2the notes

1
CLASSIFICATION OF COSTS: Manufacturing

We first classify costs according to the three elements of cost:
a) Materials b) Labour c) Expenses

Product and Period Costs: We also classify costs as either
1 Product costs: the costs of manufacturing our products; or
2 Period costs: these are the costs other than product costs that are charged to,
debited to, or written off to the income statement each period.

The classification of Product Costs:

Direct costs: Direct costs are generally seen to be variable costs and they are called
direct costs because they are directly associated with manufacturing. In turn, the
direct costs can include:

• Direct materials: plywood, wooden battens, fabric for the seat and the back,
nails, screws, glue.
• Direct labour: sawyers, drillers, assemblers, painters, polishers, upholsterers
• Direct expense: this is a strange cost that many texts don't include; but
(International Accounting Standard) IAS 2, for example, includes it. Direct
expenses can include the costs of special designs for one batch, or run, of a
particular set of tables and/or chairs, the cost of buying or hiring special
machinery to make a limited edition of a set of chairs.

Total direct costs are collectively known as Prime Costs and we can see that
Product Costs are the sum of Prime costs and Overheads.

Indirect Costs: Indirect costs are those costs that are incurred in the factory but that
cannot be directly associate with manufacture. Again these costs are classified
according to the three elements of cost, materials labour and overheads.

• Indirect materials: Some costs that we have included as direct materials
would be included here.
• Indirect labour: Labour costs of people who are only indirectly associated
with manufacture: management of a department or area, supervisors,
cleaners, maintenance and repair technicians
• Indirect expenses: The list in this section could be infinitely long if we were
to try to include every possible indirect cost. Essentially, if a cost is a factory
cost and it has not been included in any of the other sections, it has to be an
indirect expense. Here are some examples include:
Depreciation of equipment, machinery, vehicles, buildings
Electricity, water, telephone, rent, Council Tax, insurance

2
Total indirect costs are collectively known as Overheads.

Finally, within Product Costs, we have Conversion Costs: these are the costs
incurred in the factory that are incurred in the conversion of materials into finished
goods.

The classification of Period Costs:

The scheme shows five sub classifications for Period Costs. When we look
at different organisations, we find that they have period costs that might have sub
classifications with entirely different names. Unfortunately, this is the nature of the
classification of period costs; it can vary so much according to the organisation, the
industry and so on. Nevertheless, such a scheme is useful in that it gives us the basic
ideas to work on.

Administration Costs: Literally the costs of running the administrative aspects of an
organisation. Administration costs will include salaries, rent, Council Tax,
electricity, water, telephone, depreciation, a potentially infinitely long list. Notice
that there are costs here such as rent, Council Tax, that appear in several sub
classifications; in such cases, it should be clear that we are paying rent on buildings,
for example, that we use for manufacturing and storage and administration and each
area of the business must pay for its share of the total cost under review.

Without wishing to overly extend this listing now, we can conclude this
discussion by saying that the costs of Selling, the costs of Distribution and the costs
of Research are all accumulated in a similar way to the way in which Administration
Costs are accumulated. Consequently, our task is to look at the selling process and
classify the costs of running that process accordingly: advertising, market research,
salaries, bonuses, electricity, and so on. The same applies to all other classifications
of period costs that we might use.

Finance Costs: Finance costs are those costs associated with providing the
permanent, long term and short term finance. That is, within the section headed
finance costs we will find dividends, interest on long term loans and interest on short
term loans.

Finally, we should say that we can add any number of subclassifications to
our scheme if we need to do that to clarify the ways in which our organisation
operates. We will also add further subclassifications if we need to refine and further
refine out cost analysis.

3
COST SHEET – FORMAT

Particulars Amount Amount
Opening Stock of Raw Material ***
Add: Purchase of Raw materials ***
Add: Purchase Expenses ***
Less: Closing stock of Raw Materials ***
Raw Materials Consumed ***
Direct Wages (Labour) ***
Direct Charges ***
Prime cost (1) ***
Add :- Factory Over Heads:
Factory Rent ***
Factory Power ***
Indirect Material ***
Indirect Wages ***
Supervisor Salary ***
Drawing Office Salary ***
Factory Insurance ***
Factory Asset Depreciation ***
Works cost Incurred ***
Add: Opening Stock of WIP ***
Less: Closing Stock of WIP ***
Works cost (2) ***
Add:- Administration Over Heads:-
Office Rent ***
Asset Depreciation ***
General Charges ***
Audit Fees ***
Bank Charges ***
Counting house Salary ***
Other Office Expenses ***
Cost of Production (3) ***
Add: Opening stock of Finished Goods ***
Less: Closing stock of Finished Goods ***
Cost of Goods Sold ***
Add:- Selling and Distribution OH:-
Sales man Commission ***
Sales man salary ***
Traveling Expenses ***
Advertisement ***
Delivery man expenses ***
Sales Tax ***

4
Bad Debts ***
Cost of Sales (5) ***
Profit (balancing figure) ***
Sales ***

Notes:-
1) Factory Over Heads are recovered as a percentage of direct wages

2) Administration Over Heads, Selling and Distribution Overheads are recovered as
a percentage of works cost.

5
MATERIAL

1) Reorder level = Maximum usage * Maximum lead time
(Or) Minimum level + (Average usage * Average Lead time)

2) Minimum level = Reorder level – (Average usage * Average lead time)

3) Maximum level = Reorder level + Reorder quantity – (Minimum usage *
Minimum lead time)

4) Average level = Minimum level +Maximum level (or)
2
Minimum level + ½ Reorder quantity

5) Danger level (or) safety stock level
=Minimum usage * Minimum lead time (preferred)
(or) Average usage * Average lead time
(or) Average usage * Lead time for emergency purposes

6) EOQ (Economic Order Quantity - Wilson’s Formula) = √2AO/C
Where A = Annual usage units
O = Ordering cost per unit
C = Annual carrying cost of one unit
i.e. Carrying cast % * Carrying cost of unit

7) Associated cost = Buying cost pa + Carrying cost pa

8) Under EOQ Buying cost = Carrying cost

9) Carrying Cost = Average inventory * Carrying cost per unit pa * Carrying cost %
(Or) Average Inventory * Carrying cost per order pa

10) Average inventory = EOQ/2

11) Buying cost = Number of Orders * ordering cost

12) Number of Orders = Annual Demand / EOQ

13) Inventory Turnover (T.O) Ratio = Material consumed
Average Inventory

14) Inventory T.O Period = 365 .
Inventory Turn over Ratio

6
15) safety stock = Annual Demand *(Maximum lead time - Average lead time)
365
16) Total Inventory cost = Ordering cost + Carrying cost of inventory +Purchase cost

17) Input Output Ratio = Quantity of input of material to production
Standard material content of actual output

Remarks :-

1) High Inventory T.O Ratio indicates that the material in the question is fast moving

2) Low Inventory T.O Ratio indicates over investment and locking up of working
Capital in inventories

Pricing of material Issues:-

1) Cost price method:-
a) Specific price method
b) First in First Out method (FIFO)
c) Last in First Out method (LIFO)
d) Base stock method

2) Average price method:-

a) Simple average price method = Total unit price
Total No. of purchases

b) Weighted average price method = Total cost
Total No. of units

c) Periodic simple average price method = Total unit price of certain period
Total Number of purchases of that period
(This rate is used for all issues for that period. Period means a month (or) week (or)
year)

d) Periodic weighted average price method = Total cost of certain period
Total Number of units of that period
e) Moving simple average price method
= Total of periodic simple average of certain number of periods
Number of periods

7
f) Moving weighted average price method
= Total of periodic weighted average of certain number of periods
Number of periods

3) Market price method:-

a) Replacement price method = Issues are valued as if it was purchased now at
current market price
b) Realizable price method = Issues are valued at price if it is sold now

4) Notional price method:-

a) Standard price method = Materials are priced at pre determined rate (or)
Standard rate

b) Inflated price method = The issue price is inflated to cover the losses incurred
due to natural(or)climatic losses

5) Re use price method = When materials are returned (or) rejected it is valued at
different price. There is no final procedure for this method.

ABC Analysis (or) Pareto Analysis :- In this materials are categorized into

Particulars Quantity Value
“A” – Important material 10% 70%
“B” – Neither important nor unimportant 20% 20%
“C” – UN Important 70% 10%

Note:-

1) Material received as replacement from supplier is treated as fresh supply

2) If any material is returned from Department after issue, it has to be first
disposed in the next issue of material

3) loss in the book balance of stock and actual is to be transferred to Inventory
adjustment a/c and from there if the loss is normal it is transferred to Over Head
control a/c. If it is abnormal it is transferred to costing profit and loss a/c.

4) CIF = Cost Insurance and Freight (This consignment is inclusive of prepaid
insurance and freight)

8
5) FOB = Free on Board (Materials moving by sea – insurance premium is not
paid)

6) FOR = Free on Rail (Insurance and freight is not borne by the supplier but paid
by the company or purchase)

7) For each receipt of goods = Goods Receipt note

8) For each issue of goods = Materials Requisition note (or) Material Issue note

Accounting Treatment :-

1) Normal Wastage = It should be distributed over goods output increasing per unit
cost

2) Abnormal Wastage= It will be charged to costing profit and loss a/c

3) Sale value of scrap is credited to costing profit and loss a/c as an abnormal gain.

4) Sale proceeds of the scrap can be deducted from material cost or factory
overheads.

5) Sale proceeds of scrap may be credited to particular job.

6) Normal Defectives = cost of rectification of defectives should be charged to
specific

7) Abnormal Defectives = This should be charged to costing profit and loss a/c

8) Cost of Normal spoilage is to borne by good units

9) Abnormal spoilage should be charged to costing profit and loss a/c

9
LABOUR

Method of Remuneration:

1) Time Rate system
a) Flat time Rate
b) High wage system
c) Graduated time rate

2) Payment by Results

a) Piece rate system
i) Straight piece rate
ii) Differential piece rate
• Taylor system
• Merrick system

b) Group Bonus System
i) Budgeted Expenses
ii) Towne gain sharing scheme
iii) Cost efficiency bonus
iv) Priest man system

c) Combination of Time and Piece rate
i) Gantt task and Bonus scheme
ii) Emerson Efficiency system
iii) Point scheme
• Bedaux system
• Haynes manit system

d) Premium bonus plans
i) Halsey premium plan
ii) Halsey weir premium plan
iii) Rowan scheme
iv) Barth scheme
v) Accelerating premium bonus scheme

e) Other incentive schemes
i) Indirect monetary incentive
• Profit sharing
• Co-partnership
ii) Non-Monetary Incentive

10
1) Time rate system = Hours worked * Rate per hour (Basic wages)

2) Piece rate system:

i) Straight piece rate earnings = Number of units produced * Rate per unit

ii) Differential Piece rate

a) F.W.Taylor’s differential rate system
» 83% of piece rate when below standard
» 125% of piece rate when above or at standard

b) Merrick differential or multiple piece rate system

Efficiency level Piece rate
» up to 83% »Normal piece rate
» 83% to 100% » 110% of Normal rate
» Above 100% » 120% of Normal rate

iii) Gantt Task and Bonus system

Output Payment
» Below standard » Time rate (guaranteed)
» At standard » 20% Bonus of Time rate
» Above standard » 120% of ordinary piece rate

iv) Emerson’s Efficiency system

Efficiency Payment
» Below 66.7% » Hourly Rate
» from 66.7% » Hourly rate (+) increasing bonus according to degree
to 100% of efficiency on the basis of step bonus rates
» Above 100% » Hourly rate (+) 20% Bonus (+) additional bonus of 1%
of hourly rate for every 1% increase in efficiency

v) Halsey Premium Plan = Basic wages + 50% of time saved * Hourly Rate

vi) Halsey Weir Premium Plan = Basic wages + 30% of time saved * Hourly rate

vii) Rowan Plan = Basic wages + Time saved * Basic Wages
Time allowed

viii) Bedaus Point system = Basic wages + 75% * Bedaus point/60 * Rate/hr

11
ix) Barth’s System = Hourly rate * √Std time *Time taken

Labour Turnover:-

1) Separation rate method = Separation during the period
Average No. of worker’s during the period

2) Net labour T.O rate (or) Replacement method
= Number of replacements

3) Labour flux rate = No. of separation + No. of replacement

Accounting Treatment

1) Normal Idle time = Charged to factory overheads

2) Normal but un-controllable = It should be charged to job by inflating wage rate.

3) Abnormal = It should be charged to costing P & L a/c

12
OVER HEADS

Reapportionment of service department expenses over production department :-

1) Direct redistribution method:
• Service department costs are divided over production department.
• Ignore service rended by one dept. to another

2) Step method of secondary distribution (or) Non reciprocal method:
• Service department which serves largest number of service department is
divided first and go on.

3) Reciprocal service method:

i) Simultaneous equation method (or) Algebraic method
• Equation is formed between service departments and is solved to find the
amount due.

ii) Repeated distribution method:
• Service department cost separated repeatedly till figure of service dept. is
exhausted or too small.

iii) Trial and Error method:
• Cost of service department is apportioned among them repeatedly till the
amount is negligible and the total is divided among production department.

Treatment of Over/Under absorption of overheads:-

i) If under absorbed and over absorbed overheads are of small value then it should be
transferred to costing profit and loss a/c

ii) If under and over absorption occurs due to wrong estimates then cost of product
manufactured should be adjusted accordingly.

iii) If the same accrued due to same abnormal reasons the same should be transferred
to costing profit & loss a/c

Apportionment of overhead expenses – Basis

a) Stores service expenses = Value of materials consumed

b) Factory rent = Floor area

13
c) Municipal rent, rates and taxes = floor area

d) Insurance on Building and machinery = Insurable value

e) Welfare department expenses

f) Supervision
Number of employees
g Amenities to employee’s
)
h Employees liability for insurance
)

j) Lighting power = Plug point

k) Stores over heads = Direct material

l) General over heads = Direct wages

Reapportionment of service department cost to production department :-

1) Maintenance dept. = Hours worked for each dept.

2) Pay roll and time keeping = Total labour (or) machine hours (or) Number of
employees in each department

3) Employment (or) Personnel department = Rate of labour T.O (or) No. of
employees of each department

4) Stores Keeping department = No. of requisitions (or) value of materials of each
department

5) Purchase department = No. of purchase orders value of materials of each
department

6) Welfare, ambulance, canteen, service, recreation room expenses
= No. of employees in each department.

7) Building service department = Relative area each dept.

8) Internal transport service (or) overhead crane service
= weight, value graded product handled, weight and distance traveled.

14

9) Transport department = Crane hours, truck hours, truck mileage,
Number of packages.

10) Power house (electric power cost) = Housing power, horse power machine hours,
No. of electric points etc.

11) Power house = Floor area, cubic content.

15

RECONCILATION OF COST AND FINANCIAL A/C

Causes of differences:-

1) Purely financial items :
i) Appropriation of profits ►Transferred to reserves, goodwill, preliminary
expenses, dividend paid etc.
ii) Loss on sale of investment, penalties and fines
iii) Income ► Interest received on Bank deposits, profit on sale of investments,
fixed assets, transfer fees.

2) Purely cost account items: - Notional Rent / Interest / Salary

3) Valuation of stock:-

i) Raw-material = In financial a/c’s stock is valued at cost or market value
Whichever is less, while in cost a/c’s it is valued at LIFO, FIFO
etc.

ii) Work in progress = In financial a/c’s administrative expenses are also
considered while valuing stock, but in cost a/c’s it may be
valued at prime (or) factory cost (or) cost of production

iii) Finished Goods = In financial a/c’s it is valued at cost or market price
whichever is less, in cost a/c’s it is valued at total cost of production.

4) Overheads: In financial = Actual expenses are taken
In cost = Expenses are taken at predetermined rate.

5) Depreciation: In financial = Charged in diminishing or fixed balance method
In cost = Charged in machine hour rate

6) Abnormal Gains: In financial = Taken to profit & Loss a/c
In cost = Excluded to cost a/c’s or charged in costing
profit & Loss a/c

16

JOB AND BATCH COSTING

With job costing, we are dealing with one off situations. We are dealing with
organisations that carry out functions and services on a one at a time basis. Good
examples of job costing situations include jobbing builders: the builder who will
provide a householder, or a shop owner, or a factory owner with a service that he
provides for no one else. The jobbing builder will build an extension, or renovate
some property to a design that will probably not be copied anywhere else at any
time: it is a one off job. Job costing can apply in non manufacturing situations as
well as in manufacturing situations.

Even though many jobbing enterprises are small scale, we are not suggesting
that all jobbing enterprises are small scale enterprises. An engineering shop may be
working on a job for a customer that takes several months and many man and
machine hours to complete.

Here are two definitions:

A job is “A customer order or task of relatively short duration”
Job costing is “A form of specific order costing; the attribution of cost to jobs”

Batch costing is not normally seen as much of an advance on job costing.

A batch is A group of similar articles which maintains its identity throughout
one or more stages of production and is treated as a cost unit Batch costing is A form
of specific order costing; the attribution of costs to batches.

Economic Batch Quantity = EBQ = √2AS/C
Where A = Annual Demand
S = Setting up cost per batch
C= Carrying cost / unit of production.

17

PROCESS COSTING

Format of process a/c

Particulars Unit Rate Rs. Particulars Unit Rate Rs.
To Direct material By Normal Loss
To Direct Labour By Units transferred
To Indirect material to other process
To Other Expenses By Abnormal loss
(B/F)
To Abnormal gain(B/F)
Total Total

Format of Abnormal loss

Particulars Unit Rs. Particulars Unit Rs.
To Process a/c By Sale of wasted
units
By costing P & L a/c
Total Total

Format of Abnormal gain a/c

Particulars Units Rs. Particulars Units Rs.
To Normal Loss a/c By Process a/c (names of different
To costing P&la/c process)
Total Total

1)To find the cost per unit for valuation of units to be trans. to next process and also
for abnormal, loss or gain = Total process cost – Salvage value of normal spoilage
Total units introduced – Normal loss in units

2) To find abnormal loss (or) gain (all in units):
= Units from previous process + fresh units introduced – Normal loss – units
transferred to next process (If the result is positive then abnormal loss. If
negative then abnormal gain)

3) In case of opening WIP and closing WIP are given then there are different
methods of valuation of closing WIP
i) FIFO Method ii) LIFO Method
iii) Average Method iv) Weighted Average Method

4) Various statements to be prepared while WIP is given:

18
i) Statement of equivalent production
ii) Statement of cost
iii) Statement of apportionment of cost
iv) Process cost a/c
5) FIFO Method: In these method total units transferred to next process includes
full opening stock units and the closing stock includes the units
introduced during the process. In this method the cost incurred
during the process is assumed as to be used

a) First to complete the units already in process
b) Then to complete the newly introduced units
c) For the work done to bring closing inventory to given state of completion

6) LIFO Method = Cost incurred in process is used for:

a) First to complete newly introduced units

b) Then to complete units already in process in this method closing stock is
divided into two :
i) Units which represent opening stock but lie at the end of the period
ii) Newly introduced units in closing stock.

7) Average Method: In this method
a) No distinction is made between opening stock and newly introduced material.

b) In finding cost per unit, cost incurred for opening stock is also to be added with
current cost. (This addition is not done in LIFO & FIFO method as cost
incurred in that process is only taken)

8) Weighted average method: This method is only used when varied product in
processed through a single process. General procedure is adopted
here.

a) Statement of weighted average production should be prepared. Under this
statement output of each products is expressed in terms of points.

b) Cost of each type of product is computed on basis of Points.

Points of vital importance in case of Abnormal Gain / Loss:

a) Calculate cost per unit by assuming there is no abnormal loss / gain

b) Cost per unit arrived above should be applied for valuation of both abnormal

19
Loss/gain units and output of the process.

c) Separate a/c for both abnormal loss/gain is to be prepared.

JOINT PRODUCT AND BY PRODUCT COSTING

Methods of apportioning joint cost over joint products :

1) Physical unit method = Physical base to measure (i.e.) output quantity is used to
separate joint cost. Joint cost can be separated on the basis of ratio of output
quantity. While doing this wastage is also to be added back to find total quantity.

2) Average unit cost method = In this method joint cost is divided by total units
Produced of all products and average cost per unit is arrived and is multiplied
With number of units produced in each product.

3) Survey method or point value method = Product units are multiplied by points or
weights and the point is divide on that basis.

4) Standard cost method = Joint costs are separated on the basis of standard cost set
for respective joint products.

5) Contribution margin method = Cost are divided into two categories (i.e.) variable
and fixed. Variable costs are separated on unit produced. Fixed on the basis of
contribution ratios made by different products.

6) Market value method:-

a) Market value at the point of separation: Joint cost to sales revenue percentage
is found which is called as multiplying factor = Joint cost * 100
Sales Revenue
• Joint cost for each product is apportioned by applying this % on sales revenue
of each product.
• Sales revenue = Sales Revenue at the point of separation.
• This method cannot be done till the sales revenue at the separation point is
given.

b) Market value after processing: Joint cost is apportioned on the basis of total
sales Value of each product after further processing.

c) Net Realizable value method = Form sales value following items are deducted
i) Estimated profit margin

20
ii) Selling and distribution expenses if any included.
iii) Post split off cost
The resultant amount is net realizable value. Joint cost is apportioned on this
basis.

Bi-product → Method of accounting

• Treat as other income in profit and loss a/c

• Net Realizable value of Bi-product is reduced from cost of main product.

• Instead of standard process, Standard cost or comparative price or re-use
price is credited to joint process a/c.

21

OPERATION COSTING

Service costing is “A cost accounting method concerned with establishing the costs
of services rendered”. Service costing is also applied within a manufacturing setting.

The Differences Between Product Costing and Service Costing?
• There may be very few, if any, materials to worry about
• Overheads will comprise the most significant portion of any costs of which,
labour costs may well comprise as much as 70%

No. Enterprise Cost per unit
1. Railways or bus companies Per passenger-kilometer
2. Hospital Per patient/day, per bed/day
3. Canteen Meals served , cups of tea
4. Water supply service Per 1000 gallons
5. Boiler House 1000 kg of steam
6. Goods Transport Per tonne km, quintal km
7. Electricity Boards Per kilowatt – hours
8. Road maintenance department Per mile or road maintenance
9. Bricks One thousand
10. Hotel Per room/day

In this various terms such as passenger km, quintal km, tonne km, these are
all known as composite units and are computed in 2 ways:

a) Absolute (weighted average): (e.g.) tones km - Multiplying total distance by
respective load quantity.

b) Commercial (simple average): (e.g.) tonne Km–Multiplying total distance by
average load quantity

All accumulated cost is classified into 3 categories:

1) Standing charges (or) fixed cost
2) Running cost (or) variable cost
3) Maintenance charges (or) semi variable cost

Running charges = Fuel, Driver Wages, Depreciation, oil etc.

Maintenance charges = Supervision salary, Repairs and Maintenance

22

Note:-
• % of factory overheads on direct wages
• % of administration overheads on works cost
• % of selling & distribution overheads on works cost
• % of profit on sales

Operating cost sheet :-

Particulars Total cost Cost per km
A Standing charges :-
License fees
Insurance Premium
Road tax
Garage rent
Driver’s wages
Attendant-cum-cleaner’s wages
Salaries and wages of other staff
Total
B Running charges :-
Repairs and maintenance
Cost of fuel (diesel, petrol etc.)
Lubricants, grease and oil
Cost of tires, tubes and other spare parts
Depreciation
Total
C Total charges [ (A) + (B) ]

23

CONTRACT COSTING

Contract costing is “A form of specific order costing; attribution of costs to
individual contracts”.

A contract cost is “Aggregated costs of a single contract; usually applies to major
long term contracts rather than short term jobs”.

Features of long term contracts:

• By contract costing situations, we tend to mean long term and large contracts:
such as civil engineering contracts for building houses, roads, bridges and so
on. We could also include contracts for building ships, and for providing
goods and services under a long term contractual agreement.
• With contract costing, every contract and each development will be
accounted for separately; and does, in many respects, contain the features of a
job costing situation.
• Work is frequently site based.

We might have problems with contract costing in the following areas

• Identifying direct costs
• Low levels of indirect costs
• Difficulties of cost control
• Profit and multi period projects

The source of the following has eluded me: my sincere gratitude for whoever the
author might be.

"Contract Costing such jobs take a long time to complete & may spread over two or
more of the contractor's accounting years”.

Features of a Contract

• The end product
• The period of the contract
• The specification
• The location of the work
• The price
• Completion by a stipulated date

24
• The performance of the product

Collection of Costs :

Desirable to open up one or more internal job accounts for the collection of
costs. If the contract not obtained, preliminary costs be written off as abortive
contract costs in P&L In some cases a series of job accounts for the contract will be
necessary:
• to collect the cost of different aspects
• to identify different stages in the contract

Special features

• Materials delivered direct to site.
• Direct expenses
• Stores transactions.
• Use of plant on site

Two possible accounting methods:

Where a plant is purchased for a particular contract & has little further value to the
business at the end of the contract
Where a plant is bought for or used on a contract, but on completion of the contract it
has further useful life to the business
Alternatively the plant may be capitalised with Maintenance and running costs
charged to the contract."

Format:-

Particulars Rs. Particulars Rs.
To Materials By materials returned **
a. Purchased directly ** By Material sold (cost
b. Issue from site ** price) **
c. Supplied by contractee **
To Wages and salaries ** By WIP
To Other direct Expenses ** Work certified **
To Sub-contractor fees ** Work Uncertified **
To Plant & Machinery (purchase By Materials at site **
price/Book value) **
To Indirect expenditure (apportioned share ** By Plant and
of overheads) machinery(WDV) **
To Notional profit (Surplus) **

25
Total Total **

Profit of Incomplete contract :-

1) When % of completion is less than or equal to 25% then full Notional profit is
transferred to reserve.

2) When % of completion is above 25% but less than 50% following amount should
be credited to profit & loss a/c = 1/3 * Notional Profit * {Cash received / Work

certified}

3) When % of completion is more than or equal to 50% then the amount transferred
to profit is = 2/3 * Notional Profit * {Cash received / Work certified}
[Balance is transferred to reserve a/c]
☺ % of completion = {Work certified/Contract price} * 100

4) When the contract is almost complete the amount credited to profit & loss a/c is

a) Estimated total profit * {Work certified / Contract price}
b) Estimated total profit * {Cash received / Contract price}
c) Estimated total profit * {Cost of work done / Estimated total profit}
d) Estimated total profit*{Cost of work done*Cash received
Estimated total cost * Work certified}

5) Work-In-Progress is shown in Balance Sheet as follows:-

Skeleton Balance sheet

Liabilities (RS) Asset (Rs)
Profit & loss a/c (will include) Work-in-progress
Profit on contract (Specify Value or work certified
the contract number) Cost of work uncertified
Less : Loss on contract Less :- Reserve for unrealized profit
(Specify the contract number) Less :- Amount received from
Sundry creditors (will include) contractee
Wages accrued
Direct expenses accrued
Any other expenses
(Specify)

6) Escalation Clause = This is to safeguard against likely change in price of cost
elements rise by and certain % over the prices prevailing at the time tendering the
contractee has to bear the cost.

26

MARGINAL COSTING

Statement of profit:-

Particulars Amount
Sales ***
Less:-Variable cost ***
Contribution ***
Less:- Fixed cost ***
Profit ***

1) Sales = Total cost + Profit = Variable cost + Fixed cost + Profit

2) Total Cost = Variable cost + Fixed cost

3) Variable cost = It changes directly in proportion with volume

4) Variable cost Ratio = {Variable cost / Sales} * 100

5) Sales – Variable cost = Fixed cost + Profit

6) Contribution = Sales * P/V Ratio

7) Profit Volume Ratio [P/V Ratio]:-
• {Contribution / Sales} * 100
• {Contribution per unit / Sales per unit} * 100
• {Change in profit / Change in sales} * 100
• {Change in contribution / Change in sales} * 100

8) Break Even Point [BEP]:-
• Fixed cost / Contribution per unit [in units]
• Fixed cost / P/V Ratio [in value] (or) Fixed Cost * Sales value per unit
(Sales – Variable cost per unit)
9) Margin of safety [MOP]
• Actual sales – Break even sales
• Net profit / P/V Ratio
• Profit / Contribution per unit [In units]

27
10) Sales unit at Desired profit = {Fixed cost + Desired profit} / Cont. per unit

11) Sales value for Desired Profit = {Fixed cost + Desired profit} / P/V Ratio

12) At BEP Contribution = Fixed cost
13) Variable cost Ratio = Change in total cost * 100
Change in total sales

14) Indifference Point = Point at which two Product sales result in same amount of
profit
= Change in fixed cost (in units)
Change in variable cost per unit

= Change in fixed cost (in units)
Change in contribution per unit

= Change in Fixed cost (in Rs.)
Change in P/Ratio

= Change in Fixed cost (in Rs.)
Change in Variable cost ratio

15) Shut down point = Point at which each of division or product can be closed

= Maximum (or) Specific (or) Available fixed cost
P/V Ratio (or) Contribution per unit
If sales are less than shut down point then that product is to shut down.

Note :-

1) When comparison of profitability of two products if P/V Ratio of one product is
greater than P/V Ratio of other Product then it is more profitable.

2) In case of Indifference point if
Sales > Indifference point --- Select option with higher fixed cost (or) select
option with lower fixed cost.

28

STANDARD COSTING

Method one of reading:-
Material:-
SP * SQ SP * AQ SP * RSQ AP * AQ
(1) (2) (3) (4)
a) Material cost variance = (1) – (4)
b) Material price variance = (2)–(4)
c) Material usage variance = (1) – (2)
d) Material mix variance = (3) – (2)
e) Material yield variance = (1) –(3)

Labour :-
SR*ST SR*AT (paid) SR*RST AR*AT SR*AT(worked)
(1) (2) (3) (4) (5)

a) Labour Cost variance = (1) – (4)
b) Labour Rate variance = (2) – (4)
c) Labour Efficiency variance = (1) – (2)
d) Labour mix variance = (3) – (5)
e) Labour Idle time variance = (5) – (2)

Variable Overheads cost variance :-
SR * ST SR * AT AR * AT
(1) (2) (3)

a) Variable Overheads Cost Variance = (1) – (3)
b) Variable Overheads Expenditure Variance = (2) – (3)
c) Variable Overheads Efficiency Variance = (1) – (2)

[Where: SR =Standard rate/hour = Budgeted variable OH
Budgeted Hours ]

Fixed Overheads Cost Variance:-
SR*ST SR*AT(worked) SR*RBT SR*BT AR*AT(paid)

29
(1) (2) (3) (4) (5)

a) Fixed Overheads Cost Variance = (1) – (5)
b) Fixed Overheads Budgeted Variance = (4) – (5)
c) Fixed Overheads Efficiency Variance = (1) – (2)
d) Fixed Overheads Volume Variance = (1) – (4)
e) Fixed Overheads Capacity Variance = (2) – (3)
f) Fixed Overheads Calendar Variance = (3) – (4)
Sales value variance:-
Budgeted Price*BQ BP*AQ BP*Budgeted mix AP*AQ
(1) (2) (3) (4)

a) Sales value variance = (4)–(1)
b) Sales price variance = (4) – (2)
c) Sales volume variance = (2) – (1)
d) Sales mix variance = (2) – (3)
e) Sales quantity variance = (3) – (1)

Note :-

i) Actual margin per unit (AMPU) = Actual sale price – selling cost per unit

ii) Budgeted margin per unit (BMPU) = Budgeted sale price – selling price per unit

Sales margin variance :-

BMPU*BQ BMPU*AQ BMPU*Budgeted mix AMPU*AQ
(1) (2) (3) (4)

a) Sales margin variance = (4) – (1)
b) Sales margin price variance = (4) – (2)
c) Sales margin volume variance = (2) – (1)
d) Sales margin mix variance = (2) – (3)
e) Sales margin quantity variance = (3) – (1)

Control Ratio :-

1) Efficiency Ratio = Standard hours for actual output * 100
Actual hours worked

2) Capacity Ratio = Actual Hours Worked * 100

30
Budgeted Hours

3) Activity Ratio = Actual hours worked * 100
Budgeted Hours

Verification: Activity Ratio = Efficiency * Capacity Ratio

STANDARD COSTING

Method two of reading:-
Material:-

a) Material cost variance = SC – AC = (SQ*AQ) – (AQ*AP)

b) Material price variance = AQ (SP – AP)

c) Material usage variance = SP (SQ – AQ)

d) Material mix variance = SP (RSQ – AQ)

e) Material yield variance = (AY – SY for actual input) Standard material cost per
unit of output

f) Material revised usage variance (calculated instead of material yield variance)
= [standard quantity – Revised standard
for actual output quantity ] * Standard price

Labour :-

a) Labour Cost variance = SC – AC = (SH*SR) – (AH*AR)

b) Labour Rate variance = AH (SR - AR)

c) Labour Efficiency or time variance = SR (SH –AH)

d) Labour Mix or gang composition Variance = SR(RSH-AH)

e) Labour Idle Time Variance = Idle hours * SR

31
f) Labour Yield Variance = [Actual Output – Standard output for actual input]
* Standard labour cost/unit of output

g) Labour Revised Efficiency Variance (instead of LYV) =
[Standard hours for actual output – Revised standard hours] * Standard rate

Notes :- i) LCV = LRV + LMV + ITV + LYV
ii) LCV = LRV + LEV + ITV
iii) LEV = LMV, LYV (or) LREV

Overhead variance :- (general for both variable and fixed)

a) Standard overhead rate (per hour) = Budgeted Overheads
Budgeted Hours

b) Standard hours for actual output = Budgeted hours * Actual Output
Budgeted output

c) Standard OH = Standard hrs for actual output * Standard OH rate per hour

d) Absorbed OH = Actual hrs * Standard OH rate per hour

e) Budgeted OH = Budgeted hrs * Standard OH rate per hour

f) Actual OH = Actual hrs * Actual OH rate per hour

g) OH cost variance = Absorbed OH – Actual OH

Variable Overheads variance :-

a) Variable OH Cost Variance = Standard OH – Actual OH

b) Variable OH Exp. Variance = Absorbed OH – Actual Variable OH

c) Variable OH Efficiency Variance = Standard OH – Absorbed OH
= [Standard hours for – Actual * Standard rate
actual output hours] for variable OH

Fixed Overheads variance :-

a) Fixed OH Cost Variance = Standard OH – Actual OH

32
b) Fixed OH expenditure variance = Budgeted OH – Actual OH

c) Fixed OH Efficiency Variance = Standard OH (units based) – Absorbed OH
(Hours based)

d) Fixed OH Volume Variance = Standard OH – Budgeted OH
= [Standard hrs for – Budgeted * standard rate
actual output hours ]

e) Fixed OH capacity variance = Absorbed OH–Budgeted OH

f) Fixed OH Calendar Variance = [Revised budgeted hrs – Budgeted hrs]
* Standard rate/hrs

Note:- When there is calendar variance capacity variance is calculated as follows :-
Capacity variance = [Actual hours – Revised * Standard
(Revised) Budgeted hrs] rate/hour

Verification :-

i) variable OH cost variance = Variable OH Expenditure variance
+ Variable OH Efficiency variance

ii) Fixed OH cost variance = Fixed OH Expenditure variance + Fixed OH volume
variance

iii) Fixed OH volume variance = Fixed OH Efficiency variance + Capacity variance
+ Calander variance

Sales variances :-

Turnover method (or) sales value method :-

a) Sales value variance = Actual Sales – Budgeted Sales

b) Sales price variance = [Actual Price – Standard price] * Actual quantity
= Actual sales – standard sales

c) Sales volume variance = [Actual-Budgeted quantity] *Standard price
= Standard sales – Budgeted sales

d) Sales mix variance = [Actual quantity – Revised standard quantity] * Standard
price

33
= Standard sales – Revised sales

e) Sales quantity variance = [Revised standard variance – Budgeted quantity]
* Standard price
= Revised Standard sales – Budgeted sales

Profit method:-

a) Total sales margin variance = (Actual Profit–Budgeted price)
= {Actual quantity * Actual profit per unit}-
{Budgeted quantity * Standard profit per unit}
b) Sales margin price variance=Actual profit–Standard profit
= {Actual Profit per unit – Standard profit per unit} * Actual quantity of sales

c) Sales margin volume variance = Standard profit – Budgeted Profit
= {Actual quantity – Budgeted quantity} * Standard profit per unit

d) Sales margin mix variance = Standard profit – Revised Standard profit
= {Actual quantity – Revised standard quantity} * Standard profit per unit

e) Sales margin quantity variance = Revised standard profit - Budgeted profit
= {Revised standard quantity – Budgeted quantity} * Standard profit per unit

34

STANDARD COSTING

Diagrammatic Representation: -
Material Variance: -

Material cost variance = SC – AC = (SQ*AQ) – (AQ*AP)

Labour Variances:-

Labour Cost variance = SC – AC = (SH*SR) – (AH*AR)

Fixed Overhead Variance : -
a) Standard OH = Standard hrs for actual output * Standard OH rate per hour

35
b) Absorbed OH = Actual hrs * Standard OH rate per hour

c) Budgeted OH = Budgeted hrs * Standard OH rate per hour

d) Actual OH = Actual hrs * Actual OH rate per hour

e) Revised Budgeted Hour = Actual Days * Budgeted Hours per day
(Expected hours for actual days worked)

When Calendar variance is asked then for capacity variance Budgeted
Overhead is (Budgeted days * Standard OH rate per day)

Revised Budgeted Hour (Budgeted hours for actual days) = Actual days * Budgeted
hours per day

Variable Overhead Variance : -

36

Sales Value Variances : -

Sales value variance = Actual Sales – Budgeted Sales

Sales Margin Variances : -

37

Total sales margin variance = (Actual Profit–Budgeted price)
= {Actual quantity * Actual profit per unit}-
{Budgeted quantity * Standard profit per unit}

[Where :-

SC = Standard Cost, AC = Actual Cost
SP = Standard Price, SQ = Standard Quantity
AP = Actual Price, AQ = Actual Quantity
AY = Actual Yield, SY = Standard Yield
RSQ = Revised Standard Quantity, SR = Standard Rate,
ST = Standard Time AR = Actual Rate,
AT = Actual Time RST = Revised Standard Time,
BP = Budgeted Price, BQ = Budgeted Quantity
RBT = Revised Budgeted Time
BMPU = Budgeted Margin per Unit
AMPU = Actual Margin per Unit

Reconciliation:-

Reconciliation statement is prepared to reconcile the actual profit with the
budgeted profit

Particulars Favorable Unfavorable (Rs)
Budgeted Profit :
Add Favorable variances
Less Unfavorable variances
Sales Variances :
Sales price variance
Sales mix variance
Sales quantity variance
Cost variance :-
Material :
Cost variance

38
Usage variance
Mix variance
Labour :
Rate variance
Mix variance
Efficiency variance
Idle time variance
Fixed overhead variance :
Expenditure variance
Efficiency variance
Fixed overhead variance :
Expenditure variance
Efficiency variance
Capacity variance
Calendar variance

NON-INTEGRATED ACCOUNTS

Scheme of journal entries:-

Material:

a) For material purchases (cash or credit)
i) Material control a/c Dr
To Cost ledger control a/c

ii) Stores ledger control a/c Dr
To Material control a/c

b) Purchases for a special job
Work-in-progress ledger control a/c Dr

39

c) Material returned to vender
Cost ledger control a/c Dr
To Stores ledger control a/c

d) Material (direct) issued to production
Work-in-progress control a/c Dr

e) Material (indirect) issued to production
Manufacturing overheads a/c Dr

f) Material returned from shop to stores
Stores ledger control a/c Dr
To Work-in-progress control a/c

g) Material transferred from Job 1 to Job 2
Job 2 a/c Dr
To Job 1 a/c

i) Material issued from stores for repairs
Manufacturing overhead a/c Dr

Labour:

a) Direct wages paid
i) Wage control a/c Dr

ii) Work-in-progress a/c Dr
To Wage control a/c

b) Indirect wages paid to workers in Production,
Administration, Selling and Distribution departments
i) Wage control a/c Dr

ii) Production Overhead a/c Dr
Administrative Overhead a/c Dr

40
Selling & Distribution Overhead a/c Dr
To Wage control a/c

c) Direct Expenses on a particular job
Job a/c Dr

Overheads:-

a) Overhead expenses incurred
Production overhead a/c Dr
Administrative Overhead a/c Dr
Selling & Distribution Overhead a/c Dr
To cost ledger control a/c

b) Carriage inward
Manufacturing Overhead a/c Dr

c) Production Overheads recovered
Work-in-progress control a/c Dr
To Production Overhead a/c

d) Administrative Overhead recovered from finished goods
Finished goods ledger control a/c Dr
To Administrative Overhead a/c

e) Selling and Distribution Overhead recovered from sales
Cost of sales a/c Dr
To Selling & Distribution a/c

f) If over/under absorbed amounts are carried forward to subsequent year, the
balance of each Overhead account will have to be transferred to respective
Overhead suspense (or reserve) Accounts as follows:

i) For over recovery : Production Overhead a/c Dr
To Production overhead suspense a/c

ii) For under recovery : Administrative Overhead Suspense a/c Dr
To Administrative Overhead a/c

Selling & Distribution Overhead Suspense a/c Dr
To Selling & Distribution Overhead a/c

41

g) In case the Under/Over absorbed overheads are transferred to costing profit & loss
a/c then the relevant entries are:
i) For Over recovery: Production Overhead a/c Dr
To Costing Profit & Loss a/c

ii) For Under recovery: Costing Profit & Loss a/c Dr
To Administration Overhead a/c

Sales:-

For sales effected: Cost ledger control a/c Dr
To Costing Profit & Loss a/c

Profit / Loss:

a) In case of profit the entry is as follows
Costing Profit & Loss a/c Dr

b) Reverse the entry in case of loss

The main accounts which are usually prepared when a separate cost ledger is
maintained is as follows:-

i) Cost ledger control a/c
ii) Stores ledger control a/c
iii) Work-in-progress control a/c
iv) Finished goods control a/c
v) Wage control a/c
vi) Manufacturing/Production/Works Overheads a/c
vii) Administrative Overhead a/c
Viii) Selling & Distribution Overhead a/c
ix) Cost of sales a/c
x) Costing profit & loss a/c

42

Transfer Pricing

A transfer price is the amount of money that one unit of an organisation
charges for goods and services to another unit of an organisation.

One of the key aspects here is that a transfer price is equivalent to an ordinary
selling price and that any department or division that sets a transfer price is
effectively selling its goods and services at a profit or a loss to another department or
division within its organisation. Any part of an organisation using transfer pricing
will be classed as a profit centre: since it is operating with a view to making a profit
(whether positive, profit, or negative, loss). If goods and services are transferred
between departments and divisions at cost, then no profit or loss arises and the issue
of transfer pricing does not, or should not, arise.

Organisations have a system of transfer pricing, therefore, in order to assess
the efficiency and effectiveness of its department and divisional managers. This

43
maybe in spite of the fact that transfer prices may be artificial in the sense that it is
felt that there is no rationale for “selling” between departments and divisions.

Criteria for fixing Transfer Pricing:-

i) External Capacity not fully utilized = Variable Cost

ii) Capacity fully Utilized
a) If single product :-
Selling Price (–) Selling Expenses

b) If multiple product
Variable cost + Opportunity cost (measured on the basis of Product
actually sacrificed)

iii) If no market for Intermediate product
Cost of supplying division of optimum level
(-) Cost of the supplying division at previous output level.
Difference in Output

(This would be equal to Variable cost when Fixed Cost is same at all levels)

Note:-

i) Ignore Variable Selling expenses on Inter Department Transfer
ii) In case of (ii) above If selling expenses is not given we have to assume some
% as selling Expenses but it should not exceed 5% .
Budgetary Control

Budget Ratios:-

1) Capacity usage Ratio
= . Budgeted Hours . * 100
Maximum possible working hours in budget period

2) Standard Capacity Employed Ratio
= Actual Hours Worked * 100
Budgeted hours

3) Level of Activity Ratio
= Standard Hours for Actual Production * 100
Standard Hours for Budgeted Production

44
4) Efficiency Ratio
= Standard Hours for Actual Production * 100
Actual Hours

5) Calendar Ratio
= Actual Working days * 100
Budgeted working days

Zero Base Budgeting:

The name zero base budgeting derives from the idea that such budgets are
developed from a zero base: that is, at the beginning of the budget development
process, all budget headings have a value of ZERO. This is in sharp contrast to the
incremental budgeting system in which in general a new budget tends to start with a
balance at least equal to last year's total balance, or an estimate of it.

Definition of Zero Base Budgeting (ZBB)

“A method of budgeting whereby all activities are reevaluated each time a
budget is set. Discrete levels of each activity are valued and a combination chosen to
match funds available”.

Objectives and Benefits of ZBB

What zero base budgeting tries to achieve is an optimal allocation of
resources that incremental and other budgeting systems probably cannot achieve.
ZBB starts by asking managers to identify and justify their area(s) of work in terms
of decision packages (qv).

An effective zero base budgeting system benefits organisations in several
ways. It will

• Focus the budget process on a comprehensive analysis of objectives and
needs
• Combine planning and budgeting into a single process
• Cause managers to evaluate in detail the cost effectiveness of their operations

45
• Expand management participation in planning and budgeting at all levels of
the organisation

Activity Based costing

In Traditional Method we split the Over Head incurred in production, based
on machine hours which are not acceptable for many reasons.

In ABC method Over Head are splited according to the related activity, for
each type of Over Head. Overhead are apportioned among various Production cost
centers on the basis of Activity cost drivers.

Relevant Costing - some theory

Introduction: -

A management decision involves predictions of costs & revenues. Only the

46
costs and revenues that will differ among alternative actions are relevant to the
decision. The role of historical data is to aid the prediction of future data. But
historical data may not be relevant to the management decision itself. Qualitative
factors may be decisive in many cases, but to reduce the number of such factors to be
judged, accountants usually try to express many decision factors as possible in
quantitative terms.

Meaning of Relevant Costs: -

Relevant costs represent those future costs that will be changed by a
particular decision. While irrelevant costs are those costs that will not be affected by
a decision. In the short run, if the relevant revenues exceed the relevant costs then it
will be worthwhile accepting the decision. Therefore relevant costs playa major role
in the decision-making process of an organization. A particular cost can be relevant
in one situation but irrelevant in another, the important point to note is that relevant
costs represent those future costs that will be changed by a particular decision, while
irrelevant costs are those costs that will not be affected by that decision. We shall
now see what are relevant costs and revenues for decision-making process. In
summary relevant information concerns:

Other Important Terminologies : -

Relevant costs are costs appropriate to aiding the making of specific
management decisions. Actually, to affect a decision a cost must be:

Future: Past costs are irrelevant as they are not affected them by future decisions &
decisions should be made as to what is best now.

Incremental: This refers to additional revenue or expenditure, which may appear as a
result of our decision-making.
(A cash flow - Such charges as depreciation may be future but do not represent cash
flows and, as such, are not relevant.)

Sunk costs: Past costs, not relevant for decision making

Committed costs: This is future in nature but which arise from past decisions,
perhaps as the result of a contract.

Relevant Costs: Problem areas:

1 Problems in determining the relevant costs of materials:

47
When considering various decisions, if the any materials required is not taken
from existing stocks but would be purchased on a later date, then the estimated
purchase price would be the relevant material cost. A more difficult problem arises
when materials are taken from existing stock. In this situation the relevant cost of
materials for a particular job (say job X) depends on

Material is in regular use of the company
Material is not in regular use of the company
Material is in short supply.

If the material is in regular use of the company then the material taken from
existing stock requires replacement for the purpose of regular use therefore the
relevant cost of material will be the Replacement cost.

If the material is not in regular use of the company the relevant cost of the
materials depends on their alternative use. The alternative use of the materials will be
either to sell them or to use them on other jobs. Hence the cost of using the materials
results in an opportunity cost consisting of either

The net sales revenue if the materials were sold (or) The expense that would be
avoided if the materials were used on some other job Whichever is greater.

If the material is in short supply the only way material for the job under
consideration can be obtained is by reducing production of some other product / job.
This would release material for the order. but the reduced production will result in
loss of contribution which should be taken in to account when ascertaining the
relevant costs for the specific order. Therefore the relevant cost will be Contribution
lost (before the material cost since the material cost will be incurred in any case) will
be the relevant cost.
labour:
2 Determining the direct labour that are relevant to short - term decision depends on
the circumstances.

Where a company has temporary sparse capacity and the labour force is to be
maintained in the short - term, the direct labour cost incurred will remain same for all
alternative decisions. The direct labour cost will therefore be irrelevant for short -
term decision - making purposes.
However where casual labour is used and where workers can be hired on a
daily basis; a company may then adjust the employment of labour to exactly the
amount required to meet the production requirements. The labour cost will increase
if the company accepts additional work, and will decrease if production is reduced.
In this situation the labour cost be a relevant cost for decision - making purposes.

48
In a situation where full capacity exists and additional labour supplies are
unavailable in the short - term, and where no further overtime working is possible,
the only way that labour resources could then be obtained for a specific order would
be to reduce existing production. This would release labour for the order. but the
reduced production will result in loss of contribution, which should be taken in to
account when ascertaining the relevant costs for the specific' order. Therefore the
relevant cost will be Contribution lost (before the labour cost) will be the relevant
cost.

PROBLEMS

1. In a firm, material A has no alternative uses and 200 units of which lie in stock.
The information below has been collected. You are required to find the relevant price
of 120 units and 250 units respectively.
Book value
Current price
Sale price obtainable

Rs.2 per kg Rs.3 per kg Rs.2.80 per kg

2. Assume in the above problem the material is in regular use of the company

3. Assume in the above problem the material is in short ‘supply and it is not possible
to obtain the stock of material for some more time. At present the material is used in
another product on which a contribution at the rate of Rs.1 O/unit is earned (after
meeting the material cost). Each unit of the product requires 1 KG of Raw material
A.

Cash and fund flow statement

Rules for preparing schedule of changes in working capital :-

Increase in a current asset, results in increase in working capital – so Add
Decrease in current asset, results in decrease in working capital – so Decrease
Increase in current liability, results in decrease in working capital – so Decrease
Decrease in current liability results in increase in working capital – so Add

Funds from operations – Format

Particulars Rs. Rs.
Net profit ***

49
Add : Depreciation **
Goodwill written off *
Preliminary Exp. Written off **
Discount on share written off *
Transfer to General Reserve **
Provision for Taxation *
Provision for Dividend **
Loss on sale of asset *
Loss on revaluation of asset ** ***
*
**
*
**
*
**
*
**
*
***
Less : Profit on sale of asset **
Profit on Revaluation of asset * ***
**
*
Fund flow statement ***

Fund flow statement

Particulars Rs.
Sources of funds : - ***
Issue of shares ***
Issue of Debentures ***
Long term borrowings ***
Sale of fixed assets ***
Operating profit ***
Total Sources ***
Application of funds : - ***
Redumption of Redeemable preference shares ***
Redumption of Debentures ***
Payment of other long term loans ***
Purchase of Fixed assets ***
Operating Loss ***
Payment of dividends, tax etc ***
Total Uses ***

50
Net Increase / Decrease in working capital
(Total sources – Total uses) ***

Cash flow statement

Cash From Operation : -
= Net profit + Decrease in Current Asset
+ Increase in Current Liability
- Increase in Current Asset
- Decrease in Current Liability

Cash flow statement

Sources Rs. Application Rs.
Opening cash and bank ** Opening Bank O/D **
balance ** Redumption of Preference Shares **
Issue of shares ** Redumption of Long term loans **
Raising of long term loans ** Purchase of fixed assets **
Sales of fixed assets ** Decrease in Deferred payment Liability **
Short term Borrowings ** Cash Outflow **
Cash Inflow ** Tax paid **
Closing Bank O/D Dividend paid **
Decrease in Unsecured loans, Deposits **
Closing cash and bank balance **
** **

Ratio Analysis

51
A) Cash Position Ratio : -

1) Absolute Cash Ratio = Cash Reservoir
Current Liabilities

2) Cash Position to Total asset Ratio = Cash Reservoir * 100
(Measure liquid layer of assets) Total Assets

3) Interval measure = Cash Reservoir
(ability of cash reservoir to meet cash expenses) Average daily cash expenses
( Answer in days)

Notes : -
• Cash Reservoir = Cash in hand + Bank + Marketable Non trade investment at
market value.
• Current liabilities = Creditors + Bills Payable + Outstanding Expenses +
Provision for tax (Net of advance tax) + Proposed dividend + Other
provisions.
• Total assets = Total in asset side – Miscellaneous expenses – Preliminary
expenses + Any increase in value of marketable non trading Investments.
• Average cash expenses =Total expenses in debit side of P & L a/c – Non cash
item such as depreciation, goodwill, preliminary expenses written off, loss on
sale of investments, fixed assets written off + advance tax (Ignore provision
for tax) . The net amount is divided by 365 to arrive average expenses.

Remarks : - In Comparison
• When absolute cash ratio is lower then current liability is higher
• When cash position to Total Asset ratio is lower then the total asset is
relatively higher.
• When cash interval is lower the company maintain low cash position. It is not
good to maintain too low cash position or too high cash position.

B) Liquidity Ratio : -

1) Current ratio = Current asset
Current Liability

2) Quick ratio or Acid Test ratio = Quick Asset
Quick liability

Notes : -

52
• Quick Asset = Current Asset – Stock
• Quick Liability = Current liability – Cash credit, Bank borrowings, OD and
other Short term Borrowings.
• Secured loan is a current liability and also come under cash credit
• Sundry debtors considered doubtful should not be taken as quick asset.
• Creditors for capital WIP is to be excluded from current liability.
• Current asset can include only marketable securities.
• Loans to employees in asset side are long term in nature and are not part of
current assets.
• Provision for gratuity is not a current liability.
• Gratuity fund investment is not a part of marketable securities.
• Trade investments are not part of marketable securities.

Remarks : -
• Higher the current ratios better the liquidity position.

C) Capital structure ratios : -

1) Debt equity ratio = Debt = External Equity
(or) Leverage ratio Equity Internal Equity
= Long term debt = Share holders fund
Long term fund Long term fund

2) Proprietary ratio = Proprietary fund
Total Assets

3) Total Liability to Net worth ratio = Total Liabilities
Net worth

4) Capital gearing ratio = Preference share capital + Debt
Equity – Preference share capital

Notes : -
• Share holders fund (or) Equity (or) Proprietary fund (or) Owners fund (or)
Net worth = Equity share + Preference share + Reserves and surplus – P & L
a/c – Preliminary Expenses.
• Debt (or) Long term liability (or) Long term loan fund = Secured loan
(excluding cash credit) + unsecured loan + Debentures.
• Total asset = Total assets as per Balance sheet – Preliminary expenses.
• Total liability = Long term liability + Current liability (or) short term liability

53
• Long term fund = Total asset – Current liability = Share holders fund + long
term loan fund.

Remarks : -
• In debt equity ratio higher the debt fund used in capital structure, greater is
the risk.
• In debt equity ratio, operates favorable when if rate of interest is lower than
the return on capital employed.
• In total liability to Net worth Ratio = Lower the ratio, better is solvency
position of business, Higher the ratio lower is its solvency position.
• If debt equity ratio is comparatively higher then the financial strength is
better.

D) Profitability Ratio : -

1) Gross Profit Ratio = Gross Profit * 100
Sales

2) Net Profit Ratio = Net Profit * 100
Sales

3) Operating Profit ratio = Operating profit * 100
Sales

4) Return to shareholders = Net profit after interest and tax
Share holders fund

5) Return on Net Worth = Return on Net worth * 100
Net worth

6) Return on capital employed (or) Return on investment = Return (EBIT)
Capital Employed

7) Expenses Ratios :-

a) Direct expenses Ratios : -
i) Raw material consumed * 100
Sales
ii) Wages * 100
Sales
iii) Production Expenses * 100
Sales

54
b) Indirect expenses Ratios : -
i) Administrative Expenses * 100
Sales
ii) Selling Expenses * 100
Sales
iii) Distribution Expenses * 100
Sales
iv) Finance Charge * 100
Sales

Notes : -
• In the above the term “term” is used for business engaged in sale of goods,
for other enterprises the word “revenue” can be used.
• Gross profit = Sales – Cost of goods sold
• Operating profit = Sales – Cost of sales
= Profit after operating expenses but before Interest and tax.
• Operating Expenses = Administration Expenses + Selling and distribution
expenses, Interest on short term loans etc.
• Return = Earning before Interest and Tax
= Operating profit
= Net profit + Non operating expenses – Non operating Income
• Capital employed = Share holders fund + Long term borrowings
= Fixed assets + Working capital
• If opening and closing balance is given then average capital employed can be
substituted in case of capital employed which is
Opening capital employed + Closing capital employed
2

E) Debt service coverage ratios = Profit available for debt servicing
Loan Installments + Interest

Notes : -
• Profit available for debt servicing = Net profit after tax provision +
Depreciation + Other non cash charges + Interest on debt.

Remarks : -
• Higher the debt servicing ratio is an indicator of better credit rating of the
company.
• It is an indicator of the ability of a business enterprise to pay off current
installments and interest out of profits.

55

F) Turnover Ratios: -

i) Assets turnover = Sales
Total assets

2) Fixed assets turnover = Sales [Number of times fixed assets has
Fixed assets turned into sales]

3) Working capital turnover = Sales
Working capital

4) Inventory turnover = Cost of goods sold
(for finished goods) Average inventory

5) Debtors turnover (or) Average collection period = Credit sales (in ratio)
Average accounts receivable
(or) = Average accounts receivable * 365 (in days)
Credit sales

6) Creditors turnover (or) Average payment period Credit purchases (in ratio)
Average accounts payable
(or) = Average accounts Payable * 365 (in days)
Credit Purchases

7) Inventory Turnover (for WIP) = Cost of production
Average Inventory (for WIP)

8) Inventory Turnover (for Raw material) = Raw material consumed
Average inventory (for raw material)

10) Inventory Holding Period = 365 .
Inventory turnover ratio

11) Capital Turnover ratio = Cost of sales
Capital employed

Note : -
• Working capital = Current asset – Current liability
= 0.25 * Proprietary ratio
• Accounts Receivable = Debtors + Bills receivable
• Accounts payable = Creditors + Bills Payable

56

Remarks : -
• If assets turnover ratio is more than 1, then profitability based on capital
employed is profitability based on sales.
• Higher inventory turnover is an indicator of efficient inventory movement. It
is an indicator of inventory management policies.
• Low inventory holding period lower working capital locking, but too low is
not safe.
• Higher the debtors turnover, lower the credit period offered to customers. It is
an indicator of credit management policies.
• Higher the creditors turnover, lower the credit period offered by suppliers.

G) Other Ratios: -

1) Operating profit ratio = Net profit ratio + Non operating loss / Sales ratio

2) Gross profit ratio = Operating profit ratio + Indirect expenses ratio

3) Cost of goods sold / Sales ratio = 100% - Gross profit ratio

4) Earnings per share = Net profit after interest and tax
Number of equity shares

5) Price earning ratio = Market price per equity share
Earning per share

6) Pay out ratio = Dividend per equity share * 100
Earning per equity shares

7) Dividend yield ratio = Dividend per share * 100
Market price per share

8) Fixed charges coverage ratio = Net profit before interest and tax
Interest charges

9) Interest coverage ratio = Earning before interest and tax
Interest charges

10) Fixed dividend coverage ratio = Net profit .
Annual Preference dividend

11) Over all profitability ratio = Operating profit * 100

57
Capital employed

12) Productivity of assets employed = Net profit .
Total tangible asset

13) Retained earning ratio = Retained earnings * 100
Total earnings

H) General Remarks: -
• Fall in quick ratio when compared with last year or other company is due to
huge stock pilling up.
• If current ratio and liquidity ratio increases then the liquidity position of the
company has been increased.
• If debt equity ratio increases over a period of time or is greater when
comparing two ratios, then the dependence of the company in borrowed
funds has increased.
• Direct expenses ratio increases in comparison then the profitability decreases.
• If there is wages / Sales ratio increases, then this is to verified
a) Wage rate
b) Output / Labour rate
• Increment in wage rate may be due to increased rate or fall in labour
efficiency.
• Again there are many reasons for fall in labour productivity namely abnormal
idle time due to machine failure, power cut etc.
• Reduction in Raw material consumed / sales ratio may be due to reduction in
wastage or fall in material price.
• Increase in production expenses ratio may also be due to price raise.
• Stock turnover ratio denotes how many days we are holding stock.
• In stock turnover ratio greater the number of days, the movement of goods
will be on the lower side.
• Financial ratios are Current ratio, Quick ratio, Debt equity ratio, Proprietary
ratio, Fixed asset ratio.
• Short term solvency ratios are current ratio, Liquidity ratio
• Long term solvency or testing solvency of the company ratios are Debt equity
ratio, fixed asset ratio, fixed charges coverage ratio (or) Interest coverage
ratio.
• To compute financial position of the business ratios to be calculated are –
current ratio, Debt equity ratio, Proprietary ratio, fixed asset ratio.
• Fictitious asset are Preliminary expenses, Discount on issue of shares and
debentures, Profit and loss account debit balance.

58

Assignment

1) Basis of Technique used is minimization Technique

2) It can also be done in maximation Technique

3) Various steps in Assignment Problem are

Step 1: Check whether the problem is balanced or unbalanced by checking
whether row is equal to column, if unbalanced add dummy column or
row to balance the problem

Step 2: Identify Least Number in each row and subtract with all number in that
Row.

Step 3: Identify least number of each column and subtract with all number in that
column.

Step 4: Check whether solution is reached with zero selection in one row and
column, ie. Cover all the zero with minimum number of lines, solution is
reached only when selected zeros is equal to number of rows or columns
or number of lines is equal to order of matrix.

Step 5: If solution is not reached so maximum sticking

Step 6: Select the least element in within the unstriked Element

Step 7: The element selected above is
i) Subtracted with all the unstriked element
ii) Added to all the double striked element (Intersection of two
lines)

Step 8: Check the solution

Step 9: If solution is not reached continue with the process from step 5.

59

Linear Programming

Simplex Method:-
Steps:-

1. Determine the objective function Z. Objective may be maximization or
minimization.

2. For maximation problem the constraints would be < sign.
For minimization problem the constraints would be > sign.

3. Introduce slack variable
For < sign – add the slack variable ie. Add S1
For > sign – subtract the slack variable and add artificial variable
ie. Subtract S1, add A1.

4. Change the Objective function
For S1 – Add ‘0S1’
For A1 – Add ‘MA1’

5. Simplex table format:-
Cj
Quantity Variable Const. X Y Z S1 S2 RR
S1
S2
Zj
Cj -
Zj

6. Zj is arrived by summation of constant column with X,Y,Z columns

7. Criteria for selecting the key column :-
For Maxima ion Problem – Highest value of Cj – Zj
For Minimization Problem – Lowest Value of Cj – Zj

8. Divide the Quantity Column with Key column to arrive at RR

9. Criteria for Selecting the Key row :-
For Maximation & Minimization Problem – Lowest Positive RR is selected

60

10. The Meeting Point is key Element

11. Criteria for deciding the optimal solution
For Maximation Problem – All elements in Cj – Zj row is negative or zero.
For Minimization Problem – All elements in Cj – Zj row is positive or zero

Note – For finding whether all the elements in Cj – Zj row is positive or zero
for minimization problem substitute all the ‘M’ with highest value.

12. If solution is not reached next table is formed.

13. Input for next table is
First key row in the next table is filled by dividing all the numbers in the key
row of the previous table with the key element.
Remaining all the rows is arrived as follows: -
Corresponding previous _ (Value relating to that * Corresponding
Table row element row in the key column element in key row
in the 2nd table as
filled in previous
step)

14. Check the optimal solution, if not reached form the third table.

15. If solution is reached then answer is amount in quantity column
corresponding to the variable.

Other Points : -

• We can convert the Minimization Problem into Maximation Problem. This is
known as duality.

• We can change the > sign to < sign to match the problem
E.g. X + Y < 100
is converted into -X - Y > -100

61

Transportation

• The procedure followed is Minimization Procedure

• Problem is generally solved in Vogel’s Approximation Method(VAM)

• Steps for the problem is : -
1. Convert profit matrix into loss matrix.

2. Balance the problem.

3. Arrive at Row penalty and column penalty
Row penalty and column penalty is calculated at (2nd least – 1st least) in the
corresponding row or column.

4. Select from the entire Row penalty and column penalty maximum number.

5. From the entire Row or Column minimum is selected.

6. Strike the row or column which gets eliminated.

7. Continue until the entire item in the table is strike.

8. Write separately Initial solution table.

9. Check for Degeneracy. Degeneracy occurs when all the elements in the initial
solution is equal to (Row + column – 1)

10. If degeneracy occurs introduce efcilon – ‘e’. ‘e’ is introduced in least
independent cell.

11. Form UV Matrix. It is formed by the element in the original solution
corresponding to the element in the Initial solution.

12. Find unalloted elements in the UV Matrix

13. Find Ij i.e.(Original Matrix element – Unalloted element found above)

14. Check for optimal solution ie. All items must be zero or positive.

62

15. If not reached select the maximum negative in Ij matrix.

16. Form a loop and reallocate the solution.
17. Repeat from step 9.

Notes: -

1. If there is zero in Ij matrix while arriving at optimal solution then there is
another solution for the problem.

2. Dummy column can be introduced in profit or loss matrix.

3. If there is penalty/redundancy payment for unsatisfying demand etc. is given
then fills the dummy row or column with that amount or fill it with zeros.
4. If there is constraint in the problem first satisfy the constraint and then solve.

5. various other methods for solving the problem is
• Least cost method
• North west corner rule

6. Generally VAM method is used

63

Network Analysis (CPM/PERT)

CPM
• Total float = LS – ES (or) LF – EF

• Free float = Total float – Head event slack

• Independent float = Free float – Tail event slack

• In the diagram Es = Lf in the critical path

• Critical path is the longest duration

• To find the minimum time associated cost (i.e. Additional cost incurred per
unit of time saved) following formula is used :-
Crash cost per day (or) Activity cost supply
= Crash cost – Normal cost
Normal time – Crash time

• Interfacing float = It is the part of the total float which causes reduction in the
float of the succession activities. In other words it is the portion of activity
float which cannot be continued without affecting adversely the float of the
subsequent activity or activities.

• Steps in proceeding the problem : -

2. First find and fill the ES and LF column from the diagram.

3. Then find LS and EF as follows :-
Ls = Lf – Duration
Ef = Es + Duration

4. Find total float

5. Find free float. Wherever total float column has zero free float column is also
taken has zero and remaining elements is filled as said above

64
6. Find Independent float. Wherever free float column has zero Independent
float column is also taken has zero and remaining elements is filled as said
above

Notes: -
1. ES = Earliest Start. Indicates earliest time that the given activity can be
scheduled
2. EF = Earliest Finish. Time by which the activity can be completed at the
earliest.

3. LF = Latest Finish. Latest allowable occurrence time of the head event of the
activity.

4. LS = Latest Start.

5. Total duration of the critical path is the maximum time/amount consumed for
the activity. This should be crashed with respect to crashing days and
crashing cost. This crashing should not change the critical path.

PERT : -

• Expected (or) Average time is found by assigning weights as follows : -
1 for optimistic
4 for Most likely
1 for pessimistic
Average time = 1 optimistic + 4 most likely + 1 pessimistic
6
• Standard Deviation = (Pessimistic time – Optimistic time)
6
• Variance = (Standard Deviation)2

• Probability of completing the project in N days
= Required time(N) (-) Expected time (critical path duration)
Standard Deviation
[Nothing but Z = (X - Mean) / Standard deviation]
= Y (say)
= Find Z(y)
= Probability %
- If required time > Expected time then = 0.5 + Z(Y)
- If required time < Expected time then = 0.5 – Z(Y)

65

Learning Curve

Learning is the process of acquiring skill, Knowledge, and ability by an
individual. According to learning curve theory the productivity of the worker
increases with increase in experience due to learning effect. The learning theory
suggests that the best way to master a task is to “learn by doing”. In other words, as
people gain experience with a particular job or project they can produce each unit
more efficiently than the preceding one.

The speeding up of a job with repeated performance is known as the learning
effect or learning curve effect.

The cumulative average time per unit produced is assumed to fall by a
constant percentage every time the total output is doubled. So generally learning
effect is found in the multiples of 2. If learning curve effect is asked between two
even numbers then Learning curve equation is formed ie. Learning curve effect is
expressed mathematically as follows:

Learning curve equation =
Y = a(x) -b Where Y = Average time per unit
a = Total time for first unit
x = Cumulative number of units manufactured
b = the learning curve index

Learning curve index (b) = log (1- % decrease)
Log 2

66

Management Accounting and Financial Analysis

International Financial Management

1. Direct Quote (eg) 1$ = Rs.49

2. Indirect Quote (eg) Rs.1 = .0204$

3. TT Rate = Telegraphic Transfer Rate

4. TOM Rate = Tomorrow Rate

5. Spot Rate = Today’s rate. Normally it will be 3td day rate from TT Rate.

Direct Quote is used in all country except UK where indirect quote is used.

Offer Rate = Selling Rate

Spread Rate = Offer Rate – Bid Rate

Spread Rate (%) = Offer Rate – Bid Rate * 100 (111lr to that of NP Ratio)
Offer Rate

Swap points is ascending stage it is at premium. If it is descending stage it is
at discount.

If it is said as INR/$ then the meaning is
• Numerator factor = Local Currency = INR
• Denominator factor = Foreign Currency = $

Forward Quotation (%) (I.e. Premium/Discount expressed at annualized %)
= Forward Rate – Spot Rate * 12 * 100 (in months)
Spot Rate n

= Forward Rate – Spot Rate * 365 * 100 (in days)
Spot Rate n

67
If the quote is direct or Indirect is to be found and the relation is with
£ (pound) both direct and Indirect quote is to be said.

Maturity Value = P (1+r) n

Interest Rate Parity:
i) Domestic Rate < Foreign Rate + Forward Premium / Discount
(In this case invest in foreign currency)
ii) Domestic Rate > Foreign Rate + Forward Premium / Discount
(In this case invest in Domestic Currency)

Forward Rate: It is rate negotiated for the delivery to be made / taken on a future
date for present transaction.

Future spot rate: It is actual rate prevailing on the agreed future date.

Other points:-
• Currency country which has less Interest rate will have forward rate at
premium and vice versa
• If two rates ie.20.23 / 35 is given then highest rate is offer rate, lowest
rate is bid rate.
• If INR / DG is given and we have to DG / INR then it is 1 / (INR / DG)
• 1 / (Bid Rate) = Offer Rate.
• 1 / (Offer Rate) = Bid Rate.

Interest rate swap: - Generally interest rate differs from company to company
because of their grade (reputation) and rates can be fixed rates or floting rate. If there
is 2 company under different grade and different fixed / floating rate can gin
advantage by reducing their interest rate by “Interest rate swap”.

In this if ‘Company A’ wants to borrow at floating rate and ‘Company B’
wants to borrow and fixed rate, then interest rate swap is applied by which company
A borrows at floating Rate of company B and company B borrows at fixed rate of
company A. By this swap one company gains and other company losses. Net gain is
splited between two companies so that the two companies benefits by paying lower
interest rate for their barrowing.

To look at the problem quickly the theory followed in “Difference in fixed
rate interest of two companies is profit” and “Difference in floating rate interest of
two companies is loss”. Then net gain / loss are found.

68

Capital Budgeting

Process of Capital Budgeting:

• Huge cash outlay.
• Decision taken is irressable.
• Invest in lumsum the receipt is piecemeal
• Wrong decision will affect the very base of the company.

Capital Budgeting Rules:

• Ignore accounting profit and take only cash flows.
• Try only incremental basis ignore Average calculation.
• Consider all incidental effects.
• Ignore sunk cost (ie. Cost remain unaltered for various alternatives available
is sunk cost)
• Consider opportunity cost (Opportunity Loss is Opportunity cost)
• Beware of allocated cost – Ignore them
• Depreciation is an important cash flow when taxation is considered. If no
taxation, no depreciation.
• Interest should not be considered as part of the cost, in the arrival of cash
inflow for investing decision problems. If deducted add back post tax interest.
• Separate investing decision and financing decision.
• Be consistent with inflation rates. All future cash flows is assumed as without
inflation. Such cash flows are referred as real cash flows.
• Cash flows under the influence of inflation would be referred to as money
cash flows. (Money cash flows (or) Nominal Cash Flows (or) Market cash
flows)
• Unless otherwise stated cost of capital is considered after tax basis because
cash flows will be considered only on after tax basis. (PV factor is the inverse
of compounding factor)
• Equation to find out the PV of an amount if cost of capital and Inflation rate
is given
(1 + Money Rate) = (1 + Real Discount rate) * (1 + Inflation Rate)

69
Method of evaluating Capital Budgeting:

1. Pay back method
2. Annual Rate of Return
3. Discounted cash flow
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI) (or) Benefit cost Ratio
• Equated Annuity Cost (EAC) (or)
Equated Annuity Benefit (EAB)
• Discounted Pay Back (or) Time adjusted BEP

Expressed Bench mark Formula When to use
In (Basis of
Selection)
Pay Back Years Shortest Recovery time When no cost of
Period of investment capital is given
Annual Rate % Highest 1) AR / II When no cost of
Of Return 2) AR / AI capital is given
NPV Rs. Greatest Discounted CI When two projects is
Value - Discounted CO same in all aspects
ie. No disparity
IRR % Highest At this rate Rarely used in
Discounted CI = finding Cost of
Discounted CO Capital.
and NPV = 1,
PI = 1
Profitability Points Highest Discounted CI Size Disparity
Index (PI) Discounted CO
EAC (or) Rs. EAC = EAC = Life Disparity
EAB Lowest Discounted CO
EAB = PV Factor
Highest EAB =
1) Discounted CI
Annuity Factor
2) NPV
PV Factor
Discounted Years Shortest Recovery time Break even time
Pay Back of Investment

Where: - AI = Average Investment CI = Cash Inflow
AF = Annuity Factor CO = Cash Outflow

70
II = Initial Investment

Capital Budgeting
Problems

Mutually Mutually
Size Life
Exclusive Inclusive

Internal Rate of Return (IRR):-
IRR otherwise called as yield on investment, Marginal efficiency of capital,
Marginal productivity of capital, Rate of Return, Time adjusted rate of return.

Discounting + Difference calculated in present value and required cash outlay
Factor Difference in calculated present values
* Difference in Rate

To approximately locate the factor in which the amount returns
F = I / C Where F = Factor to be located
I = Original Investment
C = Average Cash Inflows per year
In the PV table year column must be seen to trace the nearest fake annuity.
Year column is the year of economic life of machine.

Notes: - If actual cash flow is higher than average cash flows in the initial years then
increase the fake IRR point a few % upward. If it is lower in the initial years then
decrease the percentage few points lower to find fake IRR

If discount rates are not known but cash inflows and outflows are known then
IRR is calculated as I = R / (1+r)
Where I = Cash outflow (or) Initial Investment
R = Cash inflow
R = Rate of return yielded by the Investment (or IRR)

Calculating Discounting Factor:-
1 / (1+rate) n Where n = Years

Method of ranking projects:-
Desirability factor (Profitability Index) vs. NPV Method vs. IRR
Selection of projects out of two mutually exclusive projects having same
funds at disposal then NPV method is preferred.
In IRR Method the presumption intermediate cash inflows are reinvested at
same rate i.e. IRR. But in NPV method it is reinvested at cut off rate.

71
Reinvestment at cut off rate is more possible than IRR. Hence Net Present
Values being obtained from discounting at a fixed cut off rate are more reliable in
ranking 2 or more projects than IRR.

Models of Risk Analysis:-
i) Hiller’s Model: He takes into account mean of present value of the cash flows and
the SD of such cash flows.

n
M = (1+r)-1 mi (used to determine the present value of mean)
i=0
n
2
= (1+r)-2i * 2
i (Used to find the present value of variance)
i=0
Where mi =Mean of cash flow in the ith period – expected cash flow for year i
2
i = Variance in the ith period.
r = Discounting Factor
M = Total of Present value of mean
2
= Total of present value of variance
Bench mark = Project with lower SD will be preferred.

1) Real Cash flows restated in terms of nominal cash flows as follows:-
(1 + inflation rate) * Real cash flows
After this discounting cash flow is applied to find NPV.

2) Converting nominal discounting rate into real terms
Real discount rate = 1 + Nominal discount rate -1
1 + inflation rate
With this real discount rate the Cash Inflows are discounted to find NPV.

3) Pay back reciprocal
= Average annual cash inflows (It is used for reasonable approximation of
Initial Investment IRR)

4) The formula for deflation is
Index Number at the beginning * Cash Inflows
Index Number at the end
(or) Cash Inflows / (1+Inflation Rate) n
Note: If in a problem Real cash flows are given and Inflation Rate and Cost of
Capital is given then
i) Convert Real Cash Flows into Normal Cash Flows by using formulae said in (1)
above.

72
ii) Adjust for Depreciation and tax and find Cash Flow after Tax before
Depreciation.
iii) Deflate the amount arrived above by using formulae said in (4).
iv) With the amount arrived above find NPV using COC.

Summary:-
i) Risk Adjusted Discount rate approach
= NPV for CFAT at Risk adjusted Discount Rate.
ii) Certainty Equivalent Approach
= NPV for (Certainty Equivalent Coefficient * CFAT) at Risk less Interest
rate.
iii) Probality Discount approach
= NPV for (CF) at risk less Interest rate.

73

Analysis of Risk and Uncertainty

1) Sensitivity Analysis: - It provides different cash flow estimates under 3
assumptions a. worst
b. The expected (Most likely)
c. The best.
NPV is found under these three assumptions and decision is taken.
2) Precise measure of risk:-
a) Standard deviation: - Absolute measure of risk.
n
= √ ∑ Pi ( CF – CF ) 2
i=1

CF = Cash flow i = Year
CF = Mean cash flow (CF of particular projects total divided by number of CF)
= ∑ CF * P
P = Probability

n
b) Variance = ( ) 2 = ∑ Pi ( CF – CF ) 2
i=1

c) Co – Variance (a,b) = Pi ( CFa – CFa ) ( CFb – CFb )

d) Coefficient of correlation of two variable factor = Co – Variance (a,b)
a b
e) Return of portfolio = Wa * Ra + Wb * Rb Where W – Proportion invested
R – Return
2 2 2 2
f) Risk of portfolio = √ Pa * a + Pb * b + 2Pa * Pb * a * b * Cor(a,b)

g) Co – Efficient of variation = A relative measure of risk.
Standard Deviation
V= Expected cash flow mean (or CF
(or) )
(Or) Expected NPV (NPV
)

NPV = NPV * Probability

74
h) Risk adjusted discount rate approach: - In this risk adjusted discount rate is taken
as PV factor and calculated as NPV method.
=∑ (CFAT) t - CO Where Kr = Risk adjusted discount rate
(1 + Kr) t
i) Certainty Equivalent (CE) approach = Risk less Cash Flow
Risky Cash Flow

j) If Correlation Coefficient [Cor(a,b)] is
Cor(a,b) p .
+1 (Pa * a) + (Pb * b) [ie. If it is perfectly positively correlated]
-1 (Pa * a) – (Pb * b) [ie. If it is perfectly negatively correlated]
0 Above p formula will apply

k) Probability Distribution approach: -

t (SD of CF) = √ ∑ p (CF – CF)2 = ∑ CF - CO = NPV
(1+i) t
Where
CF = Cash Flow CF = Mean i.e. Total of cash flow multiplied by probability
for the period (or) expected value for CFAT in period t)
i = Risk less rate of interest.
t = SD for period t (SD for particular period)

l) SD for the probability distribution of NPV is (ie. SD of CF)
(NPV) = √ ∑ ( t2) / (1 + i) 2t (this is used for uncorrelated CF)
(NPV) = ∑ ( t) / (1 + i) t (used for perfectly correlated CF)
Where I = Rate of Return.

m) Optimum proportion at which risk is minimum = Xa = b / ( a + b)
(or) a X - b (1-X) = 0
NPV for the period is calculated by taking CF as CF for respective period and
calculated normally

Note:-
i) In certainty Equivalent approach rate of discount is the risk less rate of
Interest as the risk is adjusted with CFAT.
ii) In this case CFAT is multiplied with certainty equivalent and PV is
calculated by risk less rate of interest.
iii) If projects are ranked with respect of risk and return. Project with respect
to risk requires ∑ NPV (i.e. ∑(NPV * Probability)) and the project with respect
to
return find co-efficient of variation = / ∑ NPV

75

iv) Probability that NPV would be Zero or less
Z = 0 – NPV The Z Value is converted with the ‘Z Table’
values and the probability of the NPV being
zero or less would be = 0.5 – (Z Value).
v) Probability that NPV being greater than Zero would be
1 – (Probability less than Zero)

vi) Probability that NPV within the range X and Y
Z1 = X – NPV Z2 = Y – NPV

vii) If in the Risk adjusted Discount approach both cost of control and Risk
adjusted discount rate is given
• For the CF of the years apply Risk adjusted discount rate to find
Discounted CF.
• For the Scrap value of the machine after the end of the life the CF on
sale is discounted at cost of capital % to find Discounted CF.
viii) If probability (or) Certainty equivalence is given then find the Adjusted
CF (CF * Probability) and then use the Risk less Rate of return to find Discounted
CF.
ix) Risk is Standard deviation

Summary:-
i) Risk Adjusted Discount Rate Approach
= NPV for CFAT at Risk Adjusted Discount Rate
ii) Certainty Equivalent Approach
= NPV for (CE coefficient * CFAT) at Risk less interest rate
iii) Probability Discount Approach
= NPV for (CF) at Risk less Interest Rate

76

Derivatives

Call Option: - Gives buyer “Right but not the obligation” to buy the share.
Put Option: - Gives buyer “Right but not the obligation” to sell the share.

Value of the Call Option:-
i) Black Scholes Model:-
Value of the call option = VO
= [S * N (d1)] – [(x) * (e-t*rf) * (N (d2))]
Where d1 = ln (s/x) + (rf + { 2 / 2}) * t
√t
ln = Natural log
d2 = d1 - √t
s = Present spot rate
x = Future strike (excise) price
rf = Risk free rate

Seven step to solve the problem:-
i) Find log (s/x)
ii) Find d1
iii) Find d2
iv) Find N (d1)
v) Find N (d2)
iv) Find N (d1) Normal Table
v) Find N (d2) Value
+ 0.5

vi) Find ‘e’ value
vii) Apply Black Schools Model.

Sub step to step 1:-
a) Log (s/x) = Log s – Log x
0.4343
b) If x and s are 2 digit figure the value shall be (1 + Log table value).
c) If x and s are 3 digit then the value shall be (2 + Log table value).

Sub step to step 6:-
a) It is to find the power value of ‘e’.
b) e-t*rf = 1 (or) 1 .
1 + r/365 * No. of days (t) 1 + r/365 * No. of Months (t)

77
Value of Put option: -
= [(x) * (e-t*rf) * (N (-d2))] - [S * N (-d1)]

Excise price:-
It is the price at which the person writes the prices on a share to buy after a
period.
Expected Value of the share:-
It is the total of estimate market price of the share multiplied with the
respective probability.

Expiration value: - Excise price – Expected Value

Expected (or) Theoretical value of the call option price at expiration (Pay off of Call
option) :-
= ∑ (Estimated market price – Excise Price) * Probability (or)
= [Max (s – x), 0] * Probability

Pay off of call option

Expected (or) Theoretical value of the put option price at expiration (Pay of put
option):-
= ∑ (Excise Price - Estimated market price) * Probability (or)
= [Max (x – s), 0] * Probability

Pay off of Put option

Where (Estimated market price – Excise Price) is called pay off. If it is negative it is
taken as zero.
s = Estimated Market Price.

Put call parity = Put call parity equation is
(Value of call option + Present value of excise price) = (value of put option +
Spot rate)

Note:-

i) Changes to be made in computation of Black Scholes model for dividend stocks:-
Substitute in all the places of “s” with “s – PV of dividend”
ii)In the above all PV is found at Risk free rate.

78

Beta

Beta means, it measures the volatility of securities to the changes in the
market.

β (level of risk) = s * Cor (s,m) where s = SD of return on securities
m m = SD of return on market portfolio
(or) Covariance(s,m) / 2m
β should always be applied on risk premium and not to the entire return.

rs = rf + (rm – rf ) * β Where rf = Risk free rate
rs = Expected return on securities (or) [Capital
Appreciation + Dividend of the
company]
rm = Expected return on market portfolio (or)
[Market index {Market rate} appreciation + Market dividend yield
%]

Portfolio Theory (PT):-

rp (expected return under CML) = rf + (rm – rf) * ( p / m)
The above formula is based on total risk.
Where p = SD of efficient portfolio.

When expected return under efficient portfolio is asked then
rp (expected return under efficient portfolio) = Capital market line(CML) –
Express equilibrium price relationship between expected return and DS

Capital Asset Pricing Model (CAPM):-
rs (expected return portfolio in CAPM) = rf + (rm – rf) * [( s / m) *
cor(s,m)]
(or) rf + [(rm – rf)] * β

Where rm = rf + Market premium

Beta of the portfolio = ( βa * Pa ) + ( βb * Pb )

Where Pa, Pb = Proportion of investment in Company A and Company B.

Note:-

79
i) (rm – rf) = Market risk premium (or) Compensation per unit of risk.
ii) Cor(s,m) is +1 under CML
iii) rf + (rm – rf) * [( s / m) * cor(s,m)] = This portion in CAPM formula is
risk premium
iv) (rm – rf) / m = Market risk return trade off (slope).

Notes:-
To find the investment to be made in risk free investments to get a certain β is

β of expected portfolio = (W1 * β1) +(W2 * β2)
(or) = (W1 * β1) + (1-W1) β2

Where W1 is weitage given to existing securities.
W2 is weitage given to risk free securities.

In this case β1 is β of existing securities and
Β2 is β of rf securities (ie.0)
This can also be use to find investment in other then rf securities. In that case
that β is substituted in β2.

The weitage (W1,W2) is multiplied with market value of existing portfolio to
find the proportion of investment.

80

Holding Companies

Index of Main Points:-

1. If there is a Debit balance in Minority Interest first it is adjusted against
uncalled capital and balance is adjusted against reserve.
2. In case of Cumulative Preference shares of subsidiary dividend declared must
be deducted from P & L a/c of subsidiary.
3. If no dividend is declared in above case then don’t deduct.
4. If dividend is declared for Cumulative Preference shares then deduct from
P & L a/c of subsidiary and balance is splited. If not declared then it must be
shown outside the Balance sheet.
5. But in the case1
6. CFS deduct in the above case whether declared or not.
7. Preference shares of subsidiary held by the holding company is to be
cancelled against investment of Holding company while preparing CFS.
8. If Holding company sells goods below cost then unrealized loss is calculated
by taking cost or Net Realizable Value whichever is lower for valuation.
9. If there is difference in accounting policy between Holding and subsidiary
then both should be brought under uniform policy before consolidation.
10. If uniform policy cannot be brought then it should be disclosed.
11. The effect of change in Accounting Policy before acquit ion must be taken as
pre acquit ion reserve and after post acquit ion reserve.
12. If Holding Company holds Debenture in subsidiary then while preparing CFS
it should be cancelled as Inter Company loan.
13. In above case if excess is paid for Debenture holders then the excess is
adjusted against consolidated reserve.
14. Pre acquit ion reserve and profit is treated as capital profit
15. Post acquition reserve and profit is treated as revenue reserve and revenue
profit respectively.
16. Miscellaneous expenses of subsidiary must be deducted against reserve as
Capital or Revenue Reserve.
17. In case of Inter Company transactions if it is down stream then unrealized
profit of Holding company must be adjusted against Consolidated P & L a/c.
18. In case of Inter Company transaction if it is upstream it is splited into two as
belonging to Holding company and Minority Interest and the former is
deducted against Consolidated P & L a/c and Minority Interest is deducted
from computation of Total Minority Interest.
19. Post acquit ion dividend received is to be retained in P & L a/c.
20. Pre acquit ion dividend received is to be transferred from Holding company
P & L a/c to Cost of Investment.

81
21. Post acquit ion dividend receivable (Proposed) by Holding company out of
subsidiary current year profit is to now credited to Holding company
Consolidated P & L a/c.
22. In case of analysis of profit Proposed Dividend must be deducted from
current year profit only.
23. If in the above case if there is inadequate profit for dividend, the
appropriation should be done 1st out of current year profits and thereafter out
of b/f profit.
24. In case Inter Company sale or purchase is carried between two subsidiaries
then for consolidated stock it is considered as it is 1st transferred from one
subsidiary to Holding – upstream rule apply and then from Holding to 2nd
subsidiary – Down stream rule apply.
25. In Inter Company transaction if there is sale of Fixed Asset between Holding
and Subsidiary unrealized profit should be removed only to the extent of
unamortized portion.
26. In the absence of information regarding rate of depreciation, depreciation
must be ignored.
27. In case of acquition and sale of shares, profit on such sale must be included in
P & L a/c while calculating reserves for CBS.
28. In the event of current year dividend is greater than the trading profits AND
if there is another source of income i.e. Subsidiary dividend then the dividend
declared must be deducted only in Apportionment of profits.
29. Inter corporate loans in general refer to borrowings from corporate bodies.
30. In case of reverse working
for stock consolidation = Company A + Company B – Stock reserve
for Debtors and creditors = Company A + Company B – Inter company
consolidation transactions
31. In case of Associate accounting Inter Company transaction should not be
cancelled only Holding company interest of unrealized profit is only taken.
32. Losses in associate are taken only up to the liability in share capital.
33. Minority Interest calculation is not applicable in case of associate accounting.
34. In the case where subsidiary company is foreign company then convert the
accounts into Indian Currency and remaining are same. For conversion rules
applicable are:-
Share capital – Rate on the date of acquition of share.
Reserves – Pre – Rate on the date of acquition
Post – Average rate
Current Assets, Current liabilities – Closing rate
Fixed assets, Investments – Rate on the date of acquition
35. Exchange rate difference which occurs on the above conversion is to be
setoff against post acquition Profit / Reserves and the balance is only to be
apportioned for consolidation procedure.

82
36. In case of two or more acquition by Holding Co. (or) acquition and sale, In
all the cases date for apportionment etc is the date of 1st acquition and share
holding pattern is the final share holding pattern.
37. In case of Associate accounting, to find the carrying amount of Investment of
the associate in the consolidated balancesheet the calculation is similar to
minority interest. Only difference is to add the goodwill found in COC.
,ie, Share Capital ***
(+) Capital Profit ***
(+) Revenue Profit ***
(+) Goodwill *** ***

83

Amalgamation

Index of Main Points:-

1. Points to be satisfied to treat the amalgamation in the nature of merger
• All assets and liabilities of transforer is to be taken over at their book
values by resulting company
• All or at least 90% of the Share Holding of Amalgamating Company
must be the Share Holders of Amalgamated Company.
• Equity shares of selling company must be given only equity shares of
purchasing company.
• Liabilities of Transferor must not be discharged; it must be taken over
by the resulting company. But exemption is the fraction shares can be
given in cash.
• Same risk and return and nature of company must be same.
2. Order of Adjustment of consideration is first General Reserve and then P & L
a/c. If the problem has statutory reserve it should not be adjusted. It is carried
over as such.
3. As per SEBI guidelines, underwriting commission is 2.5% on equity shares
and on 1st 5000 Preference Shares it is 1.5% and the balance Preference
Shares it is 1%.
4. Capital employed is considered as Net Revaluation amount of Tangible
Asset.
5. In case purchasing company holding shares in selling company, Net asset
method is applied as usual and outside shareholders portion is calculated
separately as balancing figure.
6. If in the above case, settlement of equity share holding of selling company is
given then that exchange pertains to outside share holder’s settlement and it
should not be splitted.
7. In the books of selling company the shares held by the purchasing company
must be cancelled by transferring it to realization a/c
Equity share capital a/c Dr
To Realization
8. If Preference share holders of selling company is discharged by preference
share holders of purchasing company at premium then the premium portion
must be transferred to realization a/c in the books of selling company.
9. In case of Merger while drafting Journal Entry in the books of purchasing
company for Incorporation of Asset & Liability in the workings, the
consideration is aggregate consideration including shares already purchased
by purchasing company and current purchase payable.

84
10. In case of merger in the books of purchasing company while calculation
excess / shortage to be adjusted against the reserve of selling company. The
purchase consideration is aggregate consideration including amount already
paid (shares of selling company held by purchasing company) + amount now
paid (amount paid to outsiders).
11. Business purchase in case of shares of selling company held by purchasing
company is the amount given to outsiders only.
12. If in the asset side of selling company Debtors is given as Gross (–)
Reserves / Provision for Doubtful Debts then in the books of selling company
while transferring all assets and liabilities to realization account Debtors is
transferred at gross amount and provision is transferred along with liability.
But in the above case in the books of purchasing company while
incorporating assets and liabilities of selling company debtors is taken net of
provisions.
13. On entry for takeover of assets and liabilities of selling company in
purchasing company books – Assets debited must be excluding goodwill in
purchase method and difference in debit or credit is treated as Goodwill /
Reserves.
14. Investment allowance Reserve is not a current liability.
15. When purchasing company holding shares in selling company then the shares
held by purchasing company must be cancelled in the selling company books.
16. While canceling the shares held by the purchasing company it must be
cancelled at fair value.
17. To bring the reserve like Investment allowance reserve in purchasing
company books the entry will be Amalgamation adjustment a/c Dr
To Investment allowance reserve
In the amalgamated B/S investment allowance reserve will appear in
the liability side and amalgamation adjustment account will appear in the
asset side for same amount.
18. Incase of Inter Company holding if divided is declared by any one company
then dividend receivable by other company is to be 1st incorporated as pre
amalgamation event. Dividend receivable account Dr
To P & L a/c
Entry in the 1st company which has declared dividend P & L a/c Dr
To proposed dividend
19. In case of Internal reconstruction cancellation of Arrears Dividend forgone
by shareholder will not affect the B/S. So no entry. In this case Arrears of
dividend is seazed to be contingent liability. Preference shareholders will
seize to have the voting right at par with equity shares which was available
due to arrears of dividend.
20. In Demerger while making transfer entry of Asset and liability in purchasing
company fixed asset net is to be taken but while making the transfer entry in

85
selling company fixed asset gross is taken in credited and provision for
depreciation is debited.
21. In case of Inter Company / Single side holding etc. to find the intrinsic value
of each company, the investment held by one company in the shares of other
company is also to be valued as intrinsic value only and not to be taken at
book value. For inter company holding this intrinsic value of shares of each
company can be found by framing a linear equation.
22. In case of calculation of purchase consideration (Cross holding)
Total number of shares in selling company ***
(-) Share already held by Purchasing company ***
Number of shares held by outsiders ***
Value of above number of shares Rs. ***
Number of purchasing company to be issued to selling company ***
(-) Number of shares already held by selling company ***
Net number of shares purchasing co. has to issue to selling co. ***
23. In case of settlement of shareholders of selling company the amount will be
= Shares now received from purchasing company + Purchasing company
shares already held by selling company.
24. In amalgamated B/S if there is Debit in P & L a/c it should be netted of with
General Reserve as per schedule VI.
25. In case of assets and liabilities is taken over at revalued amount it is in the
nature of purchase and in the journal entry for incorporating account
takenover only the revalued amount is to be taken.
26. In case of selling company holding shares in purchasing company then
investment is to be valued at intrinsic value if specified.
27. In the above case of holding company gives shares at particular value to the
subsidiary company for settlement then investment is to be valued at the
value
28. When selling company holding shares in purchasing company then while
transferring assets and liabilities to realization account in selling company
books, Assets transferred must be excluding the Investment in purchasing
company.

2the notes

More Related Content

What's hot (17)

Similar to 2the notes (20)

2the notes