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10/22/2009

ACCOUNTING FOR MANAGERS


BY A.ARULDOSS VITHAKAN

1
Management Accounting- meaning
& definition

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 Definition
 Process of preparing management accounts that
provide accurate and timely key financial and
statistical information required by managers to make
day-to-day and short-term decisions. Unlike
financial accounting (which produces annual reports
mainly for external stakeholders such as creditors,
investors, and lenders) management accounting
generates monthly or weekly reports for the firm's
internal audiences such as department managers and
the chief executive officer. These reports typically
show the amount of available cash, sales revenue
generated, amount of orders in hand, state of
accounts payable and accounts receivable,
outstanding debts, raw material and in-process 2
inventory, and may also include trend charts,
variance analysis, and other statistics. Also called
Management Accounting- meaning
& definition

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 Managerial accounting or Management
Accounting is concerned with providing
information to managers-that is, people
inside an organization who direct and control
its operation. In contrast, financial
accounting is concerned with providing
information to stockholders, creditors, and
others who are outside an organization.
 Managerial accounting provides the essential
data with which the organizations are
actually run. Managerial accounting is also
termed as management accounting or
cost accounting. Financial accounting
provides the scorecard by which a 3

company's overall past performance is


judged by outsiders.
Management Accounting- meaning
& definition

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 Managerial accountants prepare a variety of
reports. Some reports focus on how well
managers or business units have performed-
comparing actual results to plans and to
benchmarks.
 Some reports provide timely, frequent updates
on key indicators such as orders received,
order backlog, capacity utilization, and
sales.
 Other analytical reports are prepared as
needed to investigate specific problems such
as a decline in the profitability of a product 4
line
Management Accounting-
meaning & definition

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 . And yet other reports analyze a developing
business situation or opportunity. In contrast,
financial accounting is oriented toward
producing a limited set of specific prescribed
annual and quarterly financial statements in
accordance with
Generally Accepted Accounting Principles (GAAP)
. (Ray H. Garrison, Eric W. Noreen 1999).

5
Scope of management Accounting
 Financial accounting: it is traditional accounting

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which provides historical but valuable information
on the operational results of the company and
the financial position as on any particular date
 Cost accounting; Provides cost ascertained for the
product(s) or service(s) and also provide ares or
items for cost savings
 Statistical methods: plys a pivotal role in analysis
and presentation of date for decision making.
 Operations research : Helps in making rational
decisions using all internal and external data.

6
FUNCTIONS OF MANAGEMENT ACCOUNTING

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Management Accounting vs
Financial Accounting

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Financial Accounting Managerial Accounting
Reports to those outside the Reports to those inside the

organization owners,
Emphasis is on lenders,
summaries of organization
Emphasis is foron planning,
decisions
tax authorities
financial andand regulators.
consequences
Objectivity of past directing
verifiability affecting
Relevanceand motivating,
theoffuture.
items relating to
activities.
of data are emphasized. controlling and performance
decision making is
evaluation.
emphasized.

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Management Accounting vs
Financial Accounting

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 Precision of information is Timeliness of information is
required.
Only summarized data for the required.
Detailed segment reports
entire organization is
Must follow about
Need departments,
not follow products,
prepared.
generally
Mandatoryaccepted accounting customers,
for external generally
principles and employees
accepted
(GAAP)
Not mandatory. are principles
accounting
.reports. .prepared.

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Management Accounting vs
Cost Accounting
Sl>No Point of Cost Accounting Management

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1 Difference
Objectives Its main objective is to ascertain the
cost
Accounting
To make decision throughsupplement
presentation of accounting
2 Scope It deals with only cost and related
aspects
Not only deals with cost but also
information
concerned about revenue. It is wider
3 Utilization
Of data
It is only quantitative information
pertaining to the transaction
it uses
than both
cost quantitative and
accounting
qualitative information for decision
4 Utility It ends only with presentation of
information
It starts from where cost accounting
making
ends Meaningful cost information and
5 Nature It deals with past and present data. It dealsinputs
major with future policies
for decision
course of actions.
and
making

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ADVANTAGES AND LIMITATIONS OF
MANGEMENT ACCOUNTING
ADVANTAGES LIMITATIONS

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FACILITATES PLANNING OF IT SI BASED ON PAST DATA
THE FUNCTIONS
FACILITATES OF THE
REPORTING FROM FINANCIAL
THOUGH BROADER AND
IN COST
BUSINESS ENTERPRISE
HELPS IN ORGANISING ACCOUNTING
SCOPE
CREATES, PAVES WHICH
WAY FOR
CONFUSION HAS
IN
GUIDES THROUGH PROPER AN
THE IMAPACT
INACCURACY ON THE
MINDS OFVDECISION
RESISTANCE FROM
CO-ORDINATION
EXTENDS THE TOOL OF AN EFFECTIVENES
MAKERS
EMPLOYEES
DECISIONS INARE
FOROF
INTERPRETING
MADE BY
ANALYSIS OF COMPARISON MANAGEMENT
THE INFORMATION
IMPLEMENTATION
MANAGEMENT ANDOF THEBY
NOT
IN BETWEEN ACTUALS AND ACCOUNTING
SYSTEM
MANAGEMENT
STANDARD PERFORMANCE ACCOUNTANT

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Financial Statements
Introduction

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 Accounting is defined as an information
system receiving its input from various
financial transactions, processing these
transactions and giving as output the
financial statements and other reports that
will enable the users to make suitable
decision dealing with business and economic
entities. The records of the transactions are
summarized into two major statements
known as 'financial statements' or 'final
accounts'. They comprise of:

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Financial Statements
Introduction

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 a) Balance sheet, which shows the financial
position of the concern, by listing out all the
assets and properties that the concern owns
and the amount it owes to others and
 b)     Profit and Loss Account (or Income
Statement) which shows the various sources
of income and the different heads of
expenditure. The difference between the
income and expenditure is the profit made
by the concern.

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RATIO ANALYSIS

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RATIO ANALYSIS:

 13.1 INTRODUCTION:

 Financial statements provide useful


information relating to financial performance
and about the financial standing of the
company.
 These statements may be more fruitfully used
if they are analysed and interpreted to have
an insight into the strengths and
weaknesses of the firm.

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RATIO ANALYSIS

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 Ratio analysis is the process of determining
and presenting in arithmetical terms, the
relationship between figures and group of
figures drawn from the financial statements.
Ratio is the basis of this analysis.
 A more meaningful financial analysis involves
ratios and their comparison relating to a
business concern (a) over a period of years;
(b)against another unit; (c) against the
industry as a whole; (d) against
predetermined standards; (e) for one
department or division against another
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department or division of the same unit.

RATIO ANALYSIS

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MEANING AND RATIONALE OF RATIO

ANALYSIS: Financial statements can be


effectively analyzed using ratio analysis. They:
 Assist in analyzing the performance of the
company and comparing the performance
with that of other similar companies;
 Highlight the relative strengths and
weaknesses of a company - whether it is
profitable, financially sound or in a state of
decline;

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RATIO ANALYSIS

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 Help in determining whether the company has
earned sufficiently on the funds invested and its
debt servicing ability;
 Enable the forecasting of future performance.
 13.3 INTERPRETATION METHODS: The
importance of ratios, as a tool of analysis, lies in
its proper interpretation by the financial analyst.
There are four different methods applied for
interpretation of ratios.
 Based on a single ratio The significance of the
relationship between two figures provides
certain information..
 Based on inter related ratios. For instance
when we analyse the net profit ratio and the
total investment is turned over in sales in every
year, we can understand how the earning power 17
is affected by these variables.

RATIO ANALYSIS

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 Inter-firm comparison h will provide very valuable
information in most cases as members in the same
industry face similar problems both internal and
external which enables effective decision making..
 Compare ratios in the past and the present one to
evaluate the firm’s performance.
 13.4. CLASSIFICATION OF RATIOS: Traditional
classification of ratios- profit & loss ratios, Balance
sheet ratios and composite ratios is not an effective
way of classification to derive any decision inputs
since financial statements cannot be analysed in
isolation. dered to be of use to classify the ratios on
functional basis. The board categories are:
 Profitability ratios.
 Coverage ratios.
 Turnover ratios.
 Financial ratios. -liquidity ratios and -stability ratios 18
RATIO ANALYSIS

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 Profitability ratios provide answers to
questions -(i) Is the profit earned by the firm
adequate? (ii) What is the rate of return?(iii)
What is the earnings per share? (vi) What is
the rate of return to equity holders?

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.
March 2001 ((Rupees in Crores )
2001 2000
Net Slaws 701 623
Cost
Stocksof goods sold 421 552 475
Wages and slaries
 68
Other Manufacturing
 63
Expenses

Gross Profit 149 148


Operating Expenses 60 49
Depreciation
 30
General administration 12

Selling
 18
Operating profit 89 99
Other income(expenses) - 6
Profit before interest 89 105
and tax
Interest 21 22
Profit before tax 68 83 20
Provision for tax 34 41
Profit after tax 34 42
Balance sheet of Horizon Limited as on 31 March
2001 (Account Form)

LIABILITIES 2001 2000 ASSETS 2001 2000


Share Capital 150 150 Fixed assets 330 322
( net )

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 Equity 150 150 Dross Block 500 462
 Preference - - Accu. Deprreciation 170 140
Reserves & 112 106 Investments 15 15
Surplus
Secured Loans 143 131 Current assets
 Term Loans 70 58 Loans & 234 156
Advances
 Cash Credit 73 73 Cash & Bank 10 6
Unsecured 69 25  Debtors 114 68
Loans
Bank credit 25 25  Inventories 105 72
Inter Corporate
 44 -  Advances 5 10
Deposits
Current 105 81 Miscellaneous - -
Liabilities & Expenditure &
Provisions
Trade credit
Losses
75 60
 Advances 20 13 21
 Provisions 10 8
579 493 579 493
Balance sheet of Horizon Limited as on 31st March 2001
(Account Form)
I Sources of Funds 2001 2000
1.Shareholders Funds 262 256
(a)Share capital 150

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(b) 112
Reserves & surplus
2. Loan Funds 212 156
Secured Loans 143
Unsecured loans 69
Total 474 412
II . Application of
Funds
Fixed assets 330 322
Investments 15 15
Current assets, loans 234 156
& advances
105 81
Less: Current
liabilities &
provisions 129 75
( 4Net Current
)Miscellaneous Expenditure & Losses) 22
aAssets
Total 474 412
RATIO
 ANALYSIS
Profitability ratios provide answers to questions -(i) Is
the profit earned by the firm adequate? (ii) What is the

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rate of return?(iii) What is the earnings per share? (vi)
What is the rate of return to equity holders?
 Ratios are calculated based on the data provided in
Horizon limited P&L account and balance sheet
given above.
 1. Profitabilty ratios in relation to Sales:
 (a) Gross/Net profit margin:: It measures the
relationship between profits and sales. As the profits
may be gross or net, there are two types of profit
margin.
 This ratio is calculated by dividing the gross profit by
sales. Thus,
 Gross Profit ratio= gross profit ÷ Net sales ×
100
 = net sales-cost of goods sold÷ net
sales×100 23
 Illustration: Data – Net sales-701; Cost of
goodssold-552 Net Profit-34 Thus
 Significance: Higher margin generally indicates

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effective management and better operating
efficiency. Low gross margin is definitely a danger
signal, warranting a careful and detailed analysis
of the factors responsible for it
 Net Profit margin ratio

 =Net profit ÷ Net sales×100 = 34 ÷ 701 ×100


= 4.85%
 Significance

 This ratio helps in determining the efficiency with


which affairs of the business are being managed.
An increase in the ratio over the previous period
indicates improvement in the operational 24

efficiency of the business provided the gross


profit ratio is constant.
. Profitability Ratios Related to Investments:
 (a) Return on Assets (ROA):The profitability ratio is
calculated in terms of the relationship between net

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profits and assets. This ratio is also known as "profit-
to-assets ratio".
 Illustration: Data-PAT-34; Assets for 2001 and
2000 are 412 and 474
 Return on Assets= Profit after tax ÷ Average Total
Assets
 = 34 ÷ {(412+474) /2} =7.7%
Significance: Higher the ratio better is the utilisationof

assets for generating profit.


 (b) Return on Capital Employed (ROCE)): Since
return will be influenced by factors such as the type of
the industry, the risk involved the risk of inflation, and
fluctuations in external economic conditions, 25
shareholder can measure the success of a company in
terms of profit related to capital employed.
Investments:

 Sum total of long-term funds employed (average

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totalassets)in business i.e.;
 Illustration: PBIT-89, Tax rate 50%; Assets for 2001
and 2000 are 412 and 474
 ROCE =Profit before interest and tax (1-Tax

rate) ÷ Average Total Assets


 The numerator of this ratio viz.., is also called as net
operating profit after tax.
 Thus ROCE = 89(1-0.5) ÷ { (412+474)/2} =0.101
or 10.1%
 Significance
 'Return on Capital Employed' is the post-tax
version of earning power and show satisfactorily the
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over-all performance of an undertaking

 (c) Return on Shareholders' Equity
 Profitability from the point of view of the equity shareholders will
be judged after taking into account the amount of dividend

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payable to the preference shareholders. It is calculated using
the data : Net Profit (equity earning after tax)=34; average of
years 2001 and 2000 equity of 262 and 256 = Equity earnings
÷ Average equity
 = 34 { 262+256)/2}= 0.131 0r 13.1%
 It reveals whether the firm has earned a reasonable profits to its
equity shareholders or not by comparing it with its own part
records, inter firm comparison and comparison with the overall
industry average.
 Earnings Per Share (EPS)
 This ratio indicates the availability of total profits per share. The
following formula may be employed to determine EPS.
 = 34 ÷ 15= Rs. 2.26 per share of face value of RS.10 =22.
 EPS can be used to draw inferences on the basis of (i) its trend 27
over a period of time, (ii) comparison with the EPS of other
firms, and (iii) comparison with the industry average.
Earnings Yield/Price Earning Ratio (P/E)
 This ratio is computed by dividing the market price of the
shares by the EPS. Thus, Market Price per equity
share/earnings per share.

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 Using the data- market price is Rs.30 and earning per share is
Rs.5, then P/E ratio is = 30/5=6
 This ratio is useful in financial forecasting and it also helps in
knowing whether a share is under-valued or over-valued.
Example :
P/E Market Price EPS Market value Status
8 140 20 Rs.20*8=160 under valued
6 140 20 Rs.20*6=120 Over valued

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Coverage Ratios

 A firm must be in a position to meet its obligations


like payment of interest on loans, repayment of

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loans, redemption of preference shares/
debentures etc are to be met out of its earnings
and not out of sale proceeds of its assets. This
ability is indicated by the coverage ratios.
 (1) Interest Coverage Ratio

 . It indicates whether the business would


earn sufficient profits to pay periodically the
interest charges. The higher the number, the
more secure the lender is in respect of his
periodical interest income. It is calculated as
follows: Data for calculation: EBITt=89 AND
Interest is 21 29

 EBIT/Interest = 89 ÷ 21 = 4.24
Coverage Ratios
 2) Dividend Coverage Ratio

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 It measures the ability of a firm to pay dividend on preference
shares which carry a stated rate of return. Data for
Illustration: EAT is Rs.10000 and Preference dividend
payable is Rs.1000. Thus the ratio is
 =10000/1000= 10 times
 Debt Coverage Ratio: This is an ideal ratio for measuring
the capability of an enterprise to meet its long term
liabilities. This is computed by the following formula: Cash
Generated/Repayment installment + interest
payable. Data for calculation is : cash generated 20000
and repayment installment is rs.3000 and interest is
Rs.1000 .Thus the ratio=20000/4000= 5 times
 Significance: In both cases higher the ratio better is the
company’s ability to s meet its obligations and both
shareholders and lenders feel better. 30

Turnover Ratios
 The turnover ratios indicate the efficiency with
which the capital employed is rotated in the

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business. The overall profitability of the business
depends on two factors: (i) the rate of return on
capital employed; and (ii) the turnover. Higher
the rate of rotation, the greater will be the
profitability.
 Turnover ratio is calculated as under:

 Sales/capital employed*100.

 Data for calculation: Sales is 701 and

capital employed is 262, Thus the


ratio is= 701/574*100 =133

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Turnover Ratios
 (1) Fixed Assets Turnover Ratio

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 Since investment in fixed assets is made for the
ultimate purpose of effecting sales, this ratio is
used to measure the fulfillment of that object.
This ratio is computed based on data : Sales is
701 and average net fixed assets is
(330+322)/2=326
 Net Sales/ Average Net Fixed assets = 701/
(330+322)/2 =701 ÷ 326 = 2.15
 If the ratio is low it may indicate excessive
investments in fixed assets.

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 (2) Working Capital Turnover Ratio

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 This ratio Is used to asses the efficient use of
working capital and is computed by dividing the
net sales by net working capital. Ratio is
computed by: Net sales/Net working Capital
 Higher ratio may be favorable but it may also
indicate inadequacy of net working capital.
Similarly low ratio may indicate either excessive
working capital or slow turnover of inventories or
receivables.
 (a) Debtors Turnover ratio

 The Debtors Turnover Ratio (DT) or Receivables


Turnover Ratio (RT) indicates the rate at which 33
cash is generated by turnover of receivable or
debtors.
 Debtors Turnover Ratio, together with Average
Collection Period, involves the following steps:

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 Calculation of daily sales – Net credit sales during
the year/ no of working days
 Calculation of Average Collection Period: No of trade
debtors- Sales per day/ amount of trade
debtors.
 Debtors Turnover ratio is = Credit sales/average
debtors.
 If credit sales is 545 and average debtors is 235 the
ratio is=544/235=2.32
 Significance
 Debtors being a major component in the current assets
it is necessary to have close and continuous watch
and it should not exceed a reasonable proportion of
net sales. This will reveal as to how many days 34
average sales are tied up in the value of amounts'
owing by debtors.
 (b) Creditors turnover ratio

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 This ratio indicates the number of days of credit enjoyed
by the unit for purchase of its raw materials. It is
calculated by the following formula:
 Purchases per day= Total credit purchase/360
 Higher ratio means that the unit is enjoying good
reputation but the liquidity position of the unit may
become unstable
 Inventory Turnover Ratio
 Inventory Turnover Ratio (ITR), also known as Stock
Turnover Ratio establishes relationship between the
cost of goods sold during a given period and the
average amount of inventory outstanding during that
period.
 The ratio can be computed in two ways – Cost of 35
goods sold/Average Inventory
 =552 ÷ (105+72)/2 = 552 ÷ 88.5 = 6.24
 Significance

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 An inventory turnover ratio, standing by itself, means
absolutely nothing and to give meaning to a turnover
figure one must undertake a comparative analysis
either with industry or for the individual firm over time
or with principal competitors to derive decision inputs.
 14.2 IV. Financial Ratios
 Financial Ratios indicate the financial position of a
company. Financial ratios can be divided into two
broad categories:
 Liquidity ratios
 Stability ratios
 (1) Liquidity ratios
 Liquidity ratios measure the firm's ability to meet its
current obligations when due 36


 A low liquidity may lead to default which may hurt firm’s
standing and also affect creditors confidence. A very

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high degree of liquidity is also bad because the funds
are unnecessarily tied up in current assets which earn
nothing. A striking balance, therefore, is necessary.
 The important liquidity ratios are as follows:
 Current ratio = Current assets/ Current
Liabilities= 224 ÷ 178 = 1.32
 Significance
 The current ratio is an index of the concern's financial
stability since it shows the extent of the working
capital which is the amount by which the current
assets exceed the current liabilities. As stated earlier,
a higher current ratio would Indicate Inadequate
employment of funds while a poor current ratio is a
danger signal to the management. It shows that 37
business is trading beyond its resources.
 (b) Acid Test / Quick ratio

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 This ratio is very akin to the current ratio. The only
difference is that it compares very liquid assets (by
excluding inventory) with current liabilities. Thus,
quick ratio is calculated as under:
 Current assets-Inventory/current liabilities= (224-
95)/178=0.73
 This ratio, in fact, measures the ability of the enterprise
to pay off its impending current obligations
immediately. If the quick ratio is less but the current
ratio is high, it may mean that the unit is holding high
level of inventory.
 (2) Stability Ratios: Fixed assets ratio
 This ratio indicates how much the assets of an 38
enterprise cover the amount of secured long term
loans. Long term loans are secured by mortgage on
 The ratio is computed as under:
 =Net fixed assets/Long term debts= 330 ÷

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(150+112+70) = 330 ÷ 332 = 0.99
 Ideally speaking, minimum acceptable ratio should
be 2:1. However, the ratio has its own limitations
in as much as that the same can easily be
inflated by revaluation of fixed assets. Further, in
case of failure of a project, the value of assets in
liquidation is likely to be very low.
 b) Debt to Equity Ratio

 Debt to Equity Ratio (DE) relates all recorded


creditors' claims on assets to the owners'
recorded claims in order to measure the firm's
obligations to creditors in relation to funds 39

provided by the owners. It is also known as


'External-Internal Equity Ratio'.
 On the basis of figures given in the Balance Sheet, it is
clear that liabilities to third parties are Rs. 45.000 and

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those to proprietors are Rs. 1,05,000 so that Debt to
Equity Ratio would be:45000/150000= 3:7
 Significance
 The D/E ratio is an important tool of financial analysis to
appraise the financial structure of a firm. A high ratio
shows a large share of financing by the creditors
relatively to the owners . The D/E ratio indicates the
margin of safety to the creditors.
 14.3 Advantages of Ratio Analysis
 Following are some of the advantages of ratio analysis:
 Ratio Analysis simplifies the comprehension of
financial statements.
 : Ratio Analysis provides data for inter-firm
comparison. 40
 Ratio Analysis also makes possible comparison of
the performance of the different divisions of the

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firm. The ratios are helpful in deciding about their
efficiency or otherwise in the past and likely
performance in the future.
 Ratio analysis helps in planning and forecasting.
Over a period of time
 Thus, "ratios can assist management in its basic
function of forecasting, planning, coordination, control
and communication".
 14.4 Limitations of Ratio Analysis
 Ratio analysis is, as already mentioned, a widely-used
tool of financial analysis. Yet, it suffers from various
limitations. The operational implication of this is that
while using ratios, the conclusions should not be taken
on their face value. Some of the limitations which 41
characteristics ratio analysis are:

Current Ratio -- Trend Analysis
Comparison

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Trend Analysis of Current Ratio

2.5
2.3
Ratio Value

2.1
BW
1.9 Industry
1.7
1.5
2005 2006 2007
Analysis Year

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Acid-Test Ratio -- Trend Analysis
Comparison

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Trend Analysis of Acid-Test Ratio

1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
2005 2006 2007
Analysis Year

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Summary of the Liquidity Trend
Analyses

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 The current ratio for BW has been rising at the
same time the acid-test ratio has been
declining.
 The current ratio for the industry has been
rising slowly at the same time the acid-test
ratio has been relatively stable.
 This indicates that inventories are a significant
problem for BW.
BW

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Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio

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Ye ar BW     Industry
2007 .90  .90
2006 .88  .90
2005
.81  .89
BW has average debt utilization
relative to the industry average

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Coverage Ratio -- Trend Analysis
Comparison

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Trend Analysis of Interest Coverage Ratio
11.0

9.0
Ratio Value

7.0 BW
Industry
5.0

3.0
2005 2006 2007
Analysis Year

46
Summary of the Coverage Trend
Analysis

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 The interest coverage ratio for BWhas
BW been
falling since 2005. It has been below
industry averages for the past two years.
 This indicates that low earnings (EBIT) may be
a potential problem for BW.
BW
 Note, we know that debt levels are in line with
the industry averages.

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Activity
Ratio Comparisons

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Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2

 BW has improved the average collection


period to that of the industry average.

48
Common-size Analysis

 An analysis of percentage financial statements

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where all balance sheet items are divided by
total assets and all income statement items
are divided by net sales or revenues.

Assets 49
10/22/2009
Liab+Equit
50
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51
Index Analyses

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 An analysis of percentage financial statements
where all balance sheet or income
statement figures for a base year equal
100.0 (percent) and subsequent financial
statement items are expressed as
percentages of their values in the base year.

52
Indexed Balance Sheets

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Assets
53
Indexed Balance Sheets

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Liab+Equit 54
Indexed Income Statements

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55
Funds Flow Analysis

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 Introduction :There are certain other fruitful
relationships between the balance sheets at
the commencement and at the end of the
accounting period on which these two
statements of financial position ( Profit &
Loss statement and balance Sheet) fall to
throw any light.
 Viewed in this sense. two statements. i.e.,
Statement of Changes in Cash (popularly
called Cash Flow Statement) and Statement
of Changes in Working Capital (popularly
known as Sources and Uses Statement or
Funds Flow Statement) measures the
changes that have taken place in the 56

financial position of a firm between two


balance sheet dates.
TRANSACTIONS INVOLVE BETWEEN
Curre nt Asse ts &
No n­ Curre nt 
Asse ts

FLOW OF FUNDS
INFLOW &
OUTFLOW
57
 Meaning of funds flow statement

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 It will be appropriate to explain the meaning of the
term 'Funds' and the term 'Flow of Funds' before
explaining the meaning of the term 'Funds Flow
Statement'.
 Meaning of Funds - The term "fund" generally refers
to cash, to cash and cash equivalents, or to working
capital.
 Current assets
 These are assets which are expected to be realised in
cash or sold or consumed or turned over within one
operating cycle of the unit normally not exceeding
12 months.
 Current Liabilities 58
 These denote liabilities which would be payable or
expected to be turned over within one year from the
 Non-Current Assets

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 All assets other than current assets come within
the category of non-current assets.
 Non-Current Liabilities

 All liabilities other than current liabilities come


within the category of non-current liabilities.
 Concept of flow

 The 'Flow' of funds refers to transfer of economic


values from one asset to another, from one
equity to another, from an asset to equity or
vice versa or a combination of any of these.

59
 The funds-flow-statement shows how the

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financial resources have been used during a
particular period of time.
 It is, thus, a historical statement showing
sources and application of funds between the
two dates designed especially to analyse the
changes in the financial conditions of an
enterprise.
 General Rules

 The changes in the individual components of


working capital are separately shown in a
statement called "The Statement of Changes
in Working Capital". Symbolically, working60
Capital (WC) = Current Assets (CA)-
Current Liabilities (CL)
 (a) Transactions affecting WC :

10/22/2009
 An increase/ decrease in CA causes an
increase/decrease in WC respectively.
 An Increase/decrease In CL causes a decrease /
increase in WCrespectively..
 (b) Transactions not affecting WC :

 An Increase in CA and increase in CL does not affect


WC.
 A decrease in CA and decrease in CL does not affect
WC.
 Concrete examples corresponding to each General
Rule
 Issue of equity shares causes an Increase in cash 61
(CA) in non-current liability (NCL).

 Purchase of non-current asset (NCA) decrease in cash

10/22/2009
(CA) and increase In (NCA).
 Bank overdraft to repay long-term loans increase in,
CL and decrease in NCL.
 Bank overdraft paid by issue of debentures causes a
decrease; in bank overdraft (CL) and an increase in
NCL.
 Purchase of Inventories on credit causes an increase
in inventory (CA) and an Increase in creditors (CL).
 Payment of creditors causes a decrease in cash (CA)
and a decrease in creditors (CL).

62
 Managerial uses of Funds Plow Analysis
 a rich insight into the financial operations of the
concern.
 to distribute dividends in absence of or in excess
of current Income for the period?
 How was the expansion in plants and equipment
financed?
 How was the sale proceeds of plant and machinery
used?
 How were the debts retired?
 What became to the proceeds of share issue or
debenture issue?
 How was the increase in working capital financed?
63
 Where did the profits go?
 Preparation of Funds Flow Statement
 In order to prepare a Funds Flow Statement, it
is necessary to find out the "sources" and
"applications" of funds.
 Sources of funds: The sources of funds can
be both internal as well as external.
 Internal sources : The profit or loss figure, as
shown in the profit and loss account of the
firm, does not Indicate the quantum of
working capital provided by business
operations . Therefore, appropriate
adjustments are to be made to the profit
disclosed by the profit and loss account to 64
arrive at the funds from business operations.
 For this purpose:
 (i) add all expenses which do not reduce
working capital are to be added back,
 (ii) such items have not contributed to the
working capital are to be subtracted, and
 (iii) all such revenues which are not directly
caused by business operations should also
be deducted
 (2) External sources
 These sources include:
 Long Term Financing
 Sale of Non-Current Assets
65
 Funds from increase in share capital

 Applications of Funds
 Redemption of Preference Shares and/or
Debentures
 Recurring Payments to Investors
 Purchase of fixed assets
 Payment of tax liability
 Technique of preparing a Funds Flow
Statement
 Preparation of statement of sources and
applications of funds is a time consuming task.
There is no prescribed format for the funds "flow
statement. The only important point to be borne
66
in mind is that the items should be arranged and
described in such a way as to exhibit clearly the
PROFORMA
STATEMENT OF SOURCES AND
APPLICATIONS OF FUNDS

Sources Rs. Applications Rs.

Issue of share capital Redemption of Redeemable Preference  


share capital
Issue of debentures Redemption of debentures  

Institutional obtained Loan Repayment of Institutional Loans  

Sale of investments and other fixed Purchase of investments and other fixed  
assets assets
Trading Profits or funds from Payment of dividend (for last year and  
assets operations interim)
Non-trading Income Non-trading expenses  

Total Total

Decrease in working capital as per Increase in working capital as per


statement of changes in working statement of changes in working capital
capital 67

Total Total
DIFFERENCES BETWEEN INCOME STATEMENT
AND FUND FLOW STATEMENT
Fund Flow Statement Income Statement
It explains sources and It reveals net profit or net loss
application
No standardofformat
fundsisduring a during
As per adouble
particular
entryperiod
book
particular
required
It considerperiod
for preparation
both of
capital and keeping
It consider only revenue
Fund
revenueFlow
It discloses Statement
nature
exactofflow
income
of and nature of income
It is prepared not and
fund flow
expenditure
funds from operations expenditure
statement

68
DIFFERENCES BETWEEN BALANCE SHEET AND FUND
FLOW STATEMENT
Fund Flow Statement Balance Sheet

It presents significant changes It incorporates assets and


between two Balance Sheets liabilities as on a particular date

It is prepared on the basis of It is prepared on the basis of Trial


trading, P& L and balance sheet Balance as on a dtae.

It provides additional information It provides financial position of


to management for decision the company as on a particular
making date
Fund flow operation, changes in It si prepared after Trading and
working capital are required to P7L account is completed
69
prepare fund flow statement.
 LIMITATIONS:
1.Since it is based on historical data it ignores future
project operations.
2.It does not focus on transactions involved in n non-
fund items
3.Since it simply presents in adifferent format of
same information from financial statements , it
does not provide any additional infotrmation
4.It also ignores tranasctions between current
accounts and non-current accounts.
5.
70
Lesson: 16: Cash Flow Analysis

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 Learning Objectives:
 Understand preparation of Cash Flow Statement
 Difference between cash flow and funds flow
statements
 Uses of cash flow analysis
16.1 Introduction: Cash flow analysis involves preparation of

Cash flow Statement for identifying sources and applications


of cash. Cash flow statement may be prepared on the basis of
actual or estimated data ( 'Projected Cash Flow Statement', -
'Cash Budget').
 In essence, cash flow statements are statements of changes
in financial position prepared on the basis cash or cash-
equivalents.
 16.2 Preparation of Cash Flow Statement : The principal
difference between a statement of changes in financial 71
position and the cash flow statement lies in the amount
shown as resources provided by business operations.
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 16.2.1 Cash from operations
 Cash from operations is the main internal source. The
Net Profit shown by the Profit and Loss Account will
have to be adjusted for non- cash items for finding
out cash from operations. Some of these items are as
follows:
 (i) Depreciation: Depreciation does not result in
outflow of cash and therefore, net profit will have to
be increased.
 (ii) Amortization of intangible assets: Goodwill,
preliminary expenses, etc., when written off against
profits, reduce the net profits without affecting the
cash balance.
 (iii) Loss on sale of fixed assets: It does not result In
outflow of cash and, therefore, should be added back
to profits. 72

 (iv) Gains from sale of fixed assets: Since sale of


fixed assets Is taken as a separate source of cash, it
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 (v) Creation of reserves: If profit for the year
has been arrived at after charging transfers to
reserves, such transfers should be added back to
profits.
 For the sake of convenience computation of cash
from operations can be studied by taking two
different situations:
 (1) When all transactions are cash
transactions:
 (2) When all transactions are not cash
transactions: The computation of cash from
operations in such a situation can be done
conveniently if it is done in two stages:
 (i) Computation of funds (i.e., working capital)
from operations.
 (ii) Adjustments in the funds so calculated for 73
changes in the current assets (excluding cash)
and current liabilities.
CASH FROM OPERATIONS = NET PROFIT

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+ Decrease in Debtors - Increase in Debtors
+ Decrease in Stock - Increase in Stock
+Decrease in Prepaid Expenses -Increase in Prepaid Expenses

+Decrease in Accrued Income -Increase in Accrued Income

+ Decrease in Creditors - Increase in Creditors


+Decrease in Outstanding - Increase In Outstanding
Expenses Expenses
74
SOURCES OF CASH ( INFLOW OF CASH)

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 Cash from operations or trading
 Sale of fixed assets for cash

 Sale of inventories for cash

 Raising of long term loans

 Issue of shares , debentures etc


APPLICATION OF CASH(OUTFLOW OF CASH)

 Cash lost in operations or trading losses

 Redemption of shares/ debentures

 Purchase of fixed assets

 Repayment of long term loan


75

Computation of cash flow staement

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1.cash from operations i.e. internal sources of
cash calculated by preparing combined
statement of adjusted Profit & Loss account
2.External sources and application of cash i.e.
flow of cash involved in non current items
ascertained by the statement of sources
and application of cash.

76
Sources of cash- Inflow Application of cash-

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Cash from operations Cash lost in operations
outflow
Sale of fixed assets Purchase of fixed assets
Sale of inventories Purchase of investment
Isue of shares Redemption of preference
Issue of debentures Shares/ Debentures
Raising of long term loan Decrease in any liability
Increase in any liabilities Increase ion any assets
Decrease in any assets

77
Cash from operations (Adjusted P & L Account)

Particulars Particulars
To Depreciation On F.

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Assets
To Transfer of General
Reserve
To loss on sale of fixed
assets

78
6.2.2 Format of a Cash Flow Statement

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 A cash flow statement can be prepared in the


following form:
 CASH FLOW STATEMENT for the year ending on ....
Balance as on 1.1.91

Cash Balance

Bank Balance

Add: Sources of Cash

Profit as per Profit and Loss Account

Add/Less Adjustment for non-cash items

Add: Increase in current liabilities

Decrease in current assets

Less: Increase in current assets


Decrease in current liabilities
Total cash available (1)
Less: Applications of Cash: 79
Closing Balance*
Cash Balance
Bank Balance
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 Managerial accounting is managers oriented
therefore its study must be preceded by
some understanding of what managers do,
the information managers need, and the
general business environment. Accordingly
we shall briefly examine these subjects.
 NEED: Every organization-large and small-has
managers. Someone must be responsible for
making plans, organizing resources,
directing personnel, and controlling
operations. Every where mangers carry out
three major activities-planning, directing and
80
motivating, and controlling.
COST ACCOUNTING
 Cost is defined as total of all expenses incurred in a
given thing,

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 Cost is defined as “the amount measured in money
or cash expected or other property transferred,
capital stock issued, services performed or a
liability incurred in considerations of goods or
services received or to be received”
 Cost is also defined as scarificemade by the
company to produce goods or to provide services.
 Cost is “ cost to the company including manufaturing
costs, administrative cost and selling & distribution
cost”
 Price is the cost +plus profit or it is cost to the
consumer.
 Value- is the perceived value of the consumer 81
IMPORTANT CONCEPTS
 Costing- the technique and processofascertaining
costs. It refers to the principles and rulkes

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concerned with appropriate allocation of
expenditure for the determination. the cost of a
product or service.
 Cost Accounting- the method of accounting for
cost it is defined as the technique and process of
ascertaining cost.
 Cost Accountancy is the application of principles
of costing and cost accounting.
 Cost control- It involves pre-determination of
targeted cost, measuring the actual costs ,
investigating into reasons for variations and
82
instituting corrective action.

 Cost reduction refers to real and permanent
reduction in the unit cost of a product.. It

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invoplves saving in cost without compromising
product features and quality.
 Cost allocation is the allotment of whole item of
cost to cost centres.
 Cost absorption refers to the process of
absorption of all overhead costs located to or
apportioned over a particular cost centre or
production department
 Cost centre refers to a location or a person or an
equipment or group of equipments for which cost
may be ascertained
83
CLASSIFICATION OF COST

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84
COST SHEET-ELEMENTS OF COST

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              OVERHEADS
85
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86
CODE OC CONDUCT OF
Management Accountants

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 Practitioners of management accounting and
financial management have an obligation to
the public, their profession, the organization
they serve, and themselves, to maintain the
highest standards of ethical conduct. In
recognition of this obligation, the Institute of
management Accountants has promulgated
the following standards of ethical conduct
for practitioners of management accounting
and financial management. Adherence to
these standards internationally is integral to
achieving objective of management
accounting. Continue Reading. 87
10/22/2009
 Competence:
 Practitioners of management accounting and financial
management have a responsibility to:
 Maintain an appropriate level of professional
competence by ongoing development of their
knowledge and skills.
 Perform their professional duties in accordance with
relevant laws, regulations and technical standards.
 Confidentiality:
 Practitioners of management accounting and financial
management have a responsibility to:
 Refrain from disclosing confidential information
acquired in the course of their work except when
authorized, unless legally obligated to do so. 88


10/22/2009
 Inform subordinates as appropriate regarding the
confidentiality of information acquired in the course
of their work and monitor their activities to assure the
maintenance of that confidentiality
 Refrain from using or appearing to use confidential
information acquired in the course of their work for
unethical or illegal advantage either personally or
through third parties
 Integrity:
 Practitioners of management accounting and financial
management have a responsibility to:
 Avoid actual or apparent conflicts of interest and advise
all appropriate parties of any potential conflict.
 Refrain from engaging in any activity that would 89
prejudice their ability to carry out their duties
ethically.
10/22/2009
 Refuse any gift, favor, or hospitality that would
influence or would appear to influence their actions.
 Refrain from either activity or passively subverting the
attainment of the organization's legitimate and
ethical objectives.
 Recognize and communicate professional limitations or
other constraints that would preclude responsible
judgment or successful performance of an activity.
 Communicate unfavorable as well as favorable
information and professional judgment or opinion.
 Refrain from engaging or supporting any activity that
would discredit the profession.

90
10/22/2009
 Objectivity:
 Practitioners of management accounting and financial
management have a responsibility to:
 Communicate information fairly and objectively
 Disclose fully all relevant information that could reasonably
be expected to influence an intended user's
understanding of the reports, comments, and
recommendations presented.
 Resolution of Ethical Conflicts:
 In applying the standards of ethical conduct, practitioners
of management accounting and financial management
may encounter problems in identifying unethical
behavior or in resolving an ethical conflict. When faced
with significant ethical issues practitioners of
management accounting and financial management
should follow the established policies of the organization
bearing on the resolution of such conflict. If these
policies do not resolve the ethical conflict, such 91
practitioner should consider the following course of
action.

10/22/2009
 Discuss such problems with immediate superior except
when it appears that superior is involved, in which
case the problem should be presented to the next
higher managerial level. If a satisfactory resolution
cannot be achieved when the problem is initially
presented, submit the issue to the next higher
managerial level.
 If the immediate superior is the chief executive officer
or equivalent, the acceptable reviewing authority
may be a group such as the audit committee,
executive committee, board of directors, board of
trustees, or owners. Contact with a level above the
immediate superior should be initiated only with the
superior's knowledge. assuming the superior is not
involved. 92
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 Except where legally prescribed,
communication of such problems to
authorities or individuals not
employed or engaged by the
organization is not considered
appropriate.
 Clarify relevant ethical issues by
confidential discussion with an
objective adviser to
 obtaina better understanding of possible
course of action
 Consult your own attorney as to legal
93
obligations and rights concerning the
ethical conflict.
10/22/2009
 If the ethical conflict still exists after
exhausting all levels of internal review, there
may be no other recourse on significant
matters than to resign from the organization
and to submit an informative memorandum
to an appropriate representative of the
organization. After resignation, depending
on the nature of the ethical conflict, it may
also be appropriate to notify other parties.

94
INTRODUCTION TO MANAGEMENT
 What follows should ACCOUNTING
prove that management
accounting is everywhere.

10/22/2009
 Everywhere we go and everywhere we look, we can find
evidence that the management accountant got there
first … or ought to have!
 Just take a look around any room you are in at any time:
 an office, a bedroom or a kitchen
 you will see furniture, electronic equipment, clothes.
 Take a look outside and you'll see cars, street lights,
pavements.
 When you watch television, you will probably see some
advertisements for products and services that the
advertisers would like us to spend our cash on:
holidays, loans, food … 95

10/22/2009
 So it goes on:
 All these products and services have benefited
from the influence of management accountants
at some stage.
 It is the management accountant's job to:
 take the costs, inputs and processes associated with
products and services
 organise them in such a way that we know
 costs per unit to make them,
 labour hours per unit taken to

provide them,
 number of vehicles needed to
96
distribute them.

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⁵ Management accountants can work on any
product or service in any organisation,
anywhere in the world.
⁵ Whether an organisation calls its accountant a
management accountant, a financial
accountant or just an accountant does not
matter.
⁵ If an organisation needs to calculate costs per
unit; cost of goods and materials in stock;
and evaluating productivity and efficiency, it
needs someone to do the work of a
management accountant. 97

10/22/2009
 We can draw our first conclusion:
 Management Accountants are
Indispensable!
 It is true:
 if an organisation needs to know costs per
unit and all of the other things we have
talked about so far,
 it needs management accountancy work
to be done
 … whether we call it management accounting
or not. 98

Simple Definition of Management
Accounting

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⁚ the provision of information required by
management for planning, organising and
control
Management accounting is concerned with
information for management purposes:
⁚ internal information for the organisation
itself and very rarely made public,
⁚ unlike financial accounting information.

99
10/22/2009
 This definition concentrate on part of
management accounting concerned with:
 accumulation of product and service costs,
 preparation of statements relating to
materials, labour and overheads;
 standard costs, budgeting
 and management accounting for decision
making.
 Consequently, not concerned with
controllership, audit and the treasurer's
function of firms. 100
 Corporate planning needs considering when
looking at standard costs and budgeting.
More Complex Definition of
Management Accounting

10/22/2009
 Provision of information required by
management for planning, organising and
control - for such goals as:
­ recording, analysing and reporting actual
costs and inputs of products, services
and processes
­ evaluating stocks of raw materials, W-I-P
and finished goods
­ working with other functions:
­ establishing standards of performance
­ establish cost, revenue and quantity
budgets
­ (plus) evaluating alternative opportunities 101
10/22/2009
 This definition concentrate on part of
management accounting concerned with:
 accumulation of product and service costs,
 preparation of statements relating to
materials, labour and overheads;
 standard costs, budgeting
 and management accounting for decision
making.
 Consequently, not concerned with
controllership, audit and the treasurer's
function of firms. 102
 Corporate planning needs considering when
looking at standard costs and budgeting.
10/22/2009
 Even more complex definitions of
management accounting include:
 corporate planning, controllership

 and both internal and external audit function


duties.
 These definitions might also include the
treasurer's function in their definition of
management accounting.

103
Management Accounting Within the
Organisation

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 a management accountant is a servant.
 the definition shows management accountants
provide information required by
management:
 not for themselves or accounting friends; but
for other management colleagues.
 bear this in mind as you study management
accounting and what it contains.
 when you are asked to provide information,
draw up a statement … anything:
 you are doing it on behalf of someone else. 104
Figure 1 Traditional Organisation Chart

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105
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 This traditional organisation chart view of a
business:
 we see that everyone is working inside their
functional structure.
 Production people work for the Production
department(s), Marketing people work for
marketing, ICT (Information and Computer
Technology) people work for ICT and so on.
 The traditional view is fine in identifying where
everyone belongs,
 but not in identifying where everyone works and
what kind of work they do.
 A matrix organisation chart gives us this
additional information. 106

Figure 2: Matrix Structure

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107
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 Might not agree with everything in Figure 2, but
 it gives an idea of how people work within an
organisation.
 it shows that production department people tend
to work for themselves;
 marketing staff work for themselves and
production department.
 ICT department does networking work for all
departments;
 but only does web site work for itself, Marketing
and R&D.
 Finance function in three areas, with two shown.
Their work involves the rest of the organisation.

108
Taking a Management Accountant View of
Everything
- and Mini Project 1

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Some golden advice:

 wherever you are and whatever you are doing,


take a management accountant's eye view
of everything!
 Seriously: if you ever want to be a
management accountant, think like a
management accountant
 and take a look at the world around you from
the management accountant's point of view.

109
10/22/2009
 Many of the following examples are based on
real live products, real live organisations and
real live situations:
 to see how everyday bits of paper can be used
to help to understand, for example, how we
might classify costs, see how costs behave.
 to show how your ordinary every day kettle or
car or house can be taken apart and put
back together in management accounting
terms.
 to encourage you to:

 breathe, eat and drink management 110

accounting:

Mini Project 1

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 Have you ever seen a car or van pulling a
trailer as it drives around town?
 You know the sort of thing:

 attached to the back of the car like a caravan


but it is much smaller, open topped and it
has just got two wheels and might have a
motor bike in it or some building materials …
 let us consider that from a management
accounting point of view.

111
10/22/2009
 Figure 1 shows an example of what we mean by a
trailer:
 it has a steel frame with a wooden base, the
wheels are small car wheels which are attached
by a metal axle that itself is attached to metal
bars that are welded to the frame:
 Figure 2 will help you to understand its design
and construction,
 … what could the management accountant
possibly do with that/this, I hear you ask?

112
 Figure 1 Figure 2

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Task:
Prepare a table with two columns to
demonstrate how the management
accountant would accumulate the
costs of manufacture when this trailer Operation
is being made. Your two columns
should have the headings: - Costs accumulated
When you have tried this mini project
yourself, take a look at the solution
before continuing.

113
Solution
Operation to Mini Project 1
Costs Accumulated
Agree customer specification Designer’s time

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Draw up plans Paper, pens, labour
Order materials Labour: clerical
Buy materials Transport, labour
Transfer plans to steel Materials, labour
Cut, shape and weld steel strips and rods Materials, labour, equipment
Materials, labour, equipment
Fix wheels Materials, labour, equipment
Fix and secure floorboards Labour, equipment (?)
Smoothing etc Materials, labour, equipment ?
Paint Materials, labour
Apply edging strips

114
Cost Objectives and Units

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 In a factory, office or non profit making
organisation, a phrase to use is cost
objective.
 Learn the language of management
accountants!
 Cost objective is a fundamental part.
 Purpose of cost accounting is the cost
objective.
 Additionally, a cost unit is a product or
service for which we want to find a total
cost. 115
 In fact, term cost unit is synonym for cost
object or cost objective (Williamson
A cost object:
is any activity Cost objectives and Cost units
 for which a ... measurement of costs is desired …
Examples … include :

10/22/2009

 … cost of a product,
 … cost of rendering a service to a bank customer or
hospital patient,
 … cost of operating a particular department or sales
territory,
 or indeed anything for which one wants to measure the
cost of resources used.
 Source: (

116
ACTIVITY BASED COSTING (ABC)
 Different stages of Activity Based Costing:
1.Identify different activities within the organisation.

05/02/11
2.Relate the activities cost to the activities.
3.Support activities are then spread across the primary
activities.
4.Determine the activity
5.Calculate the activity cost drivers rate. cost drivers.
6.Assign the overhead cost to concerned product
based on actual use of each activity.
7.Add prime cost to arrive at the total cost of
production.

117
Cost Drivers Activity
Number of receiving orders Oredering

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Number of deliveries Delivery
Number of purchase orders Order taking
Kilometer travelled per delivery Deliveries
Number of customers visit
Customer visit

Number of inspections inspection


Number of set ups Set up
118
 Business Definition for: Cost Driver
 a factor that determines the cost of an activity. Cost

10/22/2009
drivers are analyzed as part of activity based
costing and can be used in continuous improvement
programs. They are usually assessed together as
multiple drivers rather than singly. There are two
main types of cost driver: the first is a resource
driver, which refers to the contribution of the
quantity of resources used to the cost of an activity;
the second is an activity driver, which refers to the
costs incurred by the activities required to complete
a particular task or project.

119
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120
Examples of Transaction based cost drivers
Support Department cost(cost Possible cost drivers
pool)

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Production scheduling Of production run nos.
Material Handling of production runs nos
Set up costs Of production runs nos
Finished goods handling and Of production runs nose and
dispatch of goods number of destinations and
deliver ordesr
Purchasing cost Number of purchase orders
Raw material stock handling Of orders received
Invoicing Number of invoices
121
CLASSIFICATION OF ACTIVITIES IN A
MANUFACTURING ORGANISATION

1.Unit level activities- activities performed when


each unit is produced.

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2.Batch level activities-. activities performed when
each batch is produced.
3.Product level activities- activities to support
production of each different types of products ;
maintenance and operation of equipments and
testing / engineering charges.
4.Facility level cost-general manufacturing process.
These activities are common to variety of
products

122
DIFFERENCE BETWEEN ACTIVITY BASED
COSTING AND CONVENTIONAL COSTING
Activity based costing Conventional or Traditional

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Begins with identifying activities costing
and then on
Focuses produce
activities performed
to, produce
Cost drivers used
Overhead cost are assigned to a
cost
O/H centre
cost are assigned based on
cost drivers
Variable rate
overheads are
appropriately
No to individual
need to alocate service
product
department costs
It assumes thatfixed overhead
costs vary in proportion
tochanges in the volume of
output.
123
Target Costing
 Target cost is the cost that can be incurred while
still earning the desired profit

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 Selling price – desired profit = target cost
 The customer sets the price
 Profit must be achieved through cost control
 Contradicts the traditional approach: design product,
determine cost, set price
 Intense customer focus
 What do they want?
 How much will they pay for it?
 Can we make a profit on it?
 Want answers to these questions before committing to the
project

124

 Cost control from the beginning
 70-90% of costs are committed to at the design stage

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 Focus on product and process design to engineer out
costs from the beginning
 Saves costly changes later on
 Product, manufacturing process, delivery process
designed simultaneously
 Ensures features customers demand, but within
acceptable cost parameters
 Eliminates the temptation to add costly features
 Customers may not value the added features
 Forces consideration of manufacturability
 Reduces the need for subsequent changes

125
 Cost control at all phases of the product life
cycle

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 Design
 Production
 Delivery/setup
 Customer’s cost of ownership
 Emphasizes future sales instead of current cost

savings
 Service and repair
 Disposal and recycling
 Marketing
 Design/engineering
 Manufacturing
 Purchasing
 Including suppliers 126


Cross Functional Team
Marketing Distribution
Design/engineering Service/support

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Manufacturing Cost accounting
Purchasing Finance
Including suppliers Legal

127
Target Costing Process
 Twostage process

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Establish the target cost
Market research

Product planning, concept

development stages
Achieve the target cost
Value engineering, continuous

improvement
Design stage

Continuous improvement in

later stages

128
Establishing the Target Cost
 Determine the product and its market
 Who is the target market?

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 What do they want?
 What do competitors offer?
 Introduce concept or prototype
 Evolutionary or revolutionary?
 Refine until it meets customer needs

129
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 Determine the selling price
 Must be acceptable to the customer
 Must be able to withstand competition
 Techniques
 Existing price +/- value of features added or
deleted
 Consensus of focus group

 Price predicted to achieve a desired market share

130
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 Determine the required profit
 Return on sales
 Desired return
 Historical return for similar products

 Industry average for similar products

 Return on sales will fluctuate over the life of the


product
 Price and costs fluctuate
 Unit price, cost and profit are almost
meaningless because they fluctuate
 Life cycle totals are more meaningful

131
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 Total expected revenue throughout product life
- -Total desired profit throughout product life
 Total target cost
Achieving the Target Cost

 Must include the features the customer wants


while maintaining cost at or below target
 Want to meet the customers needs, but not
exceed them
 Eliminating desired features will result in an
undesirable product
 Adding unwanted features will increase cost

 Failingto keep cost at or below target will result


in unacceptable profits 132
EXHIBIT 1
CUSTOMER REQUIREMENT RANKINGS

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Less Ranking More Raw % of Total Competitive
Customer Requirement Important Important Score Raw Score Comparison
1 2 3 4 5 1 2 3 4 5
Multiple speeds 4 4 14.8%
Horizontal oscillation 3 3 11.1%
Vertical oscillation 1 1 3.7%
Light weight 4 4 14.8%
Adjustable height 1 1 3.7%
Airflow capacity 4 4 14.8%
Quietness 5 5 18.5%
Compact size 3 3 11.1%
Looks nice 2 2 7.4%

Total 27 100%

Us
Competitor
Both

133
Marginal Costing
 Materials, labour and other expenses constitute
the different elements of cost which can be

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classified as Fixed costs(which do not vary
but remain constant within a given period of
time and range of activity in spite of
fluctuations in production) and Variable
costs(are (those costs which may increase or
decrease in proportion to increase or decrease
in output.) The cost of product or process can
be ascertained using the different elements of
cost according to any of the following two
techniques:

134
 Absorption costing technique is also
termed as Traditional or Full Cost Method.
According to this method, the cost of a

05/02/11
product is determined after considering
both fixed and variable costs. The variable
costs, such as those of direct materials,
direct labour etc., are directly charged to
the products while the fixed costs are
apportioned on a suitable basis over
different products manufactured during a
period.
 Under the marginal costing technique,
only variable costs are taken into account
for purposes of product costing, inventory
valuation and other important
management decisions and no attempt is135
made to find suitable bases of
apportionment of fixed costs.

 Concept of Marginal Cost It is described as
the cost which arises from the production of

05/02/11
additional increments of output and it does not
arise in case the additional units are not
produced.
 Marginal costs in the short run are the total
variable cost. In the long run marginal costs
will also include fixed costs in planning
production activities involving an Increase in
the production capacity. Thus, marginal costs
are related to change in output under
particular circumstances of a case.
 As already pointed out marginal costing is a
technique where only the variable costs are
considered while computing the cost of a 136
product.
 The fixed costs are met against the total fund
arising out of the excess of selling price over
total variable cost. This fund is known as

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contribution in marginal costing.
Illustration
 A company is manufacturing three products A, B

Details and C. The costs of their manufacture are as


Products
follows: A B C

Rs. Rs. Rs.
Direct materials per unit 3 4 5

Direct labour per unit 2 3 4

Selling price per unit 10 15 20

Variable cost 1 1 1

Output (units) 1000 1000 1000


Total Over headsRs.6000 out 137
of which Rs.3000 are fixed
Statement of Cost and Profit
(under marginal coating technique)
Details Product A Product B Product C

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Per Total Per Unit Rs. Total Rs. Per Unit Rs. Total Rs.
Unit Rs. Rs.

Direct Materials 3 3000 4 4000 5 5000

Direct Labour 2 2000 3 3000 4 4000

Variable 1 1000 1 1000 1 1000


Overheads

(6000-
3000=3000/3)

Total Marginal 6 6000 8 8000 10 10000


Cost

Contribution 4 4000 7 7000 10 10000


(Sales-variable
cost)
Selling Price 10 10000 15 15000 20 20000
138
 Thus the total contribution from the three products
A, B and C amounts to Rs. 21,000 (4000 + 7000 +
10000). The profit will now be computed as follows:

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 Total Cost contribution Rs.21000
 Less: Fixed cost 3000
 Profit 18000
 Hence it is clear that marginal costing is not a
system of cost finding such as job, process or
operating costing, but it is a special technique
concerned particularly with the effect of fixed
overheads on running the business.
 Characteristic Features of Marginal Coating
 A technique of analysis and presentation of cost
rather than an independent method of costing.
139

Marginal costing is based on the important distinction
between product costs and period costs.
Regards as product costs only those manufacturing cost

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which have a tendency to vary directly with the volume of
output.
It guides pricing and other managerial decisions on the basis
of ‘Contribution’ (also known as gross margin’)
Excess of contribution over fixed cost is the profit and the
deficiency of contribution to fixed cost is the loss.
Marginal Coating Vs Absorption Coating
Since marginal costing is an alternative to absorption costing,
it is necessary to compare the two and suggest if possible,
the technique which is more appropriate in routine costing.

140
Absorption/Total Costing Marginal costing
bo th fixe d and variable  o ve rhe ads  o nly variable  o ve rhe ads are  
are  charge d to  pro duc tio n. c harge d to  pro ductio n while  fixe d 

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o ve rhe ads are  transfe rre d in full to  
the  c o sting pro fit and lo ss acc o unt. 

sto c ks o f wo rk in pro gre ss and  o nly variable  c o sts are  co nside re d 
finishe d g o o ds are  value d at wo rks  while  c o mputing the  value  o f wo rk 
co st and to tal c o st o f pro duc tio n  in pro gre ss o r finishe d go o ds. 
re spe ctive ly. Thusc lo sing ­sto c k in ­ marginal 
c o sting is unde rvalue d as c o mpare d 
to  abso rptio n c o sting.

pro fit is the  diffe re nc e  be twe e n  the  exc e ss o f sale s re ve nue  o ve r 
sale s re ve nue  and to tal c o st. marginal c o st is kno wn as 
c o ntributio n 

pro ble m o f appo rtio nme nt o f fixe d  Marginal c o sting exc lude s fixe d 
co sts  c o sts. 
141
 Marginal Costing - Role of Contribution
 Contribution is of vital importance for the system of
marginal costing. The rationale of contribution

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lies in the fact that, where a business
manufacturers more than one product, the profits
realised on individual products cannot possibly be
calculated due to the problem of apportionment
of fixed costs to different products which is done
away with under marginal costing. Answer to the
challenge is contribution.

142
Marginal coating and decision making
 All decisions relate to the future. Consequently, one needs
Information regarding future costs and revenues. He has,
therefore, to fall back upon Information pertaining to past costs,

05/02/11
records of performance, future costs and revenue', likely state of
the market etc. It is, in this context, that the technique of
marginal costing assists management in making predictions
about the future in relation to alternative courses of action.
 (i) Fixation of selling prices
 Although prices are more controlled by market conditions
and. other economic factors than by decisions of
management, yet the fixation of selling prices is one of
the most important functions of management. This
function is to be performed:
 Under normal circumstances,
 In times of competition,
 In times of trade depression,
 In accepting additional orders for utilising idle
capacity, and
 In exporting and exploring new markets. 143

 Pricing in depression
 Prices fall during depression and the product may be
sold below the total cost. In case there is a serious

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but temporary fall in the demand on account of
depression leading to the need for a drastic
reduction in prices temporarily, the minimum
selling price should be equal to the marginal cost.
 (ii) Accepting additional orders, exploring
additional markets and exporting
 Bulk orders may be received from large scale buyers
or foreign dealers asking for a price which is below
the market price. This calls for a decision to accept
or reject the order. If the price is below the total
cost, it may tempt to reject such offer. But
marginal costing takes a different view. It
recommends for accepting the order, provided that
the quoted price is more than the marginal costs.

144
 (iii) Profit planning
 Profit planning is the planning of future operations to

05/02/11
attain maximum profit or to maintain a specified level
of profit. Marginal costing, through the calculation of
contribution ratio enables the planning of future
operations in such a way as to attain either minimum
profit or to maintain a specified level of profit. Thus it
is helpful in profit planning.
 (iv) Decision to make or buy
 The technique of marginal costing enables management
to decide whether to make a particular product or
component or buy it from outside. Such decisions
become necessary when unutilized production
facilities exist, and the product being produced has a
component which can either be made in the factory
itself or purchased from outside. 145

 v) Problem of Key or Limiting Factor
 Under the marginal cost concept, profitability of a

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product or process is measured with reference
to its contribution based on the assumption
that it is possible to increase the manufacture
of the product yielding the highest marginal
contribution to any desired extent .In practice
however this assumption is not valid and the
management is confronted with factors which
put a limit on their efforts to produce as many
units of the selected products as they would
like to. Such factor which is equally important in
the determination of profitability is called 'Key
Factor' or 'Limiting Factor', or 'Governing
Factor', or 'Principal Budget Factor', or 'Scarce
Factor'. 146
05/02/11
 (vi) Choice of profitable product mix
 When a concern manufactures more than one
product, a problem is faced by the management
as to which product mix will give maximum
profits. The best product mix is that which yields
the maximum contribution. The products which
give the maximum contribution are to be
retained and their production should be
increased. The products which give
comparatively less contribution should be
reduced or closed down altogether.
 iv) Evaluation of alternative methods of
products
 Marginal costing is helpful in comparing the
147
alternative methods of production i.e. machine
work and hand work. The method which gives
the greatest contribution is to be adopted,
05/02/11
 viii) Determination of optimum activity
level
 One of the very common confronting a
business is regarding the level of activity for
which it should have plans in hand. Such
plans may envisage an expansion or
contraction of productive activities
depending upon the qualitative conditions in
the market. The expansion or contraction
has to be arranged before the events
overtake the business. In this context,
management would like to have an idea of
148
the contribution at different levels of
activities and marginal proves very useful
Break even Analysis and Profit planning
 Profit planning is necessarily a part of operations
planning. It involves the prediction of most

05/02/11
aspects of a firm's operations
 Thus "Profit planning is the planning of future
operations to attain maximum profit or to
maintain a specified level of profit".

149
Break even Algebraic Method
 break even sales in terms of units can be found out by the

05/02/11
formula,
 BEP (units) = Fixed cost/Selling Price per unit-variable cost
per unit or Fixed costs/contribution
 Profit Volume ratio=marginal contribution *100/Sales
 Break-ev en point = Fixed cost/P.V.Ratio
 Break-even point(in units) = Fixed cost/ cost per unit.
 Illustration: Following data is estmated for next year:
 Budgeted output 80,000 units
 Fixed Expenses Rs.400000
 Variable expenses per unit Rs.10
 Selling price per unit Rs.20
 (a) Draw a break even chart showing the break even chart. If the
selling price is Rs.18 per unit what eillbe the new break even
point/
 Draw a combination break even chart.
150
05/02/11
 Original P.V.ratio= S-P/S *100 = 20-
10/20 *100 =50%
 New P.V.Ratio = 18-10/18 *100 =
44.44%
 BEP (Original ) = Fixed
cost/P.V.Ratio =400000/50%=
Rs.800000
 BEP (in Units) =Fixed cost/ Cost per
unit= 400000/10=40000 units
 BEP (new)=400000/44.44=
151
Rs.900000
 BEP(in
C-V-P Analysis
A powerful tool for Planning and Decision
making.

05/02/11
 CVP emphasizes the interrelationships between
costs, quantity sold and price, and therefore,
brings together all the financial information of
the firm.
 It is used in answering questions, such as:
 1. How will total revenues and costs be affected,
if the output level (volume in CVP analyses)
changes.
 If selling prices are raised or lowered, what will
be the effect on output level and profit.
 3. What is the number of units to be sold to
break even.
 4. How will expansion of business into foreign
markets affect costs, selling price and output152

level.
 5. What is the impact of a given reduction in
C-V-P ASSUMPTIONS AND TERMINOLOGY
 CVP analysis is based on several assumptions:
 1. Changes in the level of revenues and costs arise only

05/02/11
because of changes of product (or service) units
produced or sold.
 2. The focus is on the total costs of the firm as a whole,
which means manufacturing, marketing and
administrative. Thus fixed and variable costs would
include costs of the above functions.
 When represented graphically, the behaviours of total
revenues and total costs are linear in relation to output
level within a relevant range ( time period).
 Selling price, variable cost per unit and fixed costs
(within a relevant range and period) are known and
constant.
 5. The analysis either covers a single product or assumes
that the proportion of different products when multiple
products are sold will remain constant as the level of
total units sold changes.
 6. All revenues and costs can be added and compared
without taking into account the time value of money.
153