would you pick?
Which prize would you pick if you could earn 10 per cent on your money? At about
what interest rate would you consider the two prizes to be of equal value to you?
Internal Rate of Return
You have already observed the superiority of the Discounted Cash Flow technique
over the Payback Period and the Accounting Rate of Return methods. The main point
of difference is the recognition of the tune value of future inflows in the former.
The Internal Rate of Return is another method under the Discounted Cash Flow
technique which is used for appraising the investment proposals. Under this method,
we derive the discounting rate at which the aggregate of the PVs of all future cash
inflows equals the present cash outflows for the proposal. The following illustration
will make it clear for you.
Illustration 15.6
Present Value of Net Cash Flow
Year Net Cash At Discount Rate 20% At Discount Rate 10%

Flow
Discount Rs. Discount Rs.
Factor* Factor*
0 - 100 1.000 - 100.00 1.000 (-) 100.00
1 40 0.833 33.30 0.909 36.40
2 35 0.694 24.30 0.826 28.90
3 30 0.579 17.40 0.751 22.50
4 25 0.482 12.10 0.683 17.30
5 20 0.402 8.00 0.621 12.40
(-) 4.90 17.30
*See Table 1
106 From the above illustration you will realise that at the discount rate of 20 %, the
aggregate of the PVs (Rs. 95.10) of future cash inflows is Rs. 4.90 less than the
current outflow of each investment of Rs. 100. At discount rate of 10 %, the
aggregate of PVs of future cash inflows is Rs. 17.30 more than the initial cash Methods
outflow. In order to equate the inflows and outflows, the rate of discount will be
located by interpolation between the two aforesaid rates of 20% and 10 %: This
can be done as shown below. Thus the two inflows will be equal if a discount
rate of 17.8% is applied. Obviously if this discount rate is higher than the target
rate or the interest rate used to work out the cost of funds, the investment project
should be acceptable.
(NPVL)
IRR = LRD + ×R
PV
Where IRR is the Internal Rate of Return
LRD is the Lower rate of discount
NPVL is the Net Present Value at lower rate of discount (i.e. differences
between present values of cash inflows and present value of cash outlay
or outflows).
PV is the difference in present values at lower and higher discount rates
R is the difference between two rates of discount
Substituting the values, we get:
(17.30)
IRR = 10+ ×10 = 17.8
(22.20)
IRR through Payback Reciprocal
The calculation of IRR involves a trial and error procedure, which is tedious and time
consuming. This problem can be overcome by using reciprocal of payback, which is
a good approximation of the IRR. The method can be used in both the cases where a
fixed cash flow is received over the life of the asset and where varying cash flows are
received.
Where cash inflows are constant (or the same) every year (called annuity):
The procedure to calculate IRR is as under:
i) Determine the pay back period of the proposed project
ii) Look for the factor closest to the pay back period in the year row of Table 2
(the present value of annuity). The relevant year for the purpose would be
equivalent to the life period of the project. For instance, if the life of the project
is 6 years and its pay back period is 4 years, then we have to look for the factor
closest to 4.000 for the year 6 in Table 2. According to Table 2 the factor
closest to 4.0 for 6 years are 3.998 (13 % rate of interest) and 4.111 (12 %
discount rate). The value closest to 4.0 is 3.998. Therefore, the actual value lies
between 12 and 13 per cent, tilting on the side of 12 per cent. This value can be
calculated by interpolation as shown in Illustration 15.6.
Where the stream of cash flows is of varying nature:
The calculation of IRR under such circumstances is a little more difficult. The way to
simplify the process is to use a `fake annuity' as a starting point.
The following procedures may be followed:

i) Calculate the average annual cash flows to get a fake annuity.
ii) Determine `fake payback period' by dividing the initial outlay with the average
annual cash flows after taxes (CFAT) as calculated in step (i).
iii) Look for the factor in Table 2 closest to the fake payback period in the same 107
manner as in the case of annuity.
Financial and
iv) Adjust the IRR obtained in step (iii) by comparing the pattern of average
Investment Analysis annual cash flows as per step (i) to the actual varying stream of cash flows. If
the actual cash flow stream happens to be higher in the initial years of the
project's life than the average stream, adjust the IRR a few percentage points
upward. Conversely, if in the early years the actual cash flow is below the
average, adjust the IRR a few percentage points downward.
v) Find out the present value of the uneven cash flows, taking the IRR as the
discount rate as estimated in step (iv) by using Table 1.
vi) If by chance, the PV of CFAT equals the initial outlays, you have arrived at
the right IRR. Otherwise repeat step (v), that is, if you have not struck the right
rate of IRR. The net present value will either be positive or negative. If it is
positive, work for another rate (i.e. higher rate) which will turn it into a
negative figure. If the NPV is negative, work for another rate (i.e. lower rate)
which will turn it into a positive figure., When two consecutive discount rates
have been found out one of which causes the NPV to be positive and the other
causes it to be negative, the actual IRR can be ascertained through the process
of interpolation as explained in Illustration 15.6.
In short, therefore, whether the cash inflows of a project are the same each year or are
different, you should select two discounting rates in such a manner that the NPV
result of the lower rate of discount is a positive amount and the NPV result of the
higher discounting rate is a negative amount. You can then apply the interpolation
formula and arrive at the correct IRR. If you are strong enough in your intuition and
can, with a little effort, guess the two consecutive discounting rates, you need not
even bother about what is mentioned in part (b) of the above discussion (viz., when
the stream of cash flows is of varying nature).
IRR, like the NPV, takes into consideration time value of money and also the total
cash inflows and outflows over the entire life of the project (asset). For managers it is
easier to understand, as the calculation is always a percentage and not an absolute
amount as under Net Present Value method. An added advantage is that it does not
require a discounting rate. The method itself provides a rate of return. If projects are
chosen with IRR greater than the required rate of return, the method would lead to
the realisation of the objective of maximization of wealth of the shareholders.
However, IRR requires tedious calculations (based on trial and error procedure or
interpolation), as you must have already noted. Under the IRR method it is assumed
that cash flows are reinvested at the same rate as IRR. This also implies that if IRR of
two projects is say 16% and 20%, the cash flows arising from these two projects will
also be reinvested at their respective rates i.e. 16% and 20%. The reinvestment of
cash flows at two different rates within the same company may sound rather unrealis-
tic. Whether cash flows from projects would be reinvested in the company or used
for other purposes may depend on several factors. In some cases the Cash generated
may not be used internally.
Activity 15.3
An administrator of a hospital is considering a proposal to purchase a new machine.

that will aid productivity in the X-ray department. The machine will cost Rs: 13,791
now and is expected to have a five-year useful life and a zero disposal value, and will
result in operational savings of Rs. 4,000 annually. The hospital is not subject to
income taxes.
The administrator has two alternatives; alternative A is to continue to operate the X-

ray department without change (i.e. do nothing). Alternative B is to buy the new
machine, which will reduce hand processing. Because no change in revenue is indi-
108 cated, the cash savings is the difference between the cash operating costs under two
alternatives.
1. Compute the project's expected net present value. Assume that the required Methods
rate of return (also referred to as the minimum desired rate of return or hurdle
rate) is 6 per cent. (The relatively low interest rate is not unusual for a non-
profit institution).
2. Compute the expected internal rate of return on the project.
Profitability Index
It may at times be observed that if we use Internal Rate of Return method, a proposal
may be rejected because the IRR is less than that of the other one but actually the
former may not be a bad proposal if NPV is worked out by the target rate of discount.
Project Cash outflow Cash inflow IRR % NPV at 10%
in year 0 per annum Rs.
for 5 years
Rs.
A 50,000 15,000 15.4 6,850

B 68,000 20,000 14.4 7,800
If the organisation has to, choose one of the two projects and it uses the IRR
criterion, Project B will be rejected because it has lower IRR. On the other hand, if it
uses a - target rate of 10 % , project B will be selected as it has higher NPV. However
if target rate of 15 % is used, Project A will be selected as it looks better. You can
yourself compute the figures and verify the results.
It has been explained earlier that if the PV of aggregate future cash inflows is higher
than the present cash outflow by way of investment, the investment proposal is good.
If we have to choose, between two proposals then the better proposal will be the one
where the excess of discounted cash inflows over the cash outflow is larger.
Illustration 15.8
Proposal PV of total inflows Outflows Surplus
Rs. Rs. Rs.
A 4,50,000 4,00,000 50,000
B 1,20,000 1,00,000 20,000
Apparently, proposal A appeals because the net surplus over cash outflows is larger
than in case of B. Please note that we are ignoring a very significant point and it is
the `rate of return on investment'. The quantum of inflow is irrelevant unless it is
viewed against the total amount of investment. Now by applying simple method of
calculating rate of return we find that in case of A the return on investment is
50,000×100
= 12.5 per cent, whareas in case of B it is
4,00,000
20,000×100
= 20 per cent. Now it can be rationally stated that proposal B is superior to A.
1,00,000
109
Financial and
The Profitability Index (PI) is the relationship between the present values of net cash
Investment Analysis inflows and the present value of cash outflows. It can be worked out either in unitary
or in percentage terms. The formula is:
Present Value of Cash inflows

Profitability Index =
Present Value of Cash outflows
If we apply this formula to the Illustration we find that profitability index for each of
the two proposals is:
A 4,50,000 ÷ 4,00,000 = 1.125 or 112.5%

B 1,20,000 ÷ 1,00,000 = 1.20 or 120%
You will find that the result is identical as per the rate of return on investment calcu-
lated earlier. Proposal B, therefore, is superior.
Now, a question may be asked. If the result under both the aforesaid methods is
identical, then why have two methods? Please note that in case there is a `cut off rate'
prescribed by the management for approving investment proposals, a proposal will
not be approved if the rate of return is less than the `cut off rate' or the minimum
expected rate of return. The profitability index in the absence of a cut off rate may
appear to have no relevance. However, if two or more investment proposals qualify
this test, a choice may have to be made among these proposals because of resource
constraints. Hence for choice making, a proposal with high profitability index may be
approved. In case there is no basic cut off rate the profitability index can again be
regarded as a good guide for choice making.
15.6 DEPRECIATION, TAX AND INFLOWS
It must be made clear that depreciation is excluded from Discounted Cash Flow
(DCF) computations. A common error is to discount cash flows obtained after
deducting the amount of depreciation. This type of error, in fact, shows lack of
understanding of the basic idea involved in DCF. The DCF approach is
fundamentally based on inflows and outflows of cash and not on the accrual concept
of revenues and expenses. Depreciation does not involve any cash flow. It is merely a
book entry to allocate the cost of the asset over its useful life. It has of course the
effect of reducing the disposable income.
In the DCF approach, the initial cost of an asset is usually regarded as a lump sum
outflow of cash at time zero. The cash inflows in our illustrations are assumed to be
after income taxes. Depreciation, as you have noted, is not a factor in discounted
cash-flow techniques. Nevertheless, depreciation has some bearing on the annual
cash flows because of its connection with income tax. Probably, you are aware that
depreciation is deductible as a regular business expense in the determination of the
income tax payable.
Because depreciation does not require the repeated outlay of cash over the useful life
of the asset, it does not reduce the cash earnings from a particular investment. But the
incremental earnings from such an investment are taxed at the prevailing rate, and the
incremental tax payments (paid in cash) reduce cash earnings. Since depreciation on
the asset is a tax deduction, it reduces the tax payment. It thus acts to `shield' part of
the cash inflow from the tax burden.
Illustration 15.9
Newlook company has the opportunity to purchase a piece of automatic equipment

110 whose original cost is Rs. 12,000. Assuming the annual cash savings from using the
automatic equipment to be Rs.5,600 before taxes, depreciation (straight line)-Rs.2,400
(based on the initial cost of Rs. 12,000), no salvage value, five-year life and the tax Methods
rate of 50 per cent, calculate cash inflow after taxes.
Tax Purpose Cash inflow

Gross annual cash cost savings Rs. 5,600 Rs. 5,600
Less : Depreciation 2,400
Net incremental income subject to tax Rs. 3,200
Income tax at 50% (payment in cash) 1,600 1,600
Net cash inflow after taxes Rs. 4,000
Had depreciation not been deductible, the income tax on Rs.5,600 would have been
Rs.2,800 and the net incremental cash inflow Rs. 2,800. As it is, Rs. 1,200 of cash
flow is retained; the tax rate (50 per cent) applied to the depreciation deduction (Rs.
2,400) is thus regarded as a `tax shield'.
15.7 COST OF CAPITAL
The net present value techniques for investment appraisal require the use of a desired
minimum rate of return which as you have already noted, is also called the hurdle
rate, discount rate, required rate of return, or the cost of capital. The rate of
return a project is expected to give should be at least equal to the opportunity cost
rate, which is determined by what can be earned if the funds were invested elsewhere
with similar risk.
In general, the riskier the project the higher the expected rate of return. Thus, each
investment opportunity could have its own rate of return or cost of capital depending
on its risk. In this context it will not be illogical to push up the Required Rate of
Return (RRR) as the risk increases. The RRR in fact can be taken as the sum of the
risk-free rate of interest plus a risk premium. In financial management, we often
separate the investment and the financing decisions. We expect each investment
project (with risk equal to the average for the firm) to earn a rate of return equal to at
least the average cost of capital for the firm. Basically, there are two ways in which
the desired minimum rate can be established.
l. The rate could be based on the operating performance of the company itself or
the industry with which it is associated.
2. The rate could be based on the company's cost of funds.
Obviously, the former method is more subjective. Management may regard its own
operating experience as a satisfactory standard to be used for undertaking new capital
projects. If industry experience is better, management may decide to adopt this higher
level for goal-getting purposes. In some cases, it may be the wish of management to
set a ‘desired’ ate for cut-off purposes which is independent of either and reflective
of a level of future profits (i.e. the target rate) intended to improve on both.
Cost of funds (or capital), on the other hand, places the minimum level at a point
determined by what it costs the company for money in the market. Various methods
are available for determining the cost of capital. The cost in the form of interest rate
for borrowed funds (debt, loans or bonds) is fairly obvious and determinable. The
cost of preference shares is the fixed dividend payable on them. The cost of equity
funds is often less clear. The stated rate of dividends on preference shares may not be 111
a proper guide to the cost of this type of capital, because preference stock bears many
of the same characteristics as borrowed funds.
Financial and
A difficult problem therefore lies in the treatment of common shareholders equity,
Investment Analysis particularly retained earnings. You could probably say that capital from this source
has no cost, being internally generated. This thinking, however, may not be valid.
The more persuasive argument is that earnings retained in business have an
opportunity cost. If this part of capital cannot earn a satisfactory return by being
ploughed back into the operations of the business, it ought to be paid to the
shareholders in the form of dividends. One measure of this opportunity cost is the
average return which share-holders would have earned on their dividends (after
personal income taxes) if the company had not retained profits but had distributed
them in dividends (or additional dividends) and the shareholders had invested them.
The shareholders have to forego these returns if funds are retained in the business
instead.
When a company's shares are listed on a stock exchange, the market price will
usually reflect the earnings per share (after taxes) currently being earned by the
company. The company's practice with respect to dividend payment and retention of
earnings will also have an influence on the market price. Thus, one method of
determining the cost of common equity capital for the firm with listed shares is to
relate its earnings per share to the market value of the stock.
The company's cost of capital is a dynamic thing, affected by its current capital
structure, its financing plans for the future and any changes in its rate of earnings. To
determine an average cost of capital for firm it is necessary to include some provision
for capital structure, the expected cost of borrowed funds, and the market-established
cost of equity capital.
Illustration 15.10
Assume that a company has 40 per cent of its capital structure composed of deben-
tures (with 14 per cent interest) and 60 per cent of equity shares which show a market
value of Rs. 25 per equity share, reflecting current earnings per share (after taxes) of
Rs. 7. Cost of capital determined by weighted average would be:
Type of capital Weight After-tax rate Weighted average
Debentures 40% 7 2.8%

Common stock 60% 28 16.8%
100% - 19.6%
In this calculation, the rate of 7 per cent for debentures is the effective cost of interest
after taxes, since interest is a deductible expense for tax purposes (i.e. 14 per cent rate
before taxes x .50 per cent assumed tax rate). The effective rate of 28 per, cent for
common stock (Rs.7 earnings per share/Rs.25 market price) is also taken after takes,
so the weighted average of 19.6 per cent is an after-tax rate. In this case, management
presumably would reject capital penditure proposals promising less than 19.6 (or say
20) percent return after taxes. Acceptance of those indicating higher returns would, of
course, be subject to whatever other constraints management might impose, such as
total budget limitations. The RRR or cost of capital thus plays a crucial role in
determining the acceptability of an investment proposal.
15.8 LIMITATIONS OF INVESTMENT APPRAISAL

TECHNIQUES
The investment appraisal techniques appear to be exact. However, it has to be appre-

112 ciated that the true value of an investment proposal can only be approximated. The
results arrived at are dependent upon estimated factors and this has to be constantly
borne in mind. The dependability of the results would, to a large extent, depend upon Methods
the extent of objectivity and reliability of the input data, Incessant inflation also
complicates the picture. In estimating cash flows, it is important to take account of
anticipated inflation.
There are essentially three factors in the quantitative techniques for investment
appraisal: (1) capital investment, (2) return or cash flows, and (3) project or asset life.
While capital investment can be determined in some cases with a high degree of
accuracy (e.g., the purchase price and installation cost of a piece of equipment), in
other cases (e.g., development of a new product, opening a new sales territory), the
amount can only be approximated.
The return factor (cash savings, incremental inflows or earnings) nearly always
depends on estimates. And these estimates depend upon the subjective probabilities
(in analysing risk), which are assigned to possible outcomes. With uncertainties
pervading the future, projected cash flows may become, at best, half-truths. The
source of most major errors is the estimate of sales volume and price. Determining
the amount of cash savings, for example, from the use of labour-saving equipment
requires that an experienced engineer or production executive estimates the number
of labour man hours to be saved, the increase or decrease in maintenance cost, the
effects on power consumption, and a host of other factors. Estimates of the
contribution margin in increased sales volume resulting from the introduction of a
new product, the opening of a new market, or an augmentation of the advertising
programme, are always highly speculative.
Finally, the estimate of the useful or economic life of a project or asset is probably
the most tenuous of all, for it depends upon several environmental factors
technological and marketing. An engineer's guess as to the useful life of a productive
asset can be fairly reliable only lithe rate of technological change and obsolescence
can be properly estimated. The profitable career of a new product depends upon
customer acceptance and competitors reactions-both highly speculative phenomena.
Certain statistical techniques based on probability are helpful in minimising the
errors of estimating under conditions of uncertainty, but they cannot eliminate
uncertainty, and therefore error, entirely.
The soundness of the decision, therefore, would not only depend on the right choice
(or combination) of appraisal technique (or techniques), but would also depend on
sound common sense and judgement of the decision-makers.
15.9 SUMMARY
Effective deployment of capital over the long-term is one of the key means by which
management attempts to achieve the objective of wealth maximisation. Decisions
affecting investment in long-term capital projects or assets have a major impact on
the future well being of the organisation. Apart from being uncertain, such decisions,
typically, involve large commitments of funds. This unit focused on how investment
decision can be made more effective in contributing to the health and growth of the
firm. The use of the methods of analysis will enable the management to rank and
choose intelligently among proposals competing for essentially scarce long-term
funds.
The methods presently in common use are (i) the pay back period, (ii) the
accounting rate of return, and (iii) discounted cash flow techniques.
The pay back is a `rough-and -ready' means of estimating how long it will take to
recoup the original investment from the flow of cash earnings produced by the
project. It suffers from a serious drawback i.e. it provides no measure of profitability. 113
It concerns itself only with the liquidity of the investment.
Financial and
The accounting rate of return is readily understood and easily determinable, but is
Investment Analysis subject to serious limitations. It averages cash flows, and fails to distinguish between
projects with long lives and those with shorter lives and between those with uneven
cash flows. Moreover, it overlooks the all important time value of money. This model
is adequate where the return of a project plainly far exceeds the required rate or in
case of projects which are not subject to close competition for funds from other
projects.
The discounted cash-flow techniques are of two basic types: (l) the net present value
and (2) the internal rate of return. The former employs some desired (or required)
rate of return as a discount factor in determining the present worth of the cash
inflows. The investment should show an excess of present value at the desired rate
over the initial cost or investment. The latter is the rate of return, which discounts the
stream of future cash inflows to the original cost of the investment, which produces
them. Under many circumstances, both these DCF technique give identical answers.
Profitability index is the percentage relationship between present value of the cash
inflows discounted at the desired rate and the cost of the investment. This device
offers ready comparability between projects of unlike size and duration. In general,
discounted cash flow techniques provide the most reliable appraisals of alternative
investment proposals. The use of present value tables makes these techniques reason-
ably simple to employ.
Certain limitations underlie all capital budgeting appraisals. However, the three basic
factors of the quantitative analytical-techniques - investment, return, and time - are
all, to varying degrees, the results of estimates.. The estimate of future benefits is the
key measurement in investment appraisal. Certain techniques like sensitivity analysis
have been developed which help to narrow the margin of error of such estimates.
15.10 KEYWORDS
Accounting Rate of Return (ARR): A measure of rate of return for evaluating
capital investment proposals, derived from accrual accounting. methods for income
determination.
Cost of Capital: The cost of raising capital in the market, which may include interest
on borrowed money or the relation of company's earnings to the market value of its
equity shares.
Discounted Cash Flow: A measure of rate of return for evaluating capital

investment proposals based on the concept of the time value of money.
Discounting: A reduction of some future amount of money to a present value at

some appropriate rate in accordance with the concept of the time value of money.
Internal Rate of Return (IRR): That rate which equates the present value of the
future cash inflows with the cost of the investment which produces them.
Net Present Value (NPV): A technique of discounted cash flow for capital
expenditure evaluation which seeks to determine whether the present value of
estimated future cash inflows at management's desired rate of return is greater or less
than the cost of the proposal.
Payback Period: The length of time required to equate cash return with the initial
cost of capital investment, which is determined by dividing the original investment
by the annual cash inflows (cash savings after taxes).
Present Value: The amount of money which, if invested immediately at a stated rate,
would yield one or more future payments reflecting the increased value of the invest-
114 ment in accordance with the time value of money. Conversely, it may be considered
the value of a future stream of payments discounted at a given rate to the present time.
Profitability Index: The present value of future cash inflows divided by the present Methods
value of the initial outlay, also known as benefit-cost ratio.
Salvage Value: The residual value of a depreciable asset at the end of its useful life.

1. Examine different classes of capital projects and explain why they are often
approached differently?
2. What data you would seek before you appraise any capital or asset acquisition,
project?
3. Explain the concept of payback period. Why does this method enjoy a good deal
of popularity among businessmen? What are its limitations?
4. Explain Accounting Rate of Return and discuss its limitation?
5. What is the meaning of Internal Rate of Return? Are Internal Rate and Payback
related? Explain?
6. What is meant by Net Present Value? Why is Profitability Index considered
useful?
7. "Discounted cash flow techniques may be fine for some projects, but they have
one flaw - they ignore depreciation. Depreciation is an important factor in some
types of capital investment. Therefore, discounted cash flow methods are useless
when considering investment in depreciable assets". Discuss the logic of this
position.
8. How does depreciation act as a tax shield?
9. What are the essential limiting factors in the reliability of capital budgeting
measurement techniques including discounted cash flow? .
10. Explain the concept of `cost of capital' as a device for establishing a cut off point
for capital investment proposals.
11. State whether the following statements are true or false:
a) Capital investment is not necessarily an investment in

tangible property.
b) All investments are expected to yield inflows.
c) A comparison of the investment and the returns (or benefits)

cannot be made unless all monetary amounts are stated on
the same time basis.
d) The net amount invested in the new machine is the cost of the
new machine minus the net amount received from the sale of
old machine.
e) Net working capital that must be held to support the

investment is a part of the total investment in an asset or
project.
f) Depreciation on the asset is included as a cost in computing

DCF returns.
g) The net working capital released on the termination of a

project is not a return (or inflow) of the final year.
h) The costs incurred in the past have no bearing on the 115

decisions to be made in future.
Financial and
12 The Western India Company is considering the replacement of one of its
Investment Analysis machines with a newer model, which supposedly will reduce operating costs
considerably. The company has prepared the following analysis of costs:
Old Machine New Machine
Rs. Rs.
Depreciation 10,000 18,000
Labour 12,000 6,000
Other Costs 10,000 4,000
Total Annual Costs 32,000 28,000
The old machine originally cost Rs. 80,000 and has been operated for three years
out of an estimated eight-year life. The new machine, which has an estimated life
of five years, can be acquired for Rs. 90,000 less a trade-in allowance of Rs.
20,000 for the old machine. The other costs listed above consist of repairs, power
to operate the machine, lubrication and similar costs.
Which of the following statements is false?
a) Depreciation on the old machine is a sunk cost.
b) Depreciation on the old machine may be disregarded in deciding whether to

replace the old machine.
c) Labour and other costs are out-of-pocket costs.
d) The payback period of the new-machine is seven and one-half years.
13. The Greatways Company is considering replacing an old machine with a newer
model having lower maintenance costs. The old machine has a current book
value of Rs. 9,000 and a (straight line) depreciation charge of Rs. 3,000 per year
for the remaining life of 3 years including the current year. It will have no
salvage value. However, at present the machine can be sold in the market for Rs.
6,000. The existing machine requires annual maintenance costs of Rs. 3,000. The
new machine will cost Rs. 12,000 and require an annual maintenance costs of
Rs.600. It's expected useful life is 3 years with no salvage value.
Assuming straight-line depreciation also for new machine and a tax rate of 50%,
determine the incremental cash flows (both outflows and inflows) of the
replacement decision.
14. Farewell Company has an investment opportunity costing Rs.30,000 with the
following expected net cash flow (i.e. after taxes and before depreciation);
Year Net Cash flow
1 Rs. 4,000
2 4,000
3 4,000
4 4,000
5 4,000
6 7,000
7 9,000
8 12,000
9 9,000
116
10 2,000
Using 10% as the cost of capital (rate of discount), determine the following: Methods
a) Payback period
b) Net present value at 10 % discounting factor
c) Profitability index at 10% discounting factor.
d) Internal rate of return with the help of 10 % discounting factor and 15 %

discounting factor.
15. The Deccan Corporation, which has a 50% tax rate and a 20% after-tax cost of
capital, is evaluating a project which will cost Rs. 1,25,000 and will require an
increase in the level of inventories and receivables of Rs. 25,000 over its life. The
project will generate additional sale of Rs. 1,00,000 and will require cash
expenses of Rs. 25,000 in each of its 5-year life. It will be depreciated on a
straight-line basis. What are the net present value and internal rate of return for
the project?
16. The management of Maratha udyog has two alternative projects under
consideration. Project À' requires a capital outlay of Rs. 3,00,000 but project `B'
needs Rs. 4,20,000: Both are estimated to provide a cash flow for six years: A
Rs. 80,000 per year and B Rs. 1,10,000 per year. The cost of capital is 12% .
Show which of the two projects is preferable from the viewpoint of (i) Net
Present Value and (ii) Internal Rate of Return.
17. Speedex Dry Cleaning Company is considering the purchase of new wash and
dry equipment in. order to expand its operations. Two types of options are
available: a Low Speed System (LSS) with a Rs. 40,000 initial cost and a High
Speed System (HSS) with a Rs. 60,000 initial cost. Each system has a sixteen
years life and no salvage value. The net cash flows after taxes (CFAT) associated
with each investment proposals are:
CEAT for year 1 Low Speed System (LSS High Speed System (HSS)
through 16 Rs. 8,000) Rs. 12,000
Which speed system should be chosen by Speedex, assuming 15 % cost of
capital/rate of discount?
18. Space Age Printers, a large and profitable printing press, is faced with the
prospect of replacing a large printing system. Two systems currently being
marketed will do the job satisfactorily. The Superior system costs Rs. 1,50,000
and will require cash running expenses of Rs. 60,000 per year. The Matchless
system costs Rs. 2;25,000 but running expenses are expected to be only Rs.
45,000 per year. Both machines have a ten-year useful life with no salvage value
and would be depreciated on a straight-line method.
a) If the company pays a 40 % tax and has a 11 % after-tax required rate of

return, which machine should it purchase?
b) Would your answer be different if the required rate of return is 9% ?
19. Vishwa Bharti Company is examining two mutually exclusive proposals for new
capital investment. The data on the proposals are as follows:
Proposal A Proposal B
Net cash outlay Rs. 50,000 Rs. 60,000
Salvage value 2,000 NIL
Estimated life 5 years 6 years
Depreciation Straight-line Method Straight-line Method
Corporate income-tax 50% 50% 117
Cut-off rate used for appraisal 10% 10%
Financial and
Proposal A Proposal B
Investment Analysis Earning before
Depreciation and taxes
I st year Rs. 13,000 Rs. 12,000
II nd year 15,000 16,000
Illrd year 18, 000 18,000
IVth year 22,000 24,000
Vth year 12,000 24,000
VIth year - 20,000
Using both (a) present value method and (b) D C F rate of return (internal rate of
return) calculations, you are asked to advise which proposal would be financially
preferable, (you may calculate depreciation on the original cost without taking
salvage value into account. You may also ignore income tax on salvage value
received).
20. Arunachal Limited has been having a job performed by a neighbouring company
on a part used in its project at a cost of Rs.5 per part. The annual average,
production of this part is expected to be 6,000 pieces.
The Arunachal Limited itself can perform this operation by bringing into opera-
tion two machines: spare lathe which has a net book value of Rs. 2,000 and a
new machine which can be purchased at a price of Rs. 70,000.
The new machine is expected to last 7 years. The old machine has a remaining
physical life of at least 10 years and could be sold now for approximately Rs.
15,000. The final salvage value of both machine is considered negligible.
In performing the operation itself, the Arunachal Limited will incur out-of-pocket
costs for direct labour, power supply etc. of Rs. 2 per part.
Prepare an analysis (including explanatory comments) which would help to
determine whether it is profitable for the company to perform these operations
itself. The company normally expects to earn a rate of return before taxes of
about 15 % on its invested capital. Ignore income tax effect.
21. The Mahanagar Company, by purchasing and installing a small computer,
expects to realise certain cash savings in its data processing operations.
The direct cash expenses per month under the present manual-book-keeping
machine system are:
Rs.
Salaries - book-keeping and clerical 9,250
Forms and supplies 1,500
Overtime, payroll, taxes, fringes 2,250
Total 13,000
The existing furniture and equipment are fully depreciated on the books of the
company.
The computer costs Rs, 1,60,000 including alterations, installation and accessory
equipment.
The department will be staffed as follows:
Per year
Data processing supervisor Rs. 20,000
Machine Operator 8,000
Programmer 8,500
Key-punch operators (2 @ Rs. 5, 500) 11,000
Other pay roll costs 4,500
118
It is expected that forms and supplies costs will remain unchanged. Methods
The computer is expected to be obsolete in five years, having a salvage value of

Rs. 10,000 at that time.
Assuming a 50 per cent tax rate:
a) Determine the annual cash flow reflecting the tax shield and
b) Decide whether or not to purchase the computer using discounted cash

flow assuming a desired rate of return of 16 per cent after taxes.
22. The Frontline Manufacturing Company is considering the purchase of two

different types of machines to manufacture auto speed guages, one of the many
products it produces for industrial markets. The two machines are alike in the
following ways: each requires an initial investment of Rs. 15,00,000, will last for
five years after which the salvage value will be zero and has sufficient capacity to
meet the projected steady demand. The main difference between the two
machines is the timing and amount of operating cash flows. Machine A's operat-
ing cash costs would start out high and then decrease in subsequent years. For
machine B, constant operating cash costs are predicted. The incremental net cash
flows (revenues minus operating cash costs) for the two machines are expected to
be as follows:
After tax Cash Flow per year
Machine A. 15,00,000 2,00,000 4,00,000 4,00,000 6,00,000 11,00,000
Machine B 15,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
The company needs to determine which of the two machines it should buy to manu-
facture speed guages. Unsure of which method of evaluation to use, the Deputy
Managing Director asks that calculations be made for the following methods:
1. Payback period (assume, for this calculation only, that cash flows are spread
evenly throughout the year)
2. Accounting rate of return
3. Internal rate of return
4. Net present value (cost of capital = 10 per cent)
5. Net present value (cost of capital = 12 per cent)
a) Perform the above calculations for each machine. For each method state which
machine looks like a better investment.
b) Why does the net present value method yield different decisions at the two
different discount rates? Does the internal rate of return method exhibit the same
phenomenon?
c) Comment on the usefulness of each of the above Methods for choosing between
the two machines.
Answers to Questions/Exercises (11 through 22)
11. (a) T, (b) F, (c) T, (d) T, (e) T, (f) F, (g) F, (h) T.
12. (d) The payback period is approximately five and five-sixth year. The required
outlay is Rs. 70,000 (90,000-20,000). The annual savings in out-of-pocket costs 119
are 22,000 (12,000 + 10,000) less Rs. 10,000 (6,000 + 4,000), or 12,000. The
payback period is then Rs. 70,000 ÷ 12,000.
Financial and
13. Cash inflow due to sale of machine Rs 7,500
Investment Analysis Net cash outflow Rs 4,500
Total cash inflow each year with new machine Rs 1,700
14. a) Payaback period = Six years and four months
b) Net present value = Rs. 3,917
c) Profitability Index = Rs. 1.131 (or 113.1%)
d) Internal rate of Return = 12.75 (approx.)
15 NPV = Rs. 9,600
IRR = 22.78 (try interpolation between 20% and 24%)
16. NPV IRR
Project A 28,880 15.34
Project B 32,210 14.68
Project B is preferable as its NPV is more than that of A. Project A is preferable
on the basis of IRR.
17. LSS HSS
NPV 7,632 11,448
The High Speed System should be chosen by the company as its NPV is greater
than that of the Low Speed System. However, the profitability index of both the
systems is the same, that is 119.08. per cent. On the basis of this criterion, the
company could be indifferent between the two systems. The decision then would
depend on other factors.
18. a) NPV = Rs. 4,332 (negative)
Since the NPV is negative, Matchless system should not be acquired. The
company should buy the Superior system.
b) NPV = Rs. 2,016
Since the NPV is positive at 9% rate of discount the company should purchase
the Matchless system. Therefore, the answer is definitely different.
19. a) Proposal A Proposal B
NPV (Rs.) -948 1,879
b) Average cash flow (Rs) 13,600 14,500
Fake payback period 3.846 4.138
IRR 9.274 11.024
Since the NPY and IRR of proposal B are higher than those of proposal A,
proposal B would be financially preferable.
20. The present value of annual savings= Rs. 74,880
Investment required to produce the part (Rs. 70,000 + 15,000) = 85, 000 As the
present value of savings is less than the present value of investment required, the
part should continue to be purchased.
21.a) Net cash flew after taxes Rs. 58,000
Tax shield amount Rs. 15,000
b) Net present value (positive)
The computer should be purchased. Rs. 33,086
22.
Machine A. Machine B
1) Payback period 3.83 3.00

Machine B is preferable
2) ARR 32% 26.7 %
120
(Note: Calculations are based on average investment) Machine B is
preferable and can be purchased if 32 per cent is an acceptable ROI.
3) IRR 18.05 19.88% Methods
Machine B can be purchased if 19.88 per cent is considered a sufficiently high

IRR.
4) a) NPV (at 10 %) Rs. 4,05,500 Rs. 3,95,500
b) Machine A's cash inflows occur later than those of machine B. Therefore,
at higher discount rates, machine A looks less attractive than machine B.
But because machine A's total inflows are greater, at a low enough
discount rate its NPV is greater than that of machine B. The crossover
point occurs somewhere between the discount rates of 10 per cent and 12
per cent. The internal rate of return of machine B is higher than the
crossover rate (beyond which this machine becomes more attractive than
machine A), hence, machine B dominates machine A using IRR.
c) The payback period and ROI methods both ignore the time value of
money. As the two machines differ mainly in the timing of their cash
inflows, failure to consider the time value of money results in an
incomplete comparison of cash flows. The internal rate of return method
considers all the cash flows and the time value of money, but still does not
always lead to the same decisions as the net present value method. As
discussed in part (b), the IRR for each machine is constant, whereas the
relative NPV's for the two machines depends on the firm's cost of capital.
The most useful method for making the purchase decision is the net present
value method with careful thought about the firm's measure of its cost of
capital.

Van Horne, C. James, 2002. Financial Management and Policy 12th ed, Prentice-
Hall of India: New Delhi. (Chapters 4-7).
Horngren, C.T., Datar, S.M., Foster, G.M., 2002. Cost Accounting: A Managerial
Emphasis, Prentice-Hall of India: New Delhi. (Chapters 12 and 13).
E.F. Brigham Houston, J.F., 1999, Fundamentals of Financial Management (Part IV),
Dryden Press Florida.
Shrivastava, R.M., 1984. Financial Decision-making, Sterling Publishers: New

Delhi. (Chapters 8, 9 and 11).
VIDEO PROGRAMME
PrgjectAppraisal: Institutional Viewpoint
121
UNIT 16 MANAGEMENT OF WORKING Management of
Working Capital
CAPITAL
Objectives
The objectives of this unit are to familiarise you with the:
• concepts and components of working capital

• significance of and need for working capital
• determinants of the size of working capital
• criteria for efficiency in managing working capital
Structure
16.1 Introduction
16.2 Significance of Working Capital
16.3 Operating Cycle
16.4 Concepts of Working Capital
16.5 Kinds of Working Capital
16.6 Components of Working Capital
16.7 Importance of Working Capital Management
16.8 Determinants of Workings Capital Needs
16.9 Approaches to Managing Working Capital
16.10 Measuring Working Capital
16.11 Working Capital Management under Inflation
16.12 Efficiency Criteria
16.13 Determining Optimal Cash Balance
16.14 Management of Cash Flows
16.15 Summary
16.16 Key Words
16.1 INTRODUCTION
Effective financial management is the outcome, among other things, of proper
management of investment of funds in business. Funds can be invested for permanent
or long-term purposes such as acquisition of fixed assets, diversification and
expansion of business, renovation or modernisation of plants & machinery, and
research & development.
Funds are also needed for short-term purposes, that is, for current operations of the
business. For example, if you are managing a manufacturing unit you will have to
arrange for procurement of raw material, payment of wages to your workmen and for
meeting routine expenses. All the goods, which are manufactured in a given time
period may not be sold in that period. Hence, some goods remain in stock, e.g., raw
material, semi-finished (manufacturing -in-process) goods and finished marketable
goods. Funds are thus blocked in different types of inventory. Again, the whole of the 5
Financial Decisions stock of finished goods may not be sold against ready cash; some of it may be sold
on credit. The credit sales also involve blocking of funds with debtors till cash is re-
ceived or the bills are cleared.
Working Capital refers to firm's investment in short-term assets, viz. cash, short-term
securities, accounts receivable (debtors) and inventories of raw materials, work-in-
process and finished goods. It can also be regarded as that portion of the firm's total
capital, which is employed in short-term operations. It refers to all aspects of current
assets and current liabilities. In simple words, we can say that working capital is the
investment needed for carrying out day-to-day operations of the business smoothly.
The management of working capital is no less important than the management of
long-term financial investment.
16.2 SIGNIFICANCE OF WORKING CAPITAL

You will hardly find a running business firm, which does not require some amount of
working capital. Even a fully equipped manufacturing firm is sure to collapse without
(a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c)
the capacity to wait for the market for its finished products, and (d) the ability to
grant credit to its customers. Similarly, a commercial enterprise is virtually good for
nothing without merchandise to sell. Working capital, thus, is the life-blood of a
business. As a matter of fact, any organisation, whether profit-oriented or otherwise,
will not be able to carry on day-to-day activities without adequate working capital.
16.3 OPERATING CYCLE

The time between purchase of inventory items (raw material or merchandise) and their
conversion into cash is known as operating cycle or working capital cycle. The
successive events which are typically involved in an operating cycle are depicted in
Figure 16.1. A perusal of the operating cycle would reveal that the funds invested in
operations are re-cycled back into cash. The cycle, of course, takes some time to
complete. The longer the period of this conversion the longer is the operating cycle. A
standard operating cycle may be for any time period but does not generally exceed a
Figure 16.1 : Operating Cycle
6
financial year. Obviously, the shorter the operating cycle, the larger will be
the turnover of funds invested for various purposes. The channels of the Management of
Working Capital
investment are called current assets. Sometimes the available funds may be in
excess of the needs for investment in these assets, e.g., inventory, receivables
and minimum essential cash balance. Any surplus may be invested in
government securities rather than being retained as idle cash balance.
16.4 CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital, namely Gross concept and Net concept.
Gross Working Capital
According to this concept; working capital refers to the firms investment in current
assets. The amount of current liabilities is not deducted from the total of current
assets. This concept views Working Capital and aggregate of Current Assets as two
inter-changeable terms. This concept is also referred to as `Current Capital' or
`Circulating Capital'.
The proponents of the gross working capital concept advocate this for the following
reasons:
i) Profits are earned with the help of assets, which are partly fixed and partly
current. To a certain degree, similarity can be observed in fixed and current
assets so far as both are partly financed by borrowed funds, and are expected to
yield earnings over and above the interest costs. Logic then demands that the
aggregate of current assets should be taken to mean the working capital.
ii) Management is more concerned with the total current assets as they constitute
the total funds available for operating purposes than with the sources from
which the funds come.
iii) An increase in the overall investment in the enterprise also brings about an
increase in the working capital.
Net Working Capital
The net working capital refers to the difference between current assets and current
liabilities. Current liabilities are those claims of outsiders, which are expected to
mature for payment within an accounting year and include creditors dues, bills
payable, bank overdraft and outstanding expenses. Net working capital can be
positive or negative. A negative net working capital occurs when current liabilities
are in excess of current assets.
"Whenever working capital is mentioned it brings to mind current assets and current
liabilities with a general understanding that working capital is the difference between
the two".
‘Net working capital’ is a qualitative concept, which indicates the liquidity position
of the firm and the extent to which working capital needs may be financed by
permanent sources of finds. This needs some explanation.
Current assets should be sufficiently in excess of current liabilities to constitute a

margin or buffer for obligations maturing within the ordinary operating cycle of a
business. A weak liquidity position poses a threat to the solvency of the company and
makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of
current assets. Therefore, prompt and timely action should be taken by management
to improve and correct the imbalance in the liquidity position of the firm. 7
Financial Decisions The net working capital concept also covers the question of a judicious mix of long-
term and short-term funds for financing current assets. Every firm has a minimum
amount of net working capital, which is permanent. Therefore, this portion of the
working capital should be financed with permanent sources of funds such as owners'
capital, debentures, long-term debt, preference capital and retained earnings: Man-
agement must decide the extent to which current assets should be financed with
equity capital and/or borrowed capital.
Several economists uphold the net working capital concept. In support of their stand,
they state that:
• In the long run what matters is the surplus of current assets over current liabilities.
• It is this concept which helps creditors and investors to judge the financial
soundness of the enterprise.
• It is the excess of current assets over current liabilities, which can be relied upon
to meet contingencies since this amount is not liable to be returned.
• It helps to ascertain the correct comparative financial position of companies

having the same amount of current assets.
It may be stated that gross and net concepts of working capital are two important
facets of working capital management. Both the concepts have operational signifi-
cance for the management and therefore neither can be ignored. While the net
concept of working capital emphasizes the qualitative aspect, the gross concept
underscores the quantitative aspect.
16.5 KINDS OF WORKING CAPITAL

Ordinarily, working capital is classified into two categories:
• Fixed, Regular or Permanent Working Capital; and
• Variable, Fluctuating, Seasonal, Temporary or Special Working Capital
Fixed Working Capital
The need for current assets is associated with the operating cycle, which, as you
know, is a continuous process. As such, the need for current assets is felt constantly.
The magnitude of investment in current assets however may not always be the same.
The need for investment in current assets may increase or decrease over a period of
time according to the level of production. Nevertheless, there is always a certain
minimum level of current assets, which is essential for the firm to carry on its
business irrespective of the level of operations. This is the irreducible minimum
amount necessary for maintaining the circulation of the current assets. This minimum
level of investment in current assets is permanently locked up in business and is
therefore referred to as permanent or fixed or regular working capital. It is permanent
in the same way as investment in the firm's fixed assets is.
Fluctuating Working Capital
Depending upon the changes in production and sales, the need for working capital,
over and above the permanent working capital, will fluctuate. The need for working
capital may also vary on account of seasonal changes or abnormal or unanticipated
conditions. For example, a rise in the price level may lead to an increase in the
amount of funds invested in stock of raw materials as well as finished goods. Addi-
tional doses of working capital may be required to face cutthroat competition in the
8 market or other contingencies like strikes and lockouts. Any special advertising
campaigns organised for increasing sales or other promotional activities may have to
be financed by additional working capital. The extra working capital needed to Management of
support the changing business activities is called the fluctuating (variable, seasonal, Working Capital
temporary or special) working capital.
Figures 16.2 and 16.3 give an idea about fixed and fluctuating working capital.
Figure 16.2 :Fixed working capital remaining constant overtime
Figure 16.3 Fixed working capital increasing over time
As seen in Figure 16.2, that fixed working capital is stable over time, where as
variable working capital is fluctuating-sometimes increasing and sometimes decreas-
ing. The permanent working capital line, however, may not always be horizontal. For
a growing firm, permanent working capital may also keep on increasing over time as
has been shown in Figure 16.3.
Both these kinds of working capital - permanent and temporary-are required to

facilitate production and sales through the operating cycle, but temporary working
capital is arranged by the firm to meet liquidity requirements that are expected to be
temporary.
16.6 COMPONENTS OF WORKING CAPITAL

You have already noted that working capital has two components: Current assets and
Current liabilities. Current assets comprise several items. The typical items are:
i) Cash to meet expenses as and when they occur.

ii) Accounts Receivables or sundry trade debtors
iii) Inventory of:
a) Raw materials, stores, supplies and spares,
b) Work-in-process, and 9
c) Finished goods
Financial Decisions iv) Advance payments towards expenses or purchases, and other short-term ad-
vances which are recoverable.
v) Temporary investment of surplus funds which could be converted into cash

whenever needed.
A part of the need for funds to finance the current assets may be met from supply of .
goods on credit, and deferment, on account of custom, usage or arrangement, of
payment for expenses.. The remaining part of the need for working capital may be
met from short-term borrowing from financiers like banks. These items are
collectively called current liabilities. Typical items of current liabilities are:
i) Goods purchased on credit
ii) Expenses incurred in the course of the business of the organisation (e.g.,
wages or salaries, rent, electricity bills, interest etc.) which are not yet paid
for.
iii) Temporary or short term borrowings from banks, financial institutions or
other parties
iv) Advances received from parties against goods to be sold or delivered, or as
short term deposits.
v) Other current liabilities such as tax and dividends payable. Some of the major
components of current assets are explained here in brief:
Cash : All of us know that the basic input to start any business is cash. Cash is
initially required for acquiring fixed assets like plants and machinery which enables a
firm to produce products and generate cash by selling them. Cash is also required and
invested in working capital. Investments in working capital is required, as firms have
to store certain quantity of raw materials and finished goods and also for providing
credit terms to the customers.
A minimum level of cash helps in the conduct of everyday ordinary business such as
making of purchases and sales as well as for meeting the unexpected payments,
developments and other contingencies. As discussed earlier cash invested at the
beginning of-the operating cycle gets released at the end of the cycle to fund fresh
investments. However, additional cash is required by the firm when it needs to buy
more fixed assets, increase the level of operations or for bringing out change in
working capital cycle such as extending credit period to the customers.
The demand for cash is affected by several factors, some of them are within the
control of the managers and some are outside their control. It is not possible to
operate the business without holding cash but at the same time holding it without a
purpose also costs a firm either directly in the form of interest or loss of income that
could be earned out of the cash.
In the context of working capital management, cash management refers to optimizing

the benefit and cost associated with holding cash. The objective of cash management
is best achieved by speeding up the working capital cycle, particularly the collection
process and investing surplus cash in short term assets in most profitable avenues.
We will be subsequently discussing certain issues like the management of cash flows
and determination of optimal cash balance, etc. (in this unit).
Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competi-
tive pressures force most firms to offer credit. Today the use of credit in the purchase f
goods and services is so common that it is taken for granted. Selling goods or
providing services on credit basis leads to accounts receivable. When consumers
expect credit, business units in turn expect credit from their suppliers to match their
10 investment in credit extended to consumers. The granting of credit from one business
firm to another for purchase of goods and services is popularly known as trade credit.
Though commercial banks provide a significant part of requirements for working
capital, trade credit continues to be a major source of funds for firms and accounts Management of
receivable that result from granting trade credit are major investment for the firm. Working Capital
Both direct and indirect costs are associated with carrying receivables, but it has an
important benefit for increasing sales. Excessive levels of accounts receivables result
in decline of cash flows and many result in bad debts which in turn may reduce the
profit of the firm. Therefore, it is very important to monitor and manage receivables
carefully and regularly. We would be dealing with this topic in MS-41 : Working
Capital Management.
Inventory : Three things will come to your mind when you think of a manufacturing
unit - machines, men and materials. Men using machines and tools convert the
materials into finished goods. The success of any business unit depends on the extent
to which these are efficiently managed. Inventory is an asset to the organisation like
other components of current assets.
Inventory constitutes a very significant part of working capital or current assets in

manufacturing organisation. It is essential to control inventories (physical/quantity
control and value control) as these are significant elements in the costing process
constituting sometimes more than 60% of the current assets.
Inventory holding is desirable because it meets several objectives and needs but an
excessive inventory is undesirable because it costs a lot to firms.
Inventory which consists of raw material components and other consumables, work
in process and finished goods, is an important component of `current assets'. There
are several factors like nature of industry, availability of material, technology,
business practices, price fluctuation, etc. that determines the amount of inventory
holding. Holding inventory ensures smooth production process, price stability and
immediate delivery to customers. Since inventory is like any other form of assets,
holding inventory has a cost. The cost includes opportunity cost of funds blocked in
inventory, storage cost, stock out cost, etc. The benefits that come from holding
inventory should exceed the cost to justify a particular level of inventory.
Marketable Securities: Cash and marketable securities are normally treated as one
item in any analysis of current assets although these are not the same as cash they can
be converted to cash at a very short notice. Holding cash in excess of immediate
requirement means the firm is missing out an opportunity income. Excess cash is
normally invested in marketable securities, which serves two purposes namely,
provide liquidity and, also earn a return.
Activity 16.1
a) List some main items of working capital in your organisation, e.g. inventory of
raw material supplies, stores etc. (under their various heads).
..............................................................................................................……………
………………………….…………………………………………………………
………………………………………………………………………………………
……………………………………………………………………………............
b) List some of the major items of operating expenses in your organisation such as
wages and salaries of staff.
.........................................................................................................................
.......................................................................................................................
………………………………………………………………………………
……………………………………………………………………………… 11
……………………………………………………………………………….
Financial Decisions c) What is the amount of revolving fund or working capital that organisation
maintains to pay for the operating expenses?
.......................................................................................................................
………………………………………………………………………………
………………………………………………………………………………
……………………………………………………………………………….
16.7 IMPORTANCE OF WORKING CAPITAL

MANAGEMENT
Because of its close relationship with day-to-day operations of a business, a study of
working capital and its management is of major importance to internal, as well as
external analysts. It is being increasingly realised that inadequacy or mismanagement
of working capital is the leading cause of business failures. We must not lose sight of
the fact that management of working capital is an integral part of the overall financial
management and, ultimately, of the overall corporate management. Working capital
management thus throws a challenge and should be a welcome opportunity for a
financial manager who is ready to play a pivotal role in his organisation.
Neglect of management of working capital may result in technical insolvency and

even liquidation of a business unit. With receivables and inventories tending to grow
and with increasing demand for bank credit in the wake of strict regulation of credit
in India by the Central Bank, managers need to develop a long-term perspective for
managing working capital. Inefficient working capital management may cause either
inadequate or excessive working capital, which is dangerous.
A firm may have to face the following adverse consequences from inadequate
working capital:
Growth may be stunted. It may become difficult for the firm to undertake profitable
projects due to non-availability of funds.
1. Implementation of operating plans may become difficult and consequently the
firm's profit goals may not be achieved.
2. Operating inefficiencies may creep in due to difficulties in meeting even day to
day commitments.
3. Fixed assets may not be efficiently utilised due to lack of working funds, thus
lowering the rate of return on investments in the process.
4. Attractive credit opportunities may have to be lost due to paucity of working
capital.
5. The firm loses its reputation when it is not in a position to honour its short-term
obligations. As a result, the firm is likely to face tight credit terms.
On the other hand, excessive working capital may pose the following dangers:
1 Excess of working capital may result in unnecessary accumulation of invento-
ries, increasing the chances of inventory mishandling, waste, and theft.
2 It may provide an undue incentive for adopting too liberal a credit policy and
slackening of collection of receivables, causing a higher incidence of bad debts.
This has an adverse effect on profits.
3 Excessive working capital may make management complacent, leading eventu-
ally to managerial inefficiency.
4 It may encourage the tendency to accumulate inventories for making speculative
12 profits, causing a liberal dividend policy, which becomes difficult to maintain
when the firm is unable to make speculative profits.
An enlightened management, therefore, should maintain the right amount of working
capital on a continuous basis. Financial and statistical techniques can be helpful in Management of
predicting the quantum of working capital needed at different points of time. Working Capital
16.8 DETERMINANTS OF WORKING CAPITAL NEEDS
There are no set rules or formulas to determine the working capital requirements of a
firm. The corporate management has to consider a number of factors to determine the
level of working capital. The amount of working capital that a firm would need is
affected not only by the factors associated with the firm itself but is also affected by
economic, monetary and general business environment. Among the various factors
the following are important ones.
Nature and Size of Business
The working capital needs of a firm are basically influenced by the nature of its
business. Trading and financial firms generally have a low investment in fixed assets,
but require a large investment in working capital. Retail stores, for example, must
carry large stocks of a variety of merchandise to satisfy the varied demand of their
customers. Some manufacturing businesses' like tobacco, and construction firms also
have to invest substantially in working capital but only a nominal amount in fixed
assets. In contrast, public utilities have a limited need for working capital and have to
invest abundantly in fixed assets. Their working capital requirements are nominal
because they have cash sales only and they supply services, not products. Thus, the
amount of funds tied up with debtors or in stocks is either nil or very small. The
working capital needs of most of the manufacturing concerns fall between the two
extreme requirements of trading firms and public utilities.
The size of business also has an important impact on its working capital needs. Size
may be measured in terms of the scale of operations. A firm with larger scale of
operations will need more working capital than a small firm. The hazards and contin-
gencies inherent in a particular type of business also have an influence in deciding
the magnitude of working capital in terms of keeping liquid resources.
Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw materials and is completed
with the production of finished goods. If the manufacturing cycle involves a longer
period the need for working capital will be more, because an extended manufacturing
time span means a larger tie-up of funds in inventories. Any delay at any stage of
manufacturing process will result in accumulation of work-in-process and will en-
hance the requirement of working capital. You may have observed that firms making
heavy machinery or other such products, involving long manufacturing cycle, attempt
to minimise their investment in inventories (and thereby in working capital) by
seeking advance or periodic payments from customers.
Business Fluctuations
Seasonal and cyclical fluctuations in demand for a product affect the working capital
requirement considerably, especially the temporary working capital requirements of
the firm. An upward swing in the economy leads to increased sales, resulting in an
increase in the firm's investment in inventory and receivables or book debts. On the
other hand, a decline in the economy may register a fall in sales and, consequently, a
fall in the levels of stocks and book debts.
13
Financial Decisions Seasonal fluctuations may also create production problems. Increase in production
level may be expensive during peak periods. A firm may follow a policy of steady
production in all seasons to utilise its resources to the fullest extent. This will mean
accumulation of inventories in off-season and their quick disposal in peak season.
Therefore, financial arrangements for seasonal working capital requirement should be
made in advance. The financial plan should be flexible enough to take care of any
seasonal fluctuations.
Production Policy
If a firm follows steady production policy, even when the demand is seasonal, inven-
tory will accumulate during off-season periods and there will be higher inventory
costs and risks. If the costs and risks of maintaining a constant production schedule
are high, the firm may adopt the policy of varying its production schedule in
accordance with the changes in demand. Firms whose physical facilities can be
utilised for manufacturing a variety of products can have the advantage of diversified
activities. Such firms manufacture their main products during the season and other
products during off-season. Thus, production policies may differ from firm to firm,
depending upon the circumstances. Accordingly, the need for working capital will
also vary.
Turnover of Circulating Capital
The speed with which the operating cycle completes its round (i.e., cash → raw
materials → finished product → accounts receivables → cash) plays a decisive
role in influencing the working capital needs. (Refer to Figure 1(.1 on operating
cycle).
Credit Terms
The credit policy of the firm affects the size of working capital by influencing the
level of book debts. Though the credit terms granted to customers to a great extent
depend upon the norms and practices of the industry or trade to which the firm
belongs; yet it may endeavor to shape its credit policy within such constraints. A long
collection period will generally mean tying of larger funds in book debts. Slack
collection procedures may even increase the chances of bad debts.
The working capital requirements of a firm are also affected by credit terms granted
by its creditors. A firm enjoying liberal credit terms will need less working capital.
Growth and Expansion Activities
As a company grows, logically, larger amount of working capital will be needed,

though it is difficult to state any firm rules regarding the relationship between growth
in the volume of a firm's business and its working capital needs. The fact to recognize
is that the need for increased working capital funds may precede the growth in busi-
ness activities, rather than following it. The shift in composition of working capital in
a company may be observed with changes in economic circumstances and corporate
practices. Growing industries require more working capital than those that are static.
Operating Efficiency
Operating efficiency means optimum utilisation of resources. The firm can minimise
its need for working capital by efficiently controlling its operating costs. With in-
creased operating efficiency the use of working capital is improved and pace of cash
14 cycle is accelerated. Better utilisation of resources improves profitability and helps in
relieving the pressure on working capital.
Price Level Changes
Management of
Working Capital
Generally, rising price level requires a higher investment in working capital. With
increasing prices the same levels of current assets need enhanced investment.
However, firms which can immediately revise prices of their products upwards may
not face a severe working capital problem in periods of rising levels. The effects of
increasing price level may, however, be felt differently by different firms due to
variations in individual prices. It is possible that some companies may not be affected
by the rising prices, whereas others may be badly hit by it.
Other Factors
There are some other factors, which affect the determination of the need for working
capital. A high net profit margin contributes towards the working capital pool. The
net profit is a source of working capital to the extent it has been earned in cash. The
cash inflow can be calculated by adjusting non-cash items such as depreciation, out-
standing expenses, losses written off, etc, from the net profit, (as discussed in Unit 6).
The firm's appropriation policy, that is, the policy to retain or distribute profits also
has a bearing on working capital. Payment of dividend consumes cash resources and
thus reduces the firm ',s working capital to that extent. If the profits are retained in
the business, the firm's working capital position will be strengthened.
In general, working capital needs also depend upon the means of transport and
communication. If they are not well developed, the industries will have to keep huge
stocks of raw materials, spares, finished goods, etc. at places of production, as well as
at distribution outlets.
16.9 A PPROACHES TO MANAGING WORKING

CAPITAL
Two approaches are generally followed for the management of working capital: (i)
the conventional approach, and (ii) the operating cycle approach.
The Conventional Approach
This approach implies managing the individual components of working capital (i.e.
inventory, receivables, payables, etc) efficiently and economically so that there are
neither idle funds nor paucity of funds. Techniques have been evolved for the man-
agement of each of these components. In India, more emphasis is given to the man-
agement of debtors because they generally constitute the largest share of the invest-
ment in working capital. On the other hand, inventory control has not yet been
practised on a wide scale perhaps due to scarcity of goods (or commodities) and ever
rising prices.
The Operating Cycle Approach
This approach views working capital as a function of the volume of operating ex-
penses. Under this approach the working capital is determined by the duration of the
operating cycle and the operating expenses needed for completing the cycle. The
duration of the operating cycle is the number of day involved in the various stages,
commencing with acquisition of raw materials to the realisation of proceeds from
debtors. The credit period allowed by creditors will have to be set off in the process.
The optimum level of working capital will be the requirement of operating expenses
for an operating cycle, calculated on the basis of operating expenses required for a
year. 15
Financial Decisions In India, most of the organisations use to follow the conventional approach earlier,
but now the practice is shifting in favour of the operating cycle approach. The banks
usually apply this approach while granting credit facilities to their clients.
16.10 MEASURING WORKING. CAPITAL

The factors discussed in the preceding section influence the quantum of working
capital in a business enterprise. How to determine or measure the amount of working
capital that an enterprise would need was discussed to some extent in Unit 6 dealing
with funds flow analysis. Let us attempt to determine the amount of working capital
needed by taking up an illustration.
Illustration 16.1
Determine the magnitude of working capital (with the help of the following particu-
lars) for Gujarat Tricycles Limited, a newly set up enterprise:
a) The proforma cost sheet shows that the various elements of cost bear the
undermentioned relationship to the selling price:
Materials, parts and components 40%
Labour 30%
Overhead 10%
b) Production in 2004 is estimated to be 60,000 tricycles.
c) Raw material, parts and components are expected to remain in the stores for
an average period of one month before issue to production.
d) Finished goods are likely to stay in the warehouse for two months on an
average before being sold and delivered to customers.
e) Each unit of production will be in-process for half a month on an average.
f) Half of the sales are likely to be on credit. The debtors will be allowed two
months credit from the date of sale.
g) Credit period allowed by suppliers of raw material, parts and components is

one month.
h) The lag of payment to labour is one month. 50% of the overhead consists of
salaries of non-production staff.
i) Selling price will be Rs. 2000 per tricycle.
j) Assume that sales and production follow a consistent pattern.
k) Allow 20% to your computed figure for buffer cash and contingencies.
Before we attempt to calculate the working capital, it will be helpful to work out the
following basic data:
a) The yearly production is '60,000 tricycles. Hence, monthly production will

be 5000 tricycles.
b) The selling price per tricycle is Rs. 2000. The various elements of cost (i.e.
raw material, parts and components, labour and overheads) comprise 80%
(40%+30%+10%) of the selling price. Hence cost of production is Rs.1600
 80 
i.e.  2000 × 
 100 
16
Gujarat Tricycles Limited
Statement of working capital requirements Management of
Working Capital
Rs. (in lakhs)
Current Assets:
Stock of raw material, parts and components
(1 Month) 40
Stock of finished goods
(2 Months) 1,60
5,000 x 1600 u 2
Work- in-Process (1/2
Month)
5,0110 1,600 x % 40
Debtors (50% of sales) (2
months credit)
5.000 x ½ x 1.600 x 2 80 3,20
Less current liabilities
Creditors (one month) 40
Wages and Salaries:
Wages 30
Salaries (Overheads) 5 75
2,45
Add 20% for buffer cash and contingencies 49 49
Average working capital required 2,94
The various figures have been worked out as follows:

Cost of raw material etc.
Monthly production 5000 Units
Cost of material etc
per unit Rs. 800
Period for which stock
Required 1 month
Hence amount locked up
5,000 X 800 X 1 Rs. 40,00,000
Cost of finished goods
Monthly Production 5000 units
Cost of production per unit Rs. 1,600 (800 + 600 + 200)
Period for which stock
Required 2 months
5,000 X 1,600 X 2 Rs. 160,00,000
Work-in-Process Stock
Monthly Production 5,000 units
Cost of production per unit Rs. 1,600
Period for which stock required. 1/2 Month
5,000 X 1,600 X 1/2 Rs. 40,00,000
Debtors
Sales per month 5000 Units
Proportion of credit sales 50 per cent
Cost of Production per unit Rs. 3,600
Period of credit 2 months
5,000 X ½ X 1,600 X 2 Rs, 80,00,000
17
Financial Decisions Creditors
Monthly production 5000 Units
Cost of production per unit Rs. 1,600
Cost of raw material etc. being
one half Rs. 800
Period of which credit available 1 month
Hence, Working Capital unlocked
5,000 X 800 X 1 Rs. 40,00,000
Wages and Salaries
i) Wages
Monthly production 5,000 Units
Labour cost per unit Rs. 600
Lag period for payment 1 Month
Hence, Working Capital unlocked
5,000 X 600 X 1 Rs. 30,00,000
ii) Salaries
Monthly production 5,000 units
Portion of Salaries in overheads ½
Overhead cost per unit Rs. 200
Lag period for payment 1 Month
Hence, working capital unlocked
5,000 X 200 X ½ X 1 Rs. 5,00,000
16.11 WORKING CAPITAL MANAGEMENT UNDER

INFLATION
It is desirable to check the increasing demand for capital, for maintaining the existing
level of activity. Such a control acquires even more significance in times of inflation.
In order to control working capital needs in periods of inflation, the following
measures may be applied.
Greater disciplines on all segments of the production front may be attempted as

under:
a) The possibility of using substitute raw materials without affecting quality must
be explored in all seriousness. Research activities in this regard may be under-
taken, with financial assistance provided by the Government and the corporate
sector, if any.
b) Attempts must be made to increase the productivity of the work force by

proper motivational strategies. Before going in for any incentive scheme, the
cost involved must be weighed against the benefit to be derived. Though wages
in accounting are considered a variable cost, they have tended to become partly
fixed in nature due to the influence of various legislative measures adopted by
the Central or State Governments in recent times. Increased productivity results
in an increase in value added, and this has the effect of reducing labour' cost
per unit.
The managed costs should be properly scrutinized in terms of their costs and benefits.
Such costs include office decorating expenses, advertising, managerial salaries and
payments, etc. Managed costs are more, or less fixed costs and once committed they are
18 difficult to retreat. In order to minimise the cost impact of such items, the maximum
possible use of facilities already created must be ensured. Further the management
should be vigilant in sanctioning any new expenditure belonging to this cost.
The increasing pressure to augment working capital will, to some extent, be
neutralised if the span of the operating cycle can be reduced. Greater turnover with Management of
shorter intervals and quicker realisation of debtors will go a long way in easing the Working Capital
situation.
Only when there is a pressure on working capital does the management become
conscious of the existence of slow-moving and obsolete stock. The management
tends to adopt ad hoc measures, which are grossly inadequate. Therefore, a clear-cut
policy regarding the disposal of slow-moving and obsolete stocks must be
formulated and adhered to. In addition to this, there should be an efficient
management information system reflecting the stock position from various
standpoints.
The payment to creditors in time leads to building up of good reputation and conse-
quently it increases the bargaining power of the firm regarding period of credit for
payment and other conditions. Projections of cash flows should be made to see that
cash inflows and outflows match with each other. If they do not, either some pay-
ments have to be postponed or purchase of some avoidable items has to be deferred.
16.12 EFFICIENCY CRITERIA

Improved profitability of a firm, to a great extent, depends on its efficiency in manag-
ing working capital. A single criterion would not be sufficient to judge or evaluate
the efficiency in a dynamic area like working capital.
Some of the parameters for judging the efficiency in managing working capital are:
a) Whether there is enough assurance for the creditors about the ability of the
company to meet its short-term commitments on time Hence, a reliable index is
whether a company can settle the bills on due dates. The finance department has
to plan in advance to maintain sufficient liquidity to meet maturing liabilities.
b) Whether maximum possible inventory turnover is achieved. The adverse

effect of ineffective inventory management may not be offset even by the most
efficient management of other components of working capital.
c) Whether reasonable credit is extended to customers. This powerful instrument

to promote sales should not be misused. The other side of the same coin is
receiving credit. Both depend upon a company's strength as a seller and as a
buyer.
d) Whether adequate credit is obtained from suppliers. It depends upon the

company's position in relation to its suppliers and the nature of supply market
i.e. whether there is a single supplier or an oligarchy or a large number of
suppliers. With coordination of efforts buyers can be in a position to negotiate
competitive credit terms even if there is a single supplier and his ability to
control the market. At times the supplier imposes the credit terms as 100%
advance i.e. negative trade credit.
e) Whether there are adequate safeguards to ensure that neither overtrading nor
undertrading takes place.
The following indices can be used for measuring the efficiency in managing working
capital:
Current Ratio (CR)
CR = Current Assets/Current Liabilities

19
It indicates the ability of a company to manage the current affairs of business. It is
useful to study the trend of working capital over a period of time.
Financial Decisions Though the current ratio of 2:1 is considered ideal, this may have to be modified
depending on the peculiar conditions prevailing in a particular trade or industry.
It is not only the quantum of current ratio that is important but also its quality, i.e.
extent to which assets and liabilities are really current.
Quick Ratio (QR)
QR = Liquid Assets/Current Liabilities
Liquid assets mean current assets minus those, which are not quickly realizable.
Inventory and sticky debts are generally treated as non-quick assets.
The relationship of 1:1 between quick assets and current liabilities is considered
ideal, but, like current ratio, it also varies from industry to industry, depending on the
peculiar conditions of a particular industry.
Cash to Current Assets
If cash alone is a major item of current assets then it may be a good indicator of the
profitability of the organisation, as cash by itself does not earn any profit, the propor-
tion should usually be kept low.
Sales to Cash Ratio
Sales to Cash Ratio = Sales/Average cash balance during the period.
Cash should be turned over as many times as possible, in order to achieve maximum
sales with minimum cash on hand.
Average Collection Period
(Debtors/Credit Sales) x 365
This ratio explains how many days of credit a company is allowing to its customers
to settle their bills.
Average Payment Period
Average payment period = (Creditors/Credit purchases) x 365
It indicates how many days of credit is being enjoyed by the company from its
suppliers.
Inventory Turnover Ratio (ITR)
ITR = Sales/Average Inventory
It shows how many times inventory has turned over to achieve the sales. Inventory
should be maintained at a level, which balances production facilities and sale's needs.
Working Capital to Sales
Usually expressed in terms of percentage, it signifies that for any amount of sales a
relative amount of working capital is needed. If any increase in sales is contemplated
it has to be seen that working capital is adequate. Therefore, this ratio helps manage-
ment in maintaining working capital, which is adequate for the planned growth in
sales.
Working Capital to Net Worth Working Capital/Net wroth
This ratio shows the relationship between working capital and the funds belonging to
the owners. When this ratio is not carefully watched, it may lead to:
20 a) Overtrading when the conditions are in the upswing. Its symptoms being (i) High
Inventory Turnover Ratio (ii) Low Current Ratio; or
b) Under trading when the conditions of market are not good. Its major symptoms
are: Management of
Working Capital
i) Low Inventory Turnover Ratio
ii) High Current Ratio
Efficient working capital management should, therefore, avoid both excess and
deficit working capital situations.
Efficient working capital management demands proper management of its current

assets, as excess of these assets would not yield any returns. Cash and marketable
securities being least productive need to be managed even more carefully.
Cash denotes the liquidity of a business enterprise and plays an important role in
nurturing and improving the profitability of an organisation. It is, therefore, essential
to make a proper estimate of the cash need and plan for it so as to avoid technical or
legal insolvency. Hence, effective management of cash is necessary to ensure
adequate liquidity.
Activity 16.2
Meet any Accounting or Finance Executive of a business enterprise, whether in the
Public or the Private Sector, and talk to him regarding the management of working
capital in his enterprise. Please try to gather information on the following questions:
a) What methods does the enterprise employ for efficient management of working
capital?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
b) Do the methods under (a) above include Ratio Analysis? What ratios are being
computed and why?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
c) What steps the organisation has taken in the recent past to improve the
management of working capital?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
d) What are the major problems faced by the enterprise regarding management of
working capital?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
16.13 DETERMINING OPTIMAL CASH BALANCE

Holding of excessive cash is a non-profitable proposition, as idle cash does not earn
any income. Similarly shortage of cash may deprive the business unit of availing the
benefits of cash discounts, and of taking advantage of other favourable opportunities.
It may even lead to loss of credit-worthiness on account of default in paying liabilities
when the same become due. Hence, every organisation, irrespective of its size and
21
nature, has to determine the appropriate or optimum cash balance that it would need.
Financial Decisions nature has to determine the appropriate or optimum cash balance that it would need.
A firm's cash balance, generally, may not be constant over time. It would therefore be
worthwhile to investigate the maximum, minimum and average cash needs over a
designated time period.
You are aware that cash is needed for various transactions in the organisation.
Maintenance of a cash balance however has an opportunity cost in the following
ways:
a) Cash can be invested in acquiring assets such as Inventory, or for purchasing
securities. Opportunies for such investments may have to be lost if a certain
minimum cash balance is not held.
b) Holding of cash means that it cannot be used to offset financial risks from the
short-term debts.
c) Excessive reliance on internally generated liquidity can isolate the firm from
the short-term financial market.
Now the financial manager should understand the benefits and the opportunity costs
for holding cash. Thereafter, he must proceed to work out a model for determining
the optimal amount of cash. First of all a critical minimum cash balance should be
conceived below which the firm will incur definite and measurable costs. Apart from
risk aversion the existence of the minimum balance is justified by institutional
requirements such as credit ratings, checking accounts, lines of credit.
The violation of maintaining a minimum cash balance will create shortage costs
which will be determined by the actions of creditors on account of postponing their
payments or non-availing of cash discounts.
At any point of time a firm's (ending) cash balance can be represented as follows:
Ending balance = Beginning Balance + Receipts –Disbursements
If receipts and disbursements are equal for any unit of time, no problem is involved.
Ordinarily, however, receipts may be more than disbursements or vice versa. Hence,
the ending balance will keep on fluctuating. In actual practice receipts and disburse-
ments do vary, particularly in case of firms having seasonal activities.
Suppose, the receipts and disbursements are not synchronized but the variation is
predictable, then the main problem will be that of minimizing total costs. In case you
set the balance too low you will incur high transaction costs. If you set the balance
too high you will lose interest, which you can earn by investing cash in marketable
securities. The determination of optimal cash balance under these conditions of
known certainty is similar to the inventory problem: The costs of too little cash
(transaction costs) can be balanced against the costs of too much cash (opportunity
costs). Figure 16.4 clarifies this position.
Figure 16.4: The Optimal Working Cash Balance
22
Point C in Figure 16.4 denotes the point where the sum of two costs (opportunity.
and transaction costs) is minimum. Efficient management should try to locate this Management of
point for determining the optimal cash balance. M is the point where working cash Working Capital
balance is optimal.
It is seldom that receipts and disbursements are completely predictable. For a

moment let, us take one extreme case where receipts and disbursements are
completely random: A model can be developed using the Control Theory and fix
maximum and minimum optimal balances as illustrated in Figure 16.5
Figure 16.5 : Cash Balance Control Limits
You can observe from Figure 16.5 that the fluctuating cash balance is on account of
random receipts and disbursements. At time t the balance touches the upper control
point. At this point the excess of cash is invested in marketable securities. The
balance falls to zero point at time t2 and at this stage marketable securities have to be
sold to create cash balances. These two control points lay only the maximum and
minimum balance. We can conclude that where cash flows (receipts and
disbursements) are uncertain the principle will be: the greater the variability the
higher the minimum cash balance.
Activity 16.3
Meet any Accounting or Finance Executive of a business enterprise, whether in the

Public or the Private Sector, and talk to him regarding the management of working,
capital in his enterprise. Please try to gather information on the following questions:
i) What are the main groups of expenditure for which cash is needed in your
organisation:
(a) on daily basis
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........................................................................................................................
........................................................................................................................
(b) on monthly basis
........................................................................................................................
........................................................................................................................
........................................................................................................................
(c) at irregular intervals
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........................................................................................................................
Financial Decisions (d) at regular intervals, other than daily or monthly basis
........................................................................................................................
........................................................................................................................
........................................................................................................................
ii) What are the main sources of cash and what arrangements exist for collection,
accounting and banking of cash receipts?
........................................................................................................................
........................................................................................................................
........................................................................................................................
16.14 MANAGEMENT OF CASH FLOWS

The cash flows could be properly and effectively managed by:
Speeding up Collections
In order to minimise the size of cash holding, the time gap between sale of goods and
their cash collection should be reduced and the flow be controlled. Normally, certain
factors creating time lags are beyond the control of management. Yet, in order to
improve the efficiency, attention should be paid to the following.
All cash collected should be directly deposited in one account. If there are more than
one collection centres, all cash receipts should be remitted to the main account with.
top speed. Compared to a single collection centre, the aggregate requirement for cash
will be more when there are several centres. Concentration of collections at one place
will thus permit the firm to store its cash more efficiently.
The time lag between the dispatch of cheque by the customer and its credit to our
account with the bank should be reduced. Some firms with large collection transac-
tions introduce lock box system. In this system the post boxes are hired at different
centres where cash/cheques can be dropped in. The local banker can daily collect the
same from the lockers. The collecting bank is paid service charges. In order to
minimise time, banks may be asked to devise methods for speeding up the collection
of cash.
Recovering Dues
After sale of goods on credit, either on account of convention or for promoting sales,
receivables are created. It may however be useful to reduce the amount blocked in
receivables by seeing to it that they do not become overdue accounts. Incentive in the
form of discounts for early payment may be given. More important than anything
else is a constant follow-up action for the recovery of dues. This will improve
position of cash balance.
Controlling Disbursements
Needless to assert that speeding up of collections helps conversion of receivables into
cash and thus reduces the financing requirements of the firm. Similar kind of benefit
can be derived by delaying disbursements. Trade credit is a costless source of funds
for it allows us to pay the creditors only after the period of credit agreed upon. The
dues can be withheld till the last date. This will reduce the requirement for holding
large cash balance. Some firms may like to take advantage of cheque book float
which is the time gap between the date of issue of a cheque and the actual when it is
presented for payment directly or through the bank.
Investment of Idle Cash Balances
24 Two other important aspects in cash management are how to determine appropriate
cash balance and how to invest temporarily idle cash in interest earning assets or
securities. The first part relating to the theory of determining appropriate cash
balance has already been discussed earlier. Now we shall discuss the investment of Management of
idle cash balance on temporary basis. Working Capital
Cash by itself yields no income. If we know that some cash will be in excess of our
need for a short period of time, we must invest it for earning income without
depriving ourselves of the benefit of liquidity of funds. While doing this, we must
weigh the advantages of carrying extra cash (i.e. more than the normal requirement)
and the disadvantages of not carrying it. The carrying of extra cash may be
necessitated due to its requirement in future, whether predictable or unpredictable.
The experience indicates that cash flows cannot be predicted with complete accuracy.
Competition, technological changes, unexpected failure of products, strikes and
variations in economic conditions make it difficult to predict cash needs accurately.
Investment Criteria
When it is realised that the excess cash will remain idle, it should be invested in such
a way that it would generate income and at the same time ensure quick re-conversion
of investment in cash. While choosing the channels for investment of any idle cash
balance for a short period, it should be seen that (i) the investment is free from
default risk, that is, the risk involved due to the possibility of default in timely
payment of interest and repayment of principal amount; (ii) the investment shall
mature in short span of time; and (iii) the investment has adequate marketability.
Marketability refers to the ease with which an asset can be converted back into cash.
Marketability has two dimensions -price and time-which are inter-related. If an asset
can be sold quickly in large amounts at a price determinable in advance the asset will
be regarded as highly marketable and highly liquid. The assets which largely satisfy
the aforesaid criteria are: Government Securities, Bankers' Acceptances and
Commercial Paper.
Activity 16. 4
Discuss with the Chief Executive of Accounting and Finance department of your
organisation regarding the broad policies and procedures followed in the sphere of
cash management?
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.........................................................................................................................................
16.15 SUMMARY
An enterprise needs funds to operate profitably. The working capital of a business

reflects the short-term uses of funds. Apart from the investment in the long-term
assets such as buildings, plant and equipment, funds are also needed for meeting day
to day operating expenses and for amounts held in current assets. Within the time
span of one year there is a continuing cycle or turnover of these assets. Cash is used,
to acquire stock, which on being sold results in an inflow of cash, either immediately
or after a time lag in case the sales are on credit. The rate of turnover of current assets
in relation to total sales of a given time period is of critical importance to the total
funds employed in those assets.
The amount needed to be invested in current assets is affected by many factors and
may fluctuate over a period of time. Manufacturing cycle, production policies, credit
terms, growth and expansion needs, and inventory turnover are some of the important
factors influencing the determination of working capital.
25
Financial Decisions Inflation magnifies the need for working capital. The constant rise in the cost of
inputs, if not accompanied with corresponding increase in output prices puts an
additional strain on the management. However, by taking several measures on
production front and by keeping a strict watch on managed costs and expediting
collection of credit sales, etc. the management can contain or at least minimise the
upward thrusts for additional working capital.
The management should ensure the adequacy and efficiency in the utilisation of
working capital. For this purpose various ratios can be periodically computed and
compared against the norms established in this regard.
For efficient management of working capital, management of cash is as important as

the management of other items of current assets like receivables and inventories. Too
little cash may place the firm in an illiquid position, which may force the creditors
and other claimants to stop transacting with the firm. Too much cash results in funds
lying idle, thereby lowering the overall return on capital employed below the
acceptable level. An adequate amount of cash is always needed for meeting any
unforeseen contingencies and also liabilities as well as day-to-day operating expenses
of the business.
16.16 KEY WORDS

Operating Cycle in a manufacturing firm is the time gap between purchase of raw
material and sale of finished products.
Gross Current Assets means the aggregate of all current assets including cash.
Net Current Assets means the aggregate of all current assets (including cash) less
current liabilities. It is the same as working capital.
Fixed Working Capital is the amount that remains more or less permanently
invested as working capital in business.
Fluctuating Working Capital is the amount of working capital over and above the
fixed minimum amount of working capital. It may keep on fluctuating from period to
period depending upon several factors.
Inventory Turnover means number of times the average inventory has been sold
during a period. Inventory turnover ratio is obtained by dividing cost of goods sold
during a period with average inventory for the period.
Current Ratio is the relationship between current assets and current liabilities.
Quick Ratio is the relationship between quick assets and current liabilities. Inventory
is generally not reckoned among quick assets and hence excluded.
Debtors Turnover is the relationship between average debtors (receivables) and

average turnover.
Average Collection Period is the average period, which elapses between sale of
goods on credit and the collection of cash.
Average Payment Period is the period, which elapses on the average between
purchase of goods on credit and the payment to creditors.
Credit Policy is concerned with norms and guidelines for determining whether and
to what extent credit can be granted to customers in general and various categories of
customers in particular.
26
Credit Terms means the terms extended by a firm to its debtors for payment.
16.17 SELF-ASSESSMENT QUESTIONS/EXERCISES Management of
Working Capital
1. Discuss the concept of working capital. Are the gross and net concepts of
working capital exclusive? Explain.
2. Distinguish between fixed and fluctuating working capitals. What is the

significance of such distinction in financing working needs of an enterprise?
3. Discuss the significance of working capital management in a business

enterprise. What shall be the repercussions if a firm has (a) shortage of
working capital and (b) excess working capital?
4. A firm desires to finance its current assets entirely with short-term loans. Do
you think this pattern of financing would be in the interest of the firm ?
Support your answer with cogent arguments.
5. What factors a financial manager would ordinarily take into consideration

while estimating working capital needs of his firm?
6. What is an operating cycle and how a close study of the operating cycle is
helpful?
7. How would you as a Finance Manager control the need of increased working
capital on account of inflationary pressures? Narrate some real-life examples
you might have come across.
8. How would you judge the efficiency of the management of working capital
in a business enterprise? Explain with the help of hypothetical data.
9. What is optimum cash balances and how can it be arrived at?
10. If a firms estimates that it will have some idle cash balances from time to
time, what advice would you render to the firm?
11. "In managing cash the finance manager faces the problem of compromising
the conflicting goals of liquidity and profitability comment. What strategy
should the finance manager develops to solve this problem.
12. Assam Timber Ltd., a newly founded company, has applied fora short-term
loan to a commercial bank for financing its working capital requirement. You
are requested by the bank to prepare a statement on the requirement for
working capital for that company. You may add 10% to your estimated
figure to cover for unforeseen contingencies. The projected profit and loss
account of the company is as under:
Sales 25,00,000
Cost of goods sold 18,00,000
Gross Profit 7,00,000
Additional expenses 1,80,000
Selling expenses 1,50,000 3,30,000
Profit before tax 3,70,000
Provision for tax 1,20,000
Profit after tax 2,50,000
Cost of goods sold has been derived as follows:
Material sold 9,60,000
Wages & manufacturing expenses 7,40,000
Depreciation 3,00,000
20,00,000
Less Stock of finished goods
estimated at 10% of production 2,00,000
18,00,000 27
Financial Decisions The figures above relate to the goods that would be finished (or completed) and not
to work in process. Goods equal of 20% of the year's production in terms of physical
units are expected to be in progress on an average, requiring full materials but only
50 per cent of other expenses. The company intends to keep two months consumption
of material in stock.
All the expenses will be paid one month in arrears. Suppliers of material would
extend one-month credit. Sixty per cent of the sales are estimated on cash basis while
the rest are on two months credit. Seventy per cent of the income tax has to be paid in
advance in quarterly installments. The company will require Rs. 50,000 cash to meet
day-to-day needs of business. For the purpose of the question you may ignore profit
as a source of working capital.
Answer to Self-assessment Questions/Exercises

12 Total investment in
current assets 7,70,000
i) Less current liabilities:
Lag in payment of expenses 89,167
Creditors 80,000 1,69,167
6,00,833
Add 10% for contingencies 60,083
Total working capital required: 6,60,916
i) Depreciation is not a cash expense and hence it has been excluded from cost
of goods sold for the purpose of determining investment in debtors.
Similarly, depreciation has not been taken into account in determining
investment in work-in-process and stock of finished goods.
ii) For the purpose of determining investment in work-in-process, advertising

and selling expenses are not relevant. Hence, they have not to be taken into
account.
iii) For the purpose of this question profit is to be ignored as a source of working
capital. As such income tax has also been disregarded since income tax paid
out of profit.

Van Home, James C., 2002. Financial Management and Policy, Prentice-Hall of
India: New Delhi (Part V).
Khan M.Y., Jain P.K., 2002. Cost Accounting and Financial Management, Tata
McGraw Hill (Chapters 11-16).
Kulkarni, P.V., Sathya Prasad B.G., 1999. Financial Management, Himalaya
Publishing: Bombay.
Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing: Allahabad
(Chapter 9 & 10).
AUDIO/VIDEO PROGRAMMES
Video
• Working Capital Management 28
• Unique Enterprises: A Case Study
28
Capital Structure
UNIT 17 CAPITAL STRUCTURE
Objectives
The objectives of this unit are to:
• explain the importance of decisions regarding capital structure

• identify the factors that have bearing on determining the capital structure
• explain the concept of an appropriate capital structure
Structure
17.1 Introduction
17.2 What is Capital Structure ?
17.3 Features of an Appropriate Capital Structure
17.4 Determinants of Capital Structure
17.5 Summary
17.6 Key Words
17.1 INTRODUCTION
Finance is a important input for any type of business and is needed for working
capital and for permanent investment. The total funds employed in a business are
obtained from various sources. A part of the funds are brought in by the owners and
the rest is borrowed from others-individuals and institutions. While some of the funds
are permanently held in business, such as share capital and reserves (owned funds),
some others are held for a long period such as long-term borrowings or debentures,
and still some other funds are in the nature of short-term borrowings: The entire
composition of these funds constitute the overall financial structure of the firm. You
are aware that short-term funds keep on shifting quite often. As such the proportion
of various sources for short-term funds cannot perhaps be rigidly laid down. The firm
has to follow a flexible approach. A more definite policy is often laid down for the
composition of long-term funds, known as capital structure. More significant
aspects of the policy are the debt equity ratio and the dividend decision. The latter
affects the building up of retained earnings which is an important component of long-
term owned funds. Since the permanent or long-term funds often occupy a large
portion of total funds and involve long-term policy decision, the term financial
structure is often used to mean the capital structure of the firm.
There are certain sources of long-term funds which are generally available to the
corporate enterprises. The main sources are: share capital (owners' funds) and long-
term debt including debentures (creditors' funds). The profit earned from operations
are owners' funds-which may be retained in the business or distributed to the owners
(shareholders) as dividend. The portion of profits retained in the business is a rein-
vestment of owners' funds. Hence, it is also a source of long-term funds. All these
sources together are the main constituents of the capital of the business, that is, its
capital structure.
29
Financial Decisions
17.2 WHAT IS CAPITAL STRUCTURE?
The term `capital structure' represents the total long-term investment in a business
firm. It includes funds raised through ordinary and preference shares, bonds, deben-
tures, term loans from financial institutions, etc. Any earned revenue and capital '
surpluses are included.
Capital Structure Planning
Decision regarding what type of capital structure a company should have is of critical
importance because of its potential impact on profitability and solvency. The small
companies often do not plan their capital structure. The capital structure is allowed to
develop without any formal planning. These companies may do well in the short-run,
however, sooner or later they face considerable difficulties. The unplanned capital
structure does not permit an economical use of funds for the company. A company
should therefore plan its capital structure in such a way that it derives maximum
advantage out of it and is able to adjust more easily to the changing conditions.
Instead of following any scientific procedure to find an appropriate proportion of

different types of capital which will minimise the cost of capital and maximise the
market value, a company may just either follow what other comparable companies do
regarding capital structure or may consult some institutional lender and follow its
advice.
Theoretically, a company should plan an optimum capital structure in such a way that
the market value of its shares is maximum. The value will be maximised when the
marginal real cost of each source of funds is the same. In general, the discussion on
the issue of optimum capital structure is highly theoretical. The determination of an
optimum capital structure in practice is a formidable task, and we have to go beyond
the theory. That is why, perhaps, significant variations among industries and among'
different companies within the same industry regarding capital structure are found. A
number of factors influence the capital structure decision of a company. The judge-
ment of the person or group of persons making the capital structure decision plays a
crucial role. Two similar companies can have different capital structures if the
decision makers differ in their judgement about the significance of various factors.
These factors are highly psychological, complex and qualitative and do not always
follow the accepted theory. Capital markets are not perfect and the decision has to be
taken with imperfect knowledge and consequent risk. You might have become inter-
ested in identifying some of the important factors which influence the planning of the
capital structure in practice. However, before we discuss these factors let us examine
the features of an appropriate capital structure in the next section.
Activity 17.1
Look into the financial statement of one large company and one medium or small
sized company in the private sector and then arrange a meeting with their executives
in the department of Accounting and Finance. Investigate on the following lines:
a) What is the composition of the capital structure of the company? Why the
company has a particular capital structure and why not some other? Was any
capital structure planning done before the companies were set up?
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30
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b) Note the differences in the capital structures of the two companies and find Capital Structure
out the reasons for the differences.
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b) Are the capital structures of the two companies of their own making or have
they evolved on account of circumstances beyond their control?
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d) Do the companies regard their capital structures optimum? If not, what plans
do they have or propose to have to set the capital structure right?
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17.3 FEATURES OF AN APPROPRIATE CAPITAL

STRUCTURE
Capital structure is usually planned keeping in view the interests of the ordinary
shareholders. The ordinary shareholders are the ultimate owners of the company and
have the right to elect the directors. While developing an appropriate capital structure
for his company, the financial manager should aim at maximising the long-term
market price of equity shares. In practice, for most companies within an industry,
there would be a range of appropriate capital structures within which there are not
many differences in the market values of shares. A capital structure in this context
can be determined empirically. For example, a company may be in an industry that
has an average debt to total capital ratio of 60 per cent. It may be empirically found
that the shareholders in general do not mind the company operating within a 15 per
cent range of the industry's average capital structure. Thus, the appropriate capital
structure for the company ranges between 45 per cent to 75 per cent debt to total
capital ratio. The management of the company should try to seek the capital structure
near the top of this range in order to make maximum use of favourable leverage,
subject to other requirements such as flexibility, solvency, etc.
A sound appropriate capital structure should have the following features:
Profitability: The capital structure of the company should be most advantageous,

within the constraints. Maximum use of leverage at a minimum cost should be made.
Solvency: The use of excessive debt threatens the solvency of the company. Debt
should be used judiciously.
Flexibility: The capital structure should be flexible to meet the changing conditions.
It should be possible for a company to adapt its capital structure with minimum cost
and delay if warranted by a changed situation. It should also be possible for the
company to provide funds whenever needed to finance its profitable activities.
In other words, from the solvency point of view we need to approach capital structur-
ing with due conservation. The debt capacity of the company which depends on its
ability to generate future cash flows should not be exceeded. It should have enough
31
cash to pay periodic fixed charges to creditors and the principal sum on maturity.
Financial Decisions
The above are the general features of an appropriate capital structure. The particular
characteristics of a company may reflect some additional specific features. Further,
the emphasis given to each of these features may differ from company to company.
For example, a company may give more importance to flexibility than to retaining
the control which could be another desired feature, while another company may be
more concerned about solvency than about any other requirement. Furthermore, the
relative importance of these requirements may change with changing conditions.
17.4 DETERMINANTS OF CAPITAL STRUCTURE
Capital structure has to be determined at the time a company is promoted. The initial
capital structure should be designed very carefully. The management of the company
should set a target capital structure and the subsequent financing decisions should be
made with a view to achieve the target capital structure. Once a company has been
formed and it has been in existence for some years, the financial manager then has to
deal with the existing capital structure. The company may need funds to finance its
activities continuously. Every time the funds have to be procured, the financial
manager weighs the pros and cons of various sources of finance and selects most
advantageous sources keeping in view the target capital structure: Thus the capital
structure decision is a continuous one and has to be taken whenever a firm needs
additional finance.
Generally, the factors to be considered whenever a capital structure decision is taken

are: (i) Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Con-
trol, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation
costs. Let it’s briefly explain these factors.
Leverage or Trading on Equity
The use of sources of finance with a fixed cost, such as debt and preference share
capital, to finance the assets of the company is known as financial leverage or
trading on equity. If the assets financed by debt yield a return greater than the cost
of the debt, the earnings per share will increase without an increase in the owners'
investment. Similarly, the earnings per share will also increase if preference share
capital is used to acquire assets. But the leverage impact is felt more in case of debt
because (i) the cost of debt is usually lower than the cost of preference share capital,
and (i i) the interest paid on debt is a deductible charge from profits for calculating
the taxable income while dividend on preference shares is not.
Because of its effect on the earnings per share, financial leverage is one of the impor-
tant considerations in planning the capital structure of a company. The companies
with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable
use of the high degree of leverage to increase return on the shareholders' equity. One
common method of examining the impact of leverage is to analyse the relationship
between Earnings Per Share (BPS) at various possible levels of EBIT under alterna-
tive methods of financing. The EBIT-EPS analysis is one important tool in the hands
of the financial manager to get an insight into the firm's capital structure
management. He can consider the possible fluctuations in EBIT and examine their
impact on EPS under different financing plans.
You may refer to the section Èffects of Financial Leverage' in Unit 13 (Leverage
Analysis), particularly Table 13.3 for a recapitulation of the effects of financial,
leverage on earnings per share (EPS) under various financing plans with different
mix of equity and fixed return securities, For your facility, we reiterate the
demonstration of the effect of financial leverage on EPS by considering three
alternative financing plans in Illustration 17.1.
32
Illustration 17.1 Capital Structure
Plan A : No debt, all equity shares
Plan B : 50% debt (10%), 30% preference shares (12%), 20% equity shares
Plan C : 80% debt (10%), 20% equity shares
The face value of equity Shares is Rs. 10. The Rates in parentheses indicate the fixed
return on debt and preference shares.
The total amount of capital required to be raised is Rs. 2,00,000. The company
estimates its earnings before interest and taxes (EBIT) at Rs. 50,000 annually.
Table 17.1
Effect of Financial Leverage on EPS
(in Rs.)
Financing Plan
A B C
Earnings before interest and taxes 50,000 50,000 50,000
Interest - 10,000 16,000
Earnings before taxes 50,000 40,000 34,000
Income Tax (50%) 25,000 20,000 17,000
Earnings after taxes 25,000 20,000 17,000
Preference share dividend - 7,200 -
Earnings available on equity shares 25,000 12,800 17,000
No. of shares 20,000 4,000 4,000
Earnings per share (EPS) 1.25 3.20 4.25
The effect of financial leverage (trading on equity) is presented in Table 17.1. It will
be seen that Plan C is the most attractive from shareholders' point of view as the EPS
of Rs. 4.25 is the highest under this plan. The lowest EPS is when the company does
not use any debt or fixed return securities. You will note that the proportion of fixed
return, securities under plans B and C is the same (80%). However, plan C gives a
higher EPS for the reason that dividend on preference share is not deductible for
income tax purposes while interest is a deductible charge. Assuming that the esti-
mates about EBIT turn out to be correct, the shareholders would be benefited to the
maximum if plan C is adopted. The shares of the company will command a high
premium in the market and would be greatly in demand. The managements of
companies sometimes intentionally want to make their equity shares very attractive
and prized possessions. This they can achieve by the practice of trading on equity.
The secret of the advantage in financial leverage lies in the fact that whereas the
overall return (before tax) on capital employed is 25% the return on preference share
and debt is only 12% and 10% respectively. The savings resulting from this
difference enable the management to enhance the return on equity shares.
Although leverage increases EPS under favourable conditions, it can also increase
financial risk to the shareholders. Financial risk increases with the use of debt be-
cause of (a) the increased variability in the shareholder's earnings and (b) the threat of
insolvency. A firm can avoid financial risk altogether if it does not employ any debt
in its capital structure. But when no debt is employed in the capital structure, the
shareholders will be deprived of the benefit of increases in EPS arising from financial
leverage. 33
Financial Decisions
Therefore a firm should employ debt to the extent the financial risk perceived by the
shareholders does not exceed the benefit of increased EPS.
Cost of Capital
Measuring the costs of various sources of funds is a complex subject and needs a
separate treatment. Needless to say that it is desirable to minimise the cost of capital.
Hence, cheaper sources should be preferred, other things remaining the same.
The cost of a source of finance is the minimum return expected by its suppliers. The
expected return depends on the degree of risk assumed by investors. A high degree of
risk is assumed by shareholders than debt-holders. In the case of debt-holders, the
rate of interest is fixed and the company is legally bound to pay interest, whether it
makes profits or not. For shareholders the rate of dividend is not fixed and the Board
of Directors has no legal obligation to pay dividends even if the profits have been
made by the company. The loan of debt-holders is returned within a prescribed
period, while shareholders can get back their capital only when the company is
wound up. This leads one to conclude that debt is a cheaper source of funds than
equity. The tax deductibility of interest charges further reduces the cost of debt. The
preference share capital is cheaper than equity capital, but is not as cheap as debt is.
Thus, in order to minimise the overall cost of capital, a company should employ a
large amount of debt.
However, it should be realised that a company cannot go on minimising its overall

cost of capital by employing debt. A point is reached beyond which debt becomes
more expensive because of the increased risk of excessive debt to creditors as well as
to shareholders. When the degree of leverage increases, the risk to creditors also
increases. They may demand a higher interest rate and may not further provide loan
to the company at all once the debt has reached a particular level. Furthermore, the
excessive amount of debt makes the shareholders' position very risky. This has the
effect of increasing the cost of equity. Thus, upto a point the overall cost of capital
decreases with debt, but beyond that point the cost of capital would start increasing
and, therefore, it would not be advantageous to employ debt further. So there is a
combination of debt and equity, which minimises that firm's average cost of capital
and maximises the market value per share.
The cost of equity includes the cost of new issue of shares and the cost of retained
earnings. The cost of debt is cheaper than the cost of both these sources of equity
funds. Between the cost of new issues and retained earnings, the latter is cheaper.
The cost of retained earnings is less than the cost of new issues because the company
does not have to pay personal taxes which have to be paid by shareholders on distrib-
uted earnings, and also because, unlike new issues, no floatation costs are incurred if
the earnings are retained. As a result, between these two sources, retained earnings
are preferable.
Thus, when we consider the leverage and the cost of capital factors, it appears
reason-able that a firm should employ a large amount of debt provided its earnings do
not fluctuate very Widely. In fact, debt can be used to the point where the average
cost of capital is minimum. These two factors taken together set the maximum limit
to the use of debt. However, other factors should also be evaluated to determine the
appropriate capital structure for a company.
Theoretically, a company should have such a mix of debt and equity that its overall
cost of capital is minimum. Let us understand this concept by taking an Illustration.
34
Illustration 17.2 Capital Structure
A company is considering a most desirable capital structure. The cost of debt (after
tax) and of equity capital at various levels of debt equity mix are estimated as
follows:
Debt as percentage of Cost of debt Cost of equity
total capital employed (%) (%)
0 10 15
20 10 15
40 12 16
50 13 18
60 14 20
Determine the optimal mix of debt and equity for the company by calculating
composite cost of capital?
For determining the optimal debt equity mix, we have to calculate the composite cost
of capital i.e. Ko which is equal to Kip1+Kep2
Where Ki = Cost of debt
pl = Relative proportion of debt in the total capital of the firm
Ke = Cost of equity
p2 = Relative proportion of equity in the total capital of the firm
Before we arrive at any conclusion, it would be desirable to prepare a table showing
all necessary information and calculations.
Table 17.2
Cost of Capital Calculations
Ki % Ke % pl p2 Kip1+kep2= Ko
10 15 0.0 1.00 0+15.0=15

10 15 0.2 0.8 2.0+12.0=14
12 16 0.4 0.6 4.8+9.6=14.4
13 18 0.6 0.5 7.8+9.0=16.8
14 20 0.6 0.4 8.4+8.0=16.4
The optimal debt equity mix for the company is at a point where the composite cost
of capital is minimum. From Table 17.2 it is evident that a mix of 20% debt and 80%
equity gives the minimum composite cost of capital of 14%. Any other mix of debt
and equity gives a higher overall cost of capital. The closest to the minimum cost of
capital is a mix of 40% debt and 60% equity where Ko is 14.4%. It can therefore be
concluded that a mix of 20% debt and 80%,equity will make the capital structure
optimal.
Cash Flow
One of the features of a sound capital structure is conservation. Conservation does

not mean employing no debt or a small amount of debt. Conservatism is related to the
assessment of the liability for fixed, charges, created by the use of debt or preference
capital in the capital structure in the context of the firm's ability to generate cash to
meet these fixed charges.
The fixed charges of a company include payment of interest, preference dividend and
principal. The amount of fixed charges will be high if the company employs a large
amount of debt or preference capital. Whenever a company thinks of raising addi-
tional debt, it should analyse its expected future cash flows to meet the fixed charges. 35
It is obligatory to pay interest and return the principal amount of debt. If a company
Financial Decisions
is not able to generate enough cash to meet its fixed obligations, it may have to face
financial insolvency. The companies which expect large and stable cash inflows can
employ a large amount of debt in their capital structure. It is somewhat risky to
employ sources of capital with fixed charges for companies whose cash inflows are
unstable or unpredictable.
Control
In designing the capital structure, sometimes the existing management is governed by

its desire to continue control over the company. The existing management team may
not only what to be elected to the Board of Directors but may also desire to manage
the company without any outside interference.
The ordinary shareholders have the legal right to elect the directors of the company.
If the company issues new shares, there is a risk of loss of control. This is not a very
important consideration in case of a widely held company. The shares of such a
company are widely scattered. Most of the shareholders are not interested in taking
active part in the company's management. They do not have the time and urge to
attend the meetings. They are simply interested in dividends and appreciation in the
price of shares. The risk of loss of control can almost be avoided by distributing
shares widely and in small lots.
Maintaining control however could be a significant question in the case of a closely

held company. A shareholder or a group of shareholders could purchase all or most
of the new shares and thus control the company. Fear of having to share control and
thus being interfered by others often delays the decision of the closely held
companies to go public. To avoid the risk of loss of control the companies may issue
preference shares or raise debt capital.
Since holders of debt do not have voting right, it is often suggested that a company
should use debt to avoid the loss of control. However, when a company uses large
amounts of debt, lot of restrictions are imposed on it by the debt-holders to protect
their interests. These restrictions curtail the freedom of the management to run the
business. An excessive amount of debt may also cause bankruptcy, which means a
complete loss of control.
Flexibility
Flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions. The capital structure of a firm is flexible if it has no difficulty in
changing its capitalisation or sources of funds. Whenever needed the company should
be able to raise funds without undue delay and cost to finance the profitable invest-
ments. The company should also be in a position to redeem its preference capital or
debt whenever warranted by future conditions. The financial plan of the company
should be flexible enough to change the composition of the capital structure. It
should keep itself in a position to substitute one form of financing for another to
economise on the use of funds.
Size of the Company
The size of a company greatly influences the availability of funds from different
sources. A small company may often find it difficult to raise long-term loans. If
somehow it manages to obtain a long-term loan, it is available at a high rate of
interest and on inconvenient terms. The highly restrictive covenants in loans
agreements of small companies make their capital structure quite inflexible. The
36 management thus cannot run business freely. Small companies, therefore, have to
depend on owned capital and retained earnings for their long-term funds.
A large company has a greater degree of flexibility in designing its capital structure. Capital Structure
It can obtain loans at easy terms and can also issue ordinary shares, preference shares
and debentures to the public. A company should make the best use of its size in
planning the capital structure.
Marketability
Marketability here means the ability of the company to sell or market particular type
of security in a particular period of time which in turn depends upon -the readiness of
the investors to buy that security. Marketability may not influence the initial capital
structure very much but it is an important consideration in deciding the appropriate
timing of security issues. At one time, the market favours debenture issues and at
another time, it may readily accept ordinary share issues. Due to the changing market
sentiments, the company has to decide whether to raise funds through common
shares or debt.
If the share market is depressed, the company should not issue ordinary shares but
issue debt and wait to issue ordinary shares till the share market revives. During
boom period in the share market, it may not be possible for the company to issue
debentures successfully. Therefore, it should keep its debt capacity unutilised and
issue ordinary4shares to raise finances.
Floatation Costs
Floatation costs are incurred when the funds are raised. Generally, the cost of floating
a debt is less than the cost of floating an equity issue. This may encourage a company
to use debt rather than issue ordinary shares. If the owner's capital is increased by
retaining the earnings, no floatation costs are incurred. Floatation cost generally is
not a very important factor influencing the capital structure of a company except in
the case of small companies.
Activity 17.2
You have just read about several factors that affect the determination of capital
structure in a company. In this context, meet the finance manager of a large company
and ascertain which of these factors had bearing on their capital structure and to what
extent.
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Financial Decisions
17.5 SUMMARY
Capital structure is the composition of various sources of long-term finance in the
total capitalisation of the company. The two main sources are ownership and creditor
ship securities. Both types of securities as well as the long-term loans from financial
institutions are used by most of the large industrial companies.
Capital structure planning, initially and on continuing basis, is of great importance to

any company as it has a considerable bearing on its profitability. A wrong initial
decision in this respect may prove quite costly for the company.
While taking a decision about capital structure, due attention should be paid-to
objectives like profitability, solvency and flexibility. The choice of the amount of
debt and other fixed return securities on the one hand and variable income securities,
namely equity shares on the other, is made after a comparison of the characteristics
of each kind of securities and after careful consideration of internal and external
factors related to the firm's operations. In real life situations compromises have to be
made somewhere on the line between the expectations of companies seeking funds
and the expectations of those that supply them. These compromises do not change the
basic distinctions between debt and equity. Generally, the decision about financing is
not of choosing between equity and debt but is of selecting the ideal combination of
the two. The decision on debt-equity mix is affected by considerations of suitability,
risk, income, control and timing. The weights assigned to these factors will vary from
company to company depending on the characteristics of the industry and the particu-
lar situation of the company. There cannot perhaps be an exact mathematical solution
to the decision on capital structuring. Human judgement plays an important role in
analysing the conflicting forces before a decision on appropriate capital structure is
reached.
17.6 KEY WORDS

Capital Structure (also known as Financial Structure) is the mix of various types of
long-term sources of funds, namely debentures, bonds, loans from financial institu-
tions, preference shares and equity shares (including retained earnings).
Cost of Capital is the (weighted) average cost of various sources of finance used by
a company.
Financial Leverage (or Trading on Equity) is an aspect of financial planning which

enables the company to enhance the return on equity shares by using debt with lower
fixed cost which is less than the overall return on investment. Financial leverage
magnifies the effect of changes in EBIT (Earnings Before Interest and Taxes) on EPS
(Earnings Per Share).

1) What is capital structure? Explain the importance of capital Structure and
planning?
2) What are the features of an appropriate capital structure?
3) What are the determinants of capital structure? Explain briefly.
4) Do you think that different factors affecting capital structure decision will be
viewed differently by different companies? Support your answer with
suitable examples.
38 5) Make a comparative assessment of different types of securities from the

point of view of capital structuring. Under what conditions different types of
securities would be considered more suitable?
6) Write notes on the following: Capital Structure
a) Trading on equity
b) Cost of capital
c) Flexibility in capital structure
d) Closely held company
7) A company wishes to determine the optimal capital structure from the

following information. Determine the optimum capital structure from the
viewpoint of minimising the cost of capital.
Financing Debt Equity After tax Cost
Plan Amount Amount Cost of equity
debt Ki% Ke%
A 8,00,000 2,00,000 14 20
B 6,00,000 4,00,000 13 18
C 5,00,000 5,00,000 12 16
D 2,00,000 8,00,000 11 18

Khan M.Y. and Jain P.K. 2002. Cost Accounting and Financial Management, Tata
McGraw Hill (Part-4).
Kulkarni,.P.V. Sathya B.G. 1999. Financial Management, (nineth revised edition),

Himalaya Publishing : Bombay.
Gitman, L.J.1985. Principles of Managerial Finance, Harper & Row : New York
(Chapters 12 and 13).
James C., Van Horne and John M. Wachowicz 1985. Fundamentals of Financial
Management, Prentice-Hall of India : New Delhi (Chapter 17).
39
Financial Decisions
UNIT 18 DIVIDEND DECISIONS
Objectives
The objectives of this unit are:
• to acquaint you with the meaning, types and purpose of dividend
• to highlight the various factors which influence the determination of dividend policy
Structure
18.1 Introduction
18.2 Forms of Dividend
18.3 Dividend Policy
18.4 Role of Financial Manager
18.5 Role of Board of Directors
18.6 Factors Affecting Dividend Decision
18.7 Summary
18.8 Key words
18.1 INTRODUCTION
A business organisation always aims at earning profits. The utilisation of profits earned
is a significant financial decision. The main issue here is whether the profits should be
used by the owner(s) or retained and reinvested in the business itself. This decision
does not involve any problem is so far as the sole proprietory business is concerned. In
case of a partnership the agreement often provides for the basis of distribution of profits
among partners. The decision-making is somewhat complex in the case of joint stock
companies.
Since company is an artificial person, the decision regarding utilisation of profits rests
with a group of people, namely the board of directors. As in any other types of
organisation, the disposal of net earnings of a company involves either their retention
in the business or their distribution to the owners (i.e., shareholders) in the form of
dividend, or both. Yet the decision regarding distribution of disposable earnings to the
shareholders is a significant one. The decision may mean a higher income, lower
income or no income at all to the shareholders. Besides affecting the mood of the
present shareholders, dividend may also influence the mood, behaviour and responses
of prospective investors, stock exchanges and financial institutions because of its
relationship with the worth of the company, which in turn affects the market value of
its shares. The decision regarding dividend is taken by the Board of Directors and is
then recommended to the shareholders for their formal approval in the annual general
meeting of the company. Disposal of profits in the form of dividends can become a
controversial-issue because of conflicting interests of various parties like the directors,
employees, shareholders, debenture holders, lending institutions, etc. Even among the
shareholders there may be conflicts as they may belong to different income groups.
While some may be interested in regular income, others may be interested in capital
appreciation and capital gains. Hence, formulation of dividend policy is a complex
decision. It needs careful consideration of various factors. One thing, however, stands
out. Instead of an ad hoc approach, it is more desirable to follow a reasonably long-
40 term policy regarding dividends.
Dividends Decisions
18.2 FORMS OF DIVIDEND
Dividend ordinarily is a distribution of profits earned by a joint stock company among
its shareholders. Mostly dividends are paid in cash, but there are also other forms
such as Scrip dividends, Debenture dividends, Stock dividends, and, in unusual
circumstances, Property dividends. These are briefly described below:
Scrip Dividends
Dividends can be paid only out of profits earned in the particular year or in the past
reflected in the company's accumulated reserves. Profits do not necessarily mean-
adequate cash to enable payment of cash dividends: In case the company does not
have a comfortable cash position it may issue promissory notes payable in a few
months. It may also issue convertible dividend warrants redeemable in a few years.
Debenture Dividends
Companies may also issue debentures in lieu of dividends to their shareholders. These
debentures bear interest and are payable after a prescribed period. It is just like
creating a long-term debt. Such a practice is not common.
Bonus Shares or Stock Dividends
Instead of paying dividends out of accumulated reserves, the latter may be capitalized
by issue of bonus shares to the shareholders. Thus, while the funds continue to
remain with the company; the shareholders acquire the right and this way their
market-able equity increases. They can either retain their bonus shares and thus be
entitled to increased total dividend or can sell their bonus shares and realise cash.
Ordinarily, bonus shares are not issued in lieu of dividends. They are periodically
issued by prosperous companies in addition to usual dividends, Certain guidelines, as
laid down by the government, are applicable for issue of bonus shares in India.
Property Dividends
This form of dividend is unusual. Such dividend may be in the form of inventory or
securities in lieu of cash payment. A company sometimes may hold shares of other
companies, e.g., its subsidiaries that it may like to distribute among its own
shareholders, instead of paying dividend in cash. In case the company sells these shares
it may have to pay capital gains, which may be subject to taxation. If these shares are
transferred to its shareholders, there is no tax liability.
18.3 DIVIDEND POLICY

The objective of corporate management usually is the maximisation of the market
value of the enterprise i.e., its wealth. The market value of common stock of a
company is influenced by its policy regarding allocation of net earnings into `plough
back' and `payout'. While maximising the market value of shares, the dividend policy
should be so oriented as to satisfy the interests of the existing shareholders as well as to
attract the potential investors. Thus, the aim should be to maximise the present value
of future dividends and the appreciation in the market price of shares.
Policy Options
Dividend policy refers to the policy that the management formulates in regard to
earnings for distribution as dividend among shareholders. It is not merely concerned
with dividends to be paid in one year, but is concerned with the continuous course of
action to be followed over a period of several years. Dividend decision involves
dealing with several questions, such as: 41
Financial Decisions • Whether dividend should be paid right from the initial year of operation i.e., regular
dividends.
• Whether equal amount or a fixed percentage of dividend be paid every year,

irrespective of the quantum of earnings as i n case of preference shares, i.e.
stable, dividends.
• Whether a fixed percentage of total earnings be paid as dividend which would

mean varying amount of dividend per share every year, depending on the quantum
of earnings and number of ordinary shares in that year, i.e., a fixed payout ratio.
• Whether the dividend be paid in cash or in the form of shares of other companies held
by it or by converting (accumulated) retained earnings into bonus shares, i.e.,
property dividend or bonus share dividend.
Dividend Policy Goals
There are several factors, which influence the determination of the dividend policy. As
such no two companies may follow exactly similar dividend policies. The dividend
policy has to be tailored to the particular circumstances of the company. However, the
following aspects have general applicability:
• Dividend policy should be analysed in terms of its effect on the value of the company.
• Investment by the company in new profitable opportunities creates value and when
a company foregoes an attractive investment, shareholders incur an opportunity
loss.
• Dividend, investment and financing decisions are interdependent and there is often a
trade off.
• Dividend decision should not be treated as a short run residual decision because '
variability of annual earnings may cause even a zero dividend in a particular year.
This m a y have serious repercussions for the company and m a y result in the
delisting of its share for the purpose of dealings on any approved stock exchange.
• A workable compromise is to treat dividends as a long-run residual to avoid

undesirable variations in payout. This needs financial planning over a fairly long
time horizon.
• Whatever dividend policy is adopted by the company, the general principles

guiding the dividend policy should, as far as possible, be communicated clearly to
investors who may then take their decisions in terms of their own preferences and
needs.
• Erratic and frequent changes in dividends should be avoided. Reduction in the rate
of dividend is a painful thing for the shareholders to bear. The management will
find it hard to convince the shareholders of the desirability of a lower dividend for
the sake of preserving their future interests.
18.4 ROLE OF FINANCIAL MANAGER

The disposal of the earnings-retention in business or distribution among shareholders -
is an issue of fundamental importance in financial management. The financial manager
plays an important role in advising the management i.e., Board of Directors regarding
42 the decision. It is the latter's privilege to take the decision. The retention of profits in
business helps the company in mobilising funds for expansion. Economist's, however,
believe that the entire earnings of a business should be paid to its owners
who should then decide where to reinvest them. That all of them may decide to reinvest Dividends Decisions
the distributed earnings in the same company is another thing.
In case the company has more favourable reinvestment opportunities within it as

compared to those offered outside, it would be more profitable for the company to
retain earnings than to pay them out as dividends. The shareholders can later be
compensated by issue of bonus shares. Let us illustrate this point by taking an
example. Suppose the net profit after taxes of a company is Rs. 1 lakh and is totally
distributed as dividend to shareholders. The relevant figures would then appear as
follows:
1 Amount of dividend to shareholders Rs. 1,00,000
2 Less income-tax (say at 40%) on personal income Rs. 40,000
3 Net amount available to shareholders for reinvestment (1 minus 2) Rs. 60,000
4 Less reinvestment cost say at 10% Rs. 6,000
Rs. 54,000
It is clear from the above example that if dividends are not paid, Rs. 1 lakh of income
is available to the company for reinvestment in business. In case dividends are paid,
it is likely that not more than Rs. 54,000 would be available for reinvestment (in the
same or any other business), assuming that the stockholders are willing to reinvest
their entire dividend income. If better outside investment opportunities are available
to the shareholders, depending upon the environment prevalent in the capital market,
they may not appreciate the recommendation (or action) of the Board of Directors for
retention of larger amounts in the business, as they might perceive it to their
detriment. As such they would be interested in receiving larger dividends. The
dividend policy, particularly the timing of the declaration of dividend, influences the
market value of a company's shares. The financial manager, therefore, should be well
informed about the capital market trends and the tax policies of the government,
besides the rationale behind the, investment programme of the company.
18.5 ROLE OF THE BOARD OF DIRECTORS

The Board of Directors has the power to determine whether and at what rate dividend
shall he paid to the shareholders. The payment of dividend is not obligatory. Even a
majority of shareholders have no right to interfere with the authority of the Board. So
long as the Board acts in good faith, acts on the basis of a reasonable policy, and it
does not flagrantly abuse its fiduciary responsibility, its decision cannot be
challenged and there is no way to force a dividend by direct legal action.
However, there are some restrictions, dictated by law or prudence, on the discretion
of the Board of Directors which are as follows.
i) Dividends may be declared out of any unappropriated surplus.
ii) If there is a loss, it should be absorbed first before dividends can be declared.
iii) Dividend declarations which impair the capital strength of a corporation must
be discouraged.
iv) Dividend declarations which might lead to insolvency should be discouraged.
v) A due provision for depreciation, depletion, etc. should be made prior to

dividend declaration.
vi) Directors can be sued by shareholders, if-they have declared any unlawful
dividends or have grossly neglected their interests.
vii) The rights of creditors should be taken care of while taking a decision on 43
dividend.
Financial Decisions The corporate management is an elective management. The power of recommending a
dividend is delegated by the shareholders to the Board of Directors. The Board declares
a dividend in its duly convened meeting by a resolution which sets forth the rate of
dividend, the class of stockholders to whom dividend is payable, and the date and
mode of dividend payment.
At times the interest of the shareholders may come into conflict with those of the
company. The Board is expected to act judiciously in taking decision on dividends.
The decision has two dimensions. First, the corporate management must satisfy the
shareholders by offering them a fair return on their investment by way of dividends.
Second, the management has a commitment to ensure the financial stability of the
corporation by withholding dividends (i.e. by not declaring dividends), if it feels this
course is necessary in order to enable the company to stand on a firm ground.
The dividend decision thus is a difficult one because of conflicting objectives and also
because of lack of specific decision-making techniques. It is not easy to lay down an
optimum dividend policy, which would maximise the long-run wealth of the
shareholders. However, there is no gain saying that dividend decision involves sound
judgement.
There are certain factors that impinge upon the dividend decision and, therefore, should
be taken into consideration while deciding a policy in this respect.
18.6 FACTORS AFFECTING DIVIDEND DECISION

It is possible to group the factors affecting dividend policy into two broad categories:
• Ownership considerations
• Firm-oriented considerations
Ownership Considerations: Where ownership is concentrated in few people, there are

no problems in identifying ownership interests. However, where ownership is
decentralised on a wide spectrum the identification of their interests becomes difficult.
Further; the influence of stockholders' interests on dividend decision becomes uncer-
tain because: (a) the status or preferences of stockholders relating to their position,
capital gains, current income, etc. cannot be precisely ascertained; (b) a conflict in
shareholders' interests may arise. In spite of these difficulties, efforts should be made to
ascertain the following interests of shareholders to encourage market acceptance of the
stock:
• Current income requirements of stockholders
• Alternative uses of funds in the hands of stockholders
• Tax matters affecting stockholders
Since various groups of shareholders may have different desires and objectives,
understandably, investors gravitate to those companies that combine the mix of growth
and desired dividends. Since companies generally do not have a singular group of
shareholders, the objective of the maximisation of the market value of shares requires
that the dividend policy be geared to investors in general.
Firm-oriented Considerations: Ownership interests alone may not determine the

dividend policy. A firm's needs are also an important consideration which include the
following:
44 a) Contractual and legal restrictions
b) Liquidity, credit-standing and working capital

c) Needs of funds for immediate or future expansion Dividends Decisions
d) Availability of external capital

e) Risk of losing control of organisation
f) Relative cost of external funds
g) Business cycles
h) Post dividend policies and stockholder relationships.
The following factors affect the shaping of a dividend policy.
Nature of Business
This is an important determinant of the dividend policy of a company. Companies

with unstable earnings adopt dividend policies, which are different from those which
have steady earnings. Consumer goods industries usually suffer less from uncertain-
ties of income and, therefore, pay dividends with greater regularity than the capital
goods industries. Industries with stable income are in a position to formulate consis-
tent dividend policies. Thus, public utilities may be able to establish a relatively fixed
dividend rate. Mining companies, on the other hand, with long gestation period and
multiplicity of hazards, may not be able to declare dividends for years. But once they
get established, they might afford to make liberal dividend payments. If earnings
fluctuate and losses are caused during depression, the continued payment of dividends
may become a risky proposition.
A company with `wasting' assets-such as timber, oil or mines-which get depleted

over time may well pursue a policy of gradually returning capital to its owners
because its resources are going to be exhausted. Such a company may offer
dividends, which include, in part, a. return of the owner's investment.
Generally speaking, large and mature companies pay a reasonably good but not a
excessive rate of dividend. Excessive dividends may be paid only by `mushroom'
companies. A healthy company with an eye on future, follows a somewhat cautious
policy and build up reserves. A company which believes in publicity gimmicks may
follow a more liberal dividend policy to its future detriment. A firm with a heavy
programme of investment in research and development would see to it that adequate
reserves are built up for the purpose.
Attitude and Objectives of Management
While some organisations may be niggardly in dividend payments, some others may be
liberal. A large number of firms may be found within these two extremes.
Niggardly organisations prefer to conserve cash. Though such an approach may

easily meet their future needs for funds, it deprives the stockholders of a legitimate
return on their investment. Liberal organisations, on the other hand, feel that
stockholders are entitled to an established rate of dividend as long as their financial
condition is reasonably sound. Within these two extremes, a number of corporations
adopt several variations.
The attitude of the management affects the dividend policies of a corporation in

another way. The stockholders who control the management of the company may be
interested in èmpire-building'. They may consider ploughing back of earnings as the
most effective technique for achieving their objectives of building up the corporation
is perhaps the largest in the field.
Composition of Shareholding
There may be marked variations in dividend policies on account of the variations in

the composition of the shareholding. In the case of a closely held company, the 45
personal objectives of the directors and of a majority of shareholders may govern the
Financial Decisions decision. Widely held companies have scattered shareholders. Such companies may
take the dividend decision with a greater sense of responsibility by adopting a more
formal and scientific approach.
The tax burden on business corporations is a determining factor in formulation of

their dividend policies. The directors of a closely held company may take into
consideration the effect of dividends upon the tax position of their important
shareholders. Those in the high-income brackets may be willing to sacrifice
additional income in the form of dividends in favour of appreciation in the value of
shares and capital gains. However, when the stock is widely held, stockholders are
enthusiastic about collecting their dividends regularly, and do not attach much
importance to tax considerations.
Thus a company, which is closely held by a few shareholders in the high income-tax
brackets, is likely to payout a relatively low dividend. The shareholders in such a
company are interested in taking their income in the form of capital gains rather than in
the form of dividends, which are subject to higher personal income taxes. On the
other hand, the shareholders of a large and widely held company may be interested in
high dividend payout.
Investment Opportunities
Many companies retain the earnings to facilitate planned expansion. Companies with
low credit ratings may feel that they may not be able to sell their securities for raising
necessary finance they would need for future expansion. So, they may adopt a policy
for retaining larger portion of earnings.
In the context of opportunities for expansion and growth, it is wise to adopt a conser-
vative dividend policy if the cost of capital involved in external financing is greater
than the cost of internally generated funds.
Similarly, if a company has lucrative opportunities for investing its funds and can
earn a rate, which is higher than its cost of capital, it may adopt a conservative
dividend policy.
Desire for Financial Solvency and Liquidity
Companies may desire to build up reserves by retaining their earnings, which would
enable them to weather deficit years or the downswings of a business cycle. They
may, therefore, consider it necessary to conserve their cash resources to face future
emergencies. Cash credit limits, working capital needs, capital expenditure commit-
ments, repayment of long-term debt, etc. influence the dividend decision. Companies
sometimes prune dividends when their liquidity declines.
Regularity
A company may decide about dividends on the basis of its current earnings which
according to its thinking may provide the best index of what a company can pay, even
though large variations in earnings and consequently in dividends may be observed
from year to year. Other companies may consider regularity in payment of dividends
as more important than anything else. They may use past profits to pay dividends
regularly, irrespective of whether they have enough current profits or not. The past
record of a company in payment of dividends regularly builds up the morale of the
stockholders wh o may adopt a helpful attitude towards it in periods of emergency or
financial crisis. Regularity i n dividends cultivates an investment attitude rather than
speculative one towards the shares of the company.
Restrictions by Financial Institutions

46
Sometimes financial institutions which grant long-term loans to corporations put a
clause restricting dividend payment till the loan or a substantial part of it is repaid.
Inflation Dividends Decisions
Inflation is also a factor, which may affect a firm's dividend decision. In period of
inflation, funds generated from depreciation may not be adequate to replace worn out
equipment. Under these circumstances, the firm has to depend upon retained earnings
as a source of funds to make up for the shortfall. This is of particular relevance if the
'assets have to be replaced in near future. Consequently, the dividend payout
ratio will tend to be low.
On account of inflation often the profits of most of the companies are inflated. A
higher payout ratio based on overstated profits may eventually lead to the
liquidation of the company. You are aware that inflation has become an integral part
of the present financial climate: While shareholders may delight in immediate
income, they will feel sorry lithe company has to suffer in a few years on account of
not retaining sufficient earnings to support future growth or not being able to
maintain its position in the market place.
Inflation has another dimension. In an inflationary situation, current income

becomes more important and shareholders in general attach more value to
current yield than to distant capital appreciation. They would thus expect a
higher payout ratio.
Other Factors
Age of the company has some effect on the dividend decision. Established
companies often find it easier to distribute higher earnings without causing an
adverse effect on the financial position of the company than a comparatively
younger corporation which has yet to establish itself.
The demand for capital expenditure, money supply, etc. undergo great
oscillations during the different stages of a business cycle. As a result,
dividend policies may fluctuate from time to time.
In many instances, dividend policies result from tradition, ignorance and

indifference rather than from considered judgement. An industry or a company
may have established some `satisfactory standard' for the payment of
dividends; and this standard becomes a convention or custom for that industry
or company.
Activity 18.1
Meet an executive in the Accounting and Finance Department of your

organisation (or any other commercial or industrial organisation in case you
are not working in such an organisation) and discuss with him on matters
related to dividend on the following lines:
a) What dividend the company paid last year?

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Financial Decisions b) What dividend the company paid over the last 10 years? Did the company
skip dividend in any year? Why it had to do so? What is the trend in
payment of dividend over this period? Are the dividends constant, increasing
or decreasing ? What are the reasons for a particular trend?
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c) What are the main features of and the major influences on the company's policy
on dividends?
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18.7 SUMMARY
Dividend is a portion of the profits distributed to shareholders in a company and is
usually expressed as a percentage of nominal value of shares. Dividends are often paid
in cash, though in theory other forms also exit.
Though the declaration and payment of dividends is a matter, which concerns the
Board of Directors, the finance manager plays an important role by advising the Board
of Directors regarding the enunciation of a proper dividend policy.
Dividend policy involves the decisions whether to retain earnings in the firm for capital
investment and other purposes, or to payout the earnings in the form of cash dividend
to shareholders. Many financial managers believe that a stable dividend policy with a
certain percentage on capital paid up on shares and with periodic increases is a better
course to follow. Besides being psychologically appealing, stable dividend also has an
information content in that it indicates to investors the management’s expectation on
levels of long- run earnings and growth.
Often the company has to strike a balance between its own needs for funds for
financing growth opportunities and the needs and expectations of the investors. In view
of this, therefore, dividend policy cannot or should not be regarded as a residual policy.
48 While it is true that companies with strong investment opportunities have relatively low
dividend payout ratio and vice versa, most financial managers like to follow a stable
dividend policy.
There are several factors which impinge upon the dividend decision. The attitude and Dividends Decisions
objectives of management, nature of business, composition of shareholdings, cash
position, and future needs for funds are some of the important considerations which
have a bearing on the dividend decision.
18.8 KEY WORDS

Capital Gain is a gain, which arises on transfer (or selling) of a capital asset due to
appreciation in its market value. Under the Indian Income Tax Act, a capital asset
must be held for a minimum of three years in order that it gives rise to a capital gain to
its owner.
Bonus Shares are shares, which are issued by. a company free of charge to its existing
shareholders in proportion to the shares held by them. Bonus shares are issued when
a company wished to increase its capital by using its retained profits (or free reserves)
and feels that its existing share capital does not give a true picture of the amount of
capital employed in the firm.
Dividend Payout Ratio is the ratio of dividend declared and paid to the total
disposable profits.

1 What is dividend and why is dividend decision important?
2 "While formulating a dividend policy the management has to reconcile its own
needs for funds with the expectations of shareholders". Explain the statement.
What policy goals might be considered by management in taking a decision on
dividends?
3 Discuss the role of a financial manager in the matter of dividend policy. What
alternatives he might consider and what factors should he take into consideration
before finalising his views on dividend policy?
4 “Dividend can be paid only out of profits”. Explain this statement. Will a company
be justified in paying dividend when it has written off accumulated losses of the
past?
5 What factors a company would in general consider before it takes a decision on

dividends?

Van Home, James C., 2002. Financial Management and Policy, Prentice-Hall of India:
New Delhi.
Brigham, E.F., 1999. Fundamentals of Financial Management, Dryden Press: Florida

(Part V)
Kulkarni, P.V., Sathya Prasad B.G., 1999. Financial Management (nineth revised
edition), Himalaya Publishing: Bombay.
Gitman, L.J., 1985. Principles of Managerial Finance, Harper & Row: New York
(Chapter 14)
49

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Accounting and its Functions

UNIT 1 ACCOUNTING AND ITS

After studying this unit, you should be able to appreciate the:

1.2 SCOPE OF ACCOUNTING

activity of accounting may be called recordative. The processing method employed

1.3 EMERGING ROLE OF ACCOUNTING

In earlier times in history, wealthy people employed `stewards' to manage their

The industrial revolution in England presented a challenge to the development of

Management accounting is concerned with the preparation and presentation of ac-

Social Responsibility Accounting

Social responsibility accounting is a new phase in the development of accounting and

Human Resource Accounting

1.4 ACCOUNTING AS AN INFORMATION SYSTEM

Creditors: Creditors may be short-term or long-term lenders. Short-term creditors

Government: In a mixed economy it is considered to be the responsibility of the

Consumers and others: Consumers' organisations, media, welfare organisations and

1.5 ROLE AND ACTIVITIES OF AN ACCOUNTANT

a) An accountant is one who is engaged in accounts-keeping.

Statement (c) presents the accountant as a conscience-keeper. He is seen as a person

1.6 ACCOUNTING PERSONNEL

Accountants in employment may be in various business or non-business organisations

Internal Auditor: Internal Auditor is an employee of the organisation in contrast to

Internal audit includes continuous verification of entries appearing in the books of

We should distinguish an internal auditor from an external auditor. While an internal

Though financial management is regarded as a separate area, this function is per-

1.7 NATURE OF ACCOUNTING FUNCTION

1.8 ORGANISATION FOR ACCOUNTING AND

A typical organisation chart for accounting and finance function is presented in

Figure 1.2: Organisation Chart for Accounting and Finance

Accounting is an important service activity in business and is concerned with collect-

1.10 KEY WORDS

Accountant is a professional who is responsible for the processing of financial data

Controller of the management accountant is a staff-functionary who uses accounting

Auditive work of an accountant comprises authentication of accounting statements.

Recordative work extends to routine recording and classified posting of financial

Score-keeping is the process of data accumulation or record-keeping which enables

Attention-directing role of accounting consists of directing managerial attention to

Information system is a system, sometimes formal and sometimes informal, for

Planning is goal identification and decision-making.

Staff function is performed in an advisory capacity and without line or decision-

1.11 SELF-ASSESSMENT QUESTIONS/EXERCISES

3 State the group of persons having an interest in a business organisation and

4 Discuss the role of accountants in modern business organisations.

5 Differentiate between recordative, interpretative and auditive functions of

7 Distinguish management accounting from financial accounting.

9 State whether the following statements are true or false:

a) To have an accountant is the privilege ofa joint stock True/False

b) A controller is entrusted with the responsibilities of True/False

c) Management control differs from engineering True/False

d) An accountant is the custodian of the properties and True/False

Answers to Self-assessment Questions/Exercises

Paul Collier, May 09.2003. Accounting for Managers : Interpreting Accounting

After studying this unit, you should be able to:

• appreciate the need for a conceptual framework of accounting:

• understand and appreciate the Generally Accepted Accounting Principles

• develop an understanding of the importance and necessity for uniformity in

2.2 ACCOUNTING FRAMEWORK

The American Institute of Certified Public Accountants (AICPA) discusses financial

Generally accepted accounting principles encompass the conventions, rules and

(Source: AICPA. Statements of the Accounting Principles Board No.4 "Basic

2.3 ACCOUNTING CONCEPTS

Earlier in Unit 1 we had described accounting as the language of business. As with

Business Entity Concept