UNIT 1

1. Accounting
Accounting is the process of recording financial transactions pertaining to a business. The
accounting process includes summarizing, analyzing, and reporting these transactions to
oversight agencies, regulators, and tax collection entities. The financial statements used in
accounting are a concise summary of financial transactions over an accounting period,
summarizing a company's operations, financial position, and cash flows.

➢ Purpose of Accounting

Accounting is one of the key functions of almost any business. It may be handled by a
bookkeeper or an accountant at a small firm, or by sizable finance departments with dozens of
employees at larger companies. The reports generated by various streams of accounting,
such as cost accounting and managerial accounting, are invaluable in helping management
make informed business decisions.

The financial statements that summarize a large company's operations, financial position,
and cash flows over a particular period are concise and consolidated reports based on
thousands of individual financial transactions. As a result, all professional accounting
designations are the culmination of years of study and rigorous examinations combined with a
minimum number of years of practical accounting experience.1

➢ Meaning of Financial Accounting

Financial accounting is a branch of accounting which records each financial information

and analyse it to determine the financial position of a business. It is a process of
recording, summarising, analysing and presentation of all financial transactions of a
business in the form of financial statements. Financial accounting involves the
preparation of various financial statements like income statement, cash flow statement,
balance sheet etc. using accounting principles.

These financial statements are prepared on a routine basis by companies and presented
to all its stakeholders. Financial accounting aims at delivering the fair and accurate
image of financial affairs of business to all its stakeholders. It is done in accordance with
rules provided by GAAP or IFRS. It is an important tool for management in their decision
making as they depend on financial reports for decision making and forecasting
purposes.

Financial statements prepared by financial accounting takes into account the following
aspects of business viz. Expenses, Revenue, Asset, Equity and Liability. Financial
accounting has an important role in increasing profitability and efficiency as it helps in
managing all financial resources of the business. It is statutory required to practice
financial accounting in their operations by every business organisation. Scope of
Financial Accounting is described as givenbelow:
 ➢ Scope of Financial Accounting
Records Financial Transactions

Financial accounting record each and every financial transaction taking place in the
business organisation. It maintains a clear and systematic record of all information in the
form of journals and various subsidiary books. It avoids any confusion or loss because if
any problem arises these records can be easily checked. All transaction cannot be just
memorized by humans without recording them and that makes the financial accounting
important part of everybusiness.

Classify and Summarize Information

Information collected and recorded by financial accounting is properly categorized

according totheir nature. Financial accounting involves classifying and summarizing all
financial information recorded at the initial step. All transactions of similar nature are
grouped together under one head by making accounts like Sales, Purchase, Rent,
Salaries, Interest etc. Grouping of same nature transactions together adds convenience
in understanding of information collected.

Prepares Financial Statements

Financial accounting prepares financial statements like cash flow statement, income
statement, balance sheet etc. These financial statements depict the true financial position
of business.
Financial statements are the result of various information collected and analysed in
overall process of financial accounting. All financial strength and weakness of business
are determined by preparation of financial statements.

Interprets Financial Information

Financial accounting interprets information from several analysis conducted and

financial statements prepared. It understands and explains the results of several
relationships establishes by analysis to different users for easy understanding and
decision making. It simplifies the accounting information so that it is well understood by
persons having limited orno knowledge of accounting subject.

Communicates All Outcomes

Financial accounting serves the needs of all external stakeholders by delivering them
true and accurate picture of the company’s financial affairs. It communicates them all
financial information by providing them with financial reports routinely. All interested
parties to business are fully aware of all business financial matters and this helps them
in making conclusions. It helps them in knowing profitability and future growth aspects
through these reports.

Determines And Maintains Financial Position

Financial accounting determines fair and actual image of financial position of business.
Financeis termed as lifeline of business activities and its management is quite important
for every organization. Mismanagement of financial resources may have adverse effects
on the
 Company’s performance. Financial accounting records and analyze each financial aspect ofbusiness.

It delivers all information to internal management team from time to time for their
decision making. Management are able to take all necessary steps whenever required
related to financial resources which will improve the overall productivity. This all helps in
maintaining a proper financial position for every business.

Nature of Financial Accounting

Accounting Is First Step

Accounting is start when a financial transaction takes place. It records the financial
transection after that communicates this information to its users. Then the user this
information for their decision making.

Accounting Is An Art And Science:

Accounting is an Art and Science as well. Accounting is an art of recording,

classifying and summarizing of financial transactions. Accounting is science as
well as it requires certain principles (accounting principle).

Accounting Is A Process

Accounting is a process recording of financial transaction, summarizing,

analyzing, and reporting to the user of accounting information.

Accounting Deals With Financial Transactions Only

Financial accounting is considering only monetary transactions. It does not

take into account various non-financial aspects such as market competition,
economic conditions, government rules, and regulations, etc.

Historic In Nature

Financial accounting considers only those transactions which are of historic

nature. day-to-day activities transactions are recorded and the information is
provided after a period of time. All financial decisions of the future are taken on
the basis of this past information

Records Actual Cost

Financial accounting records the actual cost of the transaction and does not
consider the price fluctuations taking place from time to time. It records the
historical cost or the actual cost of the assets or liability.
 ➢ Objectives of Financial Accounting

Maintaining Systematic Records Of Transactions

The objective of Financial accounting is to Systematic record the financial transactions

of an organization in the books of account. Records are in chronological order or date
and time wise. It can use in the future when we require it for further process.

Ascertaining Profit Or Loss

To ascertain whether the organization have earned profit or incurred loss an Income
statement or Trading and profit & loss account is prepared. The income statement gives
the data of profit and loss of a financial year. The balance sheet gives the overall
position of the organization.

Ascertaining Financial Position

Another objective of Accounting is to ascertain the financial position by preparing the

Balance sheet. The balance sheet contains assets and liability that give information
about the financial position of the organization.

Assisting the Management

Financial accounting Provides financial information to management for decision making.

The information includes the debtors and creditor, profit & loss and other information.

Provide Accounting Information To Users

Financial Accounting provides the required information to interested users Who analyze
them as per their requirement. Users can be internal or external. Internal users are the
management, employees, and external users are creditors, tax authorities, investors,
etc.
2.Basic Accounting Principles
Accrual Principel

This is the idea that accounting transactions should be documented in the

accounting periods in which they occur, rather than in the accounting periods in
which they generate cash flows. The accrual basis of accounting is built on this
foundation.

It is critical to prepare financial statements that accurately reflect what occurred

during an accounting period rather than being arbitrarily delayed or accelerated
by cash flows. If you ignored the accrual principle, for example, you would only
record a cost once you had paid for it, which may result in a long delay due to the
payment terms for the accompanying supplier invoice.

Conservatism Principle

This is the idea that you should record costs and liabilities, but income and
assets should be recorded only when you are confident they will happen.
Because revenue and asset recognition may be delayed for some time, the
financial statements take on a more cautious tone, which may result in lower
reported profits.

On the other hand, this notion tends to encourage the recording of losses sooner
rather than later. This idea can be pushed too far if a company consistently
misrepresents its outcomes as being worse than they are.

Consistency Principle
This is the idea that once you’ve decided on an accounting principle, you should
stick with it until a clearly superior one occurs. If a company does not adhere to
the consistency principle, it may be forced to switch between several accounting
procedures for its operations, making long
-term financial outcomes exceedingly difficult to

understand.

Cost Principle

This is the idea that a company’s assets, liabilities, and equity interests should all be
recorded at
their original acquisition prices. As a number of accounting rules move toward
adjusting assets and liabilities to their fair values, this principle is becoming less
valid.

Economic Entity Principle

This is the idea that a business’s dealings should be kept distinct from its
owners’ and other firms’ as well. This avoids asset and liability intermingling
across many organisations, which can pose significant problems when a new
company’s financial records are initially reviewed.

Full Disclosure Principle

This is the idea that any information that can affect a reader’s understanding of a
company’s financial statements should be included in or alongside them.
Accounting regulations have substantially expanded on this notion by requiring a
massive quantity of data disclosures.

Going Concern Principle

This is the idea that a company will continue to exist for the foreseeable future.
This suggests that postponing the recognition of some expenditures, such as
depreciation, to subsequent periods might be justifiable. Otherwise, you’d have to
pay for all of your bills upfront and not delay them.

Matching Principle

This is the idea that as you report income, you should also record the associated
costs. As a result, you record income from the sale of inventory items while you
charge inventory to the cost of goods sold. The accrual foundation of accounting
is founded on this principle. The matching concept is not used in the cash
foundation of accounting.

Materiality Principle

This is the idea that you should record a transaction in the accounting records if
not doing so might have influenced someone reading the company’s financial
statements to make a different choice. This is a really hazy and difficult-to-
quantify idea, which has driven some smaller controllers to keep track of even the
smallest transactions.

Monetary Unit Principle

This is the idea that a company should only keep track of transactions that can
be expressed in terms of a single monetary unit. As a result, it is simple to record
the acquisition of a fixed asset because it was purchased for a defined price.
However, the worth of a business’s quality control system is not recorded. This
concept prevents a company from making unnecessary assumptions when
calculating the value of its assets and liabilities.
Reliability Principle

This is the idea that only those transactions should be recorded that can be
confirmed. For example, a supplier’s invoice is proof that a cost has been
recorded. Auditors are continuously looking for proof to justify transactions and
are particularly interested in this idea.

Revenue Recognition Principle

This is the idea that revenue should only be recognized when the earnings
process has been substantially completed. Many people have skirted around the
edges of this idea to commit reporting fraud, resulting in a large quantity of
information regarding what constitutes legitimate revenue recognition from
several standard-setting agencies.

Time Period Principle

This is the idea that a company should publish its outcomes that are operational
ones over a set period of time. This is perhaps the most self-evident of all basic
accounting principles, yet it is meant to produce a standard set of comparable
periods for trend research

h.
Financial accounting refers to recording financial transactions, summarising and interpreting them,
and communicating the results to the interested parties. Financial accounting determines profit
earned or loss incurred during a given financial period and the financial position on the date when
the accounting period ends. The final result of financial accounting is the profit and loss account for
the period ended, which indicates the profit earned or losses incurred, and the balance sheet on the
last day of the accounting period, which indicates the financial position.

➢ Main objectives of financial accounting:

1. Maintenance of records: To record financial transactions and events of the organisations in the
books of account in a systematic manner and interpret and summarize the results thereof to
the users of the financial information.
2. Ascertainment of profits or loss: For this purpose, an income statement or the trading and profit
and loss accounts are prepared.
3. Determination of financial position: Every businessman needs to know the financial status of
the organisation. For this purpose, a statement consisting of assets, liabilities, and the
shareholder’s capital is prepared, called a balance sheet statement.
4. Facilitates management: The management requires financial information for decision making
and better control, budgeting, and forecasting. Accounting helps to provide such financial
information, based on which the management can effectively take any decision.
5. Provides accounting information to users: Providing accounting information to users and
interested parties, they analyse such information as per their necessities.

➢ The essential requirements of accounting principles

Accounting information is understandable in a better manner if prepared with the following set of accounting concepts and
conventions uniformly. This means that the same accounting principles and standards are to be followed by all the entities in
preparing financial statements. These standards are used to assess the performance of the business.

Accounting information is meant for users, and it can be utilised to compare financial statements and decision-making. Given
this essential requirement, accounting concepts and accounting conventions are established.

➢ Accounting concepts

Accounting concepts are the basic assumptions on which accounting operate. These are the following accounting concepts as
discussed below:

1. The business entity concept: According to this, the business and owner are separate
entities. Business transactions are recorded in the books of accounts from the company’s point
of view, and not the owner’s. The owners are considered separate from their business’s point
of view and are regarded as creditors to the extent of their capital.
2. The money measurement concept: According to this, transactions and events are measured
in monetary terms in the books of accounts of the enterprise.
3. The going concern concept: Under this concept, it is assumed that the business will continue
for an indefinite period, and there is no intention to close the business or cut down its
operations significantly
4. The accounting period concept: According to the accounting period concept, the life of an
enterprise can be broken into smaller periods, usually termed accounting periods, so that its
performance is measured at regular intervals.
5. The cost concept: According to this concept, an asset is recorded in the books of account at
the price paid to acquire it, and the cost is the basis for all following accounting of the asset.
6. The dual concept: According to the dual aspect concept, every business transaction entered
into by the organisation has two aspects, a debit and an equal creditor amount. For every
debit, there will be an equal amount of credit.
7. The revenue recognition concept: According to this concept, revenue is determined to have
been realised when a transaction has been written in the books and the obligation to receive
the amount has been ascertained.
8. The matching concept: Here, it is ascertained that every cost incurred to earn the revenue
should be recognised as an expense in the accounting period when revenue is earned. In a
given accounting period, expenses are matched with the revenue earned.
9. The accrual concept: A transaction is said to be accrued if a transaction is recorded at the
time when it takes place and not at the time when the settlement takes place.
10. The verifiable objective concept: The verifiable objective concept states that accounting
should be free from personal bias.

➢ Accounting conventions
The guidelines that are followed to prepare financial statements are called accounting
conventions. These are as follows:

1. Full disclosure: Convention of full disclosure states that there should be complete reporting
on the financial statements of all important information relating to affairs of the business. All the
material facts are to be disclosed.
2. Consistency: Convention of consistency states that accounting practices, once selected and
adopted, should be followed consistently year after year for a better understanding and
comparability of the accounting information.
3. Prudence concept or conservatism concept: This convention states that we should not
anticipate a profit before its realizable but provide for all possible losses which might occur in
the course of business.
4. Materiality concept: The materiality concept relates to the relative information of an item or an
event. An item is considered material when such knowledge of that could influence the
decision of an investor.

Conclusion

Financial accounting is related to the recording of financial transactions, summarising and

interpreting them, and communicating the results to the interested parties. Accounting
information is understandable in a better manner if prepared with the following set of
accounting concepts and conventions uniformly. Accounting concepts are the basic
assumptions on which accounting operates. Accounting conventions are guidelines that are
followed for preparing financial statements. If the given accounting concepts and conventions
are utilised, then firms can easily have control over costs, which will lead to better financial
results.

3.indian accounting standards

As per popular definitions, Indian accounting standards are nothing but guidelines to be followed
in the accounting system. It means rules & regulations that are to be followed while recording
accounting & financial transactions. It governs the manner in which financial statements are
prepared & presented in a company.

In India, Institute of Chartered Accountants formulates & issue accounting standards. These
standards are followed by accountants of all the companies registered in India. As we have
mentioned before, these accounting standards help in preparation and presentation of financial
statements.

While you may have understood the base objective of Indian accounting standards, let us get into
the depth of these objectives and understand what kind of underlying objectives are there.

➢ Core Objectives of the Indian Accounting Standards

There is always a reason for any mission. Similarly, there are certain objectives for having
accounting standards. Let us take a look at the objectives of accounting standards so that we
understand in depth the deeper aim of it.

• The main objective of Indian accounting standards is to bring in more transparency of

annual financial statements in company accounts.
• Ensure companies in India adopt these standards to implement internationally recognized best
practices.
• One systematic, single accounting system common for all the companies. Cutting out
confusions and frauds.
• The Indian accounting standards are so simplified that they can be understood worldwide,
globally.
• There are several global requirements and the Indian accounting standards are designed
to match the global requirements.
• To increase the reliability of the financial statements.

These are some of the major objectives of Indian accounting standards

➢ Benefits of Indian Accounting Standards

Provides Reliability to Financial Statements

The financial statements are a significant measure of gaining data with respect to organizations.
Financial backers and various partners rely upon these assertions for getting data. These
individuals take significant choices based on this information as it were.

It is in this way vital that these financial statements are valid and reasonable. Bookkeeping
principles completely oversee these financial reports. It is guaranteed by accounting principles that
these assertions are genuine and reliable.
Uniformity in Accounting System

Accounting standards are the one that aids in acquiring the consistency of entire accounting. It is
one significant benefit of accounting guidelines. Accounting guidelines set similar standards and
guidelines for the treatment of accounting exchanges.

It implies that all organizations record the exchanges in a similar way. For instance, Accounting
Standard administers the entire deterioration of accounting. All organizations will be following AS-6
for issues worried about devaluation. This way it acquires consistency throughout the entire
accounting system in the country, as well as globally.

Report of Management Performance

The accounting standards make it simple in deciding responsibility of the executives. It makes it
simple to gauge the exhibition of supervisory crew and give any ideas.

It helps in breaking down administration capacity in keeping up with dissolvability of the firm,
expanding the organization's benefit and different other significant jobs.

It guides the administration to take on specific accounting standards and its strategy. Same
arrangement ought to be followed continually to keep away from any disarray.

Accounting Easy & Simple

Working in the general Indian accounting system, data is a significant benefit of accounting norms.
It gives standard guidelines to each and every accounting exchange. It eliminates all intricacy in the
accounting system.

Standard and uniform cycle is followed. It helps the clients in simple agreement and dodges any
deludes from it.

Say Goodbye to Fraudulation

Accounting standards assume a proficient part in forestalling fakes in the accounting system. Fakes
and any accounting information control may unfavorably influence the association.

Accounting norms set up various accounting rules and standards. These accounting standards
administer the entire accounting system. These standards are not discretionary to be followed yet
are obligatory to be followed.

It turns out to be practically difficult to distort and control any monetary information on a piece of
the executives. Submitting any extortion additionally becomes more enthusiastic for them.
Provides Assistance to Auditors

The Indian accounting standards help the auditors in playing out their obligations, in their audits. It
improves on their assignment and makes it simple for them to play out their jobs. Accounting
Standards have set up various guidelines, rules and guidelines to be trailed by organizations in
their accounting system.

These standards and guidelines are obligatory to be trailed by each organization. It oversees the
entire way of planning and introducing monetary guidelines. So if the examiner guarantees that
the organization has kept accounting guidelines, he can without much of a stretch confirm that all
monetary norms are reasonable and valid.

Easy Comparability

Accounting standards have improved the correlation of various financial reports. Budget reports of
two organizations can be effectively thought about. In the event that two organizations are following
a distinctive accounting framework and configuration, examination between them turns out to be
very troublesome.

Like on the off chance that one organization follows LIFO technique for stock keeping,
accounting while others follows FIFO strategy. Here examination becomes troublesome as two
are following various techniques. Accounting standards help in beating this issue.

➢ List of Accounting Standards in India

We have collated a list of Indian accounting standards that as a blooming company you must know
about. Take notes! For your in depth knowledge and understanding we have also mentioned the
objective of each accounting standard.

Ind AS 1 Presentation of Financial Statements

Objective: This standard sets out generally speaking necessities for show of financial
statements, rules for their construction and least prerequisites for their substance to guarantee
likeness.

Ind AS 2 Inventories Accounting

Objective: Its arrangements with accounting of inventories like estimation of stock, incorporations and
avoidances in its expense, divulgence necessities, and so forth.

Ind AS 7 Statement of Cash Flows

Objective: It manages cash got or paid during the period from working, financing and
contributing exercises. It additionally shows any adjustment of the money and money
counterparts of any element.

Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Objective: It prescribes choosing and changing accounting strategies along with accounting
medicines and exposures.
Ind AS 10 Events after Reporting Period

Objective: It manages any changing or unchanging occasion happening subsequent to reporting.

Ind AS 11 Construction Contracts

Objective: It manages any changing or unchanging occasion happening subsequent to reports.

Ind AS 12 Income Taxes

Objective: This standard recommends accounting for income tax. The chief issue in representing
annual duties is the means by which to represent the current and future assessment.

Ind AS 16 Property, Plant and Equipment

Objective: This recommends accounting treatment for Property, Plant And Equipment (PPE) like
acknowledgment of resources, assurance of their conveying sums and the devaluation charges
and impedance misfortunes to be perceived comparable to them.

Ind AS 17 Leases

Objective: This standard recommends fitting accounting arrangements and guidelines for tenants and
lessors.

Ind AS 19 Employee Benefits

Objective: This standard recommends bookkeeping and divulgence prerequisites identifying

with representative advantages.

Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance

Objective: This Standard will be applied in representing and in exposure of, government awards
and in revelation of different types of government help.

Ind AS 21 The Effects of Changes in Foreign Exchange Rates

Objective: This standard helps to understand how to incorporate unfamiliar cash exchanges and
unfamiliar activities in the financial reports of a company and how to make an interpretation of
budget reports into a presentation currency.

Ind AS 23 Borrowing Costs

Objective: It gives acquiring cost caused on qualifying asset should frame part of that asset, it
additionally directs on which money cost ought to be promoted, conditions for capitalization,
season of initiation and discontinuance of capitalization of getting cost.

Ind AS 24 Related Party Disclosures

Objective: This guarantees that any organization’s fiscal reports contain fundamental revelations to
cause us to notice the likelihood that its monetary position and benefit or misfortune might have
been influenced by the presence of related gatherings and by exchanges and exceptional
equilibriums.

Ind AS 27 Separate Financial Statements

Objective: This recommends bookkeeping and revelation necessities for interests in auxiliaries,
joint endeavors and partners when a company plans separate budget reports.

Ind AS 28 Investments in Associates and Joint Ventures

Objective: This standard endorses representing interests in partners and to set out necessities for
the utilization of value technique when representing interests in partners and joint endeavors.

Ind AS 29 Financial Reporting in Hyperinflationary Economies

Objective: This standard will give a comprehensive rundown of qualities that will order an
economy as hyper inflationary and detailing of working outcomes and monetary position.

Ind AS 32 Financial Instruments: Presentation

Objective: This Standard sets up standards for introducing monetary instruments as liabilities or
value and for balancing monetary resources and monetary liabilities.

Ind AS 33 Earnings per Share

Objective: This Standard recommends standards for the assurance and presentation of per share.

Ind AS 34 Interim Financial Reporting

Objective: This helps with least minimum content of an interval financial report and standards for
acknowledgment and estimation in complete or dense financial statements for a period.

Ind AS 36 Impairment of Assets

Objective: This Standard recommends techniques that a company applies to guarantee that a
company's conveying sum isn't more than its recoverable sum.

Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets

Objective: This guarantees that correct acknowledgment rules and estimation bases are
applied to arrangements, unforeseen liabilities and unexpected resources and appropriate
divulgences are made in the notes to empower clients to comprehend their tendency, timing and
sum.

Ind AS 38 Intangible Assets

Objective: This Standard recommends bookkeeping treatment for intangible assets. It

determines conditions for acknowledgment of intangible assets and how to quantify conveying
sums at which elusive resources ought to be perceived.

Ind AS 40 Investment Property

Objective: This recommends accounting treatment for speculation property and related exposure
prerequisites.

Ind AS 41 Agriculture

Objective: This prescribes accounting treatment and divulgences identified with agricultural
movement.

Ind AS 101 First-time adoption of Ind AS

Objective: Its primary goal is to plan first financial reports according to Ind AS containing
excellent data that is straightforward, tantamount and ready at prudent expense, appropriate
beginning stage for bookkeeping as per Ind AS.

Ind AS 102 Share Based payments

Objective: It manages bookkeeping of offer based installment exchanges and reflects impact of
such installment on benefit or misfortune and financial reports of elements.

Ind AS 103 Business Combination

Objective: It applies to exchanges or other occasions that meet the meaning of a business mix.
This standard aids in working on the significance, unwavering quality and equivalence of the
data that a revealing substance gives in its budget summaries about a business mix and its
belongings.

Ind AS 104 Insurance Contracts

Objective: This standard determines financial reporting for protection decreases by a back up plan
element.

Ind AS 105 Non-Current Assets Held for Sale and Discontinued Operations

Objective: This determines representing resources held available to be purchased, and sold
and divulgence of uncompleted activities.

Ind AS 106 Exploration for and Evaluation of Mineral Resources

Objective: This standard indicates financial reporting for investigation and assessment of mineral
resources.

Ind AS 107 Financial Instruments: Disclosures

Objective: This expect elements to give exposures identified with monetary instruments that will
empower clients to assess meaning of monetary instruments for substance's monetary position
and execution and nature and degree of dangers emerging from monetary instruments to which
the element is uncovered during the period and toward the finish of the detailing time frame, and
how the element deals with those dangers.

Ind AS 108 Operating Segments

Objective: This reveals data to empower clients of its fiscal reports to assess the nature and
monetary impacts of the business exercises in which it draws in and the financial conditions where
it works.

Ind AS 109 Financial Instruments

Objective: This builds up standards for financial reporting of financial assets and financial liabilities
that will introduce important and helpful data to clients of financial reports for their evaluation of the
sums, timing and vulnerability of an element's future cash flows.
Ind AS 110 Consolidated Financial Statements

Objective: This sets up standards for the presentation of the financial statements when a company
controls at least one different.
Ind AS 111 Joint Arrangements

Objective: This sets up standards for financial reporting by companies that have an interest in
game plans that are controlled jointly.

Ind AS 112 Disclosure of Interests in Other Entities

Objective: This standard requires a company to unveil data that empower clients of its fiscal reports
nature hazard and impact of such interest.

Ind AS 113 Fair Value Measurement

Objective: This characterizes reasonable worth, set outs system for estimating fair value and
divulgences about reasonable worth estimations. Such a value measurement estimation
guideline will apply when one more Ind AS requires or allows utilization of reasonable worth.

Ind AS 114 Regulatory Deferral Accounts

Objective: This determines financial statements requirements for administrative deferral account
adjustments that emerge when a company gives labor and products to customers at a cost or rate
that is liable to rate guideline.

Ind AS 115 Revenue from Contracts with Customers

Objective: This sets up rules that an organization will apply to report helpful data to clients of
financial statements about, sum, timing and vulnerability of income and incomes emerging from an
agreement with a customer.
 4. IFRS (International Financial Reporting Standard)
IFRS(International Financial Reporting Standards), which establishes principles for financial
transactions and accounting events that are displayed in financial statements globally, provides
essential standards in this area.

➢ List Of IFRS Standards :

1) First-time Adoption of International Financial Reporting Standards

It sets out the procedures that an entity must follow when it adopts International Financial
Reporting Standards for the first time as the basis for preparing its general-purpose financial
statements. This IFRS grants limited exemptions from the general requirement to comply with
each International Financial Reporting Standard effective at the end of its first IFRS reporting
period. There are many benefits of implementing IFRS in India in terms of economy, industry,
and investors.

2) Share-Based Payment

It requires an entity to recognize share-based payment transactions (for example: granted

shares, share options, or share appreciation rights) in its financial statements, also including
transactions with employees or other parties to be settled in cash, other assets, or equity
instruments of the entity. Specific requirements are included
for equity-settled and cash-settled share-based payment transactions, as well as those where the entity or
supplier has a choice of cash or equity instruments.

1) Business Combinations

It outlines the accounting when an acquirer obtains control of a business (for example
acquisition or merger). Such business combinations are accounted for using the ‘acquisition
method’, which generally requires assets acquired and liabilities assumed to be measured at
their fair values at the acquisition date. The main advantage of IFRS is it facilitates the easy
comparison of different companies, as data is presented on the same basis.

2) Insurance Contracts

It applies, with limited exceptions, to all insurance contracts (including reinsurance contracts)
that an entity issues and to reinsurance contracts that it holds. In light of the International
Accounting Standard Board’s comprehensive project on insurance contracts, the standard
provides a temporary exemption from the requirements of some other IFRSs, including the
requirement to consider International Accounting Standard- 8 Accounting Policies, Changes in
Accounting Estimates and Errors when selecting accounting policies for insurance contracts

3) Non-current Assets Held for Sale and Discontinued Operations

It outlines how to account for non-current assets held for sale (or for distribution to owners). In
general terms, assets held for sale are not depreciated, are measured at the lower of carrying
amount and fair value fewer costs to sell, and are presented separately in the statement of
financial position. Specific disclosures are also required for discontinued operations and
disposals of non-current assets.
4) Exploration for and Evaluation of Mineral Resources

It has the effect of allowing entities to adopt the standard for the first time to use accounting
policies for exploration and evaluation of assets that were applied before adopting international
financial reporting standards. It also modifies impairment testing of exploration and evaluation
assets by introducing different impairment indicators and allowing the carrying amount to be
tested at an aggregate level (not greater than a segment).

5) Financial Instruments: Disclosures

It requires the disclosure of information about the significance of financial instruments to an

entity, and the nature and extent of risks arising from those financial instruments, both in
qualitative and quantitative terms. Specific disclosures are required in relation to transferred
financial assets and a number of other matters.

6) Operating Segments

It requires particular lasses of entities (essentially those with publicly traded securities) to
disclose information about their operating segments, products and services, the geographical
areas in which they operate, and their major customers. Information is based on internal
management reports, both in

the identification of operating segments and measurement of disclosed segment information.

7) Financial Instruments

It is the International Accounting Standard Board’s replacement of International

Accounting Standard 39 Financial Instruments: Recognition and Measurement. It includes
requirements for recognition and measurement, impairment, recognition, and general hedge
accounting.

8) Consolidated Financial Statements

It outlines the requirements for the preparation and presentation of consolidated financial
statements, requiring entities to consolidate entities it controls. Control requires exposure or
rights to variable returns and the ability to affect those returns through power over an investee.

9) Joint Arrangements

It outlines the accounting by entities that jointly control an arrangement. Joint control involves
the contractually agreed sharing of control and arrangements subject to joint control are
classified as either a joint venture; representing a share of net assets and equity accounted or
a joint operation; representing rights to assets and obligations for liabilities, accounted for
accordingly.

10) Disclosure of Interests in Other Entities

It is a consolidated disclosure standard requiring a wide range of disclosures about an entity’s

interests in subsidiaries, joint arrangements, associates and unconsolidated ‘structured
entities’. Disclosures are presented as a series of objectives, with detailed guidance on
satisfying those objectives.

11) Fair Value Measurement

It applies to IFRSs that require or permit fair value measurements or disclosures and provides
a single IFRS framework for measuring fair value and requires disclosures about fair value
measurement. The Standard defines fair value on the basis of an exit price notion and uses a
fair value hierarchy, which results in a market- based rather than entity-specific measurement.

12) Regulatory Deferral Accounts

It permits an entity that is a first-time adopter of International Financial Reporting Standards to

continue to account, with some limited changes, for ‘regulatory deferral account balances in
accordance with its previous GAAP, both on initial adoption of IFRS and in subsequent
financial statements. Regulatory deferral account balances, and movements in them, are
presented separately in the statement of financial position and statement of profit or loss and
other comprehensive income, and specific disclosures are required.

13) Revenue From Contract

It specifies how and when an IFRS reporter will recognize revenue as well as requiring such
entities to provide users of financial statements with more informative, relevant disclosures.
The standard provides a single, principles-based five-step model to be applied to all contracts
with customers. It applies to an annual reporting period beginning on or after 1 January 2018.

14) Lease Accounting

It specifies how an International Financial Reporting Standards reporter will recognize,

measure, present, and disclose leases. The standard provides a single lessee accounting
model, requiring lessees to recognize assets and liabilities for all leases unless the lease term
is 12 months or less or the underlying asset has a low value. Lessors continue to classify
leases as operating or finance, with IFRS 16’s approach to lessor accounting substantially
unchanged from its predecessor, International Accounting Standard- 17. It applies to annual
reporting periods beginning on or after 1 January 2019.

15) Insurance Contract

IFRS 17 is applicable for yearly reporting periods starting on or after 1st January 2021. This
must be accommodated with IFRS 9 and IFRS 15 from the list of International Financial
Reporting Standards standards, permitted application earlier. The insurance contract consists
of both a service and a financial instrument contracts. Many such insurance contracts will
ultimately generate cash flow with considerable variability over a long span.

These were the IFRS (International Financial Reporting Standards) issued by IASB. And the
International Accounting Standards (IAS) were issued by the predecessor body IASC between
the years 1973 and 2001. In our country, Indian Accounting Standards (Ind AS) are issued by
the Accounting Standard Board to converge Indian GAAP with International Financial
Accounting Standards (IFRS). Both International Financial Reporting Standards and IAS
 continue to form a force.

5..Final accounts of company with basic adjustments

Final accounts are an integral part of a financial accounting year for every business.
In other words, it is the end product of the accounting process carried out the whole
year. These need to be prepared by every business on or by the 31st of March
every financial year as it marks the end of the year.

Final accounts refer to the accounts prepared by a business entity at the end of
every financial year. The final accounts depict a clear and accurate financial
position of the entity. This information is of use to the management, investors,
owners, shareholders, and also to other users of such information.

The final accounts of an entity consists of the following accounts:

1. Manufacturing and Trading Account

2. Profit and Loss Account
3. Balance Sheet
4. Profit and Loss Appropriation account
The trial balance forms the basis for the preparation of the final accounts. Further,
these are audited by the internal as well as external auditors, usually the Chartered
Accountants. Thus, these need to be prepared in a fair and transparent manner.

Manufacturing Account
Manufacturing entities need to prepare a Manufacturing account before preparing
the Trading Account. It determines the Cost of goods sold.
 Format of Manufacturing Account
Particulars Units Amount Particulars Units Amount

To Raw material By By-products at net

consumed: realizable value

By Closing Work-in-
Process
Opening inventory

Add: Purchases By Trading A/c

Less: Closing inventory Cost of production

To Direct Wages

To Direct expenses

Prime cost

To Factory overheads:

Royalty

Hire charges

To Indirect expenses:

Repairs & Maintenance

Depreciation

Factory cost
To Opening Work-in-
process

Trading Account
It is prepared after the manufacturing account by the manufacturing industries.
However, in case of trading concerns, it is the first account that is prepared. It
determines the gross profit or gross loss of an entity resulting from the trading
activities. Trading activities refer to the buying and selling activities of a business.

Opening stock, Purchases (less returns) and Direct expenses are written on the
debit side of the Trading account while Closing Stock and Sales (less returns) are
written on the credit side of the Trading account. When the credit side exceeds the
debit side, it shows Gross Profit and if the debit side exceeds the credit side, it
shows Gross Loss.

The gross profit or loss is transferred to the Profit and Loss A/c. The closing entries
are as follows:

For Gross Profit

Trading A/c Dr.

To Profit and Loss A/c

For Gross Loss

Profit and Loss A/c Dr.

To Trading A/c

Sample Trading Account

Trading Account
 UNIT 2
1.FINANCIAL STATEMENT ANALYSIS
Financial Statement Analysis refers to the process of reviewing and analyzing a company’s
financial statements. It is primarily done to make better financial decisions and devise plans
for the company to earn more income in the future. Financial Analysis meaning as well as
procedure is important both for the accounting exam point of view as well as for practical
purposes.

o Different types of financial statements are the income statement, statement

of cash flow, balance sheet, notes to accounts, statement of changes in
equity, and so on.
o A few common types of financial statements analysis are Horizontal Analysis,
Vertical Analysis, Liquidity Analysis, Profitability Analysis, Variance Analysis,
Valuation Analysis, and Scenario and Sensitivity Analysis.
o Comparison, analysis, and rearrangement, and interpretation of data are the
major steps involved in financial statement analysis.
o The activity of analysis of financial statements is primarily done to measure
the company’s profitability and evaluate its operational efficiency.

In the following Financial Statement Analysis study notes, let’s discuss all of these and other
significant aspects of the topic. Accounting aspirants are suggested to go through the
following study material on Financial Statement Analysis carefully for a better preparation.

The term ‘Financial Statement Analysis’ refers to the systematic numerical representation of
the relationship of one financial aspect with the other. The activity of financial statement
analysis is undertaken to analyse the company on the basis of its profitability, solvency,
operational efficiency, and growth prospects.

Financial Analysis chiefly involves bifurcating the financial records on the basis of a definite
plan, arranging them in sections, and presenting them in a user-friendly manner.

➢ Purpose of Financial Statement Analysis

Now that we are clear about the Financial Analysis meaning and definition, let us learn about
its purpose or the need of undertaking such an activity. Following is the list of purpose of
financial statement analysis:

o To measure the financial standing of the business

o To evaluate the profitability (earning capacity) of the business
o To make comparisons within the firm (intra-firm) and with other firms (inter-firm)
o To find out the business’ capability of paying interest, dividend, etc.
o To judge the performance of the management
 o To measure the firm’s short-term and long-term solvency

Types of Financial Analysis

The main types of financial statement analysis are as follows:

Types Meaning

Horizontal Analysis o It refers to the analysis of financial statement figures that are
dynamic in nature.
o It compares one item with another in a different time period.
o It analyses the business’s finances from one year to the next.
Vertical Analysis o The relationship between various items on a financial statement is
analyzed.
o For instance, one item is measured against another during an
accounting period.
o The relationship is expressed in percentage.
Liquidity Analysis o It uses ratios to determine whether or not a company will be able
to pay back any debts or other expenses.
o It is helpful for businesses as they can predict financial troubles in
future.
o This analysis is helpful for lenders, creditors, etc. who want some
insight into the business’ financial standing before giving them
any loans or credit.
Profitability Analysis o In this, the company’s rate of return is analyzed.
o As every business seeks profits, using the profitability analysis to
measure its cost and revenue over a given period can be highly
beneficial.
o A company is considered profitable if its revenue exceeds the
costs.
o Margin Ratios and return Ratios are the two main types of
profitability analysis.
Variance Analysis o It refers to the process of evaluating any differences between a
business’ budget and the actual costs incurred.
o For instance, if a business budgeted their sales of INR 10,000 but
actually sold goods worth INR 4,500, then the variance analysis
would be with a difference of INR 5,500

Valuation Analysis o It analyzes the business’ present value and can be utilized for
various instances such as mergers and acquisitions.
o Once the company’s present ratios are determined, they can be
compared to the past ratios, competitor’s ratios, etc.
o There are different types of valuation ratios such as price/
earnings and price sales.
Scenario and o The value of an investment is measured based on the current
Sensitivity Analysis scenarios and changes.
o Scenario and sensitivity analysis is helpful to predict outcomes
based on different variables.
 ➢ Importance or Uses of Financial Statement Analysis
Now that we know what is the meaning of financial statement analysis and its types, let’s
understand its importance as well.

There are various uses of financial statement analysis for different users like investors,
creditors, management, government, and so on, mentioned as below:

Users Areas of Interest

For To know the company’s profitability, liquidity, and solvency.

Management
To measure the effectiveness of the decisions taken and to take corrective
actions ahead.
For Investors To know the business’ earning capacity and its future growth prospects and evaluate the
safety of their investment and a reliable return.

For Creditors To know the liquidity and solvency position of the business.

For To know the profitability position required for taxation purposes and to take decisions
Government about price regulations.

For To know about the longevity of the business.

Customers
For To know about the progress of the company for evaluating bonus, increase in
Employees wages, job stability, etc.

➢ Techniques/ Tools of Financial Statement Analysis

The various tools of financial statement analysis help in evaluating and interpreting the
company’s financial statements for planning, investment, and performance.

The most commonly used tools of financial analysis are comparative statement (comparison
of financial statements), common size statement (vertical analysis), ratio analysis
(quantitative analysis), cash flow analysis, and trend analysis. Let’s quickly learn about these
tools.

Comparative Statement
Financial Statements of two years are compared and differences in absolute as well as
percentage terms are calculated. It is a form of horizontal analysis.

The comparative analysis is done through a Comparative Income Statement and

Comparative Balance Sheet.
Format of Comparative Income Statement
The above statement shows in percentage terms the total of income earned and the
expenses incurred during two or more accounting periods.

Format of Comparative Balance Sheet

The above statement shows the business’ assets and liabilities for two or more accounting
periods. It also presents the percentage change in the monetary value of those assets and
liabilities.

Common Size Statement

The figures of financial statements are converted into percentages with respect to a common base.

Just like comparative analysis, the common size statement analysis is also done through
an income statement and a balance sheet.

Format of Common Size Income Statement

The above Common Size Income Statement shows the sales figure to be 100 and all other
figures expressed as a percentage of sales.

Format of Common Size Balance Sheet

The common-size balance sheet shows the total of assets or liabilities to be assumed as 100
and the figures are expressed as a percentage of the total.

Ratio Analysis
It studies the relationship between various items in the financial statements. Ratio analysis is
a quantitative method of gaining insight into a company's liquidity, operational efficiency, and
profitability by studying its financial statements such as the balance sheet and income
statement. Ratio analysis is a cornerstone of fundamental equity analysis.

Cash Flow Statement

It shows the inflow and outflow of cash and cash equivalents during a particular period. Such
an analysis helps find out the causes of changes in the cash position between the two
balance sheets at two different dates.

Fund Flow Statement

A fund flow refers to the inflow and outflow of funds or assets for a company and
is often measured on a monthly or quarterly basis. A fund flow statement reveals
the reasons for these changes or anomalies in the financial position of a
company between two balance sheets. These statements portray the flow of
funds - or the sources and applications of funds over a particular period.

2.RATIO ANALYSIS
Financial professionals often perform a ratio analysis to determine measures like
profitability and business performance for different companies. This can be
helpful to identify investment opportunities or identify trends in a particular
market. Learning about this type of analysis can help you understand how people
calculate it and what its common uses are.

Key takeaways:

Ratio analysis helps people analyze financial factors like profitability, liquidity and efficiency.

Ratio analysis helps financial professionals understand company trends and

perform competitive analysis.

Common ratio analysis includes liquidity, leverage, market value and efficiency ratios.

Ratio analysis is an accounting method that uses financial statements, like

balance sheets and income statements, to gain insights into a company's
financial health. Ratio analysis will help determine various aspects of an
organization including profitability, liquidity and market value.

Ratio analysis is a helpful tool to determine from the outside what is going on
inside of a business because the financial statements required to perform ratio
analysis are available to the general public. Company insiders typically do not
use ratio analysis because they already have access to much more detailed
information that will give them a better view of the company's financial status.
Ratio analysis is a fundamental technique in financial analysis that is used
to evaluate the financial performance of a company. It involves the
calculation and interpretation of various ratios derived from the company's
financial statements, such as the balance sheet and income statement.
These ratios help in assessing the company's financial health, efficiency,
profitability, and overall performance. Ratio analysis is crucial for
investors, creditors, and management to make informed decisions about
the company's operations and financial position.

Some key types of ratios used in ratio analysis include:

1. **Liquidity Ratios**: These ratios measure the company's ability to meet its
short-term obligations. Common liquidity ratios include the current ratio and the
quick ratio.

2. **Profitability Ratios**: These ratios evaluate the company's ability to generate

profits relative to its revenue, assets, and equity. Examples include the gross
profit margin, net profit margin, return on assets (ROA), and return on equity
(ROE).

3. **Activity Ratios (Efficiency Ratios)**: These ratios assess how effectively a

company manages its assets. They include inventory turnover, accounts
receivable turnover, and total asset turnover.

4. **Solvency Ratios**: These ratios evaluate a company's long-term financial

stability and its ability to meet its long-term obligations. Common solvency ratios
include the debt-to-equity ratio, debt ratio, and interest coverage ratio.

5. **Market Ratios**: These ratios help investors assess the attractiveness of an

investment in the company's stock. Examples include the price-to-earnings ratio
(P/E ratio) and the earnings per share (EPS).

By analyzing these ratios over time and comparing them with industry standards
or competitors, analysts can gain insights into a company's financial
performance, strengths, and weaknesses. However, it's important to consider
that ratio analysis has limitations, such as not providing a complete picture of a
company's overall performance, as it doesn't take into account external factors or
qualitative aspects of a business. It is essential to use ratio analysis as one of
many tools for comprehensive financial analysis.

➢ Uses of ratio analysis

Ratio analysis compares a company's financial state to other companies or to its

own financial history. The results of ratio analysis are just static data, so you'll
need to compare it to other data for it to be useful. Here are two ways you can
use ratio analysis to calculate business trends and to compare one company
against others in its industry:

Business trends
Trends help determine the direction of a financial aspect of a business, including
whether profitability is going up or down, if the business is paying off or accruing
debt and how well the company is managing its assets under the new CEO
compared to the old.

You can determine trends by calculating these ratios over many reporting
periods. By comparing current ratios to those in the past, you can better predict
the direction the business is going in the future.

Competitive comparison

Another way to use ratio analysis is to compare a business to others in the same
industry. Businesses in the same industry will have similar capital structures and
similar fixed assets. By comparing the results of ratio analysis for these
businesses, you can determine whether a business is an industry leader or is
just keeping up with competitors.

Ratio analysis categories

There are many types of financial ratios that you can use for ratio analysis, but
the following general categories will tell you most of what you need to know to
determine the financial status of a business:

Profitability ratios

Profitability ratios are a type of financial ratio that assesses the ability of a
business to generate earnings compared to its revenue, operating costs, assets
or shareholder equity. You can use these ratios to discover how profitable a
company is. There are a few types of profitability ratios:

Operating profit

margin Gross

profit margin

EBITDA margin

Net profit margin

Return on invested capital

Higher profitability ratios mean a business is performing well. To assess if a

company has higher ratios, you can compare current ratio values to the
company's historical values or other companies in the same industry.
Liquidity ratios

Liquidity ratios, also known as coverage ratios, work with ratio analysis to
determine whether or not a company can pay off its short-term debt. These ratios
use values from financial statements to compare assets and income to the
amount of debt a business has. The term also refers to a company's ability to use
its assets to pay off its debts.

Here are a few types of liquidity ratios:

competitors may be in an economic upturn, while one whose debt increases

may not be the best investment.

Leverage ratios

Leverage ratios are also called debt ratios or solvency ratios. Like liquidity ratios,
leverage ratios deal with debt but with the goal of assessing a business's
capability to fulfill its long-term debt obligations instead of the ability to pay off its
debt in the short term. Examples of commonly used leverage ratios include:

Debt to equity

ratio Debt to

assets ratio

Interest

coverage ratio

Leverage ratios will give you a long-term view of a business's financial health
over time or compared to other enterprises.

Market value ratios

Market value ratios determine the current share price of a company's stock.
Investors use these values to determine if a business's stock is overvalued or
undervalued. Like the other types of ratio analysis, there are a few subtypes of
market value ratios, including:

Book value

per share

Dividend yield

Earnings per

share Market

value per
share

Price/earning

s ratio

You will commonly see market value ratios on stock charts. Because they are
well known, you can find average values for many industries to compare against
single companies to determine their relation to the marketplace.

Efficiency ratios

Efficiency ratios assess how well an enterprise uses its resources internally.
Some things an efficiency ratio can calculate for you are:
Inventory

turnover

Equipment

turnover

You can compare these ratios to other companies in the same industry to
determine how well a business is managed. When a business increases in
efficiency, that also increases its profitability.

Examples of ratio analyses

To better

understand

the different

types of

these ratios,

consider the

following example caculations:

Profitability ratios

The profitability ratio known as the net profit margin is the ratio of a company's
net income to its revenues. The net profit margin tells you how well a company
turned its revenue into profit and allows investors to assess a company's
financial health and stability. The net profit margin formula is:
(Net profits / Net sales) x 100 = Net profit margin

If a company has a revenue of $10,000 and made a net profit of $2,000, you can
calculate its net profit margin as follows:

$2,000 / $10,000 = 0.20 or 20%

This results in a net profit margin of 20%.

Liquidity ratios

One of the common liquidity ratios is the current ratio, which determines whether
a company can pay off its current liabilities with its current assets. The higher the
current ratio, the better chance they have at doing this. The current ratio is:

Current ratio = Current assets / Current liabilities

Say a company has current assets amounting to $50 and current liabilities of
$20. Using the current ratio formula, you'd perform the following calculation:

$50 / $20 = 2.5

This results in a current ratio of 2.5. This means the company has $2.50 of
current assets for every dollar of its current liabilities.

Leverage ratios

To better understand leverage ratios, you can use the debt-to-assets ratio as an
example. This ratio helps business owners determine how much of the
company's total assets is financed through debt. The debt-to-assets ratio is:

(Short-term debt + Long-term debt) / Total assets = Debt-to-assets

Now say your company's total assets are $220,000 and the total debt accrued is
$40,000. Based on this information, you'd perform the calculation as follows:

$40,000 / $220,000 = 0.18 or 18%

Market value ratios

The price/earnings ratio or P/E ratio evaluates a business by comparing its

current share price to its earnings per share. This ratio gives investors an idea of
the relative value of a stock when compared to the P/E ratios of other companies.
To calculate this value, you need to know the current stock price of a company,
its number of outstanding shares and the profit the company has made. Here's
the price/earnings ratio:
P/E Ratio = Market value per share / Earnings per share

Say a company's stock price closed at $90, its profit for the fiscal year was $12
billion and its outstanding shares resulted in $3 billion. You can calculate its
earnings per share by dividing its profit by its outstanding shares to get $4. Given
this information, the company's P/E ratio is:

$90 / $4 = 22.50

Efficiency ratios

The efficiency ratio known as inventory turnover compares costs of goods sold to
the average inventory as such:

Inventory Turnover = Cost of goods Sold / Average inventory

This ratio lets you know how much inventory a company has held and how
efficiently it used its inventory. A high inventory ratio indicates that a company
can move its inventory quickly. This displays good management and inventory
control.

Let's say you have a company whose cost of goods sold amounts to $100,000
and that has a year- end inventory of $10,000. Using this information, you can
determine its inventory turnover as follows:

$100,000 / $10,000 = 10
Formulas for calculating Ratio Analysis

Here are some commonly used formulas for calculating ratios in financial analysis:

1. Liquidity Ratios:
a. Current Ratio: Current Assets / Current Liabilities

b. Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities

2. Profitability Ratios:
a. Gross Profit Margin: (Gross Profit / Revenue) * 100

b. Net Profit Margin: (Net Income / Revenue) * 100

c. Return on Assets (ROA): Net Income / Average Total Assets

d. Return on Equity (ROE): Net Income / Average Shareholders' Equity

3. Activity Ratios (Efficiency Ratios):

a. Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory

b. Accounts Receivable Turnover: Net Credit Sales / Average Accounts Receivable

c. Total Asset Turnover: Revenue / Average Total Assets

4. Solvency Ratios:
a. Debt-to-Equity Ratio: Total Debt / Total Equity

b. Debt Ratio: Total Debt / Total Assets

c. Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense
5. Market Ratios:
a. Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings per Share (EPS)

b. Earnings per Share (EPS): Net Income / Total Shares Outstanding

These formulas provide a starting point for conducting ratio analysis. However,
it's crucial to ensure that the data used in these calculations is accurate and up-
to-date. Additionally, when comparing ratios across different companies or
industries, it's essential to consider variations in business models, accounting
practices, and industry norms.

➢ FUND FLOW ANALYSIS

Fund flow analysis is a technique used in financial analysis to assess the
changes in a company's financial position over a specific period. It involves
examining the inflow and outflow of funds within the organization, enabling an
understanding of the sources and uses of funds. The primary objective of fund
flow analysis is to provide insights into the movement of funds and to identify the
reasons behind changes in the financial position of a company.

Fund flow analysis involves the preparation and interpretation of a statement

known as the fund flow statement, which outlines the changes in the financial
structure of a business over a particular time frame. This statement typically
consists of two sections:

1. Sources of Funds: This section provides details about the various sources
from which funds are generated, such as issuance of stock, long-term borrowing,
or increased profits.

2. Uses of Funds: This section highlights the different uses for the generated
funds, such as investments in fixed assets, repayment of debt, or payment of
dividends.

Fund flow analysis helps in understanding how a company manages its finances,
whether it is through internal accruals or external financing. It is instrumental in
evaluating the financial health and operational efficiency of a business. By
analyzing the fund flow statement, stakeholders can make informed decisions
about investment, expansion, or divestment strategies.

Fund flow analysis is particularly useful in assessing the long-term financial

stability and viability of a company, as it enables the identification of any
discrepancies between reported profits and actual cash flow. By tracking the
movement of funds, it is possible to identify trends and patterns that may impact
the future financial performance of the company.

Objectives and uses of preparing Fund flow statement

The preparation of a fund flow statement serves various objectives and can be
used for different purposes in financial analysis. Some of the key objectives and
uses of preparing a fund flow statement include:

1. Assessing Changes in Financial Position: The fund flow statement helps in

analyzing the changes in the financial position of a company over a specific
period, allowing stakeholders to understand how funds are being generated and
utilized.

2. Identifying the Sources and Uses of Funds: It helps in identifying the sources
from which funds are generated and the areas where these funds are being
allocated within the organization.

3. Analyzing Liquidity and Solvency Position: The fund flow statement aids in
evaluating the liquidity and solvency position of the company by providing
insights into the company's ability to meet its short-term and long-term financial
obligations.

4. Understanding Capital Structure Changes: It facilitates the understanding of

the changes in the capital structure of the company, including changes in equity,
debt, and other financial instruments, over a specific period.

5. Monitoring Working Capital Management: It assists in monitoring the working

capital management of the company, helping stakeholders to assess the
efficiency of the company's utilization of its current assets and liabilities.

6. Assessing Financial Performance: By comparing the fund flow statements of

different periods, stakeholders can assess the financial performance of the
company and identify trends in the management of funds.

7. Supporting Investment and Financing Decisions: The fund flow statement

 provides valuable information that can support decision-making processes
related to investments, financing, and capital budgeting.

8. Facilitating Long-Term Planning: It aids in long-term financial planning

by providing insights into the financial health and stability of the company,
allowing for more informed decision-making regarding future investments and
expansion plans.

Overall, the fund flow statement plays a crucial role in providing a comprehensive
view of the financial health and performance of a company, enabling
stakeholders to make informed decisions and take appropriate actions to ensure
the sustainable growth and profitability of the organization.

➢ Limitations of Fund Flow Statement

While the fund flow statement is a valuable tool for assessing a company's financial
health, it has several limitations that should be considered when analyzing the financial
position of an organization. Some of the key limitations of the fund flow statement
include:

1. Limited Focus: The fund flow statement does not provide a comprehensive
view of a company's financial performance. It primarily focuses on the changes in
the working capital and cash flows, neglecting other important aspects of the
financial position, such as profitability and market dynamics.

2. Historical Perspective: The fund flow statement provides information about past
financial activities and does not offer real-time insights into the current financial
condition or the future prospects of the company.

3. Non-Cash Transactions: It may not adequately reflect non-cash transactions,

which can affect the interpretation of the company's actual cash position and
financial performance.

4. Subject to Manipulation: Similar to other financial statements, the fund flow

statement can be manipulated by management through various accounting
techniques, potentially obscuring the actual financial condition of the company.
5. Ignores Price Level Changes: The fund flow statement does not account for
changes in the price level, which can lead to distortions in the analysis of the
financial position, especially in the case of long-term investments and assets.

6. Limited Comparison: Comparing the fund flow statements of companies

operating in different industries or with different accounting practices may not
provide meaningful insights due to variations in the nature of their business
operations.

7. No Standardized Format: There is no standardized format for preparing the

fund flow statement, which can lead to inconsistencies in the presentation and
interpretation of the financial data.

8. Limited Predictive Value: While it can provide insights into the historical
movement of funds, the fund flow statement has limited predictive value, making
it less effective in forecasting future financial trends and performance.

To overcome these limitations, it is essential to use the fund flow statement in

conjunction with other financial statements and analysis techniques to gain a
comprehensive understanding of the company's financial health and
performance.

Conditions of Funds Flow

The flow of funds takes place when transactions between the following items occur:

1. Fixed and Current Assets (Assets purchased in Cash)

2. Current Assets and Capital (Redemption or Issue in Cash)
3. Fixed Assets and Current Liabilities ( Assets purchased in Credit)
4. Current Liabilities and Capital ( Debentures issued to Creditors)

How to prepare Funds Flow Statements?

Before preparing the funds statements, let’s review the sources from where we
will extract the required information.

1. The balance sheet of the current year and the previous year.
2. Profit and Loss Statement of the current year.
3. All the relevant information affects the firm’s fund flow.
After that, we need to prepare three statements, as discussed in the sections above.

Firstly, we analyze the changes in working capital. The statement depicts an

increase/decrease in current assets and liabilities between the two years.

Accounting Treatment in Fund Flow Statement:

• Record the net increase in working capital under the application of funds.
• Whereas a decrease in working capital under the sources of funds.

Format of Changes in Working Capital

Secondly, we calculate the funds from operations. It depicts an increase or

decrease in working capital due to operating activities.

We can calculate it by preparing the statements given below:

1. Statement of Funds Flow from Operations, or

2. Adjusted Profit and Loss Account

Accounting Treatment in Fund Flow Statement:

 • Funds from operations appear under sources of funds.
• Funds lost in operations appear under the application of funds.

➢ Format of Funds from Operations

Format of Adjusted Profit and Loss Account

The third or final step in the process is making the fund flow statement. The
fund’s statement has two separate sections, that is:

1. Sources of Funds: It depicts the items responsible for the inflow of funds into the business.
2. Application of Funds: This section shows the outflow of funds from the business.

Note: We can prepare it in the form of an account or statement. However, there is no

difference in items of both formats.
➢ Format of Fund flow Statements in the form of an
account
 ➢ Format of Fund flow Statements in the form of a Statement

Points to Remember

One must consider the following points while preparing funds flow statements:

• Always prepare the changes in working capital first.

• The funds flow statement and operations funds must be prepared simultaneously.
• Provide necessary working notes for the adjustments.

Importance of the fund flow statements

The fund flow statements are helpful to the firm’s stakeholders. This is because,
it conveys vital information about the business. Besides this, the importance or
uses of fund flow statements are as follows:
Management
Fund Flow Statements help management in the following ways:

1. It helps management to determine the plan of action for the future.

2. The fund flow analysis enables optimum resource allocation.
3. After analyzing the application of funds, management can formulate its dividend policy.
4. The management can analyze and improve its working capital positions.
5. It depicts the firm’s financial position, which helps acquire loans easily.

Investors
Investors can get some vital information about the firm like:-

1. Abilities of the firms to pay them dividend

2. Firm’s capabilities to pay their obligations
3. Effective sourcing and usage of the funds

Creditors
Fund flow statements provide the actual financial position of the business. The
creditors can find out the companies’ capabilities of repaying their debts. It
includes the short and long-term liabilities of the business.

Government
The government uses these statements to know the firm’s capital budgeting
sources. The government forms industrial policies based on the data
given in this statement. Fund flow statements also help the government in
capital control.

Financial Institutions
The financial institutions seek information about the firm’s liquidity and
profitability. They get this information by way of Fund flow statements.

Researchers
Researchers use various financial statements to assess a business’s financial
soundness. Fund flow statements help derive
conclusions about the financial position of
enterprises.

Limitations of Fund Flow Statements

There are certain limitations associated with the fund flow statement listed below:

• Only provides additional information about funds. Therefore, it cannot be

considered a substitute for financial statements.
• It uses historical data, so it is not prepared with much accuracy.
• These statements only cover changes in working capital, not cash. However,
for businesses analyzing changes in cash is very essential.
• Important non-fund transactions are not included in these statements.
Example of Fund Flow Statement
The Balance sheet of MRF Ltd. for 2011 and 2012 is given below. From the shared data
prepare:

• Statement of Working Capital Changes

• Fund Flow Statement

Additional Information:

1. Dividend paid Rs.400/-, Taxes Rs.250/-.

2. Issue of Bonus Shares Rs.800/-.
3. MRF Ltd. purchased land for Rs.1500/-.
4. Sale of Furniture costing Rs.1000/- for Rs.800/- (accumulated depreciation Rs.600/-).
Solution:

We will record the increase in working capital of Rs.4880/- under the application of funds.

Working Notes

Note 1:
Note 2:
Opening balance of Land Rs.7000/-
Add: Land Purchased Rs.1500/-
Less: Closing balance Rs.5000/-
Hence, the Sale of Land is equal to Rs.3500/-

➢ CASH FLOW STATEMENT

A cash flow statement is a financial statement that provides an overview of the

cash inflows and outflows within an organization during a specific period. It
presents information about the sources and uses of cash, allowing stakeholders
to understand how changes in the company's balance sheet and income
statement impact its cash and cash equivalents.

The cash flow statement is divided into three main sections:

1. Operating Activities: This section includes cash flows from the company's core
business operations. It encompasses cash receipts from sales of goods or
services and cash payments to suppliers, employees, and other operating
expenses. It also incorporates changes in working capital elements such as
accounts receivable, accounts payable, and inventory.

2. Investing Activities: This section comprises cash flows related to the purchase
and sale of long-term assets and other investments. It includes cash flows from
the acquisition or sale of property, plant, and equipment, as well as investments
in securities or other businesses.
3. Financing Activities: This section involves cash flows related to the company's
financing activities. It includes cash received from issuing or borrowing funds, as
well as cash used for debt repayment, share repurchases, or dividend payments.

The cash flow statement is crucial for understanding a company's liquidity,

solvency, and overall financial health. It provides insights into how effectively a
company manages its cash position and whether it can meet its short-term and
long-term financial obligations. By analyzing the cash flow statement, investors,
creditors, and management can evaluate the company's ability to generate cash,
its investment and financing decisions, and its overall cash flow management
practices.

➢ IMPORTANCE OF CASH FLOW STATEMENT

The cash flow statement is a crucial financial document that holds significant
importance for various stakeholders, including investors, creditors, and
management. Some key reasons highlighting the importance of the cash flow
statement are:

1. Assessing Liquidity and Solvency: The cash flow statement provides insights
into a company's ability to meet its short-term obligations. It helps stakeholders
assess the company's liquidity position by analyzing its ability to generate and
utilize cash effectively.

2. Evaluating Operating Performance: It allows stakeholders to evaluate the

efficiency of a company's core operations by assessing the cash generated from
its day-to-day business activities. This analysis provides a clear picture of the
company's operational strengths and weaknesses.

3. Facilitating Investment Decisions: Investors often use the cash flow statement
to evaluate the financial health and stability of a company. A positive cash flow
from operating activities indicates that the company is generating sufficient cash
to sustain and grow its operations, making it an attractive investment opportunity.
4. Assessing Financial Structure: The cash flow statement helps in evaluating a
company's financial structure by providing insights into its financing and
investment activities. It aids in understanding the sources of funds and how the
company is utilizing them, which is crucial for assessing its long-term financial
sustainability.

5. Forecasting Future Cash Flows: By analyzing past cash flow statements,

stakeholders can make more accurate predictions about a company's future cash
flows. This information is essential for making informed decisions about
investment, financing, and dividend policies.

6. Detecting Financial Irregularities: Discrepancies between the reported profits

and the actual cash flow can indicate potential financial irregularities or
accounting manipulations. Therefore, the cash flow statement is instrumental in
detecting any discrepancies and ensuring the accuracy and transparency of
financial reporting.

7. Monitoring Cash Management: The cash flow statement helps in monitoring

and managing the cash position of the company. It allows management to
identify periods of cash shortages or surpluses, enabling them to make timely
adjustments to ensure the smooth functioning of the business operations.

Overall, the cash flow statement plays a critical role in providing a comprehensive
understanding of a company's financial health, liquidity position, and cash
management practices, thereby enabling stakeholders to make well-informed
decisions about the company's future prospects.

OBJECTIVES OF CASH FLOW STATEMENT

The primary objectives of the cash flow statement revolve around providing a
comprehensive understanding of the cash position and cash flow dynamics
within a company. The cash flow statement serves to achieve several key
objectives, including:

1. Assessing Liquidity Position: One of the main objectives is to assess the

liquidity position of the company. By analyzing the cash flow statement,
stakeholders can determine the company's ability to meet its short-term financial
obligations.
2. Understanding Operating Activities: The cash flow statement helps in
understanding the cash flow generated from the company's core operating
activities. This is essential for evaluating the efficiency and profitability of the
company's primary business operations.

3. Evaluating Financing and Investing Activities: It aids in evaluating the

company's financing and investing activities by providing insights into the sources
and uses of cash for these activities. This is crucial for assessing the company's
capital structure and investment decisions.

4. Facilitating Financial Planning: The cash flow statement assists in financial

planning by providing information about the cash flows that are expected to be
generated in the future. This information is instrumental in creating effective
financial strategies and plans for the company.

5. Enhancing Decision-Making: It serves to enhance decision-making for

investors, creditors, and management. By providing a clear picture of the
company's cash flow dynamics, the cash flow statement helps stakeholders
make informed decisions regarding investments, credit extension, and overall
financial management.

6. Detecting Financial Irregularities: The cash flow statement can help in

detecting any potential financial irregularities or discrepancies between reported
profits and actual cash flow. It serves as a tool for ensuring transparency and
accuracy in financial reporting.

7. Facilitating Comparison and Analysis: By presenting the cash flow information

in a structured format, the cash flow statement facilitates easy comparison and
analysis of the financial performance of the company over different periods. This
allows stakeholders to identify trends and patterns that can inform future
decision-making processes.

Overall, the objectives of the cash flow statement are centered around providing
stakeholders with a comprehensive understanding of the company's cash flow
dynamics, financial health, and ability to meet its financial obligations.
Cash Flow from Three Different Activities

1. Format of Cash Flow from Operating Activities

* Net profit before taxation and extraordinary items is calculated as:
Difference between Fund Flow and Cash Flow

Following are the key differences between fund flow and cash flow:
Fund Flow Cash Flow
Funds flow statements record the changes Cash flow statements record the movement of cash
in working capital. only.

It helps understand the financial position It helps understand the net cash flow of the
of the company. company.

The fund flow statement determines the The cash flow statement records changes in
source and application of funds. opening balance and closing balance of cash.

It works on the accrual basis of It works on a cash basis of accounting.

accounting.
The analysis is for the long term. The analysis is for a short duration.
Fund flow is useful for capital budgeting. Cash flow is useful for cash budgeting.
 ➢ CASH FLOW AND FUND FLOW ANALYSIS APPLICATION IN
FINACIAL DECISION MAKING

Cash flow and fund flow analysis play crucial roles in financial decision-making
for businesses. Here's how these analyses can be applied in various financial
decision-making scenarios:

1. Investment Decisions:

- Cash flow analysis helps in evaluating the potential returns and risks
associated with different investment options. It provides insights into the cash-
generating capabilities of different projects, helping in the selection of projects
with favorable cash flows.

- Fund flow analysis aids in understanding the long-term financial requirements

of investment projects. It assists in determining the availability of funds for
financing the investments and in assessing the impact of these investments on
the company's financial position.

2. Capital Structure Decisions:

- Cash flow analysis assists in determining the appropriate mix of debt and
equity in the capital structure. It helps in evaluating the company's ability to
generate cash for servicing debt obligations, thereby ensuring a sustainable
capital structure.

- Fund flow analysis is useful in understanding the long-term capital

requirements of the business. It helps in determining the optimal level of long-
term funds needed to support the company's growth objectives.

3. Dividend Policy Decisions:

- Cash flow analysis provides insights into the company's cash reserves and its
ability to distribute dividends. It helps in determining whether the company has
sufficient cash flows to support dividend payments without compromising its
operational and investment requirements.

- Fund flow analysis assists in understanding the impact of dividend payments

on the company's long-term financial position. It helps in assessing the
availability of funds for dividend distribution while ensuring the company's
financial stability and growth prospects.
4. Working Capital Management Decisions:

- Cash flow analysis aids in monitoring and managing the

company's working capital requirements. It assists in ensuring that
the company maintains an optimal level of liquidity to meet its short-
term obligations and operational needs.

- Fund flow analysis helps in understanding the changes in the

company's working capital position over time. It provides insights
into the effectiveness of the company's working capital
management strategies and assists in making necessary
adjustments to improve the company's overall financial health.

By incorporating both cash flow and fund flow analyses into the
decision-making process, businesses can make more informed and
effective financial decisions, ensuring sustainable growth and long-
term financial stability.
 UNIT -3
1.COST ACCOUNTING

Cost accounting is a branch of accounting that deals with the identification,

measurement, accumulation, analysis, interpretation, and communication of
costs. Its primary objective is to provide information to management for planning,
controlling, and decision-making purposes within an organization. Cost
accounting is particularly focused on determining the cost of producing a product
or service and assists in identifying areas for cost reduction, cost control, and
overall improvement of operational efficiency.

Key components and techniques associated with cost accounting include:

1. Cost Classification: Differentiating between various types of costs such

as direct costs, indirect costs, fixed costs, variable costs, and overhead costs.

2. Cost Measurement and Cost Estimation: Calculating the actual and

estimated costs associated with the production of goods or services.

3. Cost Control: Monitoring and controlling costs to ensure that they align
with the predetermined budgets and plans.

4. Standard Costing: Setting predetermined costs for materials, labor, and

overhead and comparing these with the actual costs to assess performance and
variances.

5. Variance Analysis: Analyzing the differences between actual costs and

budgeted costs to identify the reasons for the differences and to take necessary
corrective actions.

6. Marginal Costing: Analyzing the impact of changes in production

volume on the total costs and profits of the organization.
 7. Activity-Based Costing (ABC): Allocating costs based on the specific
activities involved in the production process, enabling a more accurate
understanding of the cost drivers and cost behavior within the organization.

8. Cost-Volume-Profit Analysis (CVP): Evaluating the relationship between

costs, sales volume, and profits to assess the company's breakeven point and to
make informed decisions about production and pricing strategies.

Overall, cost accounting provides crucial insights into the cost structure of
a business, enabling management to make informed decisions about pricing,
budgeting, investment, and various other aspects of operational and financial
management.

KEY TAKEAWAYS

• Cost accounting is the reporting and analysis of a company's cost structure.

• Cost accounting involves assigning costs to cost objects that can include
a company's products, services, and any business activities.
• Cost accounting is helpful because it can identify where a company is
spending its money, how much it earns, and where money is being lost.
• Having a clear idea of the costs associated with running a business
makes it easier for management to boost profitability.
• Cost accounting is distinct and separate from general financial accounting,
which is designed for outside audiences and heavily regulated

➢ Types of Costs in Cost Accounting

Businesses can incur many types of costs depending on their industry. Here are
a few of the most common costs involved in cost accounting.

Direct Costs

A direct cost is a cost directly tied to a product's production and typically includes
direct materials, labor, and distribution costs. Inventory, raw materials, and
employee wages for factory workers are all examples of direct costs.

Indirect Costs

Indirect costs can't be directly tied to the production of a product and might
include the electricity for a factory.
Variable Costs

Costs that increase or decrease with production volumes tend to be classified as

variable costs. A company that produces cars might the steel involved in
production as a variable cost.

Fixed Costs

Fixed costs are the costs that keep a company running and don't fluctuate with
sales and production volumes. A factory building or equipment lease would be
classified as fixed costs.

Operating Costs

Operating costs are the costs to run the day-to-day operations of the company.
However, operating costs—or operating expenses—are not usually traced back
to the manufactured product and can be fixed or variable.

➢ ELEMENTS OF COST
 ➢ CLASSIFICATION OF COST
Costs can be classified in various ways depending on the purpose and context of
the analysis. The classification of costs is crucial for understanding the different
cost components within a business. Here are some common classifications of
costs:

1. By Nature of Expenses:

- Direct Costs: Costs that can be directly traced to the production of specific
goods or services, such as raw materials and direct labor.

- Indirect Costs: Costs that are not directly attributable to a specific product
or service, such as overhead costs and administrative expenses.

2. By Behavior in Relation to Activity:

- Fixed Costs: Costs that do not change with the level of production or sales,
such as rent and salaries.

- Variable Costs: Costs that vary in direct proportion to the level of production
or sales, such as raw materials and sales commissions.

- Semi-Variable Costs: Costs that have both fixed and variable

components, such as utilities and maintenance costs.

3. By Traceability to Products or Services:

- Product Costs: Costs directly related to the production of goods or services,

including direct materials, direct labor, and manufacturing overhead.

- Period Costs: Costs not directly associated with the production process
but incurred during a specific period, such as selling and administrative
expenses.

4. By Controllability:

- Controllable Costs: Costs that can be influenced or controlled by

management, such as discretionary expenses and certain overhead costs.
 - Uncontrollable Costs: Costs that cannot be easily influenced by
management, such as market-driven costs and certain external factors.

5. By Time:

- Historical Costs: Costs that have already been incurred in the past and are
recorded in the accounting books.

- Predetermined Costs: Costs estimated in advance for budgeting and planning

purposes, such as standard costs and budgeted costs.

6. By Relevance to Decision Making:

- Relevant Costs: Costs that are pertinent to a specific decision-making

scenario, such as future costs and incremental costs.

- Irrelevant Costs: Costs that do not impact decision-making and are not
considered in the decision-making process.

Understanding the various classifications of costs is essential for effective cost

management, budgeting, and decision-making within an organization. It allows
businesses to identify cost- saving opportunities, assess profitability, and make
informed strategic choices.

COST SHEET

Cost Sheet – Introduction

A cost sheet is a statement designed to show the output of a particular

accounting period along with its break-up of costs. The data incorporated in
cost sheet are collected from various statements of accounts which have
been written in cost accounts.

Cost Sheet is a statement, prepared at given intervals of time, which

provides information regarding elements of cost incurred in production. It
discloses the total cost as well as the cost per unit of the product
manufactured during the given period. If it is desired to compare the costing
results of a particular period with any of the preceding periods, comparative
columns can be provided in the Cost Sheet.
In a cost sheet, the total cost and the unit cost of a product are presented in
analytical form showing the details of various elements of cost in total and /or
per unit depending on the requirements. Cost sheets are generally prepared
under the unit costing method.

The cost sheet is prepared to ascertain cost of product/job/operation or to

give quotations or to determine tender price for supply of goods or providing
service. A cost sheet helps in the determination of cost per unit and in the
fixation of selling price of the product.

By comparing the cost sheets of the two periods, the management can
ascertain the inefficiencies, if any, in production and take corrective action
whenever required. If the same product is being produced in two or more
factories under the same management or under different managements, cost
comparisons are possible by preparing cost sheets for various factories. Thus
a cost sheet can be used as a basis for cost control and cost reduction.

Depending on the situation, a cost sheet can be a simple cost sheet or a cost
sheet with adjustment for opening and closing stock of work-in-progress and
finished goods. It may be observed that there is no hard and fast rule of the
sequence of unit cost and total cost column. The total cost column can
precede the unit cost column.

Cost Sheet – Meaning

Cost sheet is a statement presenting the items entering into cost of products
and services, analysed by their elements, functions and even by their
behaviour. It is a statement prepared to show the different elements of cost.

A cost sheet may be defined as “a detailed statement of the elements of cost

incurred in production, arranged in a logical order under different heads such
as material, labour and overheads, prepared at short intervals of time”. Within
the strict meaning of the term it does not include sale proceeds and profit
earned. If these are included it is called as “Statement of Cost and Profit”.

Cost sheet reveals the details of total cost of the job, order or operation. It
shows the total cost as well as different elements of the total cost and cost
per unit. Thus, Cost Sheet is a statement which presents an assembly of the
components of cost.

Cost sheet is a statement prepared to show the cost of production in an

industry in terms of total and also in several stages. It also shows the cost at
every stage in terms of total production and each unit. This can be prepared
for any period of time such as a week, month, quarter year, half year or a
year based on the requirement of the industry.

A cost sheet is an exercise in collection of information regarding all the costs

incurred in the industry and arranging them in a certain order. The information
required to prepare a cost sheet is gathered from several records in the
organization.
Since a cost sheet is only a statement, it can be prepared in any format so
as to suit the needs of the organization. A cost sheet is also called a
statement of cost. A typical cost sheet does not include total sales and profit.
If a cost sheet includes sales and profit, it is called a statement of cost and
profit.

Cost Sheet – Definitions

All costs incurred or expected to be incurred during a given period are

presented in the form of a statement, popularly called cost sheet or statement
of cost or production statement.

The chartered Institute of Management Accountants, London defines cost

sheet as “a document which provides for the assembly of the detailed cost of
a cost centre or cost unit” The cost sheet is prepared with separate columns,
one for the cost per unit and the other for the total cost.

Separate columns can also be provided for the current cost and cost of the
previous periods. The cost sheet is generally prepared periodically, say
weekly, monthly, quarterly and yearly. There is no prescribed format or form
of the cost sheet. It’s from, contents and arrangement vary from firm to firm.

According to Harold J. Wheldon, “Cost sheets are prepared for the use of
the management and consequently, they must include all the essential details
which will assist the management in checking the efficiency of production.”

According to Walter W. Bigg, The expenditure, which has been incurred

upon production for a period, is extracted from the financial books and the
store records, and out in a memorandum statement. If this statement is
confined to the discloser of the cost of the units production during the period, it
is termed cost sheet.

Top 4 Objectives of Cost Sheet

(1) It reveals the total cost and cost per unit of goods produced.

(2) It discovers the break-up of total cost into different elements of cost.

(3) It provides a comparative study of the cost of current period

with that of the corresponding previous period.

(4) It acts as a guide to management in fixation of selling prices and quotation of tenders.
Cost Sheet – Basic Features

The basic features of cost sheet are as follows:

(i) This statement is usually prepared under the output costing method,
where the object is to ascertain the per unit cost of production.

(ii) A cost sheet is prepared for a specified period of time, generally for a
month, quarter, half year or year.

(iii) The cost sheet generally contains the following information –

(a) Period,

(b) Total Output,

(c) Cost of raw materials consumed,

(d) Cost of direct labour,

(e) Details of chargeable expenses

(f) Details of overheads namely factory, office and administration

and selling and distribution, and

(g) Aggregate of elements of cost at various stages e.g., Prime Cost,

Works Cost, Office Cost and Total Cost.
COST SHEET PERFORMA
2.MARGINAL COSTING
Marginal costing is a cost accounting method that focuses on identifying and
analyzing the variable costs associated with producing goods or services. It is
also known as variable costing or direct costing. Marginal costing provides
valuable insights into cost behavior and aids in decision-making, especially in
scenarios where a company needs to assess the impact of various production
levels or pricing strategies.

Key principles and features of marginal costing:

1. Variable Costs: Marginal costing distinguishes between variable costs and

fixed costs. Variable costs are those costs that change directly with changes in
production or sales volume, such as raw materials, direct labor, and variable
overhead.

2. Contribution Margin: The contribution margin is a crucial concept in marginal

costing. It is the difference between total sales revenue and total variable costs.
This metric represents the amount available to cover fixed costs and generate a
profit. Contribution margin per unit or per product is useful in assessing
profitability.

3. Fixed Costs: Fixed costs remain constant within a certain production or sales
range. They include costs like rent, salaries of permanent staff, and depreciation.
In marginal costing, fixed costs are treated as period costs and are not allocated
to individual products.

4. Break-Even Analysis: Marginal costing is often used in break-even analysis,

which helps determine the level of sales needed to cover both variable and fixed
costs. Beyond the break- even point, the company starts to generate a profit

.
 5. Decision-Making: Marginal costing is useful for making short-term decisions,
such as pricing, product mix, discontinuing product lines, or special order
decisions. Managers can assess the impact of these decisions on the
contribution margin and overall profitability.

6. Cost-Volume-Profit (CVP) Analysis: CVP analysis is closely related to

marginal costing. It helps in understanding how changes in sales volume, selling
price, or variable costs affect a company's profits.

7. Reporting: Marginal costing can provide management with more insightful

reports, such as contribution margin income statements, which segregate
variable and fixed costs. This aids in better decision-making.

It's important to note that while marginal costing is valuable for short-term
decision-making, it may not provide a comprehensive view of a company's financial
performance. Traditional absorption costing methods, which allocate fixed costs to
products, are typically used for financial reporting and taxation purposes. Companies
often use both methods to gain a comprehensive understanding of their costs and
profitability.

➢ Calculation of Marginal cost

Marginal costing is a cost accounting technique that helps businesses

determine the cost of producing one additional unit of a product or service.
Marginal costing is also known as “variable costing“. Because it only
considers the variable costs associated with producing an additional unit of a
product or service, such as direct labour and materials.

Under marginal costing, fixed costs, such as rent and salaries, are
considered period costs that are not directly related to the production of a
specific unit. Instead, fixed costs are expensed in the period they are
incurred. This differs from absorption costing, another cost accounting
technique that allocates fixed costs to each unit produced.

It can be useful for decision-making, as it allows businesses to determine the

profitability of producing additional units of a product or service. For example,
suppose a business is considering whether to produce and sell additional
product units. In that case, they can use
this method to determine the incremental production cost. Also, for selling
those units and compare it to the expected revenue from selling those units.

➢ Calculation of Marginal Cost

• Company: XYZ Pvt. Ltd., an Indian manufacturing firm.

• Product: Pen
• Initial Production: 1000 units
• Initial Total Cost: ₹50,000 (including all fixed and variable costs)
• Increased Production: 1100 units
• New Total Cost: ₹54,000

Calculation:

• Change in Total Cost (ΔTC):

• New Total Cost – Initial Total Cost
• ΔTC=₹54,000−₹50,000=₹4,000ΔTC=₹54,000−₹50,000=₹4,000
• Change in Quantity (ΔQ):
• Increased Production – Initial Production
• ΔQ=1100−1000=100ΔQ=1100−1000=100
• Marginal Cost (MC):
• MC=ΔTC/ΔQ
• MC=₹4,000100=₹40MC=100₹4,000=₹40

The marginal cost of producing one additional pen is ₹40. This means for
every extra pen produced, the cost increases by ₹40. This information is
crucial for XYZ Pvt. Ltd. to make decisions about production expansion,
pricing, and profitability.
 ➢ Advantages of Marginal Costing

Marginal costing offers several advantages to businesses. Here are some of

the key advantages of this costing technique.

Clear Cost-Volume-Profit Analysis

Marginal costing clearly explains the relationship between costs, volume,

and profit. By distinguishing between fixed and variable costs, it becomes
easier to calculate the contribution margin—the difference between sales
revenue and variable costs. This information is crucial for determining the
breakeven point and assessing the profitability of different product lines or
services.

Effective Decision Making

Marginal costing aids decision-making by providing insights into various

options’ incremental costs and revenues. Marginal costing helps assess
the impact on overall profitability. It can be evaluating the profitability of a
new project, pricing decisions, or make-or-buy choices. It enables
managers to make informed decisions by considering the incremental
contribution of each option.

Simplified Costing

Unlike absorption costing, which allocates fixed overheads to products,

marginal costing only considers variable costs directly attributable to
production. This simplifies the costing process, making it easier to
understand and apply. It also eliminates the complexities of apportioning
fixed overheads, sometimes leading to misleading cost information.

Efficient Cost Control

It facilitates effective cost control by identifying and isolating variable costs.

Managers can focus on managing and controlling these costs more directly,
as they tend to be more controllable in the short term. By monitoring and
analyzing variable costs, businesses can identify areas of cost overruns,
implement cost-saving measures, and improve overall cost efficiency.
 Flexibility in Pricing Decisions

It offers flexibility by separating fixed costs from variable costs. Businesses

can set prices based on incremental production costs. It ensures that each
unit sold contributes towards covering the variable costs and generating a
positive contribution margin. This approach helps in optimizing pricing
strategies and achieving profitability objectives.

Performance Evaluation
Marginal costing facilitates performance evaluation at various levels, such as
products, departments, or business segments. Focusing on contribution margins it
provides a more accurate assessment of profitability. Also, it analyses the
performance of different units within the organization. Managers can identify
underperforming products or divisions and take necessary corrective actions.

➢ Disadvantages of Marginal Costing

While this costing method offers several advantages, there are also some
disadvantages that businesses should be aware of. Here are some of the
key disadvantages:

Doesn’t consider all costs: This approach only considers variable costs and
doesn’t consider fixed costs, such as rent and salaries. This can lead to an
incomplete picture of a business’s costs and profitability.

Can be misleading: It can be misleading in situations where fixed costs are

high and production levels are low. In such cases, the marginal cost per unit
may be high, leading to the incorrect conclusion that the product could be
more profitable.

Difficult to allocate fixed costs: This costing method doesn’t allocate fixed
costs to each unit produced. Hence making it difficult to determine each
unit’s cost accurately.

Not suitable for long-term planning: It is primarily a short-term planning tool

and may not be suitable for long-term planning. In the long term, fixed costs
may change and become variable, which could affect the profitability of
products.
Doesn’t account for inventory valuation: This method needs to consider
the value of inventory, which can lead to distorted profitability figures.

Managerial applications of Marginal costing

Marginal costing has several managerial applications in various aspects of
business decision- making. Some of the key managerial applications of
marginal costing include:

1. Pricing Decisions: Marginal costing helps in setting appropriate prices for

products or services. By considering the variable costs and contribution margin,
managers can determine the minimum price at which a product should be sold
to cover its variable costs and make a profit.

2. Product Mix Decisions: Companies often produce multiple products or offer

different services. Marginal costing can help managers assess the profitability of
each product or service and make informed decisions about which products to
prioritize or discontinue.

3. Special Order Decisions: When a company receives a special order that

deviates from its regular pricing or production processes, marginal costing can
be used to evaluate whether accepting the order would be profitable, taking into
account the additional variable costs and the contribution margin.

4. Make or Buy Decisions: In cases where a company has the option to produce
a component in- house or purchase it externally, marginal costing can help
assess the cost implications of both options and determine the most cost-
effective choice.

5. Shut-down or Continuation Decisions: If a product line is not performing well,

marginal costing can help in deciding whether to continue or discontinue it. By
analyzing the contribution margin of the product line and comparing it to fixed
costs, managers can make informed decisions.
6. Sales Volume Decisions: Managers can use marginal costing to estimate
the level of sales needed to cover both variable and fixed costs, thereby
determining the break-even point and profit potential at different sales
volumes. This information is crucial for sales planning and forecasting.

7. Investment Decisions: When considering capital investments, such as

purchasing new equipment or expanding production capacity, marginal
costing can help assess the potential return on investment and whether the
additional production will be profitable.

8. Cost Control and Cost Reduction: Marginal costing provides insights into
variable costs, which can help identify cost reduction opportunities. Managers
can focus on reducing variable costs to improve the overall profitability of the
company.

9. Budgeting and Performance Evaluation: Managers can use marginal costing

to create flexible budgets that incorporate variable and fixed costs. These
budgets can be used for performance evaluation by comparing actual results to
budgeted figures.

10. Profit Planning and Target Setting: Marginal costing facilitates the setting of
profit targets by considering the desired level of profit and the contribution
margin. This helps in developing achievable financial goals.

11. Inventory Valuation: Marginal costing can be applied to inventory

valuation, particularly when using techniques like the FIFO (First-In-First-
Out) method for determining the cost of goods sold. It can provide a more
realistic picture of the cost of inventory consumed.

Overall, marginal costing is a valuable tool for managerial decision-making, as it

allows managers to analyze and understand the impact of variable costs on
profitability and make informed choices to improve the financial performance of
a business.
Difference between Marginal costing and Absorption costing
Marginal costing and absorption costing are two distinct approaches to
accounting for the costs of producing goods or services. They differ primarily in
how they treat fixed manufacturing overhead costs. Here are the key differences
between marginal costing and absorption costing:

1. Treatment of Fixed Manufacturing Overhead Costs:

- Marginal Costing: Under marginal costing, fixed manufacturing overhead

costs are treated as period costs. These costs are not allocated to individual
products. Instead, they are expensed in the period they are incurred. This
means that fixed overhead costs do not form part of the product's cost in the
income statement.

- Absorption Costing: In absorption costing, fixed manufacturing overhead

costs are treated as product costs and are allocated to each unit of production.
These costs become part of the cost of goods sold. As a result, the cost of each
product includes both variable and fixed manufacturing overhead costs.

2. Impact on Profit:

- Marginal Costing: Profit is calculated as the difference between total sales

revenue and total variable costs. Fixed costs are deducted from this profit
separately. This means that profit can vary with changes in production or sales
volume but remains unaffected by changes in the level of fixed costs.

- Absorption Costing: Profit is calculated after deducting both variable and

fixed manufacturing overhead costs from total sales revenue. Profit can be
significantly affected by changes in production volume because fixed
overhead costs are spread across more units as production increases,
potentially leading to higher reported profits.
3. Inventory Valuation:

- Marginal Costing: Inventory valuation is typically based on variable

production costs. Fixed overhead costs are not included in the valuation of
closing inventory. This can result in differences in the reported value of closing
inventory compared to absorption costing.

- Absorption Costing: Inventory valuation includes both variable and fixed

manufacturing overhead costs. This approach aligns more closely with
Generally Accepted Accounting Principles (GAAP) and is often used for
financial reporting and tax purposes.

4. Decision-Making:

- Marginal Costing: Marginal costing is particularly useful for short-term

decision-making. It provides insights into how variable costs affect profitability
and is often employed for pricing, product mix decisions, and evaluating the
financial impact of special orders.

- Absorption Costing: Absorption costing may provide a more comprehensive

view of costs, which can be valuable for long-term planning and financial
reporting. It is typically used for income tax purposes and is considered more
in line with Generally Accepted Accounting Principles (GAAP).

In summary, the main difference between marginal costing and absorption

costing lies in how they treat fixed manufacturing overhead costs and the
resulting impact on profit calculation and inventory valuation. Both methods
have their advantages and are suitable for different purposes, so companies
may use one or both approaches depending on their specific needs and
regulatory requirements.
Marginal Costing Formulas

Marginal Costing Formulas can be used in financial modeling to analyze

the generation of the cash flow. you can easily calculate the cash flow with
the given below marginal costing formula.

Marginal Costing Equation: We know that profit is difference between sales

& total cost. Total can bifurcated in to Fixed & Variable costs. Thus,

Profit = Sales – Total Cost Where Total cost= Variable Cost + Fixed Cost

The above formula can also be written as:

1. Profit = Sales – Variable Cost – Fixed Cost

Or

Fixed Cost + Profit = Sales – Variable Cost.

2. Profit per unit = Selling Price – Variable Cost per unit – Fixed Cost per unit

3. Fixed Cost:

F.C, as the name suggests, remain fixed in amount. The amount spent
towards such an expensive remains the same irrespective of the Volume
of production. They may have to be incurred even if there is no production.
For ex: rent of factory building, Salaries, Audit fees, go down rent etc.

Fixed cost = Sales – Variable Cost – Profit (Loss);

or

Fixed cost = (Sales*PV Ratio) – Profit (Loss).

4. Variable Cost:

Variable cost varies in direct proportion to the volume of production. No

variable costs are included if production is stopped. As production
increases, variable costs increase. However, Variable cost P.U will not
change. For Ex: if it is estimated that 2 units are required to produce 1 unit
of finished product, then material cost will continue to increase as the
number of units finished stock desired increases. All direct costs are
Variable cost. Commission to sales persons, certain taxes, etc.
 Variable cost = Sales – Fixed Cost – Profit (Loss);
or

Variable Cost = Sales*Variable cost ratio where Variable cost ratio = 1 –

PV Ratio.

5. Semi -Variable Cost:

S.V.C change with the changes in out put of production, but the change
not proportionate. For the purpose of analysis, S.V.C is split in to Fixed
Cost and Variable Cost. S.V.C normally has a fixed cost component, which
needs to be incurred irrespective of no. of units produced. Telephone
expenses are a example of S.V.C. Telephone exp. Can be split in to a
fixed component of a rent that needs to be paid whether or not the
telephone is used. The charge for every call made constitutes the variable
component.

Two point Method:

Under this method, the out put at two different levels is compared with
corresponding amount of semi variable expenses. Since fixed costs, the
change in amount of expenses is on account of variable costs, divided by
the change in out put, and gives the variable costs per unit. If the number
of units at a given level of output is multiplied with variable cost per unit, we
get the variable proportion in the total amount of expenses at the given
level. The difference between the two amounts gives us the ‘Fixed Cost’
component in the semi – variable cost.

6. Contribution:

Contribution is the difference between sales and Variable Costs. Since

sales & Variable Cost can be both expressed in P.U. terms, contribution is
usually expressed in P.U. terms.

Contribution = Sales –Variable Cost,

or

Contribution per unit = Selling Price per unit – Variable Cost per unit,
or

Total contribution = Contribution P.U. X No. of Units sold.

 7. P/v Ratio:

P/v Ratio stands for Profit /Volume Ratio. However, it is ratio of

contribution to sales. It is calculated by applying the following formula:

P/v Ratio = (Contribution / Sales)*100,

or

P/v Ratio = (Sales-Variable Costs)/ Sales*100;

or

P/v Ratio = 1 – Variable cost ratio (Variable Cost Ratio is the % of

variable cost to sales),
or

P/v Ratio = {Change in Profit (contribution)/Change in Sales} * 100.

8. BEP (Break – Even Point):

Break Even Point is a point of no profit no loss for an entity. At this level,
total cost of production is equals to total sales. BEP is Calculated as:

BEP (In Rs.) = Fixed Cost / P/V Ratio;

or

BEP (In Units) = Fixed Cost / Contribution PER UNIT; or Fixed costs /
(Selling Price PER UNIT. – Variable Cost PER UNIT);
Or

BEP (In Rs.) = BEP in Units X Selling Price PER UNIT;

or

BEP (In Rs.) = (Fixed Cost X Total Sales)* Contribution.

9. Desired sales or Desired Profit:

Units to be sold to earn Desired Profit = (Fixed Cost + Desired

Profit)/ Contribution PER UNIT.

Desired Sales to earn Desired Profit = (Fixed Cost / Desired Profit) / P/v Ratio.
 10. Margin of Safety (MOS):

MOS (In Rs.)= Total Sales – BEP Sales;

or

MOS (In Rs.) =Profit/ PV ratio;

or

MOS (In Units) = Profit / Contribution per unit.

3.Standard Costing

Standard costing is a cost accounting method that involves establishing

predetermined cost standards for various elements of production, such as
materials, labor, and overhead. These standards represent the expected costs of
producing a product or providing a service under normal conditions. Standard
costing is widely used in manufacturing and other industries to evaluate
performance, control costs, and make informed management decisions. Here are
the key components and features of standard costing:

1. Standard Costs: Standard costs are pre-established cost figures that

represent the ideal or budgeted costs for each cost component involved in
production. There are typically three main standard costs:

- Standard Material Cost: The expected cost of materials required to produce a

unit of a product or service.

- Standard Labor Cost: The anticipated cost of labor, including direct

labor and indirect labor, required to produce a unit.

- Standard Overhead Cost: The projected cost of manufacturing

overhead, including fixed and variable overhead costs, per unit.

2. Establishing Standards: Companies establish standard costs by

analyzing historical data, market conditions, industry benchmarks, and
other relevant factors. These standards are periodically reviewed and
updated to reflect changing circumstances.
 3. Variance Analysis: Standard costing relies heavily on variance
analysis, which involves comparing actual costs to standard costs.
Variances are categorized into two main types:

- Favorable Variances: When actual costs are less than the standard
costs, it results in a favorable variance. This indicates cost efficiency or
positive performance.

- Unfavorable Variances: When actual costs exceed the standard

costs, it leads to an unfavorable variance. This suggests cost overruns or
negative performance.

4. Cost Control: Standard costing helps companies monitor and control

costs by identifying the reasons behind variances and taking corrective
actions when necessary. Management can focus on areas with
unfavorable variances to improve efficiency.

5. Performance Evaluation: Standard costing provides a framework for

evaluating the performance of departments, processes, and individuals. It
can be used to reward employees for meeting or exceeding cost
standards.

6. Budgeting: Standard costs play a crucial role in the budgeting process.

They are used as the basis for developing budgets, allowing companies to
set financial targets and allocate resources effectively.

7. Inventory Valuation: Standard costing can also be used for inventory

valuation purposes. Closing inventory is valued based on standard costs,
and the difference between the actual and standard inventory values is
recorded as a variance.

8. Pricing Decisions: Standard costing can help in making pricing

decisions by providing a clear understanding of the expected costs of
production. Companies can set prices that consider both standard costs
and desired profit margins.
 material prices, production disruptions, or shifts in labor efficiency.
Companies should regularly review and update their standards to keep
them relevant.

Advantages of standard costing

Here are the top benefits of using standard costing:

Helps with accurate budgeting

Manufacturers rely on standard costing for creating budgets, as it is

difficult to calculate the actual costs of producing an item before the
production is complete. Manufacturing budgets are usually a smart
estimate and not the actual price. They compare standard and actual
costs once manufacturing is complete to identify the variances. They can
then use this information to make the following year's budget more
accurate.

Simplifies inventory costing

Calculating the required inventory is easier when using standard costs

than actual costs. Generally, during production, the cost of manufacturing
varies from one batch to another. This can be due to several factors, such
as production delays, variations in raw material pricing and changes in
employee salaries. With standard costing, manufacturers can calculate
inventory value by multiplying the actual inventory with the standard cost
of each item. This helps them estimate the inventory costs that are likely to
be very close to the actual costs.

Makes it easy to price products accurately

Standard costing helps manufacturers fix the prices of the end products
even before manufacturing is complete. By having a clear picture of the
estimated production costs, including materials, labour and overhead
costs, companies can accurately price their products to make profits
without overpricing them. Using standard costing also makes it easy for
manufacturers to account for the changes in production costs with varying
volumes while keeping the product price uniform across batches.

Provides efficient financial records management

If a company has to rely solely on actual costs, it becomes difficult to

maintain its financial records. On the contrary, standard costing makes it
easier for companies to produce and maintain their financial records.
Since the company has an intelligent estimate of expected costs, it can
conduct other financial activities, such as borrowing and overdrafts, using
 the numbers from standard cost calculations.

Facilitates production benchmarking

Manufacturers use standard costs to set benchmarks so that they can

compare if actual costs meet these benchmarks. If the actual costs meet
standard costs, it indicates that the budgeting has been successful. If
there is an unfavourable variance with the actual costs exceeding
standard costs, then the company works on altering its production
efficiency to lower these costs in the future.

Drawbacks of standard costing

While standard costing is an efficient accounting tool, it has certain
drawbacks. Some of the disadvantages of standard costing are:

• Not applicable with cost-plus contracts: A cost-plus contract is a

contract where clients pay manufacturers based on the actual costs
incurred. In such scenarios, manufacturers cannot rely on standard
costing to draft client contracts.

• Can lead to incorrect actions: If the management notices unfavourable

variances between standard and actual costs, they can take the wrong
steps to correct the variance. For example, they might purchase raw
materials in larger volumes to reduce price variances, which can lead to
inventory backup and extra expenditure.

• Not suitable for fast-paced environments with frequent price

changes: A standard costing system assumes that prices remain constant
for a few months or a year. In manufacturing environments with short
product lives and continuous pricing changes, standard costing becomes
outdated within a few months, making it irrelevant in accounting.

• Can offer slow feedback: The accounting department does the variance
calculations, usually at the end of each production cycle or reporting
period. If the production department requires immediate feedback for
instant corrective action, then standard costing with slow feedback
becomes irrelevant.

• Does not offer unit-level information: The variance calculations from

standard costing are for the entire production department. Standard
costing cannot provide granular information about discrepancies for each
individual unit, batch or work cell.

Understanding variances in standard costing

Variance is the difference between standard and actual costs. The accounting department calculates the
variance at the end of the financial cycle and uses this data to optimise future budgets. Standard costing helps
to determine if there is a favourable or unfavourable budget

variance.

• Unfavourable variance: If actual costs are higher than standard costs,

then the company earns a lower profit than initially predicted.

• Favourable variance: If the standard costs are higher than actual

expenses, it is advantageous as it indicates higher profits.

Variances help identify the manufacturing areas that cause differences

between actual costs and standard costing. For example, accountants use
variance data to find out if the changes were due to labour cost, material
cost or operational delays.

Types of variances in standard costing

Variances in standard costing are of two types. They are:

Rate variance

Also known as a price variance, rate variance is the difference between

the actual price and the expected price of raw material, multiplied by the
actual quantity purchased. An example of rate variance is labour rate
variance. This is the difference between the actual cost of labour and the
standard cost of direct labour. When rate variance refers to the purchase
price of materials, it is known as material price variance or purchase price
variance.

Volume variance

Volume variance refers to the difference between the budgeted volume

and the actual quantity sold (or used) multiplied by the standard cost per
unit of the product. Volume variance is of the following types:

• sales volume variance that refers to the variances in the goods sold

• material yield variance that denotes the usage of raw materials

• labour efficiency variance that calculates direct labour usage

• overhead efficiency variance that relates to material overheads

•
 Formula to calculate standard costs
To calculate the standard cost of a product, you can use the

following formula: Standard cost = direct labour + materials

cost + manufacturing overhead Here is how to calculate each

of these elements in the formula:

• Direct labour = employee hourly rate x no. of hours worked x total number of units

• Materials cost = market price per unit x total number of units

• Manufacturing overhead = fixed overhead + (variable

manufacturing overhead x total number
 UNIT 4

1.Cost Control

Cost refers to the expenditure or sacrifice made to acquire goods, services, or

resources. It can be a financial value, time, effort, or any other resource that is
given up in exchange for something else. Costs are an essential aspect of
economics, business, and various decision-making processes. There are several
types of costs, including:

1. Fixed Costs: These are costs that do not change with the level of production
or output. They remain constant regardless of how much a company
produces. Examples include rent, salaries of permanent employees, and
equipment depreciation.

2. Variable Costs: Variable costs fluctuate in direct proportion to the level of

production. As a company produces more, variable costs increase, and as
production decreases, they decrease. Examples include raw materials, direct
labor, and energy consumption.

3. Total Costs: Total costs are the sum of fixed and variable costs. They
represent the overall cost incurred by a company to produce a specific
quantity of goods or services.

4. Marginal Costs: Marginal cost is the additional cost incurred when producing
one more unit of a product. It is useful for making short-term production
decisions.
5. Opportunity Costs: Opportunity cost represents the value of the next best
alternative foregone when a decision is made. It's not always expressed in
monetary terms and can involve the sacrifice of time, resources, or potential
gains.

6. Sunk Costs: Sunk costs are costs that have already been incurred
and cannot be recovered. They should not influence future decisions
because they are irreversible.

7. Explicit Costs: Explicit costs are actual out-of-pocket expenses that a

business incurs, such as wages, rent, and materials.

8. Implicit Costs: Implicit costs are the opportunity costs associated with using
resources that a business already owns. For example, if a business owner uses
their own equipment in the business, the implicit cost would be the income they
could have earned by leasing that equipment to someone else.

Cost analysis is a critical part of financial and economic decision-making.

Businesses need to understand their costs to determine pricing, make
production decisions, and assess profitability. Similarly, individuals consider
costs when making personal decisions, such as budgeting, investment, and
career choices.

➢ Meaning of Cost Control

Cost control is the process of managing and regulating the costs incurred by an
individual, organization, or project to ensure that they remain within budgetary
constraints while delivering the desired level of performance or quality. Effective
cost control is essential for financial sustainability and profitability. Here are
some key strategies and techniques for cost control:

1. Budgeting: Create a comprehensive budget that outlines expected expenses

and revenue. Regularly compare actual costs with the budgeted amounts to
identify any variances. Adjust the budget as needed to stay on track.
2. Expense Tracking: Maintain detailed records of all expenses. Implement
accounting and financial software to track costs, and categorize them for better
analysis.

3. Cost Allocation: Allocate costs to specific activities, departments, or projects.

This helps identify areas where costs may be higher than expected.

4. Cost Reduction Initiatives: Continuously seek opportunities to reduce

costs without compromising quality. This could include negotiating better
supplier contracts, finding more efficient processes, or optimizing resource
utilization.

5. Vendor Management: Negotiate with suppliers for better terms and prices.
Consider switching suppliers if more cost-effective options are available.

6. Lean Management: Implement lean principles to minimize waste, improve

efficiency, and reduce unnecessary expenses in your business processes.

7. Inventory Control: Manage inventory levels efficiently to reduce carrying

costs. Avoid overstocking, which ties up capital, or understocking, which can
lead to production delays.

8. Labor Management: Optimize workforce management by matching staffing

levels to actual workload. Use performance metrics to evaluate employee
productivity and efficiency.

9. Energy and Resource Efficiency: Implement energy-efficient technologies and

practices to reduce utility costs. Consider environmentally friendly options that
can yield cost savings over time.

10. Quality Control: Ensure that quality standards are met without excessive
costs. This helps avoid rework and customer complaints, which can be costly
in the long run.
11. Regular Performance Reviews: Conduct regular reviews of financial
performance and cost control measures. Identify areas where improvement is
needed and make necessary adjustments.

12. Benchmarking: Compare your costs and performance to industry

standards or competitors to identify areas where you may be over-
spending.

13. Cost Awareness: Foster a cost-conscious culture within your organization.

Encourage employees to think about cost-saving measures and involve them
in the process.

14. Risk Management: Identify potential risks that could lead to unexpected
costs, such as legal issues, market fluctuations, or supply chain disruptions, and
have mitigation plans in place.

15. Technology and Automation: Implement cost control software and

automation tools to streamline financial processes and gain real-time insights
into expenses.

Effective cost control is an ongoing process that requires vigilance and

adaptability. By monitoring and managing costs, organizations and individuals
can improve financial stability, maintain profitability, and make informed
decisions about resource allocation.

➢ Importance of Cost Control

Cost control is of paramount importance for individuals, businesses, and

organizations for several reasons:

1. Profitability: Effective cost control directly impacts profitability. By

managing costs efficiently, businesses can increase their profit margins,
even in situations where revenue remains constant.
2. Financial Stability: Controlling costs helps ensure financial stability. It
allows organizations to better withstand economic downturns, market
fluctuations, and unexpected expenses, reducing the risk of financial
distress.

3. Competitive Advantage: Businesses that can produce goods or services at a

lower cost can offer competitive pricing and potentially gain a competitive edge in
the market. This can lead to increased market share and customer loyalty.

4. Resource Optimization: Cost control helps in optimizing resource allocation.

By identifying areas where costs can be reduced or eliminated, organizations
can redirect resources to more productive or strategic activities.

5. Sustainability: Sustainable cost control practices can make a business more

environmentally responsible by reducing waste and resource consumption. This
is not only good for the planet but can also lead to cost savings in areas like
energy and materials.

6. Budget Adherence: Cost control is essential for adhering to budgets and

preventing budget overruns. This is critical for financial planning and
accountability.

7. Investor Confidence: Effective cost control measures can enhance investor

and stakeholder confidence. When investors see that a company is managing
its finances well, they are more likely to invest or continue to support the
organization.

8. Debt Reduction: Cost control can free up funds that can be used to pay
down debt. Reducing debt can lead to lower interest expenses and
improved creditworthiness.

9. Risk Mitigation: By keeping costs under control, organizations can better

prepare for and mitigate various risks, including economic downturns, supply
chain disruptions, and regulatory changes.
10. Quality Maintenance: Cost control should not come at the expense of
quality. Maintaining quality while controlling costs ensures that the
organization continues to meet customer expectations and avoid costly
rework or customer dissatisfaction.

11. Employee Morale: When employees see that the organization is committed to
efficient cost management, it can boost morale. Employees may feel more
secure in their jobs and see that the company is financially healthy.

12. Innovation and Growth: Cost control can free up resources that can be
invested in innovation and growth initiatives. It allows businesses to explore
new markets, products, or services.

13. Long-Term Viability: By consistently controlling costs, organizations can

position themselves for long-term viability. This is essential for business
sustainability in a constantly changing world.

14. Compliance and Ethics: Adhering to cost control practices also

promotes ethical behavior and compliance with laws and regulations,
which can prevent costly legal issues.

In summary, cost control is crucial for financial health, competitiveness, and

sustainability. It allows businesses and organizations to make informed
decisions, allocate resources efficiently, and adapt to changing economic
conditions, ultimately supporting their long-term success

➢ Benefits of cost control management

Cost control management offers numerous benefits to your organizations.

Here is a list of its key advantages:\

1. Cost savings
Effective cost control management helps identify areas of excessive
spending, inefficiencies, and waste. By implementing cost-saving
measures, businesses can reduce expenses, optimize resource
allocation, and improve their financial position.
2. Improved profitability
By reducing costs and increasing efficiency, cost control management
directly contributes to improved profitability. It enables businesses to
generate higher revenues, enhance profit margins, and achieve
sustainable financial growth.

3. Enhanced cash flow

Proper cost control management ensures that cash flow remains healthy
and stable. By minimizing unnecessary expenses and managing
payment cycles effectively, organizations can maintain a steady flow of
funds, meet financial obligations, and invest in growth initiatives.

4. Competitive advantage
Cost control management allows organizations to offer competitive
prices while maintaining the highest level of quality. This pricing
strategy helps attract customers, retain market share, and gain an
edge over competitors in the marketplace.

5. Resource optimization
It helps ensure that resources, including materials, labor, and
equipment, are utilized efficiently, eliminating any instances of
underutilization or excess capacity.

6. Strategic decision-making
Cost control management provides decision makers with valuable
insights and data that helps immensely in the strategic decision-making
processes. With accurate cost information, organizations can make
informed choices regarding pricing strategies, product development,
market expansion, and investment decisions.

7. Operational efficiency

Effective cost control management streamlines processes and

improves overall operational efficiency. What’s more, it helps identify
bottlenecks, implement process improvements, and optimize workflow,
resulting in higher productivity and smoother operations.

8. Risk management
Organizations can mitigate financial risks by actively monitoring and
controlling costs. It helps identify potential cost overruns, budget
deviations, or unforeseen expenses, allowing proactive measures to be
taken to prevent or minimize such risks.

9. Improved financial stability

It’s no secret that maintaining a strong financial position is vital for
business sustainability. Cost control management helps in financial
stability by reducing unnecessary expenses, avoiding inessential debt,
and enabling organizations to weather economic uncertainties or
market fluctuations.

10. Long-term growth

By optimizing costs and improving profitability, cost control
management frees up financial resources that can be reinvested in
growth initiatives. This capital can be utilized for research and
development, marketing campaigns, talent acquisition, technological
advancements, or market expansion, fostering long-term growth and
success.

Key components of cost control

Here are some of the key components of cost control:

1. Budgeting and planning

An effective cost control process begins with creating an expertly done
budgeting process that outlines the expenses that can occur and the
projection of revenues for that time period. On the other hand, planning
makes sure the financial resources are allocated strategically and align
with the organization’s business goals.

2. Cost analysisCost analysis involves examining the various cost components

within an organization. It includes identifying direct and indirect costs, analyzing
cost drivers, and understanding the factors that contribute to expenses. This
analysis helps in identifying areas where costs can be minimized or optimized.

3. Expense tracking
Tracking and monitoring expenses play a vital role in controlling cost.
Organizations must keenly track the expenses and compare it with the
budget planned. What’s more,
by tracking expenses in real-time, organizations can identify any
deviations, take corrective measures promptly, and ensure that costs
remain within a decided limit.

➢ Cost control techniques and methods

Here are some the widely used techniques and methods:\

1. Cost reduction
This involves identifying and implementing measures to minimize
expenses without compromising product or service quality. For
effective cost reduction organizations can renegotiate supplier
contracts, optimize operational processes, and improve efficiency.

2. Cost accounting
It is the process of focussing on tracking and analyzing the costs
associated with producing goods or services. Cost accounting can help
organizations understand the cost structure, allocate expenses
accurately, and make informed decisions regarding pricing, resource
allocation, and project cost control strategies.

3. Budget
In organizations the budget is a financial plan that outlines projected
revenues and expenses over a specific period. It serves as a
benchmark for cost control efforts by setting limits and targets for
various cost categories. Monitoring actual expenses against the budget
allows organizations to identify deviations and take corrective actions.
This in turn will help your company’s baseline.

4. Standard cost accounting

Standard cost accounting sets predetermined standard costs for
materials, labor, and overhead. In this process actual costs are
compared with the standard costs, enabling organizations to identify
and address cost variances. This technique helps in measuring cost
performance and improving cost control measures.

5. Earned value management

Earned Value Management (EVM) is a project management technique
that integrates cost, schedule, and performance data. It helps in tracking
the value of work completed in relation to the planned budget and
schedule. EVM helps organizations to monitor project costs effectively,
assess performance, and take corrective actions.

6. Analysis of variance
Analysis of variance (ANOVA) is a statistical technique that is used to
analyze and understand the differences between planned and actual
costs. ANOVA helps in identifying the causes of cost variances, such
as changes in material prices or production inefficiencies.

7. Budgetary control
Budgetary control involves monitoring and controlling expenses based
on the approved budget. It includes periodic reviews, tracking actual
expenses and actual expenditures, comparing them with budgeted
amounts, and implementing corrective actions when necessary.
Budgetary control helps organizations maintain financial discipline and
ensures effective cost control.

8. Outsourcing
It is the process of delegating specific tasks or functions to external
vendors or service providers. Outsourcing can help organizations
reduce costs and decarese operational expenses.

9. Continual improvement process (CIP)

It is the systematic approach to drive ongoing enhancements in cost
control. This involves identifying areas for improvement, setting goals,
implementing changes, and measuring the impact of those changes.

By employing these cost control techniques and methods,

organizations can proactively manage expenses, optimize resource
allocation, and drive financial efficiency and stability.
Cost control in different industries

Cost control practices vary across industries due to unique operational

characteristics and cost structures.

Here are some examples of cost control in different industries:

1. Manufacturing industry
In manufacturing, cost control focuses on optimizing production
processes, reducing material waste, and improving operational
efficiency. Techniques such as lean

manufacturing, just-in-time inventory management, and automation are

employed to streamline operations and minimize costs without
compromising quality.

2. Healthcare
Due to the rising medical expense in the healthcare sector, cost control
has now become essential. The cost control process in the healthcare
industry involves strategies like negotiating contracts with suppliers
and service providers, implementing cost-effective healthcare
technologies, and optimizing resource allocation.

3. Hospitality
In the hospitality industry, cost control is implemented by optimizing
expenses related to food and beverage, labor, and energy consumption.
Additionally, it involves effective inventory management, menu
engineering to optimize profitability, implementing energy-saving
measures, and optimizing staffing levels while maintaining the quality of
the service.

4. Retail
In the retail sector, cost control focuses on inventory management,
operational cost reduction, and supply chain optimization. Techniques
such as efficient inventory systems, vendor negotiation for favorable
pricing, shrinkage monitoring, and cost- effective marketing strategies
are employed to achieve these goals.

5. Construction industry
Cost control reduces project expenses, optimizes material usage, and
enhances labor productivity in the construction industry. The following
techniques are employed to control costs and improve project
profitability in the construction industry: value engineering, effective
project planning and scheduling, accurate cost estimation, and diligent
procurement practices.

6. Information technology industry

Cost control in the IT industry entails managing expenses related to

hardware, software, and technology infrastructure. This involves
techniques such as careful technology solution selection, leveraging
cloud computing for cost-effective resources, optimizing software
licensing, and implementing efficient IT service management practices.

7. Transportation and logistics industry

Cost control in the transportation and logistics sector focuses on fuel
costs, fleet management, and supply chain optimization. Strategies
include route planning and optimization, fuel efficiency programs, load
consolidation, effective maintenance practices, and leveraging
technology for real-time tracking and resource utilization.

8. Professional services industry

In professional services such as consulting or legal firms, it includes
managing overhead expenses, optimizing project management
processes, and ensuring efficient resource allocation. Techniques may
include project budgeting and monitoring, optimizing staffing levels,
leveraging technology for collaboration and document management,
and adopting efficient workflow processes.

➢ cost control strategies

Companies implement numerous cost control strategies to reduce expenses.

Here are some of the best strategies that can give you the actual
results:

1. Inventory management

In this strategy the inventory levels are effectively managed to avoid

overstocking or understocking. By monitoring and controlling inventory,
organizations can minimize carrying costs, reduce the risk of obsolete
stock, and optimize cash flow.

2. Supplier management

This focuses on developing strong relationships with suppliers to

negotiate favorable pricing, terms, and conditions. What’s more,
effective supplier management also involves selecting reliable and
cost-effective suppliers, maintaining clear communication, and
fostering collaborative partnerships to drive cost savings and improve
overall supply chain efficiency.

3. Process optimization
Process optimization aims to streamline operations, eliminate
inefficiencies, and reduce costs. This is done by analyzing and
improving workflows, identifying
bottlenecks, automating repetitive tasks, and enhancing productivity
through continuous improvement initiatives.

4. Waste reduction

The waste reduction strategy aims to minimize waste generation and

maximize resource utilization. This is achieved by implementing
recycling programs, optimizing production processes to minimize scrap
or rework, and promoting sustainable practices.

5. Pricing strategies

Pricing strategies involve setting competitive prices that balance

customer value and profitability. This may include strategies such as
value-based pricing, cost-plus pricing, or dynamic pricing. By analyzing
market dynamics, customer demand, and cost structures,
organizations can optimize pricing to maximize revenue and achieve
profitability.

Cost reduction strategies

Implement well thought cost reduction strategy by identifying areas
where costs can be reduced without compromising quality or
performance. This could involve renegotiating contracts with suppliers,
optimizing operational processes, improving energy efficiency, or
implementing technology solutions that automate tasks and streamline
operations.

1. Financial controls
By establishing financial controls you can ensure budgetary guidelines
are followed, this in turn will prevent overspending. Approval processes
for expenses, setting spending limits, and implementing monitoring
systems to detect any potential financial irregularities, are some of the
examples of financial controls.

2. Performance measurement
Measuring performance against cost targets and benchmarks is one of
the most effective ways to control cost. To assess the efficiency of your
cost management effort you can track key performance indicators
related to cost, such as cost per unit, cost variance, or cost-to-revenue
ratios.
What are the key performance
indicators for cost control?
Multiple key performance indicators (KPIs) are used to measure the success.

Here are some of them:

1. Cost variance
Cost variance is a key performance indicator that measures the
difference between the actual cost of a project, process, or activity and
the planned or budgeted cost. It helps evaluate cost management
effectiveness by identifying if the actual costs are over or under the
budgeted amounts.

2. Cost of Goods Sold (COGS)

COGS is a metric that represents the direct costs incurred in producing
goods or delivering services. It includes expenses such as raw
materials, direct labor, and direct overhead. Monitoring COGS helps
assess the efficiency of cost control measures and determine the
profitability of products or services.

3. Return on Investment (ROI)

ROI measures the profitability and financial performance of an
investment by comparing the gain or return generated from the
investment to its cost. It is calculated by dividing the net profit or return
on investment by the initial investment cost. ROI provides insights into
the efficiency of cost allocation and helps assess the overall success of
an investment.

4. Gross margin

Gross margin is a metric that calculates the percentage of revenue

remaining after deducting the direct costs associated with producing
goods or delivering services. It indicates profitability at the initial stage
of the value chain. By monitoring gross margin you can assess pricing
strategies, cost efficiency, and the overall profitability of products or
services.

5. Operating expenses
 Operating expenses, also known as OPEX, represent the ongoing
costs of running a business, excluding the cost of goods sold. It
includes expenses such as rent, utilities, salaries, marketing, and
administrative costs.

Technology and tools for cost control

In the cost control world, leveraging technology and utilizing
appropriate tools can significantly enhance an organization’s ability to
monitor and manage expenses efficiently. From automation to data
analytics, these technological solutions offer valuable insights and
streamline cost control processes:

Cost control software

Cost control software plays a vital role in helping organizations
effectively manage and optimize their expenses. These software
solutions provide features such as budget tracking, expense monitoring,
analytics, and reporting, enabling businesses to identify cost-saving
opportunities, streamline processes, and make informed financial
decisions.

Here are five top cost control software options:

1. SAP Concur: A comprehensive expense management software that
automates the entire expense process, provides real-time visibility into
spending, and offers robust reporting capabilities.
2. Coupa Expense Management: A cloud-based solution that simplifies
expense management, streamlines approvals, and offers spend
analytics for better cost control and compliance.
3. Expensify: An intuitive expense management platform that
automates expense reporting, receipt tracking, and reimbursement
processes, reducing administrative burdens and improving
accuracy.
4. Procurify: A cloud-based spend management platform that helps
control expenses through automated purchase orders, invoice
tracking, and budget monitoring, facilitating better financial control
and cost optimization.
5. Certify: A user-friendly expense management software that offers
seamless expense reporting, automated workflows, and integration
with accounting systems, improving visibility and control over
expenses.
These cost control software solutions can empower organizations to
proactively manage expenses, reduce wasteful spending, and achieve
greater financial efficiency.
 Best practices for effective cost
control
▪ Clearly define cost control goals and
Establish clear goals and objectives:
objectives that align with the overall business strategy. This provides a
clear direction and focus for cost management efforts.
▪ Conduct regular cost analysis: Regularly analyze and review costs across
various areas of the business to identify inefficiencies, cost-saving
opportunities, and areas for improvement.
▪ Implement robust budgeting and forecasting: Develop
comprehensive budgets and accurate financial forecasts to set cost
targets and track performance against those targets.
▪ Monitor KPIs: Define and monitor relevant KPIs to measure cost
performance, such as cost variance, cost of goods sold, and gross
margin. This helps identify deviations and take corrective actions.
▪ Emphasize cost awareness and accountability: Foster a cost-conscious
culture within the organization by promoting cost awareness,
accountability, and responsibility at all levels. Encourage employees
to contribute cost-saving ideas.
▪ Streamline processes and eliminate waste: Continuously review and
streamline business processes to eliminate unnecessary steps,
reduce waste, and optimize resource utilization.
▪ Vendor and supplier management: Negotiate favorable terms with vendors
and suppliers, explore competitive pricing options, and maintain strong
relationships to ensure cost- effective procurement.
▪ Embrace technology and automation: Leverage technology and automation
tools to streamline cost control processes, improve accuracy, and gain
real-time visibility into expenses.

Challenges in implementing cost

control
▪ Cost monitoring and analysis: Implement a robust system for monitoring
and analyzing costs across different departments and projects to
identify cost drivers and areas of improvement.
▪ Cost tracking and reporting: Implement effective cost tracking mechanisms
and reporting systems to provide accurate and timely cost information
to stakeholders.
▪ Employee engagement and communication: Engage employees at all
levels by providing training and awareness programs on cost control
strategies. Foster a culture of cost consciousness through regular
communication and incentives.
▪ Change management:Address resistance to change and ensure smooth
implementation of cost control initiatives through effective change
management practices.

▪ Continuous improvement: Encourage a mindset of continuous

improvement by regularly evaluating cost control strategies, seeking
feedback from stakeholders, and adapting to changing business needs.
▪ Risk management: Identify and manage potential risks that could
impact cost control efforts, such as market fluctuations, regulatory
changes, and unforeseen events.
▪ Benchmarking and best practices: Conduct benchmarking exercises
to compare cost control practices with industry peers and adopt
best practices for improved cost management.
By implementing these best practices, organizations can enhance
their cost control efforts, optimize resource allocation, and achieve
sustainable financial performance.

Future trends in cost control

Here are some of the future trends in cost control:

1. Digital transformation in cost control

The adoption of digital technologies, such as cloud computing,
automation, and artificial intelligence, will revolutionize cost control
practices. Organizations will leverage advanced tools and analytics to
optimize cost management, improve efficiency, and gain real-time
insights into financial data.

2. Sustainability and green cost control

With increasing focus on environmental sustainability, organizations will
integrate green practices into their cost control strategies. This includes
reducing energy consumption, optimizing waste management, and
implementing sustainable procurement practices, ultimately leading to
cost savings and a positive environmental impact.

3. Predictive analytics for cost control

Predictive analytics will play a significant role in cost control, enabling

organizations to anticipate cost trends, identify potential risks, and
make proactive decisions. By leveraging historical data and advanced
algorithms, predictive analytics will enhance forecasting accuracy and
 improve cost control strategies.

4. Risk management in cost control

Effective risk management will become an integral part of cost control.

Organizations will proactively identify and manage risks that may impact
cost performance, such as
 supply chain disruptions, market fluctuations, and regulatory changes.
This will involve implementing risk mitigation strategies and robust
contingency plans.

5. Cost control in the era of disruption

Rapid technological advancements and market disruptions will

necessitate agile cost control practices. Organizations will need to
adapt quickly to changing market conditions, adopt flexible cost
structures, and leverage innovative solutions to maintain cost efficiency
and competitiveness

2.BUDGETARY CONTROL

budgetary control is a means of control in which the actual results are

compared with the budgeted results so that appropriate action may be taken about any
deviations between the two.
Budgetary control is a system of controlling cost which includes preparation of

Budgets coordinating the departments and establishing responsibilities

comparing performance with budgeted and acting upon results to achieve the

maximum profitable.

The process of budgetary control includes:

• Preparation of various budgets.

• Continuous comparison of actual performance with budgetary performance.

• Revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid.

There should be enough scope of flexible individual initiative and drive.

Budgetary control is an important device for making the organization an important

tool for controlling costs and achieving the overall objectives.

Budgetary control serves 4 control purposes:

1. They help the manager’s co-ordinate resources;

2. They help define the standards needed in all control systems;

3. They provide clear and unambiguous guidelines about the

organization’s resources and expectations, and

4. They facilitate performance evaluations of managers and units.

Objectives of Budgetary Control

An effective budgeting system plays a crucial role in the success of a business organization.
The budgeting system has the following objectives, which are of paramount

importance in the overall efficiency and effectiveness of the business

organization.

These objectives are discussed below.

1. Planning

Planning is necessary for regularly doing any work. A well- prepared plan helps

the organization to use the scarce resources efficiently and thus achieving the

predetermined targets becomes easy.

A budget is always prepared for the future period and it lays down targets

regarding various aspects like purchase, production, sales, manpower planning,

etc. This automatically facilitates planning.

2. Coordination

For achieving the predetermined objectives, apart from planning, coordinated

efforts are required. Budgeting facilitates coordination in the sense that budgets
cannot be developed in isolation.

For example, while developing the production budget, the production manager

will have to consult the sales manager for a sales forecast and purchase

manager for the availability of the raw material.

The production budget cannot be developed in isolation.

Similarly, the purchase and sales budget, as well as other functional budgets

like cash, capital expenditure, manpower planning, etc, cannot be developed

without considering other functions. Hence the coordination is automatically

facilitated.
3. Control

Planning is looking ahead while controlling is looking back.

The preparation of budgets involves detailed planning about various activities

like purchase, sales, production, and other functions like marketing, sales
promotion, manpower planning. But planning alone is not sufficient.

There should be a proper system of control which will ensure that the work is

progressing as per the plan.

Budgets provide the basis for such controlling in the sense that the actual

performance can be compared with the budgeted performance.

Any deviation between the two can be found out and analyzed to ascertain the

reasons behind the deviation so that necessary corrective action can be taken to
rectify the same. Thus budgeting helps immensely in controlling function.

3 Types of Budgetary Controlling Techniques

Budgetary control is a system for monitoring an organization’s process in

monetary terms. Types of budgetary controlling techniques are;

1. Financial Budgets.

2. Operating Budget.

3. Non-Monetary Budgets.

Financial Budgets

Such budgets detail where the organization expects to get its cash for the coming

period and how it plans to spend it. Usual sources of cash include sales revenue,
the sales of assets, the issuance of stock, and loans.
On the other hand, the common uses of cash are to purchase new assets, pay

expenses, repay debts, or pay dividends to shareholders.

Financial budgets may be of the following types:

1. Cash budget

This is simply a forecast of cash receipts and disbursements against which

actual cash “experience” is measured

It provides an important control in an enterprise since it breaks down incoming

and outgoing cash into monthly, weekly, or even daily periods so that the

organization can make sure it can meet its current obligations.

The cash budget also shows the availability of excess cash, thereby making it

possible to plan for profit-making investment of surpluses.

2. Capital expenditure budget

This type of financial budget concentrates on major assets such as a new plant,

land or machinery. Organizations often acquire such assets by borrowing

significant amounts through, say, long-term bonds or securities.

All organizations, large or small, business or non-business, pay close attention

to such a budget because of the large investment usually associated with

capital expenditure.

3. The balance sheet budget

It forecasts what the organization’s balance sheet will look like if all other budgets are met.

Hence it serves the purpose of overall control to ensure that other budgets mesh

properly and yield results that are in the best interests of the organization.
Operating Budgets

This type of budget is an expression of the organization’s planned operations for

a particular period. They are usually of the following types:

1. The sales or revenue budget

It focuses on the income the organization expects to receive from normal

operations. It is important since it helps the manager understand what the future
financial position of the organization will be.

2. The expense budget

It outlines the anticipated expenses of the organization in a specified period. It

also points out upcoming expenses so that the manager can better prepare for

them.

3. The project budget

It focuses on anticipated differences between sales or revenues and expenses

i.e. profit. If the anticipated profit figure is too small, steps may be needed to

increase the sales budget or cut the expense budget.

Non-monetary budgets

Budgets of this type are expressed in non-financial sales or revenues and

expenses, i.e. profit. If the anticipated profit figure is too small steps may be

needed to increase the sales budget or cut the expense budget.

Fixed and variable budgets

Regardless of their purpose, most budgets must account for the three following kinds of costs:

1. Fixed costs
They are the expenses that the organization incurs whether it is in operation or

not. Salaries of managers may be an example of such a cost.

2. Variable costs

Such costs vary according to the scope of operations.

The best example may be the raw materials used in production. If $5 worth of

material is used per unit. 10 units would cost $50, 20 units would cost $100 and

so on.

3. Semi-variable costs

They also vary, but in a less direct fashion. Costs for advertising, repairs, and
maintenance, etc. may fall under this category.

All these categories of cost must be accurately accounted for in developing a

budget. Fixed costs are usually the easiest to deal with. Variable costs can also

be forecast, although with less precision from projected operations.

Semi-variable costs are the most difficult to predict because they are likely to
vary, but not in direct relation to operations. For these costs, the manager must

often rely on experience and judgment.

Types of Budgets
Budgets can be classified as per the following basis.

1. Based on Area of Operation.

1. Functional Budgets.

2. Master Budget.
2. Based on Capacity Utilization.
 1. Fixed Budget.

2. Flexible Budgets.

3. Based on
Time.

1. Short Term.

2. Medium Term.

3. Long Term.

4. Based on
Conditions

1. Basic Budget.

2. Current Budget.

Benefits of Budgetary Control

Budgeting plays an important role in planning and controlling. It helps in

directing the scarce resources to the most productive use and thus ensures

overall efficiency in the organization.

The benefits derived by an organization from an effective system of budgeting

can be summarized as given below.

1. Budgeting facilitates the planning of various activities and ensures that

the working of the organization is systematic and smooth.

2. Budgeting is a coordinated exercise and hence combines the ideas of

different levels of management in the preparation of the same.

3. Any budget cannot be prepared in isolation and therefore coordination

among various departments is facilitated automatically.

4. Budgeting helps planning and controlling income and expenditure to

achieve higher profitability and also acts as a guide for various
management decisions.

5. Budgeting is an effective means for planning and thus ensures

sufficient availability of working capital and other resources.

6. It is extremely necessary to evaluate the actual performance with

predetermined parameters. Budgeting ensures that there are well-

defined parameters and thus the performance is evaluated against

these parameters.

7. As the resources are directed to the most productive use, budgeting

helps in reducing the wastages and losses.

Essentials of a Good Budgetary Control System

A good budgetary control system depends upon the following conditions:

1. Support from top management

The effective implementation of the budgetary control system depends

upon the attitude and perception of management towards it.

If the top executive takes the budgeting as a mere routine job and does not take

any interest in its implementation, it will be a futile exercise.

2. Quantification of organizational goal

The goal of the organization should be clearly expressed and quantified. There

should not be any misconception and confusion in the minds of employees

regarding goals to be attained.

3. Creation of responsibility center

The entire organization should be divided into sections and subsection with

clear assignment of duties and responsibilities for each of them.

4. The split of organizations’ goals

The goals of each department or responsibility center should be spelled out

towards the attainment of the overall goals of the organization. The functional

goals should be compatible with the organizational goal.

5. Realistic

The target to be set in the budget should be fairly attainable.

If it is set at a level beyond the capacity of employees, they will lose their

interest in its implementation, on the other hand, if it is set at a very low level, it

will be meaningless as the job, in any case, will be done.

6. Participation

All the key employees should be made involved in the preparation of the budget.

Participation brings in commitment. Commitment enhances the efficiency and

productivity of employees.

7. Good accounting system

The accounting system should be designed in such a way that c the actual

performance of various responsibility centers can be readily available for

comparison with the target.

8. Coverage

To reap the benefit of a budgetary control system it should cover all the areas

organization. It should not be partially applied.

9. Creation of environment conducive to budgetary control

A proper environment should be developed in the organization for the successful

implementation of budgetary control. The employees should be educated about

the utility of the system.

They should be convinced that it is not a tool of pressurization upon them to

work more but a way to the prosperity of the organization which will ultimately

benefit them.

So seminar, lecture, executive development program, etc. should be held for this purpose.

10. Coordination

Co-ordination is an important requirement” of budgetary control. It brings in

common thinking, mutual trust, and confidence amongst various departments.

11. Flexibility

A budget should be amenable to change if the changing situation so warrants.

12. Reporting system

The success of budgetary control depends upon a good reporting system. The

actual performance vis-a-vis the target should be continuously reported to the

management to enable them to take corrective action in the areas which are not
performing well.

Steps of Budgetary Control

Budgetary control has the following stages.

1. Developing Budgets

The first stage in budgetary control is developing various budgets. It will be

necessary to identify the budget centers in the organization and budgets will have

to develop for each one of them.

Thus budgets are developed for functions like purchase, sale, production,
manpower planning as well as for cash, capital expenditure, machine hours,
Utmost care should be taken while developing the budgets. The factors

affecting the planning should be studied carefully and budgets should be

developed after a thorough study of the same.

2. Recording Actual Performance

There should be a proper system of recording the actual performance achieved.

This will facilitate the comparison between the budget and the actual. An

efficient accounting and cost accounting system will help to record the actual

performance effectively.

3. Comparison of Budgeted and Actual Performance

One of the most important aspects of budgetary control is the comparison

between the budgeted and the actual performance.

The objective of such a comparison is to find out the deviation between the two

and provide the base for taking corrective action.

4. Corrective Action

Taking appropriate corrective action based on the comparison between the

budgeted and actual results is the essence of budgeting.

A budget is always prepared for the future and hence there may be a variation

between the budgeted results and actual results.

There is a need for investigation of the same and take appropriate action so that

the deviations will not repeat in the future. Responsibilities can be fixed on

proper persons so that they can be held responsible for any such deviations.
Preparation for Budgetary Control
Budgetary control is extremely useful for planning and control as described

above. However, forgetting these benefits, sufficient preparation should be

made.

For complete success, a solid foundation should be laid down and given this the

following aspects are of crucial importance.

1. Budget Committee

For the successful implementation of the budgetary control system, there is a

need for a budget committee. In small or medium-sized organizations, the

budget-related work may be carried out by the Chief Accountant himself.

Due to the size of the organization, there may not be too many problems in the

implementation of the budgetary control system.

However, in large size organization, there is a need for a budget committee

consisting of the chief executive, budget officer and heads of main departments
in the organization.

The main functions of the budget committee are to get the budgets prepared

and then scrutinize the same, to lay down broad policies regarding the

preparation of budgets, to approve the budgets, to suggest for revision, to

monitor the implementation and to recommend the action to be taken in a given

situation.

2. Budget Centers

The establishment of budget centers is another important pre-requisite of a

sound budgetary control system. A budget center is a group of activities or a

section of the organization for which budget can be developed.

For example, manpower planning budget, research and development cost

budget, production and production cost budget, labor hour budget and so on.

Budget centers should be defined clearly so that preparation becomes easy.

3. Budget Period

A budget is always prepared before a defined period. This means that the period

for which a budget is prepared is decided in advance.

Thus a budget may be prepared for three years, one year, six months, one month

or even for one week. The point is that the period for which the budget is

prepared should be certain and decided in advance.

Generally, it can be said that functional budgets like sales, purchase,

production, etc. are prepared for one year and then broken down monthly.

Budgets like capital expenditure are generally prepared for a period from 1 year

to 3 years.

Thus depending upon the type of budget, the period of the same is decided and

it must be decided well in advance.

4. Preparation of an Organization Chart

There should be an organization chart that shows clearly defined authorities and

responsibilities of various executives. The organization chart will define clearly the
functions to be performed by each executive relating to the budget preparation

and his relationship with other executives.

The organization chart may have to be adjusted to ensure that each budget
center is controlled by an appropriate member of the staff.

5. Budget Manual
A budget manual is defined by ICMA as ‘a document which sets out the

responsibilities of the person engaged in, the routine of and the forms and

records required for budgetary control’.

The budget manual thus is a schedule, document or booklet, which contains

different forms to be used, procedures to be followed, budgeting organization

details, and set of instructions to be followed in the budgeting system.

It also lists out details of the responsibilities of different persons and the

managers involved in the process.

6. Principal Budget Factor or Key Factor

A key factor or a principal budget factor [also called constraint] is that factor the
extent of whose influence must first be assessed to prepare the functional

budgets.

Normally sales are the key factor or principal budget factor but other factors like

production, purchase, and skilled labor may also be the key factors.

For example, a company has the production capacity to produce 30,000 tones
per annum but if the sales forecast tells that the market can absorb only 20,000
units, there is no point in producing 30,000 units.

Thus the sale is the key factor in this case.

On the other hand, if the company can produce 30,000 units and the market can

absorb the entire production which means that sales are not the key factor but if

the raw material is available in limited quantity so that only 25,000 units can be

produced, the raw material will become the key factor.

The key factor puts restrictions on the other functions and hence it must be

considered carefully in advance. So continuous assessment of the business

In all conditions, the key factor is the starting point in the process of preparation of budgets.

7. Establishment of Adequate Accounting Records

The accounting system must be able to record and analyze the transactions involved.

A chart of accounts or accounts code should be maintained which may

correspond with the budget centers for the establishment of budgets and finally

control through budgets.

Advantages and Disadvantages of Budgeting

Organizations realize many benefits from budgeting including:

1. Budgets communicate management’s plans throughout the organization.

2. Budgets force managers to think about and plan for the future. In the

absence of the necessity to prepare a budget, many managers would

spend all of their time dealing with daily emergencies.

3. The budgeting process provides a means of allocating resources to

those parts of the organization where they can be used most

effectively.

4. The budgeting process can uncover potential bottlenecks before they occur.

5. Budgets coordinate the activities of the entire organization by integrating

the plans of its various parts. Budgeting helps to ensure that everyone in

the organization is pulling in the same direction.

6. Budgets define goals and objectives that can serve as

benchmarks for evaluating subsequent performance.

Budgets offer some advantages. They have potential drawbacks as well. Both

are summarized below;

 Strengths Weaknesses

1. Budgets facilitate effective control. Budgets may be used too rigidly.

2. Budgets facilitate coordination and Budgets may be time-consuming.

communication.

3. Budgets facilitate record keeping. Budgets may limit innovation and change.

4. Budgets are a natural complement to However; Budgets hampers development,

planning. change, the flexibility of the plan.

As shown in the table above, budgets facilitate effective control. By placing

financial values on operations, managers can monitor operations effectively and

pinpoint problem areas.

Second budgets facilitate communication and coordination between

departments. Budgets also help maintain records of organizational

performance.

Finally, budgets are a natural complement to planning. As managers first plan

and then develop control systems, budgets are often a natural next step.

On the minus side, some managers apply budgets too rigidly. They fail to
understand those budget adjustments are necessary to meet the challenges of

changing circumstances.

Also, the art of developing budgets can most often be time-consuming.

Moreover, budgets may limit innovation and change. When all available funds

are allocated to specific operating budgets, it may be impossible to get

Budgets are an important element of an organization’s control system. It is

difficult to imagine an organization functioning without proper budgetary

provisions.

Despite some drawbacks, budgets generally provide managers with an effective

tool for executing the control function.

Making Budgetary Control Effective

Budgetary control can be made effective if an organization can ensure the following:

1. Setting appropriate standard

This is key to successful budgeting. Many budgets fail for lack of such standards,

and some upper-level managers hesitate to allow subordinates to submit budget

plans for fear that they may have no logical basis for reviewing budget requests.

2. Ensuring top-management support

Budget making and administration must receive the whole-hearted support of top
‘management.

If top management supports budget making, requires departments and divisions

to make and defend their budgets, and participate in this review, then budgets

encourage alert management throughout the organization.

3. Participation by users in budget preparation

Besides the support of top management, the concerned managers at lower

levels should also participate in its preparation. Real participation in budget

preparation is necessary to ensure success.

It may also prove worthwhile to give department managers a reasonable

degree of latitude in changing their budgets and in shifting funds, as long as

4. Providing information to managers about performance under budget

If budgetary control is to work well, managers need ready information about

actual and forecast performance under budgets by their departments. Such

information must be so designed as to show them how well they are doing.

Conclusion

Budgeting is the formulation of plans for a given future period in numerical terms.

Organizations may establish budgets for units, departments, divisions, or the

whole organization.

The usual period for a budget is one year and is generally expressed in financial

terms. Budgets are the foundation of most control systems.

3.Variance Analysis: Material, Labour, Variances

The function of standards in cost accounting is to reveal variances between

standard costs which are allowed and actual costs which have been recorded.
The Chartered Institute of Management Accountants (UK) defines variances as
the difference between a standard cost and the comparable actual cost incurred
during a period. Variance analysis can be defined as the process of computing
the amount of, and isolating the cause of variances between actual costs and
standard costs. Variance analysis involves two phases:

(1) Computation of individual variances, and

(2) Determination of Cause (s) of each variance.

We now turn to explain below the computation of material, labour variences

I. Material Variance:
The following variances constitute materials variances:

Material Cost Variance:

Material cost variance is the difference between the actual cost of direct material
used and stand- ard cost of direct materials specified for the output achieved.
This variance results from differences between quantities consumed and
quantities of materials allowed for production and from differences between
prices paid and prices predetermined.

This can be computed by using the following formula:

Material cost variance = (AQ X AP) – (SQ X

SP) Where AQ = Actual quantity

AP = Actual price

SQ = Standard quantity for the

actual output SP = Standard price

Material Usage Variance:

The material quantity or usage variance results when actual quantities of raw
materials used in production differ from standard quantities that should have
been used to produce the output achieved. It is that portion of the direct
materials cost variance which is due to the difference between the actual
quantity used and standard quantity specified.

As a formula, this variance is shown as:

Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard Price

A material usage variance is favourable when the total actual quantity of direct
materials used is less than the total standard quantity allowed for the actual
output.
Example:
Compute the materials usage variance from the following information:
Standard material cost per unit Materials issued

Material A — 2 pieces @ Rs. 10=20 (Material A

2,050 pieces) Material B — 3 pieces @ Rs. 20 =60

(Material B 2,980 pieces)

Total = 80

Units completed 1,000

Solution:
Material usage variance = (Actual Quantity – Standard Quantity) x

Standard Price Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500

(unfavourable)

Material B = (2980 – 3000) x Rs. 20 = Rs. 400

(favourable) Total = Rs. 100 (unfavourable)

It should be noted that the standard rather than the actual price is used in
computing the usage variance. Use of an actual price would have introduced
a price factor into a quantity variance. Because different departments are
responsible, these two factors must be kept separate.

(a) Material Mix Variance:

The materials usage or quantity variance can be separated into mix variance and yield
variance.

For certain products and processing operations, material mix is an important

operating variable, specific grades of materials and quantity are determined
before production begins. A mix variance will result when materials are not
actually placed into production in the same ratio as the standard formula. For
instance, if a product is produced by adding 100 kg of raw material A and 200 kg
of raw material B, the standard material mix ratio is 1: 2.

Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix
variance will be found. Material mix variance is usually found in industries, such
as textiles, rubber and chemicals, etc. A mix variance may arise because of
attempts to achieve cost savings, effective resources utilisation and when the
needed raw materials quantities may not be available at the required time.

Materials mix variance is that portion of the materials quantity variance which is
due to the difference between the actual composition of a mixture and the
standard mixture.

It can be computed by using the following formula:

Material mix variance = (Standard cost of actual quantity of the actual mixture –
Standard cost of actual quantity of the standard mixture)

Or

Materials mix variance = (Actual mix – Revised standard mix of actual

input) x Standard price

Revised standard mix or proportion is calculated as follows:

Standard mix of a particular material/Total standard quantity x Actual input

Example:
A product is made from two raw materials, material A and material B. One unit of
finished product requires 10 kg of material.

The following is standard mix:

During a period one unit of product was produced at the following costs:

Compute the materials mix variance.

Solution:
Material mix variance = (Actual proportion – Revised standard proportion of
actual input) x Standard price

(b) Materials Yield Variance:

Materials yield variance explains the remaining portion of the total materials
quantity variance. It is that portion of materials usage variance which is due to the
difference between the actual yield obtained and standard yield specified (in
terms of actual inputs). In other words, yield variance occurs when the output of
the final product does not correspond with the output that could have been
obtained by using the actual inputs. In some industries like sugar, chemicals,
steel, etc. actual yield may differ from expected yield based on actual input
resulting into yield variance.

The total of materials mix variance and materials yield variance equals
materials quantity or usage variance. When there is no materials mix variance,
the materials yield variance equals the total materials quantity variance.
Accordingly, mix and yield variances explain distinct parts of the total materials
usage variance and are additive.

The formula for computing yield variance is as follows:

Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit

Example:
Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of

output = Rs 200 Actual input 200 kg, actual yield 182 kg. Compute the yield

variance.

In this example, there is no mix variance and therefore, the materials usage
variance will be equal to the materials yield variance.
The above formula uses output or loss as the basis of computing the yield
variance. Yield vari- ance can also be computed on the basis of input factors
only. The fact is that loss in inputs equals loss in output. A lower yield simply
means that a higher quantity of inputs have been used and the anticipated or
standard output (based on actual inputs) has not been achieved.

Yield, in such a case, is known as sub-usage variance (or revised usage

variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of
Actual Input – Standard quantity) x Standard Cost per unit of input

Example:
Standard material and standard price for manufacturing one unit of a
product is given below:

Materials yield variance always equal sub-usage variance. The difference lies
only in terms of calculation. The former considers the output or loss in output
and the latter considers standard inputs and actual input used for the actual
output. Mix and yield variance both provide useful information for production
control, performance evaluation and review of operating efficiency.

Materials Price Variance:

A materials price variance occurs when raw materials are purchased at a price
different from standard price. It is that portion of the direct materials which is due
to the difference between actual price paid and standard price specified and cost
variance multiplied by the actual quantity. Expressed as a formula,
4.Materials price variance = (Actual price – Standard price) x Actual quantity

Materials price variance is un-favourable when the actual price paid exceeds the
predetermined standard price. It is advisable that materials price variance
should be calculated for materials purchased rather than materials used.
Purchase of materials is an earlier event than the use of materials.

Therefore, a variance based on quantity purchased is basically an earlier report

than a variance based on quantity actually used. This is quite beneficial from the
viewpoint of performance measurement and corrective action. An early report will
help the management in measuring the performance so that poor performance
can be corrected or good performance can be expanded at an early date.

Recognizing material price variances at the time of purchase lets the firm carry
all units of the same materials at one price—the standard cost of the material,
even if the firm did not purchase all units of the materials at the same price.
Using one price for the same materials facilities management control and
simplifies accounting work.

If a direct materials price variance is not recorded until the materials are issued to
production, the direct materials are carried on the books at their actual purchase
prices. Deviations of actual purchase prices from the standard price may not be
known until the direct materials are issued to production.

Example:
Assuming in Example 1 that material A was purchased at the rate of Rs 10
and material B was purchased at the rate of Rs 21, the material price
variance will be as follows: Materials price variance = (Actual Price –
Standard Price) x Actual Quantity

Material A = (10 – 10) x 2,050 = Zero

Material B = (21 – 20) x 2,980 = 2980 (un-

favourable) Total material price variance = Rs

The total of materials usage variance and price variance is equal to materials cost variance.

II. Labour Variances:

Direct labour variances arise when actual labour costs are different from standard
labour costs. In analysis of labour costs, the emphasis is on labour rates and
labour hours.

Labour variances constitute the following:

Labour Cost Variance:

Labour cost variance denotes the difference between the actual direct wages
paid and the standard direct wages specified for the output achieved.

This variance is calculated by using the following formula:

Labour cost variance = (AH x AR) – (SH x SR)

Where:
AH = Actual

hours AR =

Actual rate

SH =

Standard

hours SR =

Standard

rate
1. Labour Efficiency Variance:
The calculation of labour efficiency or usage variance follows the same pattern
as the computa- tion of materials usage variance. Labour efficiency variance
occurs when labour operations are more efficient or less efficient than standard
performance. If actual direct labour hours required to complete a job differ from
the number of standard hours specified, a labour efficiency

variance results; it is the difference between actual hours expended and

standard labour hours specified multiplied by the standard labour rate per hour.

Labour efficiency variance is computed by applying the following formula:

Labour efficiency variance = (Actual hours – Standard hours for the actual
output) x Std. rate per hour.

Assume the following data:

Standard labour hour per

unit = 5 hr Standard labour

rate per hour = Rs 30 Units

completed = 1,000

Labour cost recorded = 5,050 hrs @ Rs 35

Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable) It

may be noted that the standard labour hour rate and not the actual rate is used
in computing labour efficiency variance. If quantity variances are calculated,
changes in prices/rates are excluded, and when price variances are calculated,
standard quantities are ignored.

(i) Labour Mix Variance:

Labour mix variance is computed in the same manner as materials mix variance.
Manufacturing or completing a job requires different types or grades of workers
and production will be complete if labour is mixed according to standard
proportion. Standard labour mix may not be adhered to under some
circumstances and substitution will have to be made. There may be changes in
the wage rates of some workers; there may be a need to use more skilled or
expensive types of labour, e.g., employment of men instead of women;
sometimes workers and operators may be absent.

These lead to the emergence of a labour mix variance which is calculated

by using the following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in
terms of actual total hours) x Standard rate per hour

To take an example, suppose the following were the standard labour cost
data per unit in a factory:

In a period, many class B workers were absent and it was necessary to

substitute class B workers. Since the class A workers were less experienced
with the job, more labour hours were used.

The recorded costs of a unit were:

Labour mix variance will be calculated as follows:

Labour mix variance = (Actual proportion – Revised standard proportion of
actual total hours) x standard rate per hour

Revised standard proportion:

(i) Labour Yield Variance:

The final product cost contains not only material cost but also labour cost.
 Therefore, gain or loss (higher or lower output than the standard output) should
take into account labour yield variance also. A lower output simply means that
final output does not correspond with the production units that should have been
produced from the hours expended on the inputs.

It can be computed by applying the following formula:

Labour yield variance = (Actual output – Standard output based on actual
hours) x Av. Std. Labour Rate per unit of output.

Or

Labour yield variance = (Actual loss – Standard loss on actual hours) x

Average standard labour rate per unit of output

Labour yield variance is also known as labour efficiency sub-variance which is computed in terms of inputs, i.e.,
standard labour hours and revised labour
hours mix (in terms of actual hours).

Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate

2. Labour Rate Variance:

Labour rate variance is computed in the same manner as materials price
variance. When actual direct labour hour rates differ from standard rates, the
result is a labour rate variance. It is that portion of the direct wages variance
which is due to the difference between actual rate paid and standard rate of pay
specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours

Using data from the example given above, the labour rate variance is Rs

25,250, i.e., Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs

25,250 (unfavourable)
The number of actual hours worked is used in place of the number of the
standard hours speci- fied because the objective is to know the cost difference
due to change in labour hour rates, and not hours worked. Favourable rate
variances arise whenever actual rates are less than standard rates;
unfavourable variances occur when actual rates exceed standard rates.

3. Idle Time Variance:

Idle time variance occurs when workers are not able to do the work due to some
reason during the hours for which they are paid. Idle time can be divided
according to causes responsible for creating idle time, e.g., idle time due to
breakdown, lack of materials or power failures. Idle time variance will be
equivalent to the standard labour cost of the hours during which no work has
been done but for which workers have been paid for unproductive time.

Suppose, in a factory 2,000 workers were idle because of a power failure. As a result of this, a loss of
production of 4,000 units of product A and 8,000 units of Labour efficiency sub-variance is
computed by using the following formula:
product B occurred. Each employee was paid his normal wage (a rate of? 20 per
hour). A single standard hour is needed to manufacture four units of product A
and eight units of product B.

Idle time variance will be computed in the following manner:

Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr.

Product B = 8, 000 / 8 =

1,000 hr. Total hours lost =

2,000 hr.

Idle time variance (power failure)

2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)

 5.Breakeven Point (BEP)

The breakeven point (breakeven price) for a trade or investment is determined

by comparing the market price of an asset to the original cost; the breakeven
point is reached when the two prices are equal.

In corporate accounting, the breakeven point (BEP) formula is determined by dividing the
total fixed costs associated with production by the revenue per individual unit
minus the variable costs per unit. In this case, fixed costs refer to those that do
not change depending upon the number of units sold. Put differently, the
breakeven point is the production level at which total revenues for product equal
total expenses.

KEY TAKEAWAYS

• In accounting, the breakeven point is calculated by dividing the fixed

costs of production by the price per unit minus the variable costs of
production.
• The breakeven point is the level of production at which the costs of
production equal the revenues for a product.
• In investing, the breakeven point is said to be achieved when the market
price of an asset is the same as its original cost.
A breakeven analysis can help with finding missing expenses, limiting decisions based on emotions,
establishing
 ➢ Break-even chart

Break-even is the level of output at which revenues from

sales equal total costs. It is the number of units a firm has to
produce and sell to recover its total costs.
The break-even chart includes four variables: fixed costs,
variable costs, total costs, and revenue. Each of them is
represented as a line that indicates its value depending on the
level of output.

Term Definition Example

costs that remain the

Fixe
same regardless of the rent, rates
d
number of units
cost
produced
s

costs that rise and fall in

Variable raw materials used in
direct proportion to the
costs production, direct labour
number of units
produced

rent and rates, raw

Tota fixed costs and variable
materials used in
l costs added together
production and direct
cost
labour added together
s
Revenue money earned from cash from sales
sales

How Break-Even Analysis Works

A break-even analysis is a financial calculation used to determine a company’s

break-even point (BEP). It is an internal management tool, not a computation,
that is normally shared with outsiders such as investors or regulators. However,
financial institutions may ask for it as part of your financial projections on a bank
loan application.

The formula takes into account both fixed and variable costs relative to unit price
and profit. Fixed costs are those that remain the same no matter how much
product or service is sold.
Examples of fixed costs include facility rent or mortgage, equipment costs,
salaries, interest paid on capital, property taxes and insurance premiums.

Variable costs rise and fall according to changes in sales. Examples of variable
costs include direct hourly labor payroll costs, sales commissions and costs for
raw material, utilities and shipping. Variable costs are the sum of the labor and
material costs it takes to produce one unit of your product.

Total variable cost is calculated by multiplying the cost to produce one unit by
the number of units you produced. For example, if it costs $10 to produce one
unit and you made 30 of them, then the total variable cost would be 10 x 30 =
$300.

What is Contribution Margin?

The contribution margin is the difference (more than zero) between the product’s
selling price and its total variable cost. For example, if a suitcase sells at $125
and its variable cost is $15, then the contribution margin is $110. This margin
contributes to offsetting fixed costs.

Unit Contribution Margin = Sales Price – Variable Costs

The average variable cost is calculated as your total variable cost divided by the
number of units produced.

In general, lower fixed costs lead to a lower break-even point—but only if

variable costs are not higher than sales revenue.

Why Does Your Business Need to Perform Break-Even Analysis?

A break-even analysis has broad uses on its own merit. But it’s also a critical element
of financial projections for startups and new or expanded product lines. Use it to
determine how much seed money or startup capital you’ll need, and whether
you’ll need a bank loan.

More mature businesses use break-even analyses to evaluate their risks in a

variety of activities such as moving innovative ideas to production, adding or
deleting products from the product mix and other scenarios. One example is in
budgeting the addition of a new employee. A break-even analysis will reveal how
many additional sales it will take to break even on expenses associated with the
new hire.

What Is a Standard Break-Even Time Period?

An acceptable break-even window is six to 18 months. If your calculation
determines a break- even point will take longer to reach, you likely need to
change your plan to reduce costs, increase pricing or both. A break-even point
more than 18 months in the future is a strong risk signal.

When to Use a Break-Even Analysis

Basically, a business will want to use a break-even analysis anytime it

considers adding costs. These additional costs could come from starting a
business, a merger or acquisition, adding or deleting products from the
product mix, or adding locations or employees.
 1. Expanding a business
Break-even points (BEP) will help business owners/CFOs get a reality check on
how long it will take an investment to become profitable. For example, calculating
or modeling the minimum sales required to cover the costs of a new location or
entering a new market.

2. Lowering pricing
Sometime businesses need to lower their pricing strategy to beat competitors in a
specific market segment or product. So, when lowering pricing, businesses need
to figure out how many more units they need to sell to offset or makeup a price
decrease.

3. Narrowing down business scenarios

When making changes to the business, there are various scenarios and what-
ifs on the table that complicate decisions about which scenario to go with. BEP
will help business leaders reduce decision-making to a series of yes or no
questions.

How Do You Calculate the Break-Even Point?

ERP and accounting software with managerial accounting features will typically
calculate your BEP for you, but you may want to understand what goes into that
equation.

Break-even analysis formula

Break-even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)

The Limitations of a Break-Even Analysis

On the flip side, you’ll need to decide how much effort and time you’re willing to
expend to reach the break-even point. For example, are you willing to invest a
substantial percentage of your sales team’s time and effort over several months
to reach the break-even point? Or, is producing and selling something else a
better and more profitable use of time and effort?

If you find demand for the product is soft, consider changing your pricing
strategy to move product faster. However, discounted pricing can actually raise
your break-even point. If you’re not careful, you’ll move product faster at the
lower price but will incur more variable costs to produce more units in order to
reach your break-even point.

How to Calculate Break-Even Point?

There is no net loss or gain at the break-even point (BEP), but the company is
now operating at a profit from that point onward.

For all business owners, particularly during the earlier stages of a business, one
of the most crucial questions to answer is: “When will my business break even?”
Businesses share the similar core objective of eventually becoming profitable in
order to continue operating. Otherwise, the business will need to wind-down
since the current business model is not sustainable.

An unprofitable business eventually runs out of cash on hand, and its operations
can no longer be sustained (e.g., compensating employees, purchasing
inventory, paying office rent on time).
By understanding the required output to break even, a company can set revenue
targets accordingly, as well as adjust its business strategy such as the pricing of
its products/services and how it chooses to allocate its capital.
If a company has reached its break-even point, this means the company is
operating at neither a net loss nor a net gain (i.e. “broken even”).
The incremental revenue beyond the break-even point (BEP) contributes toward
the accumulation of more profits for the company.
 business model that could benefit from improvements (e.g., sales tactics and
marketing strategies).

Furthermore, established companies with a diverse portfolio of product/service

offerings can estimate the break-even point on an individualized product-level
basis to assess whether adding a certain product would be economically viable.
In effect, the analysis enables setting more concrete sales goals as you have a
specific number to target in mind.

Break-Even Point Formula (BEP)

The formula for calculating the break-even point (BEP) involves taking the total
fixed costs and dividing the amount by the contribution margin per unit.
Break-Even Point (BEP) = Fixed Costs ÷ Contribution Margin

To take a step back, the contribution margin is the selling price per unit minus the
variable costs per unit, and represents the amount of revenue remaining after
meeting all the associated variable costs accumulated to generate that revenue.

• Contribution Margin = Fixed Costs→ That said, when a company’s contribution

margin (in dollar terms) is equal to its fixed costs, the company is at its break-even

point.

• Contribution Margin > Fixed Costs→ If the company’s contribution margin

exceeds its fixed costs, then the company actually starts profiting from the sale of its

products or services.

Quick Break Even Analysis Example (BEP)

For example, if a company has $10,000 in fixed costs per month, and their product has
an average selling price (ASP) of $100, and the variable cost is $20 for each
product, that comes out to a contribution margin per unit of $80.
• Fixed Costs per Month = $10,000

• Average Selling Price (ASP) = $100.00

• Variable Cost per Unit = $20.00

• Contribution Margin = $80.00
Then, by dividing $10k in fixed costs by the $80 contribution margin, you’ll end
up with 125 units as the break-even point, meaning that if the company sells
125 units of its product, it’ll have made $0 in net profit.
• Break-Even Point (BEP) = 125 Units

Or, if using Excel, the break-even point can be calculated using the “Goal Seek” function.

After entering the end result being solved for (i.e., the net profit of zero), the tool
determines the value of the variable (i.e., the number of units that must be sold)
that makes the equation true.

Break-Even Point Calculator (BEP)

Unit Economics and Cost Structure Assumptions

Let’s say that we have a company that sells products priced at $20.00 per unit, so
revenue will be equal to the number of units sold multiplied by the $20.00 price
tag.

• Selling Price Per Unit = $20.00

In terms of its cost structure, the company has fixed costs (i.e., constant
regardless of production volume) that amounts to $50k per year. Recall, fixed
costs are independent of the sales volume for the given period, and include costs
such as the monthly rent, the base employee salaries, and insurance.
• Total Fixed Costs = $50,000
Moving onto our final assumption, the variable costs directly associated with the
production of the products being sold are $10.00.

• Variable Costs = $10.00 Per Unit

In contrast to fixed costs, variable costs increase (or decrease) based on the
number of units sold. If customer demand and sales are higher for the company
in a certain period, its variable costs will also move in the same direction and
increase (and vice versa).
The total variable costs will therefore be equal to the variable cost per unit of
$10.00 multiplied by the number of units sold.

What is Break-Even Point?

Small businesses that succeeds are the ones that focus on business
planning to cross the break-even point, and turn profitable.

In a small business, a break-even point is a point at which total revenue equals total
costs or expenses. At this point, there is no profit or loss — in other
words, you 'break-even'.

Break-even as a term is used widely, from stock and options trading to

corporate budgeting as a margin of safety measure.

On the other hand, break-even analysis lets you predict, or forecast your
break-even point. This allows you to course your chart towards
profitability.

Managers typically use break-even analysis to set a price to understand the

economic impact of various price and sales volume calculations.

The total profit at the break-even point is zero. It is only possible for a
small business to pass the break-even point when the dollar value of sales
is greater than the fixed + variable cost per unit.

Every business must develop a break-even point calculation for their

company. This will give visibility into the number of units to sell, or the sales
revenue they need, to cover their variable and fixed costs.

Importance of Break-Even Analysis for Small Business

A business could be bringing in a lot of money; however, it could still be

making a loss. Knowing the break-even point helps decide prices, set sales
targets, and prepare a business plan.

The break-even point calculation is an essential tool to analyze critical profit

drivers of your business, including sales volume, average production costs,
and, as mentioned earlier, the average sales price.

Using and understanding the break-even point, you can measure

 • how profitable is your present product line
• how far sales drop before you start to make a loss
• how many units you need to sell before you make a profit
• how decreasing or increasing price and volume of product will affect profits
• how much of an increase in price or volume of sales you will need to
meet the rise in fixed cost

How to Calculate Break-Even Point

There are multiple ways to calculate your break-even point.

Calculate Break-even Point based on Units

One way to calculate the break-even point is to determine the number of

units to be produced for transitioning from loss to profit.

For this method, simply use the formula below:

Break-Even Point (Units) = Fixed Costs ÷ (Revenue per Unit – Variable Cost per
Unit)

Fixed costs are those that do not change no matter how many units are
sold. Don't worry, we will explain with examples below.

Revenue is the income, or dollars made by selling one unit.

Variable costs include cost of goods sold, or the acquisition cost. This may
include the purchase cost and other additional costs like labor and freight
costs.