RATIO ANALYSIS:

Financial statement of a company provide all necessary information regarding operations, incomes,
expenditure, assets and liabilities etc. these statement serve as primary source of information for
further analysis and interpretation but information is provided in absolute form which is of no worth
and use. Data given by profit and loss account and balance sheet need further processing by applying
various methods of financial statement analysis.

Ratio analysis is one of the widely used method for analysis and interpretation of financial statement
and provides very useful information for rational decision making of managers. Ratio indicate numerical
relationship between two variables and explain how they connected to each other. Ratio analysis is a
useful instrument for managers to diagnose the financial soundness of business. It becomes imperative
as value of absolute data as financial information increase multiple times after ratio analysis. Ratio is
relative form of financial data communicate the importance of various items of business.

Ratios can be expressed in the form of proportion also called pure form i.e. 3: 1, in percentage form (%)
and can be expressed as Rate i.e. current assets are 2 times of current liabilities.

Significance of ratio analysis:

a) Determines financial solvency of firm

b) Facilitate decisions making and analysis of financial statement
c) Help in intra firm inter firm comparison
d) Serve as effective tool for management control
e) Facilitate forecasting of future events
f) Helps in planning and policy formation
g) Provides useful information.
h) Act as a barometer.

CLASSIFICATION OF RATIO OR TYPES OF RATIOS:

1. Liquidity ratio:

These ratio measures the liquidity of firm and indicate its ability to meet short term obligations
they considered short term resources available to meet short term obligations. Following ratios
are covered under this category.

a) Current Ratio- it measures relationship between current asset and current liabilities. It is the
ratio of total current assets and total current liabilities, it is also known as “working capital
ratio.”

Current ratio = current assets / current liabilities

E.g. 1.

Current assets = 450000, current liability = 150000

Solution:

Current ratio = 150000/450000 = 3

Current assets are 3 times of current liability.

It indicate short term solvency of firm. Current ratio of 2:1 is considered ideal ratio i.e. current assets
should be twice of current liabilities.

Current assets- these are the assets of firm which can be converted into cash within one year it includes
cash in hand, cash at bank, debtors and bills receivables etc.

Current liabilities- these represents the amount payable to others within one year it comprises of
creditors, bill payable, bank overdraft etc.

b) Quick ratio or Acid test Ratio – it is the ratio between quick assets and current liabilities. It
depict the short term liquidity position of a company.

Quick ratio = Quick assets or liquid assets / current liabilities

[Quick assets = current assets – stock – prepaid expenses]

Quick assets are those current assets which can be converted into cash immediately
without decrease in value.

Quick ratio of 1:1 is considered ideal i.e. quick assets is equal to current liabilities.
Significance of quick ratio can be understand from the fact that sometimes current assets
have high portion of stock which creates problem while converting into cash immediately
without loss of value, In such cases quick assets proves to be as immediate cash. Hence it
serve as more rigorous testing of liquidity position.

E.g. consider following data-

Debtor = 5000

Inventory = 20000

Cash = 5000

Current liability = 20000

Solution:
Quick ratio = quick assets / current liability

QR = [cash + debtor –inventory] / current liability

QR = 10000/20000

QR= 0.5, below ideal quick ratio i.e. 1

2. SOLVENCY RATIO: these ratio shows the long term solvency position of a firm. Solvency ratio
indicate the ability of a firm to meet the long term liabilities. It includes the following ratios-

a) DEBT-EQUITY RATIO- it measures the relationship between debt and equity as a sources of
financing assets of firm. Required amount of funds can be raised from equity capital
(internal equity) and debt (outsider’s funds) to finance assets of company but the
combination of debt and equity used to raise funds has implications for long term solvency
of the firm or in other words relationship between debt and equity measures long term
solvency of firm . It is also known as external-internal equity ratio.

Debt-equity ratio = debt / equity

Or
Debt-equity ratio = outsider’s funds / shareholder’s funds
Or
Debt-equity ratio = total long term debt / shareholders’ funds

It indicate the proportion of debt and equity used in financing of assets of company.
The ideal ratio is 2:1.

Long term debt = debenture and long term loans

Shareholder’s funds = equity share capital + preference share capital + reserves &
surpluses – accumulated losses – fictitious assets

E.g. consider following data-

Equity share capital (10000 shares of 100 each) = 1000000

General reserve = 450000

Accumulated profits = 300000

Debentures = 750000

Creditors = 400000
Outstand expanses = 100000

Solution:

Debt / equity ratio = long term debt / shareholder’s fund

D/E = 750000 / [1000000+450000+300000]

D/E = 750000 / 1750000 = 0.71: 1

b) TOTAL ASSETS TO DEBT RATIO- it shows relationship between total assets and total long
term debt.

Total assets to debt ratio = total assets / long term debt

Total assets = fixed assets + current assets

Long term debt = debenture + long term loan.

It is calculated to measure the safety margin available for suppliers of long term funds in the
form of total assets. It is expressed as pure ratio.

c) PROPRIETARY RATIO- it measures the relationship between proprietary fund’s or

shareholder’s funds and total assets.

Proprietary ratio = proprietary fund’s or shareholders’ funds / total assets

It shows the portion of total assets financed by shareholder’s funds or owner’s equity
Where,
Total assets = fixed assets + current assets – fictitious assets

Shareholder’s funds = equity share capital + preference share capital + reserves &
surpluses – accumulated losses – fictitious assets

d) INTEREST COVERAGE RATIO (ICR) – it express relationship between net profit before
interest and tax (EBIT) and fixed financial charges (interest paid on long term debt). It is also
known as “debt services ratio”. It measures the debt servicing capacity of the firm.

Interest coverage ratio = net profit before interest and tax (EBIT) / fixed interest charges

It is calculated to make sure that availability of amount profit is sufficient to cover up the
interest charges.
E.g. A company net profit is 350000 during 2017. Income tax paid is 150000. Interest on debenture paid
is 125000.

Solution:

ICR = EBIT / interest charges

ICR = [350000 + 150000 + 125000] / 125000

ICR = 625000 / 125000

ICR = 5 times

3. Activity ratio or turnover ratio:

These ratios measures the operational efficiency of company. Activity ratio also known as
turnover ratio or asset management ratio, shows efficiency in assets management and
utilization. These ratio serve as a link between assets management and sales or profit. Efficient
management and utilization of assets results in larger amount of sales as speed of conversion of
assets into sales increase. Higher the activity ratio better will be the utilization of resources.
Activity ratio expressed in number of times. Hence activity ratio concerned with efficiency in
assets management. Following ratios are included under activity ratio.

a) Stock Turnover or Inventory turnover Ratio- it measures the relationship between cost of goods
sold during the concerned period and average inventory carried during that period.
It measure the firm’s efficiency in inventory management. A higher inventory turnover ratio is
better as it indicate quick conversion of inventory into sales while low inventory ratio indicate
unsold inventory and excessive investment in stock.

Stock turnover ratio = cost of goods sold / average inventory

Or
Stock turnover ratio = net sales / average inventory

Where
Cost of goods sold = [opening stock + purchase + direct expanses] – closing stock
Average inventory = [opening stock + closing stock] / 2

b) DEBTORS TURNOVER RATIO- it establish the relationship between net credit sales and average
debtors of a year. It is also known “Receivable turnover” ratio. It shows how quickly debtors are
converted into sales. It measures the liquidity of the receivables.

Debtor turnover = credit sales / average debtors

 Credit sales = total sales – cash sales –sales return
Average debtor = [opening balance +closing balance] / 2
Debtors includes book debts and bills receivables at the end of year.

c) AVERAGE COLLECTION PERIOD – it denotes approximate time period that a firm takes to collect
the debtors or account receivables.

Average collection period = 365 days or 12 months / debtor’s turnover ratio

d) CREDITORS TURNOVER RATIO – it establish the relationship between net credit purchase and
average payables. It depict the credit period enjoyed by the firm and it also indicate the number
of times the accounts payable rotate in a year.

Creditors turnover ratio = net credit purchase / average payable

Credit purchase = total purchase – cash purchase – purchase return

Average payable= [opening balance + closing balance] /2
Opening and closing balance of both creditors and bills payable are included.

e) AVERAGE PAYMENT PERIOD- it shows the approximate time period that a firm takes to paid the
account payables.

Average payable period = 365 days or 12 months / creditors turnover ratio.

f) WORKING CAPITAL TURNOVER RATIO- it measures the efficiency of working capital by establish
a relationship between cost of sales and net working [Link] shows number of times working
capital is turned over in a year i.e. conversion of working capital into sales.
Higher working capital turnover ratio shows quick conversion of investment in working capital
into sales and profit.

Working capital turnover = cost of sales / net working capital

Net working capital = current asset – current liabilities

g) FIXED ASSETS TURNOVER RATIO – it depict the relation between sales and net fixed assets and
measures the efficiency with which assets are managed and utilized. It also shows earning
capacity of firm. Higher ratio refers to efficient and full utilization of fixed assets.

Fixed assets turnover ratio = cost of sales / net fixed assets

Net fixed assets = Value of assets –depreciation

4. PROFITABILITY RATIO:
These ratios shows firm ability to earn profit. Profit means absolute amount of profit earned.
Profitability means the ability to earn profit. Profit serve as tool for measurement and control
for managers it shows the economic progress and measure worth for owners. These ratios are
measured in terms of “percentage”.
Profitability ratio widely used by managers to know the efficiency in operations and it also
shows the liquidity and solvency of business with capacity to services debt. Hence it works as
safety margin for suppliers of funds. Following ratio are calculated under profitability ratios-

a) GROSS PROFIT RATIO- it establish the relationship between gross profit and net sales of a
firm. It is also known as “gross margin ratio”.

Gross profit ratio = gross profit / net sales *100

Gross profit = net sales – cost of goods sold

Net sales = cash sales + credit sales – sales return
Cost of goods sold = opening stock + purchase + direct expanses – closing stock

Gross profit represent the difference between revenue from operations and direct
expanses. A low ratio shows low profitability. It facilitate the fixation of selling price and look
onto the efficiency of trading activities.

b) NET PROFIT RATIO- it depict the relationship between net profit and net sales. Net profit is
the difference between gross profit and indirect expanses of firm and also measures overall
efficiency of business.

Net profit ratio = net profit / net sales *100

 Net sales = cash sales + credit sales – sales return
Net profit = gross profit – indirect expanses.

c) OPERATING RATIO- it express the relationship between operating cost and net sales and
measures operational efficiency of business. Lower ratio is better for firm as lower operating
ratio is corresponding to higher profitability.

Operating cost ratio = [cost of goods sold + operating expenses] / net sales *100

Net sales = Net sales = cash sales + credit sales – sales return
Cost of goods sold = opening stock + purchase + direct expanses – closing stock
Operating expenses = administrative expenses + selling and distribution expanses + interest
on short term loan + discount allowed and bed debt.

d) Operating profit ratio – it depict the relationship between operating profit and net sales.
This ratio judge the general profitability of business. Higher the ratio better for the firm.

Operating profit ratio = operating profit / net sales *100

Operating profit = net profit + non-operating income –non-operating expanses

Net sales = cash sales + credit sales – sales return

e) Expanses Ratio- it express relationship between operating expenses and sales volume to
scrutinize in detail various components of operating expenses to make sure weather firm is
able to save over and above different items of expenditure or not. Following ratios are
calculated under expanses ratio-

1) Material consumes ratio = material consumes / net sales *100

2) Conversion cost ratio = [labour expanses + manufacturing expanses] / net sales *100

3) Administrative expenses ratio = administrative expenses / net sales *100

4) Selling expenses ratio = selling expense ratio / net sales *100.

f) Earnings ratios – these ration are calculated for companies listed on stock exchanges.
Investors primarily interested in these ratios.
 1. Earnings per share (EPS) = net profit after tax and preference dividend / no of equity
shares

2. Price earnings ratio (P/E ratio) = market price per equity share / earning per share

It indicate market value of every earning in the firm

3. Dividend payout ratio (DPS) = dividend per equity share / earning per share
It shoes what proportion of EPS are distributed as dividend.

4. Earning yield ratio = [earnings per share / market price per share]*100

It relates earnings to market price of share.

FUND FLOW ANALYSIS:

The financial statements of a firm generally comprises of profit and loss account and balance sheet that
every business need to prepare at the end of financial year. Balance sheet is the summary of assets and
liabilities and shows position of a firm on a particular date it is also called position statement as it depict
the status of firm’s assets and liabilities at the end of year but it never disclose the changes in funds
between two time period (i.e. flow of funds).

Profit and loss account or income statement is the summary of expenses and incomes during an
accounting period basically it disclose the results of business operations during an accounting.

Both the statements doesn’t or little to show about flow of funds or movement of funds as balance
sheet disclose only financial position on a particular date and income statement (profit & loss A/c) show
expenses and income earned and confined to just operational flows while a business has various sources
and application of funds which results in inflows from and outflows of funds to different sources and
have implication for firm and its managers.

Hence to collect the complete details pertaining to periodical flows of funds a different statement is
prepared called “fund flow statement”.

MEANINIG OF FUND FLOW STATEMENT:

It refers to the statement showing changes in working capital or changes in funds. In other words fund
flow statement disclose the movement of funds or in working capital in both the directions i.e. inflows
and outflows.

The term Flow refers to change and term Fund can be understand in narrow sense as cash and in
broader sense fund means money value in any form exist but here we are mainly concerned with
meaning of funds as net working capital (current assets – current liabilities). Fund flow statement shows
changes in net working capital i.e. increase or decrease in working capital.

According to “foulke” a statement of sources and application of funds is a technical device to analyse the
changes in financial condition of business enterprise between two dates.

Fund flow statement known from different names i.e. statement of sources and application of funds,
movement of funds statement, statement showing changes in financial position. Hence fund flow
statement works as effective tool in hands of managers for analysis of financial results.

For the measurement of flow of funds or change in working capital we must have knowledge about
transactions between current and non-current account.

First let’s discuss about current and non-current account. Current and non-current account further
discussed as current assets & liabilities and non-current assets & liabilities.

Current liabilities Current assets

Bills payable Cash in hand

Sundry creditors Cash at bank
Outstanding expanses Bills receivables
Bank overdraft Sundry debtors
Short term loans Marketable investment
Provisions for bad debt etc. Inventories
Prepaid expanses
Accrued income etc.

Non-current or permanent liabilities Non-current or permanent assets

Equity share capital Goodwill

Preference share capital Land
Debenture Plant and machinery
Long term loans Furniture and fittings
Capital reserve Trade mark
Capital redemption reserve etc. Patent right
Long term investment etc.

Only those transections happens between current account (both assets and liability) and non-current
account (both assets and liability) results in flow of funds.

Hence Following are the transactions causes flow of funds or change in working capital-

a) Transactions between current assets and fixed assets (non-current assets)

 b) Transactions between current assets and non-current liability.
c) Transactions between current liability and non-current liability.
d) Transactions between current liability and non-current assets.

Hence any transaction between current and non-current accounts results in flow of funds and any
transactions either between two current accounts or two non-current accounts doesn’t results in flow of
funds or change in working capital.

FUND FLOW STATEMENET:

It refers to a statement disclose net change in working capital or flow of funds. The statement include
two parts. 1) Sources of funds 2) Application of funds. And the difference between these two shows net
change in working capital during the period.

PREPARATION OF FUND FLOW STATEMENT-

a) STATEMENT OF CHANGE IN WORKING CAPITAL
Fund flow statement is prepared under fund flow analysis in order to make its preparation easy first we
prepare “schedule of change in working capital” to receive in advance the information of net change in
working capital during concerned period which is further tally with the results of fund flow statement

Reason behind preparation of “Statement of working capital change” is the easiness with which it can be
prepared than fund flow statement and it also helps to know sources and application of funds. All in it
makes easy the preparation of fund flow statement and ensure correctness of its information.

Particular Amount of Amount of Effect on working capital

previous year current year
Increase (+) Decrease (-)

CURRENT ASSETS (CA) :

Cash in hand
Cash at bank
Bills receivables
Sundry debtors
Short term investment
Prepaid expanses
Accrued income
TOTAL CURRENT ASSETS

CURRENT LIABILITIES (CL) :

 Bills payable
Sundry creditor
Outstanding expanses
Bank overdraft
Short term advances
TOTAL CURRENT
LIABILITIES :

WORKING CAPITAL
(CA –CL)
NET INCREASE/DECREASE
IN WORKING CAPITAL

Following points need to remember while making statement of change in working capital.

1) Increase in current assets results in increase in working capital.

2) Decrease in current assets results in decrease in working capital.
3) Increase in current liability results in decrease in working capital.
4) Decrease in current liability results in increase working capital.

Important formula:

a) Working capital = investment in current assets represent working capital of company.

b) Net working capital = current assets –current liability.

FUND FLOW STATEMENT:

It refers to statement of source of funds and application of those funds and finally disclose net change in
working capital by taking between these two. It is prepared with the help of information given in
balance sheet and disclose change in financial position between two dates.

Fund flow statement (for the year ended …..)

Sources of funds (inflows) Amount (rupees) Amount (rupees)

Trading profit/ fund from operations
Issue of shares
Issue of debentures
Lon term borrowings
Sale of fixed assets
 Non-trading income

Total
Application of funds (outflow)
Redemption of debenture
Redemption of preference shares
Purchase of fixed assets
Non-trading expenditure
Repayment of long term loan
Trading loss

Total
Increase/decrease in working capital

-Net change in working capital shown by “statement of change in working capital” tally with changes
shown by “fund flow statement”.

fund from operations is the major sources of funds as sales represents major sources of cash-inflows
and cost of goods sold and other expanses shows main sources of cash outflows. Net profit so calculated
as fund from operation need to be adjusted for a) “non-funds items” b) non trading losses c) items
deducted from net profit.

Calculations of funds from operations

Particular Amount
Net profit for current year

ADD: non fund items and non-trading expenditure already debited to profit and
loss account:

Depreciation and depletion

Amortization of fictitious and intangible assets i.e.
a) Preliminary expanses written off
b) Discount on issue of share off
c) goodwill return written off
d) Premium on redemption of debenture written off
Appropriation of retained earnings
a) Transfer to general reserve
b) Transfer to sinking fund
c) Proposed dividend
d) Loss on sale of fixed assets written off
 Total

Less: non fund income and non-trading incomes:

Dividend received
Profit on sale of fixed assets
Profit on revolution of fixed assets
Excess provision written back

Total
Funds from operations

Note: Non-funds non trading items: these are the items which neither effect current liability nor current
assets. This includes non-fund non trading incomes and expenditure.

CASH FLOW STATEMENT:

Cash is the life giving blood for every business enterprises. Presence of cash is must for every business
for smooth functioning of daily activities i.e. payment of wages, salaries and miscellaneous expenses.
State of cash is of prime importance for management helps in judging liquidity and sound policy
formation. Therefore to provide details information about cash, company needs separate statement
confined to cash transactions only as management of business is interested to know from where
business is generating and using its cash and cash equivalent.

Cash flow statement disclose inflows and outflows of cash and cash equivalent of a company during a
particular period. It is a systematic records of cash inflows and outflows and net change in cash for an
accounting period. It depict the change in cash position of company between two accounting period.
The term “Cash flow” means change in cash i.e. incoming or outgoing.

Institute of chartered accountant of India (ICAI) issued accounting standard (AS-3 change in financial
position statement) in June 1981 but due to its limitations ICAI in March 1997 issued AS-3 (revised)
which deals with “cash flow statement”.

The term “Cash” stands for cash and bank balance.

PREPARATION OF CASH FLOW STATEMENT

While preparing cash flow statement information required from following financial statement-

a) Balance sheet- a positional statement reports the data of assets and liabilities at the end of the
year.
 b) Profit and loss account or income statement – it shows operational incomes and expanses
during the year.
c) Additional information – any additional information given and there effects are considered.

FORMAT OF CASH FLOW STATEMENT:

Cash Flow Statement as per AS-3 (revised)

(Indirect method)

Particular Amount Amount

a) Cash flow from operating activities:
Net profit before tax and extraordinary items
Adjustment for non-cash non trading items:
ADD:
Depreciation
Loss on sale of fixed assets
Loss on foreign exchange
Interest expanses
Discount on issue of debenture
Less:
Interest income
Dividend income
Operating profit before working capital change
Adjustment for working capital change
Less: increase in current assets
Less: decrease in current liability
Add: decrease in current assets
Add: increase in current liability
Less : income tax paid
Cash flow from operations before extraordinary items
Add/Less: extraordinary items

Net Cash flow from operating activities-

b) Cash flow from investing activities

Purchase of fixed assets
Purchase of investment
Sale of investment
Sale of fixed assets
Interest received on investment
Dividend received on investment

Net cash flow from investing activities

 c) Cash flow from financing activities
Proceeds from issue of share capital
Proceeds from long term borrowing
Repayment of long term borrowing
Interest paid
Dividend paid

Net cash from financing activities

Net increase / decrease in cash and cash equivalent

Add: cash and cash equivalent at the beginning of the period

Cash and cash equivalent at the end of the period

CONCEPT OF BUDGET
Future planning is inevitable for success of business enterprise. Planning serve as future course of
actions for business and its activities. So it becomes necessary for financial managers must have a device
or instrument works as guide in future for various activities and actions to be undertaken. Budget serve
the aforesaid purpose of business enterprise.

According to ICMA (England), budget is a financial statement prepared prior to a defined period of time
of the policy to be pursued during that period for the purpose of obtaining given objectives. It includes
information on income, expenditure and capital employed.

According to “brown and Howard” a budget is a predetermined statement of management policy during
a given period which provides standard for comparison with the results actually achieved.

All in all budget is a device in the hands of management used for planning and control that describes
plans, policies and actions which are prepared in advance to be pursue in a specific future period along
with setting standards for organization to facilitate comparison and provides sense of direction to be
followed and sense of target or goal to be achieved

Basic elements of Budget-

It is prepared in advance for definite future period.

It is a planning device

It provides benchmark for comparison of actual work.

Budget is a statement in monetary terms and in terms of quantity.

BUDGETING:

Budgeting refers to the process of preparing budgets and making use of budgets for planning, control
and co-ordination of business activities.

BUDGETARY CONTROL:

Budgetary control is a specific method of control of business activities i.e. cost through the use of
budgets.

According to “CIMA” London – budgetary control is the establishment of budgets relating to the
responsibilities of executives to the requirement of a policy and continuous comparison of actual with
budgeted results either to secure by individual action the objectives or to provide basis for revision.

PRINCIPLES OF BUDGETARY CONTROL:

a) Establish budgets for each function or department of enterprise.

b) Comparison of actual performance with budgeted performance.
c) Ascertainment of variances and find out their reasons
d) Taking corrective actions if required
e) Revision of budgets consider changes in conditions.

OBJECTIVES OF BUDGETARY CONTROL:

a) To ensure efficiency and effectiveness in performance of business activities by link them with
the predefined targets.
b) Coordination of various activities as budget serve as plan or policy for future specific period.
c) Comparison of actual performance with budgeted ones to know the extent to which targets
have achieved.
d) Identifying the variances and their possible reasons and work on them for further improvement.
e) Plan and control various expenditure i.e. research and development, capital expenditure and
incomes in most profitable manner.
f) Motivation of managers, employees other staffs as goals are pre-defined for each and every one
and need to be achieved within a specified time period.
g) Delegation of authority and assigning responsibility easily to all.
h) Maximization of profit for business.

LIMITATIONS OF BUDGETARY CONTROL:

a) As budgets are based on estimates it may or may not be true.

b) Chances of opposition by staff’s members is always there.
c) Budgets involves investment of time, money and rigorous intellectual efforts so it more of a
“rigid document” as not easy to modify frequently.
 d) Operation and implementation of budgetary control system is an expensive affair.

STEPS INVOLVED IN PREPARATION OF BUDGET:

a) Appointment of budget controller: a special executive is appointed and the responsibility of

budget is assigned to him. He is equipped with all required technical details of business and
properly oversee the budget preparation process. He directly report to the president of the
company.
b) Formulation of budget committee: budget committee comprises of heads of all department of
company who submit budget of their respective departments. Every department helped by sub-
committees under it and budget committee helped the budget controller in preparing, submit,
discuss and approves the final budget figures. Budget committee also responsible for general
policies, review of budget, analysis of variances and overall coordination during budget
preparation.
c) Budget period: it refers to duration of time period for which budget is prepared. Committee has
to decide about the time period but it also several other factors nature of resources requires,
goal orientation of company, overall business Environment Company supposed to deal with.
d) Identifying key factor or limiting factor: it means all those factors of production which puts limit
on the production activities of business. E.g. production of a certain goods may be interrupted
due to capacity constraint, non-availability of raw material, limited supply of power and fuel
these factors represents limiting factors. For different industries there can be different limiting
factors i.e. supply of crude oil, power, skilled labour and availability of short term and long term
finance etc.
e) Budget center: it means any division, department of a specific part of business for which a
separate budget is prepared. It can be a department of organization production department,
marketing department, financial department etc. identification of budget centers facilitate to
bring more accuracy as the planned income and expenditure related to its origin point is identify
[Link] can also be any cost center, for which cost is separately prepared.
f) Preparation of budget manual: according to “CIMA” London a document which set out the
responsibilities for the persons engaged in the routine of the forms and records required for
budgetary control. It is a written document or booklet that specify budgeting procedures and
organization and chart out the roles and responsibilities for executives including budget
committee, budget controller and other concerned persons. It laid down about the budget
period, accounting system to be followed, budget calendar, deadlines for tasks and various
other relevant aspect related to budget. It must be well written and clear and distributed among
responsible executives and heads of department.

TYPES OF BUDGETS:
1) On the basis of capacity budget can be classified into “Fixed Budget” and
“Flexible Budget”.

a) Fixed budget:

According to “CIMA” London “A fixed budget is a budget designed to remains unchanged

irrespective of level of activity actually attained”.
Fixed budget is prepared for a particular level of activity and doesn’t change even if level of
activity changed. It is based on the assumption that sales and output can be estimated with a
fair degree of accuracy. Flexible budget is suitable for situations where fluctuations in sales and
demand is negligible and future probable event are more of certain in nature. Fixed budget is
prepared for a single capacity utilization I.e. 80% or 60%

b) Flexible budget :

As the name itself denotes flexible budget is a budget designed to change in line with the level
of activity actually attained. Flexible budget is prepared for different level of activity i.e. 60%,
70%, 80% etc. keeping in mind frequent changes in dynamic environment which results in
difficulty in estimation of future sales and demand with accuracy, Whatever will be the actual
results at the end of period compared with the budgeted figures for further analysis of variance.

SUPERIORITY OF FLEXIBLE BUDGET OVER FIXED BUDGET:

Flexible budgets are acceptable in different business sates especially in a dynamic business
environment as we all are witnessed today where changes happens frequently, of disruptive
nature it is inevitable for modern mangers keep in mind the complexities of environment and
keep more use of dynamic instrument flexible enough to incorporate changes. Flexible budget
serve the same objective by incorporating the possible changes of future in different level of
production capacities. It provides systematic description of budgeted figures for different future
scenarios.
We can systematically list down cases or situation where flexible budget is of prime importance
for business managers.
- In case of firm introduces new products or variety of existing production frequently.
- Taste and preference of customers and fashions changes frequently.
- Business environment is difficult to predict.
- Political risk in country is arises and increase gradually.
- Extent of effects of global changes based on integration of country with world economy.
 Hence flexible budget has an edge over fixed budget as fixed budget is only suitable for a single activity
or has limited applications while budget flexible serves as important tool for control and evaluation of
performance under changing conditions.

2) On the basis of coverage of function budgets are classified into

“functional budgets”.
Functional budgets- These are associated with different functions of management for every major
function a separate budget is prepared called “functional budget” it consist of production budget,
marketing budget, purchase budget, cash budget and purchase budget etc. following are the main
functional budgets.

a) Sales budget:
Sales budget represents planned sales of products of company in terms of quantity and money
during a specific period. It shows the estimations of sales of a company’s product during
budgeted period and provides detailed information of quantities and value of sales.
Sales budget is of vital importance for company as it serves as foundation for other functional
budgets i.e. finance and marketing budget. It is more difficult to construct than others due to
uncertainty associated with future demand. Nevertheless it make sure the answers of many
relevant question to managers and clarify situation to a large extent. Though sales manager is
responsible for preparation and execution of sales budget, assistant from experts of other
department is required at the same time

-information about the different products to be sold.

-time period of sales of products.
-human resource involved in sales
-location to be considered for sales.

b) Production budget:

It disclose the physical quantities of goods to be produced during budgeted period and also
shows budgeted opening and closing inventory of products. It is basically detailed plan for
production of goods for budgeted period. Production manager is responsible for preparation
and execution production budget. It facilitate the making of cost budgets.
It provide information relating to following-
-location of production
-identify the number and type of products to be produced
-timing of production of goods.
Following factors should be considered while preparing production budget.
-existing inventory policies of firm and any probable change
-existing plant capacity
-existing stock of raw material required.
 -current production policy (i.e. stable production or variable production

c) Production cost budget-

It is prepared for estimating the planned production cost for specific future period. It serve the
Budgeted figure of production cost which is aggregate of direct material cost, direct labour,
direct expanses and factory overheads. It includes detailed information on material cost, labour
cost and overhead expenses separately for budgeted period and facilitate comparison with
actual results.

d) Purchase budget:

Proper purchase planning make sure lowest price available to purchase raw material it becomes
inevitable for purchase manager to have a detailed plan relating to purchase of raw material
required. Thus Purchase budget is a financial statement showing in advance the detailed
purchase plan regarding various types of raw material required with their respective quantity
and estimated cost of material for future specific period. Following factors need to considered
before preparing budget-
-opening and closing stock of inventories
-financial resources availability
-Economic order quantity

e) Raw material budget:

Raw material budget shows the estimated quantities of various types of raw material required
for production of goods for a specific period i.e. budgeted period.
-help in providing all details of raw material
-assist in preparation of purchase budget
-serve necessary information for control of material variance.
It only deals with the direct material specific to production of primary product.

f) Factory /Production / Manufacturing overhead Budget:

It shows estimated indirect cost of production required for manufacturing a product. It refers to
a statement comprises of data regarding all indirect elements of cost of production of a product.
It represent cost of indirect material, indirect labour used and indirect expanses for budgeted
period. It also decides in advance the timing and location for overheads.
Production manager is responsible for making and execution of overheads budget.
Production overheads structure consist of fixed, variable and semi variable elements of indirect
cost.

g) Administrative cost Budget:

 Administrative cost refers to the expenses incurred for overall management of company, making
and implementation of policies, office related, directing and supervision of activities overseeing
non-core activities of business, other such activities indirectly related to production.
E.g. salary and wages to peons, office staff, insurance charge, stationary telephone postages etc.

Administrative cost budget provides the detailed information about these activities and their
respective cost. It shows estimated cost of business administration for budgeted period against
which actual cost is compared at the end of period for further analysis of variance.
Administrative manager is responsible for making this budget.

h) Selling and distribution cost Budget:

It represents the expenditure incurred to influence the current level of sales and to achieve the
desired sales level and customer base. It consist of salesman salary, sales office expanses,
advertisement and sales promotion, after sale service cost etc. it has positive effect on sales
level and customer base to a great extent if incurred properly considering the right quantity and
amount.
Sales manager is responsible for preparation and execution of sales budget. It clarify the amount
to be incurred on types of activities i.e. advertising, sales promotion, timing of expenditure and
the place to be incurred.

i) Cash budget :

It refers to the estimated cash inflows and outflows during the budget period. Cash budget as a
financial device represent receipt of cash from all possible sources and payment of cash for all
possible objectives and the remaining figure of cash at the end as surplus or deficit.
It serve as controlling device for managers as it ensure availability of sufficient amount to meet
various obligations and declares liquidity and solvency of firm. Cash budget required information
from all other budgets as cash is essential items of every budget thus it is prepared at the end.

Significance of cash budget-

-indication of liquidity of business

-make sure about solvency of enterprise
-help business identifying major sources of inflows and outflows
-decides about shortage or surplus cash availability.
-works as an instrument for measuring the financial health for suppliers of funds.

Methods of preparation of cash budgets-

a) Receipt and payment method
b) Adjusted net income method
 j) Master budget:

It refers the summary of all functional budgets. So it is an aggregated form incorporate all
functional together. Master budget has two part 1) budgeted income statement 2) budgeted
balance sheet.
According to “CIMA” London – master budget is a summary budget incorporating its
component functional budgets which is finally approved, adapted and employed.
Budget director is responsible for master budget. It is finally approved by Board of directors
presented to it by budget committee. It consist of estimated details of various functions i.e. sales
production marketing finance etc.
Therefore master budget provides consolidated view of all budgets in one single capsule form
with profit figures.

ZERO BASED BUDGETING:

Zero based budgeting refers to a technique of making budgets by taking zero as base. As a distinguish
method it requires budget preparation from scratch. It was introduced at taxes instruments in USA in
1969 by “peter Phyrr”

According to “Peter Phyrr” (known as father of zero based budgeting), zero based budgeting may be
defined as “a planning and budgeting process which requires each manager to justify the entire budget
request in detail from scratch (zero base) and shift the burden of proof to each manager to justify why
he should spend any money at all this approach requires that all activities be identified as decision
packages which are to be evaluated by systematic analysis and raked in order of Importance.

CIMA London defines zero base budgeting as a method of budgeting whereby all activities are re-
evaluated each time a budget is set discrete levels of each activity are valued and a combination chosen
to match funds available.

Each element of budget is justified from zero unlike in traditional budgeting method where incremental
approach is used by taking last year budget as base and incorporate changes as per next year. Every plan
of budget is evaluated on the basis of incremental cost and incremental benefits and resources are
allocated accordingly to ensure their effective use.

Merits of Zero based budgeting (ZBB):

- It ensure effective utilization of resources by locating the most profitable activities.

 - All expenditures are completely justified from scratch
- It identifies the non-effective activities or plans from the current budgets and make sure not
to be included in future.
- It reduce unnecessary wastage of resources and increase accountability and responsibility of
managers in this regards.

Demerits of ZBB:

- High cost of developing budgets as it requires lots of barnstorming and extra work from
executives
- Time consuming processing as each elements of budget need to justify.
- Specific training requires to be given to managers for making budgets.

MARGINAL COSTING:
It refers to managerial practice where all marginal cost (same as variable cost) is charged to the units of
product. The term marginal cost refers to additional cost of producing an additional unit of product.

According to CIMA London “marginal costing as “the ascertainment of marginal cost and of the effect on
profit of changes in volume or type of output by differentiating between fixed cost and variable cost”.

According to CIMA London “marginal cost is the amount at any given volume of output by which
aggregate cost are changed if volume of output is increased or decrease by one unit”.

It consist of all variable cost related to a product i.e. marginal cost is sum total of direct material cost,
direct labour cost, direct production overheads and variable overheads. Under marginal coast all
variable cost is charged to products unit and fixed cost is treated as period cost written off against the
profit the period or contribution.

Marginal cost =direct material + direct labour cost + direct expanses + variable overheads.

Marginal cost can be identified by variable cost per unit assigned to a product

Features of marginal costing:

a) All cost are categorized into variable and fixed cost.

b) Marginal cost is of prime important to managerial decision making.
c) Variable cost are treated as product cost and charged to unit produced.
 d) Contribution i.e. sales – variable cost against the recovery of fixed cot treated as period cost.

Income statement under marginal costing (variable)

Particular Amount
A. Sales
B. Less: variable manufacturing cost
- Direct material cost
- Direct material cost
- Variable manufacturing overheads
Cost of goods produced
Add: opening stock of finished goods ( as per variable cost )
Cost of goods available for sales
Less : closing stock of finished goods
Cost of goods sold
Add: variable selling, distribution and admin overheads
Total variable cost

Contribution (A- B)
Less: fixed cost

Net profit

Merits of marginal costing

a) Facilitate managerial decision making i.e. make or buy decision, adding a new product line,
replacement of machinery etc.
b) Feature of Segregation of cost into fixed and variable component is of prime relevance as it
ensure better cost control emphasis is given on control of variable cost.
c) Due to the constant nature of per unit variable cost it is simple in application and use as well it
don’t considered apportionment of fixed overheads.
d) Facilitate the determination of price of products on the basis of marginal cost and also aid to
profit planning by clarifying costs into fixed and variable.
COST VOLUME PROFIT ANLYSIS:
Profit is heart and soul for every business enterprise as profit is main objectives every organization strive
for or come into existent. Continuation generation of profit and improvement in profitability is of vital
importance for survival of business and its growth. Profit as crucial and deciding factor for other factors,
plans and policies is interrelated and interconnected with other factors and influence by them to a great
extent. Hence it becomes inevitable for financial managers of a business enterprise to deeply
understand the interrelation among those factors and their dynamics.

Cost volume profit analysis as a planning and control instrument for management studied the inter-
relationship among cost, volume and profit and their dynamics.

CVP analysis based on the following three factors-

- Cost of production
- Volume of output
- Profit

CVP analysis express the effect of change in cost of production on profit through change in selling price
in between. In other simple words any change in cost of production directly affect the sales volume of
product (either increase or decrease), sales volume effects contribution and resulting profit. New sales
volume will change the production volume which in turn results change in cost of production and new
cost leads to new profit amount. So this how various factors interrelated to each other as a small change
in one have multiple effect on other factors.

Techniques and concepts used to study the CVP analysis as discussed-

a) BREAK-EVEN ANALYSIS :

Break-even analysis is a technique used to study the relationship among cost, volume and profit.
Break even refers to level of output where no profit and no loss. At break-even point total cost
equals to total sales revenue.

Assumptions under break- even analysis and CVP analysis-

a) All cost is separated into fixed and variable cost.
b) Total fixed cost remains constant
c) Selling price per unit remains same
d) Variable cost per unit remains constant
e) Total variable cost is directly proportional to volume of output.
f) Only one product is there in case of multiple products sales mix doesn’t change.

Now we discuss relation among sales contribution and profit-

Sales revenue

- Variable cost
Contribution

- Fixed cost

Profit / loss.

Hence we can draw the formulas from the above equation-

a) Contribution = sales – variable cost

b) Profit /loss = contribution – fixed cost
c) Contribution = profit / loss + fixed cost.

As we can see profit depends on contribution make towards fixed cost which is directly influenced by
sales volume.

e.g. Sales = 15000 variable cost = 8000 fixed cost= 2000

Contribution = Sales – variable cost = 15000 -8000 =7000

Profit = contribution – fixed cost = 7000 -2000 = 5000

Contribution provides recovery against fixed cost and resulting profit depending upon level of fixed cost.

- If fixed cost = contribution, than profit will be zero.

- If fixed cost > contribution, there will be loss.
- If fixed cost < contribution, there will be profit.

PROFIT-VOLUME RATIO (P/V RATIO):

P/v ratio represents the relationship between contribution and sales. It is also known as contribution to
sales ratio expressed in percentage (%). it shows contribution per rupee of sales and effects on profit of
change in sales. P/v ratio is influenced by the following factors-

- Change in Sales level

- Change in variable cost
- Change in contribution or profit.

P/V ratio (%) = Contribution / Sales *100

Or
P/V ratio (%) = change in profit /change in sales *100

Where,
Contribution = [sales –variable cost] or [fixed + profit / -loss]
Significance of p/v ratio-

- It facilitate the calculation of sales level contribution variable cost break-even point profit at
given level of sales, volume of sales required to earn a given profit.
- It represents the profitability of products, higher will be better.
- Facilitate managerial decision making.
- It represents rate of profitability.

E.g. calculate p/v ratio in the following cases-

a) Contribution is ₹ 3, sales is ₹ 10.

b) Variable cost to sales ratio is 40%.

c) Fixed cost ₹ 2000, profit Rs₹ 400, sales ₹ 6000

Solution:

a) p/v ratio = contribution /sales *100

P/v ratio = 3 / 10 *100 = 30%

b) p/v ratio = contribution /sales *100

Let sales =100, now variable cost = 40

Contribution = sales –variable cost = 100-40 = 60
P/v ratio = 60 /100 *100 = 60%

c) P/v ratio = fixed cost + profit / sales *100

P/v ratio = 2400 /6000 *100 = 40%

Interpretation of P/v ratio-

If P/v ratio is 40%, it means variable/marginal cost to sales will be 60% hence we can say that 40%
portion of sales will be contribution i.e. contribution = sales – Variable cost. Let sales be

Contribution = sales – variable cost

Contribution = 100- 60 = 40.

CALCULATION OF BREAK-EVEN POINT (BEP):

Break-even point is that level of out or sales at which total cost equals to total sales revenue i.e. no
profit no loss state for a company. No company wants to operate below this level as it starts incurring
losses below this point. Hence calculation of break-even point becomes necessary for effective
management of production activities and ensure profit generating output.
Following are some formulas for Break-even point-

a) Break-even point (in units) = total fixed cost / contribution per unit

b) Break-even point (in ₹) = { total fixed cost /contribution} * sales

c) Break-Even point ( in ₹) = {total fixed cost / P/v ratio}

d) Break-even point (in %) = { break-even point (in units) /sales (in units) } *100

Given Below is the formula to calculate sales for desired profit-

a) Sales (in ₹) = { fixed cost + desired profit } / P/v ratio

Break- even level of output also be calculated in terms of cash by considering only those fixed cost paid
in cash. It is called cash break-even level.

a) Cash break-even point = cash fixed cost / contribution per unit

E.g. selling price per unit is ₹ 10 variable cost per unit is ₹ 6, fixed cost ₹ 2000, actual sales = ₹ 20000
(2000 units), Fixed cost includes depreciation of ₹ 500. Calculate following-

a) Break-even point (in ₹, in % and in units)

b) Cash break-even point.

Solution:

a) BEP (in units) = fixed cost / contribution per unit = 2000 / 10 – 6

BEP (in units) = 500 units

b) BEP (in ₹) = fixed cost / P/v ratio

BEP (in ₹) = 2000 / {10-6/10} = 2000 / 40% = ₹ 5000

c) BEP ( in %) = BEP (in units) / sales in units *100

BEP (in %) = 500 / 2000 *100 = 25%

d) Cash BEP = 2000 – 500 / 40% = 1500 / 40% = ₹ 3750.

MARGIN OF SAFETY (MS):

It refers to excess of actual sales over breakeven sales or it is the difference between actual sales and
break even sales. It is expressed in money terms.

MS represent profit earning range for firm, business is continue to make profit till MS is positive because
it means actual sales level is higher than break-even level. It is directly related to profit.

Formulas for MS-

a) MS (in units) = actual sales (in units) –breakeven sales (in units)

b) Profit = margin of safety * p/v ratio

c) MS (in value) = profit / p/v ratio

d) MS (in units) = profit / contribution per unit

At any level of Margin of Safety fixed cost is zero as it is fully covered up to breakeven point.

E.g. following data is given for ABC ltd.

Selling price per unit = Rs 10

Variable cost per unit = Rs 6

Fixed cost = Rs 3000

Actual sales = Rs 20000 or 2000 units.

Calculate margin of safety.

Selling revenue (2000*10) 20000
Less: variable cost (2000*6) 12000
Contribution 8000
Less: fixed cost 3000 Solution: contribution per
Profit (₹) 5000 unit = 10-6 = ₹ 4

MS (in units) = profit / contribution per unit =5000/4

= 1250 units

MS (in ₹) = MS (units ) * price per unit = 1250 *10

=₹ 12500
Or Or

MS (in ₹) = profit / p/v ratio =5000 / 40%

= ₹ 12500

MS (in %) = MS (in units) / sales units *100 =1250/2000*100

=62.5 %
LIMITING FACTOR / KEY FACTOR:

Will it be possible to earn any amount of profit desired by company? Is it true? If yes how? If no why?
These questions revolves around the company from its inception till it continues. All activities of
managers, executives and others are attributed to directly or indirectly investigating the situation and
finding answers of these questions. The answers of these questions is of prime importance for survival,
growth and future success.

Well the answer is clearly “NO” although every business or firm wants to earn maximum amount of
profit it can or dreams but resources constraint or scarcity of resources is always present that limits the
amount of profit to a particular level. These constraints are none other than but the limiting or key
factors of production. Why are these so called limiting factors? Either they are limited in their supply or
firm is unable to buy them in more quantity.

Hence it becomes inevitable for managers to clearly identify all key factors and the extent of their effect
on limiting production in the beginning so that managers can employ the best possible combinations of
factors available to maximize the profit.

Following are some examples of limiting factor-

- Sales
- availability of raw material
- skilled labour
- production capacity
- financial resources availability

Main objective to identifying key factor is to apply best possible course of action in case when
alternatives available. In case limiting factor or key factor present then contribution per unit of key
factor is calculated and the most profitable situation is when it is maximum.

COST INDIFFERENCE POINT:

It denotes that level of output at which total cost between two alternative courses of actions is same.
Management is indifferent between two alternative.

Cost indifference point: differential fixed cost / differential variable cost per unit

Interpretation of cost indifference point:

Level of production activity Which alternative is economical to use

a) activity level = indifference point a) Any alternative
b) activity level > indifference point b) Alternative with the lower fixed cost
c) activity level < indifference point c) Alternative with higher fixed cost.

STANDARED COSTING:
Standard costing is a technique of cost control where standards are set against each elements of cost
and compared with actual data received for further analysis of variance and reason for the same.

Standard cost is the cost which should have been under a given set of operating conditions.

According to CIMA London “standard cost is pre-determined cost based on technical estimates for
material, labour and overhead for a selected period of time for a prescribed set of working conditions”.

Features of standard cost-

- It refers to cost calculated in advance

- For a specific period
- Serve as a benchmark for comparison
- Based on scientific methods
- It states “what cost should be”?

STANDARD COSTING:

According to CIMA London “standard costing is preparation and use of standard cost and their
comparison with actual cost and analysis of variance and their causes and point of incidence”.
Brown and Howard defined as “as a technique of cost accounting which compares the standard cost of
each product or service with actual cost to determine the efficiency of the operations so that any
remedial action may be taken immediately.

Step under standard costing-

a) Fixation of standard for each element of cost i.e. material, labour etc.
b) Comparison of standard data with actual data
c) Identify all possible variance ( both favorable or unfavorable )
d) Report these variances and their possible causes to management
e) Take corrective steps for revision of standard

Suitability of standard costing-

a) Standardized Products are produced

b) Standardized method, process are used for production
c) A system where it is possible to control the cost

PRE-REQUISITE FOR STANDARD COSTING SYSTEM:

a) Establishment of cost center:

Cost center refers to departments, division or a particular part of a company to which cost is
assigned or allocated or responsibilities are clearly to that.

b) Classification and codification of accounts on a particular basis i.e. functional basis etc.

TYPES OF STANDARD:

a) Basic standard: it is established for a base year against which actual cost data of every year id
compared. Basic standard is used for long time period. Variance arises when actual cost is
different from base year data. It has no utility for cost control.

b) Current standard: these are prepared for limited period based on current conditional and
revised on a regular interval. These are of three types:

- Ideal standard: these standard represents ideal conditions a company wants to achieve. But
in reality not possible to achieve as these based on perfect conditions i.e. no loss, no
wastage, labour is skilled and perfect as well as these standard doesn’t consider unavoidable
losses i.e. normal scrap, normal idle time etc. which is not possible in reality. It is unrealistic
and unattainable just exist in theory.
Variance from ideal standard always unfavorable because they can’t be achieved in reality.
E.g. as per employees shouldn’t go for restrooms/wash room but it is taken as normal idle
time as it can’t be avoided in reality.
 - Practical or expected standard: this standard is based on expected performance to be
achieved in future after considering and making allowances for unavoidable losses i.e.
normal idle time, normal wastages etc. variances shows deviation from realistic standard
which is attainable.

- Normal standard: this is based on average performance in past this realistic and attainable
under normal conditions.

SIGNIFICANCE / IMPORTANCE OF STANDARD COSTING:

- It facilitate planning by setting up standard managers makes plans accordingly

- Standard is set for each element of cost help in delegation of required authority
- It also assist in comparison of actual data with standard data
- Ensure analysis of variance and their causes
- Facilitate coordination among different functions as it consider all types of functions while
make standard.
- Ensure correcting measure for reducing wastages and inefficiency
- Locate areas needed further improvement

ANALYSIS OF VARIANCE:
Are we able to/ really achieve what we expect from/ ln life? Sometimes possible but every time,
definitely answers is a BIG NO and here is the origin point of what is called “variance”. Organizations set
their standard for sales, cost and profit and regarding many other factors to have a sense of target in
advance but they are not able to achieve same results a there remains a difference between actual
results and standard results.

In case business organization cost serve as base for other data i.e. cost sales. Cost variance becomes the
Centre of attraction for analysis of nature of variance, its possible reason and different parts. Cost
variance refers to difference between standard an actual cost figures.

According to CIMA London “difference between standard cost and comparable actual cost incurred
during a period”.

MAIN GROUP OF VARIANCE

 a) Variance of efficiency: these are arises due to inefficiency/efficiency in use of material or labour.
Actual quantities are compared with standard quantities for measuring variance.

b) Variance of price rates: arises due to difference between actual rates and standard rate of
material, labour hours overhead rates

c) Variance of volume: refers to the difference between actual activity and standard activity.

All types of variances lies among these three group of variance explained above.

Favorable / Credit variance = Actual cost < standard cost.

Unfavorable / adverse Variance = actual cost > standard cost.

First we are making the list of complete variances clearly shows number and type of variances we study
under variance analysis:

Element of cost Efficiency variance Price variances Volume variance

Material Usage, mix, yield Price -

Labour Efficiency, idle time Rate of pay Revision

Variable overheads Efficiency Expenditure Revision

Fixed overheads Efficiency Expenditure Revision, calendar,

capacity
Sales Quantity, Mix Price

Material cost variances:

It arises due to two reasons first inefficiency in usages of material second change in material price.
 material cost
variance

material
material price
usages
variance
variances

material yeild material mix

vaiance variance

IMPORTANT TERMINOLOGY REGARDING MATERIAL VARIANCE:

a) Standard quantity for actual output (SQ) : quantity of output should have been consumed for
producing actual output

SQ = [standard quantity of material / standard output] * actual output

b) Standard cost for standard quantity of actual output = SQ * SP

c) Standard cost of actual quantity for actual output= AQ *SP

d) Standard yield (SY): shows output which should have been obtained from actual quantity of all
material.

SY = [standard output / total standard quantity of all material] * total actual quantity of all
material

e) Revised quantity = [standard quantity of one material / total standard quantity of all material]
*total actual quantity of all material.

Let’s discuss the material variance:

 a) Material cost variance (MCV) = standard cost of standard quantity of material used – actual
cost of actual quantity of material used.

MCV = [SP *SQ] – [AQ *AP]

b) Material price variance (MPV) = it is difference between standard price and actual price
paid for specific quantity of material.

MPV = [standard price – actual price] * actual quantity

Or
MPV = [SP – AP] * AQ

c) Material usage variance (MUV) = due to difference between standard quantity specified
and the actual quantity consumed.

MUV = [SQ – AQ] * SP

It is further divided into material mix and material yield variance-

d) Material yield variance (MYV) = due to difference between standard yield for actual output
and actual yield achieved.

MYV = [AY – SY] * SOP

e) Material mix variance (MMV) = due to difference between standard and actual composition
of material used.

MMV = [RSQ – AQ] * SP

E.g. 1. Calculate material cost variance from following data-

Particular Standard Actual

Qty. Unit price Qty. Unit.

Material x 30 ₹ 20 44 ₹ 25
Material y 20 ₹ 10 66 ₹5

Total Qty. of material 50 110

Standard output = 45 kg

Actual output = 90 kg
Solution:

SQ for x = [30/45] * 90 = 60

SQ for y = [20/45]* 90 = 40

Total SQ for x and y = 100

RQ for x = [60/100] * 110 = 66

RQ for y = [40/100] * 110 = 44

Let’s calculate all types of material variance-

a) MCV for x = (SQ*SP)- (AQ*AP)

MCV = (60*20) - (44*25)
MCV = 1200 – 1100
MCV = 100 (f)

b) MCV for y = (SQ*SP)- (AQ*AP)

MCV = (40*10) – (66*5)
MCV = (400 – 330)
MCV = 70 (f)

c) MPV for x = (AQ*SP) – (AQ*AP)

MPV = (44*20) – (66*10)
MPV = 880-1100
MPV = 220 (Adverse)

d) MPV for y = (66*10) – (66*5)

MPV = 660-330
MPV = 330 (F)

e) MUV for x = (SQ*SP) –(AQ*SP)

MUV = (60*20)-(44*20)
MUV = 1200 – 880 = 320 (f)

f) MUV for y = (400 – 660)

MUV = 260 (adverse)

g) MMV for x = (RQ*SP) – (AQ*SP)

MMV = (66*20) – (44*20)
MMV = 1320- 880
MMV = 440 (F)
 h) MMV for y = (44*10)-( 66*10)
MMV = 440 – 660
MMV = 220 (adverse)

Note:

SQ = standard quantity of material for actual output *

SP = standard price

SO = standard output

AQ = actual quantity

AP = Actual price

SOP = standard out price**

RSQ = revised standard quantity***

*SQ = [standard quantity of material / standard output] * actual output

**SOP = [standard quantity of all material for actual output * standard price]* standard output

***RSQ = [standard quantity of one material / standard quantity of all material] * actual quantity of all
material

LABOUR COST VARIANCE (LCV):

Labour variance arises due to two reasons first inefficiency in using labour hours and second due to
change in actual rates and standard rates.
Above diagram shows the structure of labour variance and its component.

a) Labour cost variance: due to difference between standard cost of standard labour hour and
actual cost of actual labour hours.

LCV = (SH *SR) – (AH*AR)

Labour cost is divided into two categories-

-labour efficiency variance
- labour rate variance

b) Labour efficiency variance (LEV): due to difference between standard hours set and actual
hours used.

LEV = (SH- AH)* SR

c) Labour rate variance (LRV) = due to difference between standard rate mentioned actual rate
paid to labour.

LRV = (SR – AR) * AH

Where,
SR = standard rate
AR = actual rate
AH = actual hours

Labour efficiency variance further divided into three categories-

- Labour yield variance
- Labour mix variance
- Idle time variance
 d) Labour yield variance (LYV): due to difference between standard yield mentioned and actual
yield obtained.

LYV = (AY – SY)* SOP

Where,
AY = actual yield
SY = standard yield
SOP = standard out price
SOP = standard cost of standard hours for all labour / standard output for standard hours

e) Labour mix variance (LMV) = due to difference between standard and actual composition of
labour.

LMV = standard cost of revised labour hours – standard cost of actual labour hours.
Or
LMV = (RH *SR) – (AH * SR)

Where,
RH =revised standard hour
RH = [standard hour for one type of labour / total standard hour for all labour]* total actual
hour for all labor.
AH = actual hours
SR = standard rate

f) Idle time variance (ITV): due to abnormal idle time lost due to power failure, break downs etc.
It is the difference between actual labour hours worked and actual labour hours paid.

ITV = [idle hours] * SR

Where
Idle hours = actual hour paid – actual hours worked
SR = standard rate
Idle time variance is always adverse.

OVERHEAD VARIANCE:
Overhead cost refers to sum total of all types of indirect cost i.e. overhead = indirect material cost +
indirect labour cost + indirect expanses.
Overhead variance arises due to the difference between absorbed overhead and actual overhead. Use
of overhead rate per hour or overhead rate per unit is compulsory for calculating overhead variance.

Following is the classification of overhead variance-

a) Overhead cost variance is divided into two major sections as given below-
- Fixed overhead variance
- Variable overhead variance

b) Fixed overhead variance: it is further divided into expenditure variance and volume variance.
c) Variable overhead variance: it is divided into expenditure variance and efficiency variance.

Figure given below represent the structure of overhead variance-

Important terminology need to understand and remember for easy understanding of overhead
variance concepts-
a) Standard fixed overhead absorption rate (SFOR): the rate at which fixed overhead charges to
production.

SFOR = budgeted fixed overhead / budgeted hour or budgeted output

b) Standard overhead rate per hour (SOR) = budgeted overhead / budgeted hours

c) Standard variable overhead absorption rate (SVOR): rate at which variable overheads are
charged to production.

SVOR = budgeted variable overhead / budgeted hour or output

d) Standard hour for actual output (SH) = hour should have been taken to produce actual output

SH = actual output / standard hour per unit

e) Absorbed overheads (AO) = this shows overhead charged to standard hour for actual output on
the basis of standard overhead absorption rate.

AO = standard hours * standard overhead absorption rate

f) Budgeted overheads (BO) = shows amount of overhead for budgeted hour.

BO = budgeted hour * standard overhead absorption rate per hour

g) Standard overhead (SO) = product of actual hours and standard overhead absorption rate

SO = actual hour * standard overhead absorption rate.

h) Revised budgeted hours (RBH) = budgeted hour during actual no of working days

RBH = {budgeted hours / budgeted no of working days}* actual no of working days

i) Revised budgeted overhead (RBO) = overhead for revised budgeted hours during actual no of
working days.
 RBO = revised budgeted hours * standard overhead absorption rate per hour

j) Actual overhead (AO) = overhead actually incurred

AO = actual hours * actual overhead absorption rate

Now let’s discuss in detail all types of overhead variance-

a) OVERHEAD COST VARIANCE (OCV) = due to difference between Total standard overhead
absorbed and total actual overhead incurred.

OCV = absorbed overhead (AO) – actual overhead incurred (AO)

Or
OCV = (SH *SOR) – (AH * AOR)

E.g. calculate overhead cost variance

Particular Budgeted Actual

Output (units) 15000 17000
Hours 30000 33000
Overhead 105000 118000

Solution:

SH = Budgeted hour / Budgeted output * actual output

SH = 30000/15000 * 17000

SH = 34000

SOR = budgeted overhead / budgeted hour = 105000 / 30000 = ₹ 3.50 per hour

OCV = (SH *SOR) – (AH * AOR)

OCV = (34000 *3.50) – 118000

OCV = 119000 -118000

OCV = ₹ 1000 (favorable)

b) VARIABLE OVERHEAD COST VARIANCE (VOCV) = due to difference between absorbed variable
overhead and actual variable overhead incurred.

VOCV = absorbed variable overhead – actual variable overhead

Or
VOCV = (SH *SVOR) – (AH* AVOR)

E.g. 2.

Particular Budgeted Actual

Output (units) 15000 17000
Hours 30000 33000
Variable Overhead 60000 70000

SH = 30000/15000 * 17000 = 34000

SVOR = budgeted variable overhead / budgeted hours

SVOR = 60000 / 30000 = ₹ 2 per hour

VOCV = (SH *SVOR) – (AH* AVOR)

VOCV = (34000 * 2) –70000

VOCV = 68000 – 70000

VOCV = 2000 (Adverse)

c) VARIABLE OVERHEAD EFFICIENCY VARIANCE (VOEV) = due to the difference between standard
hours for actual output and actual hours.

VOEV = absorbed variable overhead – standard variable overhead

Or
 VOEV = (SH*SVOR) – (AH* SVOR)

E.g. 3. Calculate VOEV from e.g. 2 data-

Solution:
VOEV = (SH*SVOR) – (AH* SVOR)
VOEV = (34000*2) – (33000 *2)

VOEV = 68000 – 60000

VOEV = 8000 (Favorable)

d) VARIABLE OVERHEAD EXPENDITURE VARIANCE (VOEV) = due to the difference between

standard variable overhead allowed and actual variable overhead incurred

VOEV = standard variable overhead – actual variable overhead

Or
VOEV = (AH*SVOR) – (AH* AVOR)
Or
VOEV = AH *(SVOR – AVOR)

E.g.4. calculate the variable overhead expenditure variance from E.g. 2 data.

Particular Budgeted Actual

Output (units) 15000 17000
Hours 30000 33000
Variable Overhead 60000 70000

Solution:

VOEV = (AH*SVOR) – (AH* AVOR)

VOEV = (33000*2) – 70000

VOEV = 66000 – 70000

VOEV = 4000 (adverse)

 e) FIXED OVERHEAD COST VARIANCE (FOCV) = due to difference between total standard fixed
overhead absorbed and total actual fixed overhead incurred.

FOCV = absorbed fixed overhead – actual fixed overhead incurred

Or
FOCV = (SH * SFOR) – (AH * AFOR)

E.g. 5. Calculate FOCV

Particular Budget Actual

Output in units 15000 17000
Hours 30000 33000
Fixed overhead 45000 55000

Solution:

SFOR = budgeted fixed overhead / budgeted hour

SFOR = 45000 / 30000

SFOR = ₹ 1.5 per hour

FOCV = (SH * SFOR) – (AH * AFOR)

FOCV = (34000 *1.5) – 55000

FOCV = 51000 – 55000

FOCV = 4000 (adverse)

f) Fixed overhead expenditure variance (FOEV) = due to difference between budgeted fixed
overhead and actual fixed overhead

FOEV = budgeted fixed overhead – actual fixed overhead

Or
FOEV = (BH*SFOR) – (AH * AFOR)

E.g. 6. Calculate FOEV from data of E.g. 5

 Solution:

FOEV = (BH*SFOR) – (AH * AFOR)

FOEV = (30000*1.5) – 55000
FOEV = 45000 – 55000
FOEV = 10000 (adverse)

g) FIXED OVERHEAD VOLUME VARIANCE (FOVV) = due to difference between standard hours
actual output and budgeted hours

FOVV = absorbed fixed overhead – budgeted fixed overhead

Or
FOVV = (SH*SFOR) - (BBH*SFOR)

E.g. 7. Calculate FOVV from data of E.g. 5

Solution:

FOVV = (SH*SFOR) - (BH*SFOR)

FOVV = (34000*1.5) – (30000*1.5)

FOVV = 51000 – 45000
FOVV = 6000 (favorable)

h) FIXED OVERHEAD EFFICIENCY VARIANCE (FOEV) = due to the difference between standard
hours for actual output and actual hours.

FOEV = absorbed fixed overhead – standard fixed overhead

Or
FOEV = (SH – SFOR) – (AH * SFOR)

E.g. 8. Calculate FOEV from data given in E.g. 5.

Solution:

FOEV = (SH * SFOR) – (AH * SFOR)

 FOEV = (34000*1.5) – (33000*1.5)

FOEV = 1500 (F)

i) FIXED OVERHEAD CAPACITY VARIANCE (FOCV) = due to the difference between actual hours
and budgeted hours.

FOCV = standard fixed overhead – budgeted fixed overhead

Or
FOCV = (AH*SFOR) – (BH*SFOR)

E.g. calculate FOCV for data given in example 5.

Solution:

FOCV = (AH*SFOR) – (BH*SFOR)

FOCV = (33000*1.5) - (30000*1.5)

FOCV = 4500 (favorable)

j) FIXED OVERHEAD CALENDAR VARIANCE (FOCV) = due to the difference between actual no of
working days and budgeted no of working days.

FOCV = revised budgeted fixed overhead – original budgeted fixed overhead

Or
FOCV = (RBH*SFOR) – (BH*SFOR)

E.g. calculate FOCV (calendar variance)

Particular Budget Actual

Output in units 15000 17000
Hours 30000 33000
Fixed overhead 45000 55000
No of working days 25 27
Solution:

Revised budgeted hours: [budgeted hours / budgeted no o working days] * actual no of days

RBH: [30000 /25] * 27

RBH: 32400

FOCV = (RBH*SFOR) – (BH*SFOR)

FOCV = (32400*1.5) - (30000*1.5)

FOCV = 48600 – 45000
FOCV = 3600 (F)