master of commerce...

Master Of Commerce

(MCOM)

MCO-3

Accounting for Managerial Decisions

Block-5

COST VOLUME PROFIT ANALYSIS

Unit-15 Marginal Costing

Unit-16 Break Even Analysis

Unit-17 Relevant Costs for Decision Making

Unit-18 Reporting to Management

Unit-19 Recent Developments in Accounting

UNIT 15 MARGINAL COSTINGStructure15.0 Objectives

15.1 Introduction

15.2 Segregation of Mixed Costs

15.3 Concept of Marginal Cost and Marginal Costing

15.4 Income Statement under Marginal Costing and Absorption Costing

15.5 Marginal Costing Equation and Contribution Margin

15.6 Profit-Volume Ratio

15.7 Managerial Uses of Marginal Costing

15.8 Limitations of Marginal Costing

15.9 Summery

15.10 Key Words

15.11 Answers to Check Your Progress

15.12 Terminal Questions

15.13 Further Readings

15.0 OBJECTIVESThe aims of this unit are:

! to introduce you with the concept of marginal costing;

! to explain the income statement under marginal costing and how it differs fromabsorption costing; and

! to discuss the merits and limitations of marginal costing along with developing amarginal cost equation uses of marginal costing in managerial decisions.

15.1 INTROUDCTIONThe elements of costs can be divided into fixed and variable costs. You have learntthese elements of cost in detail under Unit 2. You have also learnt that there arecertain costs which are a combination of fixed and variable costs. These costs arecalled semi-variable costs. It is necessary to segregate the mixed costs into fixed andvariable costs for managerial decisions. In this unit you will study about differentmethods of segregating mixed costs, the concept of marginal cost and marginal costingand its managerial uses in decision making.

15.2 SEGREGATION OF MIXED COSTSThe elements of cost can be divided into two categories. Fixed and variable costs.Fixed costs are those costs which do not very but remain constant within a givenperiod of time in spite of fluctuations in production Variable costs changes in directproportion to the change in output. There are certain costs, which are a combination offixed, and variable costs. It contains a fixed element as well as a unit cost for variable 1

2

An OverviewCost Volume ProfitAnalysis

expenses. Such costs increase with production but the change is less than theproportionate change in production. These costs are called semi-variable or semi-fixedor mixed costs. Example of these costs are depreciation, power, telephone etc. Rent ofthe telephone is fixed in a given period and per unit call charges is a variablecomponent. For decision making, it becomes necessary to segregate the mixed costsinto fixed and variable costs.

Methods of Segregating Mixed Cost

The following methods are applied to segregate the mixed costs into fixed costs andvariable costs:

1) Analytical Method : A careful analysis of mixed cost is done to determine howfar it varies with production. Some semi-variable costs may have 60 percentvariability while other have 40 percent variability. Accuracy of this methoddepends upon the knowledge, experience and judgement of the analyst. Thismethod is simple but not scientific.

2) High Low Method : This technique was developed by J.H. William. In thismethod, the difference in two production levels i.e. highest and lowest, arecompared out of the various levels. Since the fixed cost component remainsconstant, any increase or decrease in total semi-variable cost must be attributed tothe variable portion. The variable cost per unit can be determined by dividingdifference in total semi-variable cost with the difference in production units at twolevels.

Illustration 1

From the following information, find out the fixed and variable components.

Production (in units) Semi-Variable CostsRs.

100 1500

200 2000

250 2250

300 2500

Highest production is 300 units, then semi-variable costs is Rs. 2500. Lowest productionis 100 units, then semi-variable costs is Rs. 1500.

Variable cost per unit =Difference in CostsDifference in Volume

=Rs. 2500 – Rs. 1500 300 – 100

=Rs. 1000 = Rs. 5 200

Total semi-variable costs = Fixed cost + Variable costs per unit production

2500 = F + Rs. 5 × 300 units

F = Rs. 1000

High-low method is based on observations of extreme data, hence the result may notbe very accurate as it is based on extreme points and may not be true for normalsituation.

Marginal Costing

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Scatter Diagram Method

In this method, production and semi-variable cost data are plotted on a graph paper andtentative line of best fit is drawn. The following steps are involved :

! Volume of production is plotted on x-axis and semi-variable costs on y-axis.

! Corresponding semi-variable costs of each volume of production are plotted on agraph.

! A line of best fit is drawn through the points plotted. The point where this lineintersects with y-axis, depicts the fixed cost.

! Variable cost can be determined at any level by subtracting the fixed costelement. The slope of the total cost curve is the variable cost per unit

Total Semi-Variable Cost

Semi VariableCost

Fixed Cost

Output

The accuracy of line of best fit, depends upon the judgement and experience of theanalyst. One may draw slightly up or slightly down, the intercept on y-axis will changeor two analyst may draw a line having different slopes. This method involves analyst’ssubjectivity and may not give accurate results.

Method of Least Square :

This method is based on econometric technique, in which line of best fit is drawn withthe help of linear equations.

The equation of a straight line is

y = a + b x

Where ‘a’ is the intercept on y-axis and ‘b’ is the slope of the line. Hence ‘a’ is thefixed cost component and ‘b’ is the slope or tangent of the line or variable cost perunit. From the above equation, two equation can be drawn.

Σy = na + b ΣxΣxy = aΣx + bΣx2

Solving the equations, will give us the value of ‘a’ (fixed cost) and ‘b’ (variable costper unit).

Illustration 2

From the following semi-variable cost information, compute the fixed cost and variablecost components.

Production Semi-variable(Units) (Rs.)

100 1200200 1350150 1250190 1380180 1375

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Solution

Month Production X Semi-variable Y X2 XY

April 100 1200 10000 120000May 200 1350 40000 270000June 150 1250 22500 187500July 190 1380 36100 262200August 180 1375 32400 247500

Total ΣX = 820 ΣY =6555 ΣX2 141000 ΣXY = 1087200

ΣY = na + bΣ X

ΣXY = a ΣX + b ΣX2

Solving these equations

6555 = 6 a + 820 b

1087200 = 820 a + 141000 b

a = Rs. 1004.632

b = Rs. 1.868

After segregating the mixed costs into fixed cost and variable costs, the fixedcomponent is added to fixed costs and variable component to variable costs. Now wehave only two costs i.e. fixed costs and variable costs.

15.3 CONCEPT OF MARGINAL COST ANDMARGINAL COSTING

The term ‘Marginal Cost’ is defined as the amount at any given volume of output bywhich the aggregate costs are changed if the volume of output is increased ordecreased by one unit. In this context a unit may be single article, a batch of articles oran order. It is the variable cost of one unit of a product or a service. For example, thecost of 100 articles is Rs. 50,000 and that of 101 articles is Rs. 50,450, the marginalcost is Rs. 450 (i.e., Rs. 50,450 –50,000).

Thus, the total cost is the aggregate of fixed cost and variable cost and if production isincreased by one more unit, its cost can be computed as follows:

TCn = FC + vQ ………….. (1)

TCn+1 = FC + v (Q +1) ………….. (2)

∴ MC = v (Subtracting 1 from 2)

Marginal costing may be defined as “the ascertainment of marginal costs and of theeffect on profit of changes in volume or type of output by differentiating between fixedcosts and variable costs”. The concept of marginal costing is based on the behaviourof costs that vary with the production level. In marginal costing, costs are classifiedinto fixed and variable costs. Even semi-variable costs are analysed into fixed andvariable. The stock of work-in-progress and finished goods are valued at marginalcost. Marginal cost is equal to the increase in total variable cost because within theexisting production capacity, an increase in variable one unit of production will cause anincrease in variable costs only. The fixed costs remain same. In marginal costing, onlyvariable costs are considered in calculating the cost of product, while fixed costs aretreated as period cost which will be charged against the revenue of the period. Therevenue generated from the excess of sales over variable costs is called contribution.Mathematically,

Marginal Costing

5

Total sales – Variable costs = Contribution

Sales = Variable cost + Contribution

Sales – Variable cost = Fixed cost ± profit/loss

Contribution – Fixed costs = Profit

For example, the selling price of a product is Rs. 30 per unit and its variable cost isRs. 20, the contribution per unit is Rs.10. Let us take the following illustration how theprofit is determined by using marginal costing technique.

Illustration 3

From the following particulars find out the amount of profit earned during the yearusing the marginal costing technique :

Product A B C

Output (units) 10,000 20,000 60,000

Selling Price (per unit) Rs. 10 Rs. 10 Rs. 5

Variable cost (per unit) Rs. 6 Rs. 7.50 Rs. 4.5 0

Total Fixed Cost Rs. 80,000.

Solution

Statement of Cost and Profit (Marginal Costing)

Product

A B C TotalRs. Rs. Rs. Rs.

Sales Revenue 100,000 200,000 300,000 600,000

Marginal Costs 60,000 150,000 270,000 480,000

Contribution 40,000 50,000 30,000 120,000

Fixed Costs ---- ---- ---- 80,000

Profit ---- ---- ---- 40,000

Thus the technique of marginal costing assumes that the difference between theaggregate value of sales and the aggregate value of variable costs or marginal costs,provides a fund (called contribution) to meet the fixed costs and balance is the profit.The concept of contribution is a very useful tool to management in managerialdecisions making.

15.4 INCOME STATEMENT UNDER MARGINALCOSTING AND ABSORPTION COSTING

In marginal costing, the stock of work-in-progress and finished goods are valued atmarginal cost not including the fixed costs. Whereas under full costing or absorptioncosting, the cost of product is determined after considering both fixed and variablecosts.

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Let us explain the difference in the two methods with the help of an illustration givenbelow :

Illustration 4

GivenProduction = 100,000 units

Sales 90,000 units @ Rs. 3 per unitVariable manufacturing costs = Rs. 2 per unitFixed overheads = Rs. 50,000Selling and distribution costs = Rs. 10,000 of which Rs. 4000 is variable

Prepare the income statement under absorption costing and marginal costing.Solution

Income Statement(Under Absorption Costing)

Rs.

Sales 90,000 units @ Rs. 3 2,70,000Less: Manufacturing costs :Variable costs Rs.100,000 units @ Rs. 2 200,000Fixed overheads 50,000

2,50,000

Less : Closing stock 10,000 units 25,000 2,25,000

2,50 ,000 × 10 ,000100,000

Gross margin (Rs. 2,70,000 – Rs. 2,25,000) 45,000

Less : Selling and distribution costs 10,000

Profit (Rs. 45,000 – Rs. 10,000) 35,000

Income Statement(Under Marginal Costing)

Rs.Sales 90,000 units @ Rs. 3 per unit 2,70,000

Less : Marginal Costs

Variable manufacturing costs : Rs.

100,000 units @ Rs. 2 per unit 200,000

Less : Closing inventory of 10,000 units @ Rs. 2 20,000

1,80,000

Add : Variable selling and distribution costs 4,000 1,84,000

Contribution 86,000(Sales Rs. 2,70,000 – Variable Cost Rs. 1,84,000)

Less Fixed Costs :

Fixed overheads 50,000

Fixed selling and distribution 6,000 56,000

Profit (Rs. 86,000 – Rs. 56,000) 30,000

Marginal Costing

7

The profit computed under marginal costing is Rs. 5000 less in comparison to fullcosting. The closing stock under absorption costing is valued at Rs. 2.50 per unit (fixedand variable cost) whereas under marginal costing it is Rs. 2 per unit (only variablecost). The difference is of Rs. 0.50 per unit on a closing inventory of 10,000 unitswhich amounts to Rs. 5,000.

We can draw the following inferences:

1) When all costs are variable costs, then both the methods will report the same netincome.

2) When sales and production are in balance (no opening or closing stock) both themethods will again report the same profit.

3) When there is a closing stock (and no opening stock) the net income reportedunder absorption costing will be higher than that reported under marginal costing.Thus the technique of absorption costing may lead to odd results particularly forseasonal business in which stock level fluctuates widely from one period toanother.

4) When there is a opening stock (and no closing stock), the profit under marginalcosting will be more than the profit reported under absorption costing.

5) When the closing stock is more than the opening stock (presuming that bothopening and closing stocks are valued at same price), profit reported undermarginal costing will be less than the profit reported under full costing orabsorption costing.

The technique of absorption costing may also lead to rejection of a profitable business.An order at a price which is less than the total cost may be refused, though this ordermay be profitable. Look at the following illustration:

Illustration 5

XYZ Ltd. has a capacity to production 100,000 units and company is presentlyoperating at 70% capacity. The company is selling its product at Rs. 120 each. Thecost information is as follows.

Per Unit Total

Variable Cost Rs. 60 Rs. 42,00,000

Fixed Costs Rs. 30 Rs. 21,00,000

Total Rs. 90 Rs. 63,00,000

The company has received an order for 20,000 units at Rs. 70 per unit. Should the orderbe accepted or rejected.

Solution

Under absorption costing, cost includes both fixed as well as variable cost. Thus thecost per unit is Rs. 90 and the order at Rs. 70 per unit be rejected. Under marginalcosting, only variable costs are considered. When company will supply extra 20,000units, only variable cost will increase and fixed cost will remain same.

The fixed cost of Rs. 21,00,000 is already recovered by operating at 70% installedcapacity. Thus the order will increase the profit.

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Before Order Order After OrderRs. Rs. Rs.

Sales 70,000 @ Rs. 120 84,00,000 14,00,000 98,00,000(20,000 × Rs. 70)

Variable costs @ Rs. 60 42,00,000 12,00,000 54,00,000

Contributions 42,00,000 200,000 44,00,000

Fixed costs 21,00,000 ----- 21,00,000

Profit 21,00,000 200,000 23,00,000

Accepting the order enhances the profit by Rs. 200,000.

The difference between absorption costing and marginal costing arises mainly dueto recovery of fixed overheads and valuation of inventory.

Valuation of Stocks

In absorption costing, stocks of work-in-progress and finished goods are valued atworks cost or cost of production, which includes fixed costs also. Where as inmarginal costing, stocks are valued at marginal cost or variable cost only. Thismethod does not result in carrying over of fixed cost of one period to another, as ithappens in the case of absorption costing. In other words, valuation of stock is doneat a lower price in marginal costing, thus profit will differ under two methods ofcosting.

Absorption of Overheads

In absorption costing, both fixed and variable overheads are charged to productionwhile in marginal costing only variable overheads are charged to production. Thusunder absorption costing, there will be either over-absorption or under absorption offixed overheads, where as in marginal costing, the actual amount of fixed overheadsis wholly charged to contribution. Hence profit will differ.

Let us see following illustration how the profit fluctuates under both these methodswhen there is opening and closing stock of inventory:

Illustration 6

XYZ Ltd. produces one product. Its quarterly budget of sales, cost of sales andproduction is as follows:

Quarterly Budget Total Per UnitRs. Rs.

Sales 40,000 units @ Rs. 3 1,20,000 3Cost of Sales : Rs.Variable Manufacturing Costs 6 0 , 0 0 0 1.50Fixed Manufacturing Costs 1 2 , 0 0 0 0.30Total Cost 7 2 , 0 0 0 1.80Gross Profit 48,000 1.20Less Selling and Distribution Costs (Fixed) 28,000 0.70Net Operating Profit 2 0 , 0 0 0 0 . 5 0

Marginal Costing

9

The actual production and sales on a quarterly basis is as follows:(units)

Quarter I Quarter II Quarter III Quarter IV

Opening Inventory 0 0 9,000 2,000Production 40,000 45,000 35,000 38,000Sales 40,000 36,000 42,000 40,000Closing Inventory 0 9,000 2,000 0

Prepare quarterly income statement under absorption costing and marginal costing.

SolutionIncome Statement

(under Absorption Costing)

Quarter I Quarter II Quarter III Quarter IVRs. Rs. Rs. Rs.

Sales 1,20,000 1,08,000 1,26,000 1,20,000Manufacturing Costs :Opening inventory* 0 0 16,200 3,600

Variable Costs 60,000 67,500 52,500 57,000(Rs. 1.50 per unit)Fixed overheads 12,000 12,000 12,000 12,000Cost of goods 72,000 79,500 80,700 72,600Less Closing Stock* 0 16,200 3,600 0

Cost of Sales 72,000 63,300 77,100 72,600Gross Profit (Sales – Cost of Sales) 48,000 44,700 48,900 47,400Less Fixed Selling Costs 28,000 28,000 28,000 28,000Profit 20,000 16,700 20,900 19,400

*Opening and closing stock is valued at full cost i.e. fixed and variable which is0.30 + 1.50 respectively = Rs. 1.80.

Income Statement(Under Marginal Costing)

Quarter I Quarter II Quarter III Quarter IV

Sales 1,20,000 1,08,000 1,26,000 1,20,000Costs of Sales : Cost of opening inventory* 0 0 13,500 3,000 Variable Mfg. Exp. 60,000 67,500 52,500 57,000 Cost of good available for sale 60,000 67,500 66,000 60,000 Less Closing Stock* 0 13,500 3,000 0Cost of Sales : 60,000 54,000 63,000 60,000 Contribution (Sales – Cost of Sales) 60,000 54,000 63,000 60,000 Less Fixed Costs : Fixed Mfg. Cost 12,000 12,000 12,000 12,000 Fixed Selling Exp. 28,000 28,000 28,000 28,000

Net Profit 20,000 14,000 23,000 20,000

*Opening stock and closing stock is valued at marginal cost i.e. Rs. 1.50 per unit.

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The main features of marginal costing are:

1) All costs are classified in fixed and variable costs. Variable cost per unit remainssame and fixed costs remain same in total regardless of the changes inproduction.

2) Fixed costs are considered period costs and variable costs are considered asproduct costs. Hence fixed costs are not included in product cost.

3) Stock of work-in progress and finished goods are valued at marginal costs orvariable costs.

4) The difference in the value of opening stock and closing stock does not affect theunit cost of production as all the product costs are variable costs.

Direct Costing and Marginal Costing are used inter-changeably. As both the techniquesare more or less same. In direct costing, costs are classified into direct and indirectcosts. Direct costs are those which can be directly allocated to cost unit or cost centrewhile indirect costs can not be allocated to cost unit or costs centre directly. The onlydifference between the two is that some fixed cost could be considered to be directcosts under certain circumstances.

15.5 MARGINAL COSTING EQUATION ANDCONTRIBUTION MARGIN

In full costing or absorption costing, all costs are classified into three broad classes-manufacturing, administrative and selling. In the income statement, manufacturingcosts are deducted from the sales revenue to get the gross margin or gross profit thenadministrative and selling expenses are deducted from gross margin to arrive at netoperating income. Under marginal costing, costs are clarified into fixed and variableexpense. All variable costs, whether they are manufacturing, administrative or sellingare deducted from sales revenue. The difference is called contribution margin ormarginal income. All fixed costs are recovered from the contribution and balance isprofit or loss.

Illustration 7

Two companies A Ltd. and B Ltd. sell the same type of product. Their incomestatement are as follows:

A Ltd. B Ltd.Rs. Rs.

Sales 2,40,000 2,40,000Less Variable Cost 96,000 1,20,000Fixed Costs 64,000 40,000Profit 80,000 80,000

State which company is likely to earn greater profit if there is: (i) heavy demand,(ii ) poor demand for its products.

Solution

A Ltd. B Ltd.Rs. Rs.

Sales 2,40,000 2,40,000Variable Cost 96,000 1,20,000Contribution 1,44,000 1,20,000P/V Ratio (Contribution ÷ Sales) 0.60 0.50

Marginal Costing

11

In case of A Ltd., every sale of Rs. 100 gives a contribution of Rs. 60 whereas in caseof B Ltd. every sale of Rs. 100 provides a contribution of Rs. 50. In case of heavydemand, profit of A Ltd. will rise much faster in comparison to B Ltd. During poordemand or decline in sales of Rs. 100 will lead to decline in contribution in A Ltd. andB Ltd. by Rs. 60 and Rs. 50 respectively.

Mathematically,

Sales = Variable cost + Fixed cost ± Profit.

Sales – Variable cost = Fixed Cost ± Profit

Sales – Variable cost = Contribution

Contribution –Fixed cost = ± Profit

To make profit, contribution should be greater than fixed cost. Further, to maximizeprofit, contribution should be maximized. When contribution is equal to fixed cost, thena firm is at ‘no profit no loss point’ called break even point which you will study indetail under Unit 16.

15.6 PROFIT-VOLUME RATIOProfit volume ratio or contribution to sales ratio is a relationship between contributionand sales. It is the ratio between contribution per product to turnover of theproduct. Mathematically,

P/V Ratio =Sales – variable cost Sales

= Contribution Sales

Variable cost= 1 ---

Sales

=Fixed cost + profit Sales

=Change in contribution Change in sales

=Change in Profit Change in sales

Profit-volume ratio depicts the soundness of the company’s product. Profit volumeanalysis is used to determine break even for a product, a group of products and toknow how the profit changes if changes are made in price, volume, costs or anycombination of these. But P/V graph does not show how cost varies with the changein the level of production. The profit volume ratio and contribution has a directrelationship. The profit volume ratio can be improved by improving the contributionand contribution can be improved by :

i) increasing the selling price

ii) decreasing the marginal or variable costs.

iii) putting more emphasis on those products which have higher profit volume ratio.

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Profit Volume Graph

For preparing the profit volume graph, following steps are involved :

l Sales are depicted on x-axis and profit and loss on y-axis.

l X-axis divides the graph into two parts. The lower area of the x-axis depicts lossand upper area depicts the profit. When sales is zero, loss is equal to fixed cost.

l At a particular level of sales volume, the profit is depicted on y-axis. Both thepoints are joined by a straight line called profit line.

l The point where profit line inter-sects the x-axis is called the break even point.

l The angle between sales line and profit line is called angle of incidence.

Illustration 8

Construct profit volume graph with the help of the following data:

XYZ Ltd. reports the following results on 31st March, 2004 :

Sales @ Rs. 3 each Rs. 3,00,000/-

Variable cost Rs. 2 each Rs. 2,00,000/-

Fixed cost Rs. 50,000/-

Construct the P/V chart.

Solution

ContributionP/V ratio = Sales

Contribution = Sales – Variable Cost

= Rs. 3,00,000 – Rs. 2,00,000

= Rs. 1,00,000.

Profit-Volume Graph

X

Y

Fixed cost

Contribution line Profit

Sales volume

BEPLoss area

0

200,000

+50,000

-50,000

Marginal Costing

13

On X-axis, OX represents sales volume, on Y-axis OY represents profit while OY’loss. OFC represents fixed cost. The line FCP represents Fixed cost and profit as wellas total contribution. BE is the break-even point. The area BEX represents margin ofsafety while XBEP profit area. PBEX is the angle of incidence. You will beacquainted with all these terms in detail in Unit 16.

Where a company is manufacturing more than one product of varying profitability, theprofit-volume graph can be constructed as follows :

Illustration 9

XYZ ltd. produces three products X, Y and Z. The cost data is as follows:

Fixed Cost Rs. 25,000

X Y Z Rs. Rs. Rs.

Sales 50,000 25,000 30,000

Variable Costs 20,000 20,000 18,000

You are required to

i) Calculate the Profit-Volume ratio of each products, and

ii) Prepare a profit-volume ratio chart.

Solution

X Y Z TotalRs. Rs. Rs. Rs.

Sales 50,000 25,000 30,000 105,000

Variable Costs 20,000 20,000 18,000 58,000

Contribu0tion 30,000 5,000 12,000 47,000

Profit -volume ratio 3/5 or 0.60 5/25 or 0.20 12/30 or 0.40 47/105 or 0.45

The sequence should be X, Z and Y. (Descending order of P/V Ratio)

Product Sales Variable Contribution Cumulative Fixed Cumulative Cumulative Cost Contribution Costs Profit Sales

X 50,000 20,000 30,000 30,000 25,000 5,000 50,000

Z 30,000 18, 000 12,000 42,000 25,000 17,000 80,000

Y 25,000 20,000 5,000 47,000 25,000 22,000 105,000

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15.7 MANAGERIAL USES OF MARGINAL COSTING

Marginal Costing is a useful tool to management in taking various policy decisions,profit planning and cost control. Following are a few of the managerial problem wheremarginal costing is helpful in decision making:

1) Price Fixation

2) Accepting Special Order and Exploring Additional Markets

3) Profit Planning

4) Key Factors or Limiting Factor

5) Sales Mix Decisions

6) Make or Buy Decisions

7) Adding or Dropping Decisions

8) Suspension of Activities

1) Price Fixation

Under marginal costing, fixed costs are ignored and price is determined on the basis ofvariable costs (marginal). In normal business conditions, the price fixed must cover fullcosts otherwise firm will incur losses. In certain circumstances like trade depression,dumping, seasonal fluctuation in demand, highly competitive market etc. pricing is fixedwith the help of marginal costing rather than full costing.

During trade depression, the price may go down even below the full cost of theproduct. In such case, the management has to decide whether to close down theproduction activities until the recession is over or continue the production activities. Incase, the production activities are closed down, the firm will incur loss equal to its fixed

Profit-Volume Graph (Multi-products)

Sales

Y

12010080604020

10

10

20

20

Y

z

x

30

ofit

30

Pr (Rs. ‘000)

(Rs.

‘00 0

)

Marginal Costing

15

cost or un-escapable costs. The main emphasis of management is to minimise itslosses. The firm should continue its production activities so long as the selling price ismore than the marginal costs because any contribution earned will help in recovery ofthe fixed costs which results in reduction of loss.

Dumping means selling the product in foreign market at a price less than its total cost.The firm recover its fixed cost from the domestic market and marginal cost of theproduct becomes the basis for price fixation. Similarly if the firm produces product ofseasonal demand or perishable goods marginal costing is more useful technique thanfull costing.

Suppose the marginal cost of a product is Rs. 50 per unit and fixed cost is Rs. 200,000per annum. Selling price of the product is Rs. 55 per unit and 10,000 units can be soldat this price.

Per Unit TotalRs. Rs.

Marginal Cost 50.00 500,000

Fixed Cost 20.00 200,000

Total Cost 70.00 700,000

The selling price is less than the total cost of the product, yet is beneficial to continuethe production activity. The contribution earned is Rs. 5 per unit and total contribution isRs. 50,000. This will reduce the loss by Rs. 50,000. If the firm discontinue productionactivity, then loss will be Rs. 200,000 (Fixed Cost). Hence the firm should continueproduction activity.

If the selling price is less than marginal cost, loss will be more than the fixed costs.Hence the firm should fix the price equal to or above the marginal cost in specialcircumstances. Production should be discontinued if the price obtained is below themarginal cost so that the loss may not be more than fixed costs.

2) Accepting Special Order and Exploring Additional Markets

In case of spare capacity, a firm can increase its total profits by accepting an specialorder above the marginal cost and at a price lower than its regular selling price. Theadditional contribution earned from the special order will be the additional profit to thefirm. When additional order is accepted at a price below prevailing price to utilise idlecapacity, it should be carefully seen that it will not affect the normal market andgoodwill of the company. The special order from a local dealer should not be acceptedas it will affect the relationship with other dealers.

Illustration 10

The company is operating at 60% of the installed capacity (total capacity of 10,000units per month). Its monthly fixed expenses is Rs. 6 lakhs per month. The other costsare:

Direct Material Rs. 55 per unit

Direct Labour Rs. 10 per unit

Variable Expenses Rs. 25 per unit

The company has invested Rs. 1 crore in the business and is currently earning a returnof 7.2 per cent per annum before taxes. The managing director is prepared to acceptnew business at any price which will raise the return on investment to 20 per centbefore taxes. A special offer was received for 4000 units every month if the productis supplied at Rs. 120 per unit. Would you advise the company to accept the offer?

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SolutionTotal Capacity = 10,000 units per monthPresent Production = 6000 units per monthFixed Cost = Rs. 6 lakhs per monthMarginal Cost = Rs. 90 per unitReturn on Investment = 7.2 per centAnnual Profit = Rs. 7,20,000Profit per month = Rs. 60,000

The selling price per unit will be

Output 6000 units

Per Unit (Rs.) Total (Rs.)

Direct Cost 90 5,40,000

Fixed Cost 100 6,00,000

Total Cost 190 11,40,000

Profit 10 60,000

Selling Price 200 12,00,000

The total cost of the product is Rs. 190 per unit. The company has received the offerat Rs. 120 per unit. It appears that if the offer is accepted, the company will looseRs. 70 per unit. Hence the offer be rejected. But this analysis is fallacious as fixed costwill not change when production is increased. Here only variable cost which changes.Thus the selling price should be compared with the marginal cost which is Rs. 90 perunit. If the order is accepted each unit will provide Rs. 30 contribution towards profit.If the order is accepted then the profit position will be as follows:

Output Present 6000 units Order 4000 units 10,000 units Per Unit Total Per Unit Total Total Rs. Rs. Rs. Rs. Rs.

Sales 200 12,00,000 120 4,80,000 16,80,000

Variable Cost 90 5,40,000 90 3,60,000 9,00,000

Contribution 110 6,60,000 30 1,20,000 7,80,000

Fixed Costs 100 6,00,000 ---- ---- 6,00,000

Profit 10 60,000 30 1,20,000 1,80,000

1,80,000 × 12 × 100Return on Investment = = 21.6%

1 crore

The above statement provides that if the company accepts the offer, it will earnadditional Rs. 1,20,000 per month. The return on investment is enhanced from 7.2 percent to 21.6%. Before accepting the offer, following factors must be evaluated :

l The lower selling price for this offer, should not affect adversely the regularcustomers and goodwill of the company.

l Decrease in price should not create a doubt in the customer’s mind about thequality of the product.

l No possibility of any other more profitable use of unutilised capacity.

Marginal Costing

17

3) Profit Planning

Marginal costing is very helpful in determining the level of activity to achieve theplanned profits. The separation of costs in to fixed and variable aid managementfurther in planning and evaluating the profit resulting from a change in volume, achange in selling price, a change in fixed costs and variable costs.

Illustration 11

XYZ Ltd. is manufacturing and selling a product whose cost data is as follows:

Per Unit TotalRs. Rs.

Current Sale (20,000 units) 20 400,000

Variable Cost (20,000 units) 10 200,000

Fixed Cost 100,000

Profit 100,000

It is proposed to reduce the selling price due to competition by 10 per cent. How manyunits are to be sold to maintain the present profit level ?

Solution

New selling price after 10% reduction = Rs. 18

Contribution = Selling price – Variable Cost

= Rs.18 – Rs.10 = Rs. 8 per unit

Desired Contribution = Fixed Cost + Profit

= Rs. 100,000 + Rs.100,000 = Rs. 200,000

Desired ContributionSales required to earn desired profit (units) = —————————

Contribution Per Unit

Rs. 2,00,000= ————— = 25,000 units

Rs. 8

Fixed Cost + Desired profitDesired Sales =(Value) P/V ratio

Rs. 2,00,000 × Rs. 18= —————---—————

Rs. 8

= Rs. 4,50,000

4) Key Factors or Limiting FactorThe marginal costing technique provides that the product with highest contribution perunit is preferred. This inference holds true so long as it is possible to sell as much as itcan produce. But sometimes an organisation can sell all it produces but production islimited due to scarcity of raw material, labour, electricity, plant capacity or capital.These are called key factors or limiting factors. A key factor or limiting factor puts alimit on production and profit of the firm. In such situation, management has to take adecision whose production is to be increased, decreased or stopped. In such cases,

18


selection of the product is done on the basis of contribution per unit of scarce factor ofproduction. The key factor or scarce factor should be utilized in such a manner thatcontribution per unit of scarce resource is the maximum.

Mathematically, ContributionProfitability = —————

Key Factor

For example, if raw material is the limiting factor, the profitability of each product isdetermined by contribution per Kg of raw material. If machine capacity is a limitingfactor then contribution per machine hour is calculated. It electricity is the limitingfactor, then contribution per unit of electricity of each product is calculated.

Illustration 12

A company produces two products X and Y. The cost information is as follows:

Product X YSale Price Rs. 20 Rs. 15Variable Cost Rs. 10 Rs. 8Required Machine hours per unit 2 1Sales Potential (Units) 1000 1200Available production hours 2000

Calculate and find the best product mix.

Solution

Product X Y

Sale Price Rs. 20 Rs. 15

Variable Cost Rs. 10 Rs. 8

Contribution Rs. 10 Rs. 7

Required machine hours per unit 2 1

Contribution per machine hour Rs. 5 Rs. 7

Product Y gives the highest contribution per machine hours. The best solution would beto produce Y to the maximum extent that can be sold and remaining hours should bedevoted for production of X. Hence 1200 units of Y be produced and remaining 800hours be devoted to product X which means 400 units of X. Thus the optimum mix is400 units of X and 1200 units of Y.

5) Sales Mix Decision

In marginal costing, profit is calculated by subtracting fixed cost from contribution. Itmeans management should try to maximise the contribution. When a business firmproduces variety of product lines, then problem of best sales mix arises. The best salesmix is that which yields the maximum contribution. The products which gives themaximum contribution are to be retained and their production should be increasedkeeping in view the demand. The products, which yield less contribution, should bereduced or closed down depending upon the situation.

Illustration 13

State which of the following sales mix you would recommend to the management?

Marginal Costing

19

Elements of cost X YRs. Rs.

Sale Price 200 150

Direct Material 100 80

Direct Labour 40 30

Variable Overheads 20 20

Fixed Overheads : Rs. 100,000

Alternative Sales Mix :

a) 2000 units of X and 2000 units of Y

b) 3000 units of X and 1000 units of Y

c) 4000 units of X and Nil units of Y

Solution

Product X YRs. Rs.

Sale Price 200 150

Direct Material 100 80

Direct Labour 40 30


Contribution per unit 40 20

Choice of Sales Mix :

Sales Mix (1) : Contribution on Rs.

2000 units of X @ Rs. 40 per units = 80,000

2000 units of Y @ Rs. 20 per units = 40,000

Total Contribution = Rs. 120,000

Sales Mix (2) : Contribution on Rs.

3000 units of X @ Rs. 40 per unit = 120,000

1000 units of Y @ Rs. 20 per unit = 20,000

= Rs. 140,000

Sales Mix (3) : Contribution on

4000 units of X @ Rs. 40 per unit = Rs. 1,60,000

Sales mix 3 gives the highest contribution and is the best mix among the abovealternatives.

6) Make or Buy Decision

A particular component used in the main product may be purchased or may bemanufactured in its own factory by utilising the idle capacity of the existing facilities. Insuch make or buy decision, the marginal cost of manufacturing in the unit is compared

20


with the purchase price from the market. If marginal cost is less than the purchaseprice, then the component should be manufactured in its own unit, otherwise it shouldbe purchased from the market. Fixed expenses are not taken in the cost ofmanufacturing on the assumption that they have been already incurred, the additionalcost involved is only variable cost.

Illustration 14

XYZ Ltd. produces a variety of products and components. Their cost information andpurchase prices are as follows:

X Y ZRs. Rs. Rs.

Direct Material 12 4 2

Direct Labour 4 16 6

Variable Overhead 2 4 4

Fixed Cost 6 20 10

Bought out price 15 45 25

One of these products can be produced in the factory and rest two are to be boughtfrom outside. Select the component which should be bought from outside ?

SolutionComparative Cost Sheet

X Y ZRs. Rs. Rs.

Direct Material 12 4 2

Direct Labour 4 16 6

Variable Overhead 2 4 4

Marginal Cost 18 24 12

Bought out price 15 45 25

Saving (--) or increase (+) ----3 +21 +13

It is clear from the above statement that Y should be produced in its own unit asits marginal cost is much lower than the purchase price and other twocomponents i.e., X and Z be purchased from the market.

7) Adding and Dropping

An organisation may have a number of product lines or departments. Certainproduct lines or departments may turn out to be unprofitable with the passage oftime or due to technological developments. Production of such products ordepartments can be discontinued. The marginal costing approach assist in thesesituations to take a decision. It helps in the introduction of a new product line andwork as a good guide for deciding the optimum mix keeping in mind the availableresources and demand of the product. The contribution of different products ordepartments is to be compared and the product or department whose P/V ratio isthe lowest is to be dropped out. The following illustration explains how marginalcosting technique helps the management in decision making.

Marginal Costing

21

Illustration 15A company manufactures three products whose cost data is given below.

Product X Y Z(Rs.) (Rs.) (Rs.)

Selling Price 100 80 90Direct Material 20 12 16Direct Labour 16 16 16Variable Overhead 16 12 15

The management wants to drop out Product Y as it is not profitable. Whatadvice would you like to give the management ?Solution

Comparative Cost Statement

Product X Y Z(Rs.) (Rs.) (Rs.)

Selling Price 10 0 80 90Less Marginal Cost : Direct Material 20 12 16 Direct Labour 16 16 16 Variable Overhead 16 52 12 40 15 47Contribution 48 40 43

P/v ratio 48% 50% 47.77%

Product Y is the most profitable product line as its P/V ratio is the highest whencompared to products X and Z.8) Suspension of ActivitiesDuring trade recession and cut throat competition the demand of the product is notadequate to cover the fixed costs, management may consider to suspend theoperations for the time being. If certain portion of fixed expenses is escapable e.g.salary of temporary staff then size of contribution should exceed the escapable fixedcosts. In some units when production is restarted after suspension, some additional orspecial costs are incurred like overhauling of the plant and machinery. These costs arecalled additional costs of shut down. These costs are deducted from the escapablefixed costs and amount of contribution is compared with the net escapable fixed costs.If the contribution is greater than the net escapable fixed cost, the production should becontinued and vice versa.

Shut down point = Net Escapable Fixed Costs

Contribution per unit

Net escapable fixed cost = Total fixed cost for the period – unescapablefixed costs + additional costs of shut down.

Illustration 16XYZ Ltd. is manufacturing 200,000 boxes per annum when working at normalcapacity. The cost information is as follows :

Rs.Direct Material = 8.00Direct Labour = 2.00Variable Overheads = 3.00Fixed Overheads = 3.00Total Cost = 16.00

22


The selling price is Rs. 20 per unit. It is estimated that in the next quarter only 10,000units can be produced and sold. Management plans to shut down the plant andestimating that fixed cost can be reduced to Rs. 80,000 for the quarter. The fixedoverheads are incurred uniformly throughout the year. Additional cost of plant shutdown is Rs. 10,000.

From the above information you are requested to decide the following:

a) Whether the plant should be shut down for a period of three month

b) Calculate the shut down point for three months.

SolutionRs.

a) Sale Price 16

Marginal Costs : Rs.

Direct Material 8

Direct Labour 2


Contribution : Rs. 3 per unit.

Fixed Overhead = Rs. 3 × 200,000 = Rs. 600,000 per annum

Fixed overheads for quarter =Rs. 600,000 = Rs. 1,50,000 4

If plant is operated, the loss is : Rs.Total contribution on 10,000 units = 30,000

(10,000 units × Rs. 3)

Fixed Cost = 150,000

Loss (Fixed cost – Contribution) = 120,000

If plant is closed, then loss will be :

Unescapable fixed cost = Rs. 80,000

Addition shut down cost = Rs. 10,000

Total Loss = Rs. 90,000

As is evident from the above calculations that the plant should be closed down for thequarter, so that the loss will be reduced by Rs. 30,000.

b) Shut down point

Net Escapable Fixed Cost = Total Fixed Cost for the period – Shut down costs +additional costs.

= Rs. 150,000 – Rs. 80,000 + Rs. 10,000 = Rs. 80,000

Shut down point = Net Escapable Fixed Cost Contribution Per Unit

=Rs. 80,000Rs. 3

= 26,667 units per quarter

Marginal Costing

23

For suspension of business activity, only costs should not be taken into consideration,there are other factors also like, employees interest, fear of plant obsolescence, lossof customers in future, government action, perishable raw material and company ishaving a huge stock of material, etc.

Check Your Progress

A) Fill in the blanks:

i) The technique of marginal costing is based on classification of costs in to___________ and ____________.

ii) Contribution is the sum of _________ and ___________.

iii) In marginal costing, closing stock is valued at __________________.

iv) Profit-volume ratio is the relationship between ___________ and__________.

v) In absorption costing, closing stock is valued at ________________.

B) State whether each of the following statement is True or False.

i) Fixed cost per unit remains constant. [ T F ]

ii) Variable cost per unit remains constant [ T F ]

iii) Absorption costing is not as suitable for decision making asmarginal costing is [ T F ]

iv) Semi-variable costs consists of fixed costs and factory costs [ T F ]

v) Fixed costs are not taken in to consideration in valuation ofwork-in-progress in marginal costing [ T F ]

C) From the following choose the most appropriate answer

1) Contribution margin is also known as

a) Gross profit

b) Net profit

c) Earning before tax

d) Marginal income

2) Contribution is the difference between

a) Sales and variable cost

b) Sales and fixed cost

c) Sales and total cost

d) Factory cost and profit

24


3) When fixed cost is Rs. 20,000 and Profit volume ratio is 25 per cent, thenbreak even point will occur at

a) Rs. 5000

b) 5000 units

c) Rs. 80,000

d) 80,000 units

4) Period cost means

a) Variable cost

b) Fixed costs

c) Prime cost

d) Factory cost

5) If profit-volume ratio is 25 per cent and sales is Rs. 100,000, the variablecost will be

a) Rs. 25,000

b) Rs. 50,000

c) Rs. 75,000

d) None of the above

6) The valuation of stock in marginal costing as compared to absorptioncosting is

a) Higher

b) Lower

c) Same


15.8 LIMITATIONS OF MARGINAL COSTINGThe marginal costing has the following limitations :

1) Difficulty in cost Analysis : Separation of costs into fixed and variablebecomes very difficult under certain circumstances and in certain businesssituations. The accuracy of marginal costing results depends upon how accuratelycosts are classified.

2) Inappropriate basis of pricing : In marginal costing, there is a danger of toomany sales being made at marginal cost or marginal cost plus some contribution,resulting in under recovery of fixed overheads. This situation will arise duringdepression or increasing competition.

3) Under valuation of inventory : In marginal costing, inventories are valued atvariable costs. It may create problems in inter firm transfer of goods at marginalcosts resulting in higher profits. Employees may demand higher salaries and otherbenefits. Exclusion of fixed costs from inventory cost seems to be against theaccepted accounting procedure.

4) Same marginal cost per unit : This assumption is partly true within a limitedrange of activity. Scarcity of labour and material brings change in price, tradediscount of bulk purchases, changes in the productivity of men etc. will influencethe marginal cost per unit.

Marginal Costing

25

5) Not suitable to all concerns : This technique may not be suitable in thoseindustries which have large stock of work-in-progress e.g. contact and shipbuilding industry. If fixed expenses are not included in valuation of work-in-progress losses may occur in the initial years till the contract is completed. Oncompletion of the contract, huge profit will be depicted.

6) New Technology : With the development of science and technology, new costefficient machines are available resulting in reduction in labour costs andincreased fixed costs. The system of costing, which ignores significant portion ofcost i.e. fixed cost, can not be very effective.

15.9 LET US SUM UPThe elements of costs are material, labour and expenses. These elements of costs arebroadly put into two categories: fixed and variable costs. The cost of product orprocess can be ascertained by absorption costing and marginal costing. In absorptioncosting or full costing, cost of a product is determined after considering both fixed andvariable cost. Whereas in marginal costing only variable costs are considered incalculating the cost of product and fixed costs are charged against the revenue(consideration) of the period. Marginal costing is a definite improvement over theabsorption costing.

Marginal costing involves computation of marginal cost. The marginal cost is alsocalled variable costs. It comprises of direct material, direct labour and variableoverheads. Marginal costing helps the management in taking various managerialdecisions like price fixation, profit planning, add and drop decisions, make or buydecision, sales mix decision etc.

Marginal costing technique has some limitations. The categorisation of expenses intofixed and variable elements is tedious and complex task. The behaviour of per unitvariable and total fixed cost is questionable as assumed in marginal costing. Inspite ofthese limitations, marginal costing is a useful technique for decisions making in severalbusiness decisions.

15.10 KEY WORDSAbsorption costing or full costing: A technique where all costs, fixed and variable,are allocated to cost unit.Break Even Point: A level of production activity, where sales revenue is equal tovariable cost and fixed cost or contribution equal to fixed cost. It is also called ‘noprofit, no loss’ point.Contribution: The difference between sale price and variable costs is calledcontribution.Marginal Cost: It comprises of direct material, direct labour and variable overheadsor cost of producing one additional unit.Marginal Costing: It is a technique where only variable costs are considered whilecomputing the cost of product. The fixed costs are met against the total contribution ofall the products taken together.

15.11 ANSWERS TO CHECK YOUR PROGRESSA) i) Fixed and Variable, ii) Fixed Cost and Profit, iii) variable cost,

iv) contribution and sales, v) full costB) i) F, ii) T, iii) T, iv) F, v) TC) 1) D, 2) A, 3) C, 4) B, 5) C, 6) D

26

An OverviewCost Volume ProfitAnalysis 15.12 TERMINAL QUESTIONS

1) Under what conditions, the income statement prepared under full costing orabsorption costing and marginal costing will give similar results.

2) State the conditions, the income statement prepared with absorption costing andmarginal costing will give different results.

3) Explain the application of marginal costing in managerial decision making.

4) How semi-variable costs or mixed costs can be segregated into fixed and variablecomponents.

5) ‘The profit is the product of the P/V ratio and the margin of safety’. Comment.

6) What are the limitations of marginal costing techniques?

7) A manufacturer produces a car component. The cost sheet of the component is asfollows:

Material 4.00

Direct Labour 2.00

Variable Overheads 1.50

Fixed Overheads2.50

10.00

A foreign manufacturer who uses this car component offers to purchase 20,000 unitsat Rs. 13 per component against the usual price of Rs. 15 per unit. If this offer isaccepted the fixed expenses will go up by Rs. 40,000 annually.

Would you accept this offer? Are there any other considerations, which may affectyour decision?

(Yes, profit increases by Rs. 70,000)

8) The management of company worried about the performance of Department Xand wants to close the department. The following data is supplied by the costaccountant.

Department

X Y ZRs. Rs. Rs.

Sales 40,000 60,000 1,00,000

Variable Costs 36,000 48,000 60,000

Fixed costs (apportioned on the basis of sales) 6,000 9,000 15,000

Total Cost 42,000 57,000 75,000

Profit or Loss --- 2000 +3000 +2500

a) You are required to advise management in respect of closure of department X.

b) On the above, the specific fixed costs are ascertained as follows: X Rs. 2000;Y Rs. 13000; and Z Rs. 5000 and the balance of Rs. 10,000 is treated asgeneral fixed overheads.

(Answer : (a) Continue X (b) Close Y, Total Profit Rs. 26,000)

9) A Company manufacturers and markets three products X, Y and Z. All the threeproducts are manufactured from the same set of machines. Production is limited

Marginal Costing

27

by machine capacity. From the data given below, indicate the priorities for productX, Y and Z with a view to maximising profits.

X Y Z

Raw Material per unit 11.00 16.25 21.00

Direct Labour per unit 2.50 2.50 2.50

Variable Overheads 1.50 2.25 3.50

Selling Price 25.00 30.00 35.00

Machine time required per unit in minutes 40 20 20

(Answer : Y, Z and X. Contribution per unit : 0.225, 0.45, 0.4 respectively.)

9) XYZ Ltd. produces three products and cost data is as follows:

X Y ZRs. Rs. Rs.

Selling price per unit 100 75 50

P/V Ratio 0.10 0.20 0.40

Maximum sales potential (in units) 40,000 25,000 10,000

Raw material content as % of variable costs 50.00 50.00 50.00

The fixed expenses are estimated at Rs. 6,80,000. The company uses a single rawmaterial in all the products. Raw material is in short supply and the company has aquota for the supply of raw materials to the extent of Rs. 18,00,000 per annum forthe manufacture of its products to meet its sales demand.

a) Calculate the product mix which will give the maximum overall profits keeping theshort supply of raw materials.

b) Compute the maximum profit.

[Answer : (a) Product mix of X, Y and Z are 10,000, 25,000 and 10,000 unitsrespectively; (b) Profit Rs. 95,000 ]

15.13 FURTHER READINGSKishore, Ravi M., Management Accounting with Problems and Solutions, TaxmannAllied Services Pvt. Ltd. New Delhi, 2000.

Horngren, C.T., Gary L. Sundem and Frank H. Selto, “Management Accounting”,Prentice Hall of India, New Delhi, 1994.

Kaplan, R.S., “Advanced Management Accounting”, Engle Wood Cliffs, NJ.,Prentice Hall Inc.

Note : These questions will help you to understand the unit better. Try to writeanswers for them. But do not submit your answers to the University.These are for your practice only.

UNIT 16 BREAK EVEN ANALYSISStructure16.0 Objectives

16.1 Introduction

16.2 Break Even Analysis

16.3 Break Even Point

16.4 Impact of Changes in Sales Price, Volume, Variable Costs and Fixed Costson Profits

16.5 Required Sales for Desired Profit

16.6 Sales Volume Required to Earn a Desired Profit Per Unit

16.7 Sales Required to Maintain Present Profit

16.8 Margin of Safety

16.9 Angle of Incidence

16.10 Break Even Charts

16.11 Profit Volume Graph

16.12 Assumption in Break Even Analysis

16.13 Let Us Sum Up

16.14 Key Words




16.0 OBJECTIVESAfter studying this unit you should be able to:

l understand the concept of break even analysis, impact of change in salesvolume, price, variable cost, fixed costs on profits;

l apply cost-volume profit relationship for profit planning;

l understand the concept of margin of safety, angle of incidence, and profitvolume ratio in decision making; and

l examine the assumptions and limitations of the break even analysis

16.1 INTRODUCTIONIn this unit you will learn about the concept of break-event point and finding out ofbreak even point through mathematical equation and graphic representation Youwill be acquainted with the relationship between Cost, Volume and Profit and itsimpact on planning and evaluation of business operations. You will also study theconcepts of margin of safety, angle of incidence, limiting factor and profit volumeratio in decision making. The unit also deals with the underlying assumptions ofbreak even analysis.32

Break Even Analysis

33

16.2 BREAK EVEN ANALYSISThe analysis of cost behaviour is necessary for planning, control and decision making.Analysis of cost behaviour means analysis of variability of each cost element inrelation to the level of output. Every cost follows some definite behaviour pattern. Forexample total variable costs varies in direct proportion to the volume of output but perunit variable cost remains same. Examples of such costs are direct material, directlabour, packaging expenses, selling commission etc. These costs are called productcosts and are controllable, as they incur only when production takes place. Whereasfixed costs remains same irrespective to the level of output but per unit fixed cost goeson decreasing with the increasing level of out put as fixed cost scattered over a largenumber of units. Examples of such expenses are rent, rates and insurance, executives’salary, audit fees etc. These costs are also called period costs and are uncontrollable.The mixed costs or semi-variable costs have both the elements variable and fixed.These costs also change in the same direction in which volume of output changes butthis change is less than proportionate change in output. Examples of such costs arepower, telephone, depreciation, etc. Thus the concept of break even analysis is alogical extension of marginal costing. It is based on the same principle of classifyingthe costs into fixed and variable.

Semi-variable costs are segregated in fixed and variable components as discussed inthe earlier chapter. Fixed component is added in fixed costs and variable componentwith variable cost. Thus the costs are classified into two water tight compartments i.e.fixed and variable.

The cost behaviour play a significant role in decision making. The relationships involume, cost and profit shows that if volume increase by 10 per cent (say), then costwill not increase by 10 per cent. Because only variable cost will increase and fixedcosts remain same and unit fixed cost declines. Consequently, profit will not increaseby 10 per cent but more than that and vice versa. The level of production changesdue to many reasons, such as recession or boom, competition, introduction of newproduct, increase in demand, scarce raw material etc. The management wants toknow the effect of these changes on profit. The break-even analysis helps themanagement in decision making in these situations.

The study of cost-volume-profit relationship is some time called as “break evenanalysis.” In the opinion of some, it is a misnomer as break even analysis depicts apoint where costs and total sales revenue is same. Beyond this point, it is called cost-volume-profit relationship. Some hold the view, that break even analysis can beinterpreted in two senses – narrow and broad sense. In narrow sense, it refers todetermine the level of output where total costs equal to total revenue i.e. no profit, noloss. In the broad sense, it is used to determine the probable profit at any level ofoutput.

16.3 BREAK EVEN POINT

It is a point where sales revenue equals the costs to make and sell the product and noprofit or loss is reported. In the words of Keller and Ferrara, “the break even point ofa company or a unit of a company is the level of sales income which will equal to thesum of its fixed costs and variable costs.” Charles T. Horngren define it, “the breakeven point is that point of activity (sales volume) where total revenues and totalexpenses are equal, it is the point of zero profit and zero loss.”

There are two methods of calculating break even point. Mathematical method andGraphical method.

34

Cost Volume ProfitAnalysis

16.3.1 Mathematical Method

The break even point through mathematical method can be found out either by

i) Equation Method, or

ii ) Contribution Margin Technique.

Equation Method

We know,

Sales – Variable costs – Fixed cost = Profit (S --- VC – FC = P)

Sales – Variable costs = Fixed costs + Profit (S --- VC = FC + P)

Sales minus variable costs is called Contribution. (S --- VC = C)

Contribution = Fixed costs + Profit (C = FC + P)

At break even point, profit is zero.

∴ Contribution = Fixed Costs (at break even point)or

(SP ---- VC) Q = F

Where, SP is selling price, VC is the variable costs, F is a fixed costs and Q is thenumber of units produced and sold. Look at the following illustration how the break-even point is to be calculated:

Illustration 1

Calculate the break even point from the following information :

Selling price = Rs. 3 per unit

Variable cost = Rs. 2 per unit

Fixed cost = Rs. 90,000

Estimated sales for the period = 100,000 units or Rs. 300,000

Suppose the units to be produced and sold at break even point is Q, then

Sales – Variable Costs = Contribution = Fixed Costs

3 Q – 2 Q = 90,000

Q = 90,000 units

When we produce and sell 90,000 units, then total sales revenue is Rs. 2,70,000(90,000 units × Rs. 3 ) and total cost is Rs. 2,70,000, (VC Rs. 2 × 90000units = 1,80,000 + F C Rs. 90,000)

Contribution Margins Technique

Contribution per unit means difference between selling price and variable costsor

Contribution per unit = Selling price per unit – Variable Cost per unit

Total Contribution = Sales Revenue – Total Variable Costs

Break even point can be expressed in terms of units to be produced and sold or interms of value of goods. At break even point, we know

Break Even Analysis

35

Break Even Point in Units

Sales – Variable Costs = Fixed Costs or(SP – VC) Q = Fixed Costs or

Q = BEP (in units) = Fixed Costs SP per unit – VC per unit

or

Q = Fixed CostsContribution Per Unit

Break Even Point in Value

Multiplying both sides by selling price (SP),

SP × Q = BEP (in value) =Fixed Cost × SP per unit


or BEP (in value) = Fixed Costs × Sales

Total Sales – Total Variable Costs

or = Fixed Costs × SalesTotal Contribution

Let us calculate the break-even point with the help of above equations by using theinformation given in illustration 1

BEP (in units) =Fixed CostsSP – VC

= Rs. 90,000 = 90,000 unitsRs. 3 – Rs. 2

BEP (in value) =Fixed Cost × Selling Price

SP – VC

=Fixed Costs × Selling Price


=Rs. 90,000 × Rs. 3

Rs. 3 – Rs. 2

= Rs. 2,70,000

BEP (in value) =Fixed Costs × Total Sales

Total Sales – Variable Costs

=Rs. 90,000 × Rs. 300,000 = Rs. 2,70,000Rs. 300,000 – Rs. 200,000

It shows that a firm will be at a break even point when it is producing and selling90,000 units or having a sale of Rs. 2,70,000.

Profit /Volume Ratio (P/V ratio)

Total contribution divided by total sales is called profit-volume ratio or contributionratio (P/V ratio). Break-even point can be determined with the help of P/V ratio.

36

Cost Volume ProfitAnalysis P/V ratio =

ContributionSales

=Sales – Variable Cost

Sales

= Variable Cost

Sales O r

Fixed Cost + Profit F + PP/V Ratio = =

Sales S

BEP (in value) = Fixed Costs × Total Sales Total Sales – Variable Costs

= Fixed Costs × Total Sales Total Contribution

= Fixed Costs

Total Contribution ÷ Total Sales

= Fixed Costs

P\V Ratio

Variable Costs to Sales is called Variable Cost Ratio.

∴ BEP (in value) Fixed Costs=

1 – Variable Costs Sales

It should be noted that firms producing one product line only, the calculation of break-even point is preferred in units and firms having a variety of product lines, calculation ofbreak even point is preferred in value. P/V ratio can also be expressed in the form ofpercentage by multiplying by 100. Look at the following illustration.

Illustration 2

XYZ Ltd. is manufacturing and selling four types of products A, B, C and D. The salesmix and variable costs are as follows:

Product Sales per month Variable Cost RatioA 2,00,000 50%B 1,50,000 50%C 1,00,000 75%D 2,50,000 40%

The fixed costs are Rs. 1,50,000 per month. Calculate break even point.

Solution

Firstly calculate the variable costs and contribution.

Particular A B C D TotalSales (Rs.) 2,00,000 1,50,000 1,00,000 2,50,000 7,00,000Variable Costs (Rs.) 1,00,000 75,000 75,000 1,00,000 3,50,000Contribution (Rs.) 1,00,000 75,000 25,000 1,50,000 3,50,000Fixed Costs (Rs.) - - - - 1,50,000

Profit (Rs.) 2,00,000

1 –

Break Even Analysis

37

P/V Ratio = Total Contribution = Rs. 3,50,000

= 0.50 (i.e., 50%)Total Sales Rs. 7,00,000

Break Even Point (in value) = Rs. 1,50,000

= Rs. 3,00,000 0.50

Variable Cost Ratio = Variable Costs

= Rs. 3,50,000

= 0.50 (i.e., 50%) Total Costs Rs. 7,00,000

∴ BEP (in value) = Fixed Costs

= Rs. 1,50,000

= Rs. 3,00,0001 – Variable Costs 1 – 0.50

Total Sales

Break-even point as percentage of estimated capacity utilisation : Break-evenpoint can also be calculated as a percentage of estimated sales or capacity utilisationby dividing the break-even sales by the estimated capacity sales/utilisation.

Illustration 3

The ratio of variable costs to sales is 70 percent. The break even point occurs at60 percent of the capacity. Find the break even point sales when fixed costs areRs. 90,000. Also compute profit at 75% of the capacity sales.

Solution

As the variable cost to sales ratio = 70%

We know

P/V ratio or Contribution ratio = 1 – VC= 1 – 0.70

Sales

= 0.30

∴ BEP (in value) = Fixed Cost = Rs. 90,000 P/V Ratio 30

= Rs. 3,00,000

BEP occurs at 60 per cent of the capacity utilisationCapacity Utilisation Sales

60% Rs. 3,00,000

75%

We can apply unitary method or proportion method

X = Rs. 3,00,000 × 75

= Rs. 3,75,000 60

Now we can compute, contribution earned when sales is Rs. 3,75,000. Salesmultiplied by P/V ratio gives the contribution.

Contribution = Sales × P/V Ratio

= Rs. 3,75,000 × 30%

= Rs. 1,12,500

∴ Profit = Contribution – Fixed Costs

= Rs. 1,12,500 – Rs. 90, 000

= Rs. 22,500

38


16.3.2 Graphical MethodThe break-even point can also be shown graphically. The BEP chart shows therelationships between cost, volume and profit at various levels of output. Fixed costs,variable costs and sales revenues are shown on Y-axis and volume of out on X-axis.The break-even point is that point at which the total cost line and total sales lineintersect each other. This point represents “no profit, no loss”.

The following steps are involved in construction of break even chart:

l Sales volume is plotted on x-axis. Sales volume may be expressed in terms ofvalue (rupee), units or as percentage of capacity.

l Cost and Revenue are depicted in y-axis. Fixed costs remains constantirrespective to the sales volume. Hence it is parallel to the x-axis and startsfrom Rs. 90,000. (Data of illustration 1) Variable cost starts from (0,0)because no sales volume, no variable cost and as the volume increases variablecost also increases. When a parallel line of variable cost drawn from the fixedcost line in y - axis, it depicts the total cost line. The sales revenue curve alsostarts from (0,0).

l The point of intersection of sales revenue line and total cost line depicts, breakeven point. It occurs at a point of 90,000 units on x-axis and Rs. 2,70,000(in terms of value) on y-axis.

l The area to the left side of break even point depicts loss zone as cost curve is at ahigher level and sale revenue line is at a lower level. The area to the right handside of break even point is call profit zone as sale revenue line lies at a higher levelthan the total cost line.

l The angle formed by the intersection of sale value line and total cost line is known asangle of incidence. Larger the angle, lower is the break even point and vice versa.

Let us draw a break even chart with the help of the following illustration.

Illustration 4

Let us draw a break-even chart with the help of data given below at differentproduction levels of 0, 80,000, 90,000, 1,00,000 1,10,000, and 1,20,000 units.

Sale Price = Rs. 3 per unit

Variable Cost = Rs. 2 per unit

Fixed Cost = Rs. 90,000

Solution

The costs and profits and different levels of output is computed as follows :

Output Variable Cost Fixed Cost Total Cost Sale Rev. ProfitRs. Rs. Rs. Rs. Rs.

0 0 90,000 90,000 0 –90,000

80,000 1,60,000 90,000 2,50,000 2,40,000 –10,000

90,000 1,80,000 90,000 2,70,000 2,70,000 0

1,00,000 2,00,000 90,000 2,90,000 3,00,000 10,000

1,10,000 2,20,000 90,000 3,10,000 3,30,000 20,000

1,20,000 2,40,000 90,000 3,30,000 3,60,000 30,000

The above data if presented on a graph, it appears as follows :

Break Even Analysis

39

Break Even Chart

Contribution break even chart

From this chart we can ascertain the contribution earned at different levels of activity.Under this method, total cost line is not drawn instead the contribution line is drawnfrom the (0.0) point or origin. Intersection of cost line and sales line does not arises inthis case as break even point occurs at where contribution is equal to fixed cost. Whencontribution is greater than fixed cost it is profit and vice versa. The contribution breakeven chart shows the contribution at different levels of activity and any level of activitybelow the BEP will not cover the fixed cost.

Let us represent the data as given in illustration 4 by means of contribution break-evenChart.

Solution :

Output Variable Cost Fixed Cost Total Cost Sale Rev. Contribution(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)

0 0 90,000 90,000 0 0

80,000 1,60,000 90,000 2,50,000 2,40,000 80,000

90,000 1,80,000 90,000 2,70,000 2,70,000 90,000

1,00,000 2,00,000 90,000 2,90,000 3,00,000 1,00,000

1,10,000 2,20,000 90,000 3,10,000 3,30,000 1,10,000

1,20,000 2,40,000 90,000 3,30,000 3,60,000 1,20,000

Break even point

Angle of incidence

Profit

zone

Margin ofSafety

Loss A

rea

Variable cost

Profit

Total cost

Sales revenue

Fixed cost100

140

160

180

200

220

240

260

280

300

320

340

360

380

80

Cost

s/sa

les R

even

ues (

in ’0

00 ru

pees

)

60

40

20

0

Output (in ’000 units)

10 20 30 40 50 60 70 80 90 100 110 120 130 140

40


Contribution Break Even Chart

16.4 IMPACT OF CHANGES IN SALES PRICE,VOLUME, VARIABLE COSTS AND FIXEDCOSTS ON PROFITS

16.4.1 Impact of Sale Price Changes on Profit

Suppose the normal sales volume of X Y Z Ltd. is 1,00,000 units, selling at a price ofRs. 3 per unit. The variable cost is Rs. 2 per unit, fixed cost is Rs. 90,000. The capitalinvestment is Rs. 1,00,000. Let us study the impact of change in price on profit undertwo conditions i.e. increase in price by 5 per cent and 10 per cent and decrease in priceby 5 per cent and 10 per cent.m

Impact of Change in Sales Prices on Profit

Sl. Particulars Decrease in Price Normal Increase in PriceNo. 10% 5% Volume 5 % 10%1. Outputs (units) 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

2. Sales ( Rs.) 2,70,000 2,85,000 3,00,000 3,15,000 3,30,000

3. Variable Costs 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000 ( Rs.)

4. Marginal Incomeor Contribution 70,000 85,000 1,00,000 1,15,000 1,30,000 (2-3) ( Rs.)

5. Fixed Costs (Rs.) 90,000 90,000 90,000 90,000 90,000

6. Operating Profit /Loss (4-5) (Rs.) ----20,000 ----5,000 10,000 25,000 40,000

7. % Change inProfit ----300% ----150% ---- 150% 300%

8. Break even point (units) 1,28,571 1,05,882 90,000 78,261 69,231

9. P/V Ratio 0.2592 0.2982 0.3333 0.3651 0.3939

10. Return onInvestment % ----20% ----5% 10.00 25.00 40.00

XO

Y

Sales curve

Variable costs

Contribution curve

Profit areaFixed cost

BEPLossArea

Output

Break Even Analysis

41

From the above table, we can draw the following inferences:

1) A small change in price brings wide fluctuations in operating profit. Forexample 5 per cent decrease in price brings 150 per cent decrease in profit andvice versa. The change is 30 times.

The change can be computed as follows:

=% Change in Profit

% Change in Price

When price declines by 5 percent, then change in profit is

=

15 0%= 30 times

5%

There is an inverse relationship in change in price and change in break evenpoint. When price increase other factors remains same, the break-even pointdeclines.

Increase in sale price leads to higher contribution resulting in lower break evenpoint and vice versa. A lower number of units have to be sold in order to recoverthe fixed cost.

2) Profit-Volume Ratio: There is a direct relationship in change in price andchange in profit volume ratio. With change in price, the contribution also changesconsequently P/V ratio also changes.

3) Return of Investment: Like in operating profits, the change in price has amagnified impact on return on investment.

16.4.2 Impact of Volume Changes on Profit

Let us study the impact of change in volume on profit in the above-mentionedexample.

Sl. Particulars

Decrease in Price Normal Increase in PriceNo. 10% 5% Volume 5% 10%

1. Outputs (units) 80,000 90,000 1,00,000 1,10,000 1,20,000

2. Sales ( Rs.) 2,40,000 2,70,000 3,00,000 3,30,000 3,60,000

3. Variable Costs ( Rs.) 1,60,000 1,80,000 2,00,000 2,20,000 2,40,000

4. Contribution ( Rs.) (2-3) 80,000 90,000 1,00,000 1,10,000 1,20,000

5. Fixed Costs (Rs.) 90,000 90,000 90,000 90,000 90,000

6. Operating Profit ---- 10,000 0 10,000 20,000 30,000 (4-5) ( Rs.)

7. % Change in Profit -200 -100 - 100 200

8. Break even point (units) 90,000 90,000 90,000 90,000 90,000

9. P/V Ratio 0.3333 0.3333 0.3333 0.3333 0.3333or or or or or

Percentage 33.33% 33.33% 33.33% 33.33% 33.33%

10. Return onInvestment (%) ---10.00 0 10.00 20.00 30.00

42


From above table, the following inferences can be drawn:

1) Percentage Change in Profit: A small change in sales volume brings a widefluctuation in profit. For example, a 10 per cent change in sales volume leads to a100 per cent change in profit. It is called operating leverage or operating elasticity.Mathematically, it is

OL or OE =% Change in Profit

% Change in Sales

The operating leverage or operating elasticity is the degree of responsiveness orsensitivity of operating profit to change in sales. In the above example, operatingleverage or operating elasticity is

OL or OE = % Change in Profit

= 100%

= 10 times% Change in Sales 10%

It depicts that 1 percent change in sales leads to 10 times change in operating profit i.e.10 per cent.

2) Break Even Point: There is no impact on the break-even point. Becausecontribution per unit (Sale Price – Variable Costs) and fixed costs are notinfluenced by the change in volume. Thus break even point is unaffected whenthere is a change in sales volume.

3) P/V Ratio: Like break even point, there is no impact on profit volume ratio ascontribution per unit and sale price per unit is same as at normal level.

4) Return on Investment: Like in operating profit, the impact of change in salevolume has a magnified impact on return on investment.

16.4.3 Impact of Change in Price and Volume on Profit

Sl. Particulars Normal

No. Volume

1. Outputs (units) 1,20,000 1,10,000 1,00,000 90,000 80,000

2. Sales ( Rs.) 3,24,000 3,13,500 3,00,000 2,83,500 2,64,000

3. Variable Costs (Rs.) 2,40,000 2,20,000 2,00,000 1,80,000 1,60,000

4. Contribution ( 3-2) 84,000 93,500 1,00,000 1,03,500 1,04,000

5. Fixed Costs ( Rs.) 90,000 90,000 90,000 90,000 90,000

6. Operating Profit ----6,000 3,500 10,000 13,500 14,000

7. % Change in Profit ----160.00 -65.00 --- 35.00 40.00

8. Break even point (units) 1,28,571 1,05,882 90,000 78,261 69,231

9. P/V Ratio 0.2592 0.2982 0.3333 0.3651 0.3939or or or or or

Percentage 25.92 29.82 33.33 36.51 39.39

10. Return on Investment (%) 6.00 3.5 10.00 13.50 40.00

Activity: 1 Try to draw the inferences from the above table and also prepare thesimilar tables for increasing and decreasing the fixed costs and variable cost and studythe impact on profit, break even profit, P/V ratio etc.

Increase in Price5 % 10%Decrease in Volume10% 20%

Decrease in Price10% 5 %Increase in Volume20% 10%

Break Even Analysis

43

16.5 REQUIRED SALES FOR DESIRED PROFITBreak even point equation can be extended to estimate the profit and loss at differentlevels of production. At break even point, profit is zero but for calculating the salesvolume required to earn a desired profit, the profit value is put as desired profit. Thefollowing equations can be derived for this purpose.

Sales – Variable Costs = Fixed Costs + Desired Profit or

Contribution = Fixed Costs + Desired Profit

Sales Volume Required (in Units) =Fixed Costs + Desired Profit

SP – VC (Per unit)

= Fixed Costs + Desired Profit Contribution Per Unit

Sales Volume Required (in Value) =(Fixed Cost + Desired Profit) Sales

Sales – Variable Costs

=(Fixed Cost + Desired Profit) Sales

Total Contribution

= Fixed Costs + Desired ProfitP/V Ratio

= Fixed Costs + Desired Profit 1 – Variable Costs/Sales

Illustration 5

A company producing a single product and sells it at Rs. 10 per unit. Variable cost isRs. 6 per unit and fixed cost is Rs. 40,000 per annum. Calculate (a) Break even point,(b) Sales volume required to earn a profit of Rs. 60,000 per annum

Solution

Contribution = SP – VC = Rs. 10 – Rs. 6 = Rs. 4 per unit

BEP (in units) = Fixed CostsContribution Per Unit

= Rs. 40,000 = 10,000 units Rs. 4

BEP (in value) = Fixed CostsP/V Ratio

P/V Ratio = Total ContributionTotal Sales

= Rs. 40,000 = 0.40Rs. 1,00,000

BEP = Rs. 40,000 0.40

= Rs. 1,00,000

44


Sales volume required to=

Fixed Costs + Desired Profitearn a desired profit (in units) Contribution Per Unit

= Rs. 40,000 + Rs. 60,000 Rs. 4

=Rs. 1,00,000 = 25,000 units Rs. 4

Sales volume required to= Fixed Costs + Desired Profit

earn desired profit (in value) P/V Ratio

=Rs. 40,000 + Rs. 60,000 = Rs. 2,50,000 0. 40

16.6 SALES VOLUME REQUIRED TO EARN ADESIRED PROFIT PER UNIT

If we add the desired profit per unit with variable cost and apply the same equations,the result will provide us the sales volume required to earn a desired profit per unit.

In Units

Sales Volume Required=

Fixed Cost(in units)

SP – (VC + DP)Where DP is desired profit per unit

In Value

Sales Volume Required = Fixed Cost

(in value) VC + P1 -----

Selling Price

= Fixed Cost (VC + Desired Percentage of Profit on Sales)1 -----

SP

Illustration 6

The cost information computed by the cost accountant is as follows :

Sales = 1,00,000 units

Selling Price = Rs. 10 per unit

Variable cost or out of pocket-costs = Rs. 6 per unit

Fixed costs or burden = Rs. 60,000 per annum

Compute the following :

a) Break even points in units and value

b) Make a profit of Rs. 40,000

c) Make a profit of Rs. 2 per unit

d) Make a profit of 30% on sales

Break Even Analysis

45

Solution

a) Break Even Point (in units)

Contribution per unit = SP – VC

= Rs.10 – Rs. 6 = Rs. 4 per unit

BEP in units = Fixed CostsContribution per unit

=Rs. 60,000

= 15,000 units Rs. 4

In Value

P/V or Contribution Ratio = SP – VC SP

= Rs. 10 – Rs. 6 = 0.40 Rs. 10

BEP in value = Fixed Costs

P/V Ratio

=Rs. 60,000

= Rs. 1,50,000 0.40

b) Sales volume required to earn a profit of Rs. 40,000

In units

=Fixed Costs + Desired Profit Contribution per unit

=Rs. 60,000 + Rs. 40,000

= 25,000 unitsRs. 4

In Value

=Fixed Costs + Desired Profit P/V Ratio

=Rs. 60,000 + Rs. 40,000

= Rs. 2,50,000 0.40

c) Sales volume required to earn a profit of Rs. 2 per unit

In Unit

= Fixed CostsSP – (VC + P)

= 60,000 = 30,000 unitsRs. 10 – (Rs. 6+Rs. 2)

In Value

= Fixed Costs1 – (VC +PD)/SP

= 60,0001 – (6+2) / 10

= 60,000 = Rs. 3,00,000 2/10

46


d) Sales volume required to earn a profit of 30% on sales

In unit = Fixed CostSP – (VC + 30% of SP)

= Rs. 60,000 = 60,000 units Rs. 10 – (6+3)

In Value

= Fixed Costs1 – (VC +30% of SP) / SP

= 60,000 = Rs. 6,00,000

1 – (6+3) / 10

Calculations of selling price per unit for a particular break even point.

We know

BEP Units = Fixed CostsContribution Per Unit

∴ Contribution per unit = Fixed Costs BEP Units

Selling price per unit – Variable cost per unit = Contribution per unit

∴ Selling price per unit = Contribution per unit + Variable Cost per unit

Thus Fixed CostsSelling Price per unit = + Variable CostDesired BEP

Illustration 7

Given Fixed Costs = Rs. 40,000

Selling Price Per Unit = Rs. 40

Variable Cost = Rs. 30

The break-even point in this case is

BEP Units=

Rs. 40,000=

Rs. 40,000Rs. 40 – Rs. 30 Rs. 10

= 4000 units

What should be selling price per unit, if management wants to reduce the break-evenpoint from 4000 units to 2500 units?

Solution

Selling price per unit =Fixed Costs

+ VCDesired B E P

=Rs. 40,000

+ Rs. 30 2500 units

= Rs. 16 + Rs. 30 = Rs. 46 per unit

Break Even Analysis

47

16.7 SALES REQUIRED TO MAINTAIN PRESENTPROFIT

Calculating the sales volume required to meet the proposed expenditure

Because of high competition in the market, the management plans an aggressivepromotion policy to boost the sales, which requires an extra expenditure. In suchcases, management wants to know the additional sales volume required to cover theexpected increase in expenditure.

Here the logic should be to cover the extra expenditure, how much additional units tobe sold. Suppose contribution per unit is Rs. 10 per unit and a company spends Rs.1,00,000 extra on advertisement, then logically company must sell 10,000 extra units tocover this expenditure. Thus the formula should be

In units

Additional Sales Volume Required = Proposed ExpenditureContribution per unit

In value

Additional Sales Volume Required =Proposed Expenditure

P/V Ratio

Illustration 8

Sales 10,000 units

Fixed Cost Rs.1,00,000

Variable Cost Rs. 2,00,000

The selling price is Rs. 36 per unit. The company is spending Rs. 100,000 onadvertisement to promote its product. Find the sale volume required to earn the presentprofit.

Solution

Extra sales volume required to meet the additional publicity expenditure of Rs. 1,00,000so as to maintain the present profit level is worked out as follows:

Variable Cost Per Unit =Rs. 2,00,000

= Rs. 20 per unit 10,000 units

Contribution Margin = Rs. 36 – Rs. 20 = Rs. 16 per unit

Addition sales required (in units) = Rs. 1,00,000

= 6,250 units Rs. 16

When a company sells 6,250 unit extra, then present level of profit will be maintained.For example, before spending money the company was earning a profit of Rs. 60,000which is as follows:

Profit = Contribution – Fixed Cost

= Rs. 16 x 10,000 – Rs. 1,00,000

= Rs. 1,60,000 – Rs. 1,00,000 = Rs. 60,000

When sales volume increase to 16,250 units (i.e. 10,000 units + 6,250) then profitwill be

= Rs. 16 × 16,250 – Rs. 2,00,000 (F. C. Rs. 1,00,000 + Advertisement Rs. 1,00,000)

= Rs. 2,60,000 – Rs. 2,00,000 = Rs. 60,000

48


Calculating the sales volume required to offset price reduction

Some time management wants to follow the policy of price reduction or increasingcommission to dealers for increasing the sales or to face the competition. In these casenew values are used for calculations and formula remains the same.

Illustration 9

ABC Ltd. manufactured and markets a product whose cost data is as follows:

Material Costs = Rs. 16 per unit

Conversion (Variable Cost) = Rs. 12 per unit

Dealer’s Margin = Rs. 4 per unit (10% of selling price)

Selling Price = Rs. 40 per unit

Fixed Cost = Rs. 5,00,000

Present Sales = 90,000 units

Capacity Utilisation = 60%

Management has following two suggestions, which alternative is better so as tomaintain the present profit level?

a) Reduction in Selling Price by 5%

b) Increasing the dealer’s margin by 25% over the existing rates

Solution

Total variable costs = Rs. 16 + Rs.12 + Rs. 4 = Rs. 32 per unit

Contribution per unit = Rs. 40 – Rs. 32 = Rs. 8 per unit

Present Profit Level = Rs. 8 × Rs. 90,000 – Rs. 5,00,000 = Rs. 2,20,000

a) First alternative : Price reduction by 5%

New selling price = (Rs. 40 – Rs.2) = Rs. 38 per unit

New Dealer’s Commission = 10% of Rs. 38 = Rs. 3.80

New Contribution = Rs. 38 – ( Rs. 16 + Rs. 12 + Rs. 3.80)

= Rs. 6.20 per unit

Sales volume requires to earn a desired profit (in units)

= FC + DP


Sales volume Required = Rs. 5,00,000 + Rs. 2,20,000

(in units) Rs. 6.20

=Rs. 7,20,000 = 1,16,129 units

Rs. 6.20

b) Second Alternative : Increasing dealer’s commission by 25%

New Dealer’s Commission = Rs. 4+25% of Rs. 4 = Rs. 5 per unit

New Contribution = Rs. 40 – (Rs. 16 + Rs. 12 + Rs. 5) = Rs. 7 per unit

Sales required ( in units) =Rs. 5,00,000 + Rs. 2,20,000

Rs. 7

= 1,02,857 units

Break Even Analysis

49

In the second alternative, lesser units are required to be sold as compared to the firstalternative. Contribution margin is also high in second alternative. Hence secondalternative is better in comparison to the first alternative.

Calculating new sales volume or new selling price to offset the impact ofchange in variable costs and fixed costs.

When a company introduces new production plans or improve the process, thengenerally variable costs and fixed costs also change. In such situation, there are twoalternatives before the management to earn the same profits either to increase thesales volume or increase the selling price when costs increases and vice versa. Thenew sales volume needed to earn the same profit, when only variable costs changes,then new contribution is calculated by changing the variable cost and break evenequation remains same. If management wants to change the selling price and volumeremains the same, then new selling price is :

New selling price = Old selling price + (new variable cost --- old variable cost)

When fixed cost changes, then fixed costs is replaced by a new fixed cost in theequation and new volume of sales can be computed to earn the same profit. Ifmanagement thinks that selling price be changed and volume remain the same, thennew selling price is :

New selling price = Old selling + New fixed cost --- old fixed costsVolume of production

The logic is change in selling price is incremental change in variable cost and / or fixedcost per unit is added in selling price so as to earn the same profit. Look at thefollowing illustration how the new selling price is calculated when there is change invariable and fixed costs :

Illustration 10The cost information supplied by the cost accountant is as follows:Sales 20,00 units @ Rs. 10 per unit Rs. 2,00,000Variable cost Rs. 6 per unit Rs. 1,20,000

Contribution Rs. 80,000

Fixed Cost Rs. 30,000

Profit Rs. 50,000

Calculate the (a) new sales quantity and (b) new selling price to earn the same profit if

i) Variable cost increases by Rs. 2 per unit

ii) Fixed cost increase by Rs. 10,000

iii) Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs. 10,000

Solution

i) Variable cost increases by Rs. 2

a) New sales quantity required =

F + DPSP--- Vn

where Vn is the new variable cost

=Rs. 30,000 + Rs. 50,000

= Rs. 80,000 = 40,000 units

Rs.10 --- Rs.8 Rs.2

50


b) New selling price

= Old selling price + change in variable cost per unit

= Rs. 10 + Rs. 2 = Rs. 12 per unit

To earn the same amount of profit, management should either increase the productionto 40,000 units or increase the selling price to Rs. 12 per unit

ii) Fixed costs increases by Rs. 10,000

a) Sales volume needed to earn a desired profit

= Fn + DP SP-VC

Fn is the new fixed costs

= Rs. 40,000 + Rs. 50,000 = 22,500 units

Rs. 10 --- Rs. 6

b) New selling price

= SPo + Fn – Fo Q

SPo is old selling price, Fn is new fixed cost and Fo is old fixed cost.

= 10 +Rs. 40,000 – Rs. 30,000

= Rs. 10.50 20,000 units

To earn the same amount of profit i.e. Rs. 50,000 management should either increasethe sales volume to 22,500 units or increase the selling price to Rs. 10.50.

iii) Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs. 10,000.

a) Sales volume required to earn a desired profit

= Fn + DP SP − Vn

= Rs. 20,000 + Rs. 50,000 = Rs. 70,000 = 23,333 units Rs. 10 --- Rs. 7 Rs. 3

b) New Selling price

= SPo + (VCn – VCo ) + Fn – Fo Q

= Rs. 10 + Rs. 20,000 – Rs. 30,000 + Rs. 7 --- Rs. 6 20,000 units

= Rs. 10 – Rs. 0 .50 + Rs. 1

= Rs . 10 .50

To earn the same profit i.e. Rs. 50,000 management should either increase the sales to23,333 units or increase the selling price to Rs. 10.50.

Break Even Analysis

51

Illustration 11

The cost data of XYZ Ltd. is as follows:

Product X Product Y Product Z TotalRs.

Sales (40 : 50 : 10) (Rs.) 80,000 1,00,000 20,000 2,00,000Variable Costs (Rs.) 50,000 60,000 10,000 1,20,000Contribution (Rs.) 30,000 40,000 10,000 80,000Fixed (Rs.) ----- ----- ----- 50,000Profit ----- ----- ----- 30,000

Calculate :

i) Break Even Point, and

ii) Break even point if sales mix ratio is changed to 30:50:20

Solution

i) Break Even Point

When company is producing multi products, then for computing break evenequation in terms of value should be used.

BEP (in value ) = Fixed Costs × Total Sales

Total Sales --- Variable costs

= Rs. 50,000 × Rs.2,00,000

Rs. 2,00,000 – Rs.1,20,000

= Rs. 50,000 × Rs.2,00,000 = Rs. 1,25,000

Rs. 8 0 , 0 0 0

ii) Change in Sales Mix Ratio

New Sales mix X : Y: Z = 30:50:20

Sales

X = Rs. 2 ,00 ,000 × 30 = Rs. 60 ,000100

Y = Rs. 2 , 0 0 , 0 0 0 × 50 = Rs. 1 , 0 0 , 0 0 0 1 0 0

Z = Rs. 2 , 0 0 , 0 0 0 × 20 = Rs. 40,000100

Variable Cost Ratio (as variable cost per unit remains same)

X = Rs. 5 0 , 0 0 0 = 5Rs.8 0 , 0 0 0 8

Y = Rs. 6 0 , 0 0 0 = 6Rs. 1 , 0 0 , 0 0 0 10

Z =Rs.1 0 , 0 0 0

=1

Rs. 2 0 , 0 0 0 2

52


X Y Z Total Rs.

Sales (Rs.) 60,000 1,00,000 40,000 2,00,000Variable Costs (Rs.) 37,500 60,000 20,000 1,17,500Contribution (Rs.) 22,500 40,000 20,000 82,500Fixed Costs ----- ----- ----- 50,000Profit ----- ----- ----- 32,500

Break even point after change in sales mix

= Fixed Costs × Sales

Sales --- Variable Costs

=Rs. 50,000 × Rs. 2,00,000

=Rs.50,000 × Rs.2,00,000

Rs. 2,00,000 – Rs. 1,17,500 Rs. 82,500

= Rs. 1,21,212.12

Illustration 12

A firm produces and sells three products A, B and C. From the following data,calculated the break even point.

Product No. of Units Sold SP per unit VC per unitRs. Rs.

A 600 50 30

B 1500 60 45

C 1000 30 15

Fixed costs are Rs. 33,000 per year.

Solution

Firstly we calculate the over all P/V ratio which is :

= SP – VC or 1 − VCSP SP

Product SP VC P/V Ratio Total %Sale OverallSales Proceeds P/V Ratio

(Rs.) (Rs.) (Rs.)

A 50 30 0.40 30,000 0.20 0.08

B 60 45 0.25 90,00 0.60 0.15

C 30 15 0.50 30,000 0.20 0.10

Rs. 1,50,000 1.00 0.33

The overall P/V ratio is 0.33 (P/V Ratio × % sales proceeds). P/V ratio can also becomputed as per preceding illustration.

∴ Overall Break Even Point = Fixed CostsP/V ratio

= Rs. 330000.33

= Rs. 1,00,000

Break Even Analysis

53

The break up of total sales at Break Even Point will be:

% Sales Proceeds Sales proceeds No. of Units

A 0.20 Rs. 20,000 400

B 0.60 Rs. 60,000 1000

C 0.20 Rs. 20,000 667

Rs. 1,00,000

16.8 MARGIN OF SAFETYThe margin of safety is the difference between actual sales and sales at break even point.

M/S = Actual Sales – Sales at BEP

Suppose the actual sales of X Y Z Ltd. (example given in 16.3) is 1,20,000 units andsales at break even point is 90,000 units, then

M/S = 1,20,000 units – 90,000 units = 30,000 units

Sale price was Rs. 3 per unit.

M/S = Rs. 3,60,000 – Rs. 2,70,000 = Rs. 90,000

It can be expressed in terms of Rupees or in units, and is a absolute measure. It can beexpressed in relative terms and is

M/S = Actual Sales – Sales at Break Even Points × 100 Actual Sales

= Rs. 1,20,000 – Rs. 90,000 × 100 = 30,000 × 100 = 25% Rs. 1,20,000 1,20,000

If we use the sales data in terms of rupees and compute the relative margin of safety,the answer will remain the same, for example

M/S = Rs. 3,60,000 – Rs. 2,70,000 × 100 Rs. 3,60,000

= Rs. 90,000

× 100 = 25%Rs. 3,60,000

Margin of safety can also be computed from profit and P/V ratio, which is

M/S = ProfitP/V Ratio

Higher margin of safety provides greater protection to the company. The size ofmargin of safety is an indicator of soundness of business. It shows how much salesmay decrease before the firm will suffer a loss. Sales beyond the break-even pointrepresent margin of safety. Larger the margin of safety, greater the soundness of thebusiness, smaller the margin of safety, weaker will be the soundness of the business.The following actions help in improving the margin of safety:

1) Increase the level of production

2) Reduce the fixed and / or variable costs

3) Increase the selling price

4) Substitute the existing product with more profitable products

5) From the product mix, remove the product whose contribution ratio is very low

54


Illustration 13Calculate the P/V ratio, fixed expenses and break even point from the following data:Sales Rs. 6,00,000Profit Rs. 40,000Margin of safety Rs. 1,60,000Solution

We know

M/S = ProfitP/V ratio

P/V Ratio = Profit M/S

= Rs. 40,000 = 0.25Rs. 1,60,000

Contribution = P/V ratio × sales

= 0.25 × Rs. 6,00,000 = Rs. 1,50,000

Contribution = Fixed Costs + Profit

Fixed Cost = Contribution --- Profit

= Rs. 1,50,000 – Rs. 40,000

= Rs. 1,10,000

BEP (in value) = FC = 1,10,000 = Rs. 4 ,40 ,000P/V Ratio 0.25

16.9 ANGLE OF INCIDENCEThe angle formed at the intersection of the total sales revenue line and the total costline is called the angle of incidence. It depicts the difference between the slope of thetotal sales revenue line and total cost line. Graphically it is as follows :

BEPX

Y

Sales

B

A

Fixed cost

Total cost

Angle of incidence

Output (in units)BEP

X

Y

Sales

B

A

Fixed cost

Total cost

Angle of incidence


X

Y

Sales

B

A

Fixed cost

Total cost

Angle of incidence


XO

Y

Sales

B

A

Fixed cost

Total cost

Angle of incidence

Output (in units)

C

Break Even Analysis

55

Angle ABC is the angle of incidence. It reflects the responsiveness or sensitivity ofprofit to variation in the volume sold. The higher the angle of incidence, the greater theresponsiveness of profits to variation in the sales volume and vice versa. In subsection16.4 of this unit, we observed that small change in sales brings wide fluctuations inprofits.

Activity 2

During boom period high angle of incidence is better and in recession period low angleof incidence is better? Comment.

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

........................................................................................................................................

16.10 BREAK EVEN CHARTSThe effect of change in sales volume, price and costs on profit can be depictedgraphically as follows :

16.10.1 Effect of Price Change on ProfitWhen price is increased, the slope of sales revenue line become more steep and breakeven point lowers from BEP0 to BEP1, the margin of safety increases from BEP0X toBEP1X angle of incidence also increases. The reverse happens in case of decrease inprice.

New Sales Line

Old Sales Line

Profit after change in price

Profit before change in price

BEP1

BEP0

New M/S

Old M/S

Output (units)

Actual SalesBEP1 BEP0 XO

Y

Total cost

Variable cost

Fixed cost

(Rs)

56


16.10.2 Effect of Change in Fixed Cost on ProfitIncrease in fixed cost leads to increase in break even point, lowers the margin ofsafety and no impact on angle of incidence (Parallel lines)

16.10.3 Effect of Change in Variable Cost

Increase in variable costs leads to higher break even point, lowers the margin of safetyand reduces the angle of incidence.

New M/S

Actual SalesBEP1BEP0

X

Sales Line

BEP1

BEP

(Rs.)

0

New total cost

Variable cost

New fixed cost

Old fixed cost

Output (units)

Total cost

Old M/S

New M/S

Actual SalesBEP1BEP0

X

Sales Line

BEP1

BEP0

New profit

New variable cost

Fixed cost

Old M/S

Old profit

Old variable cost

Output (units)

Break Even Analysis

57

Activity 3Try to find out the relationships between change in price, fixed cost, variable costs andvolume on profit, margin of safety and profit volume ratio through the following equations:

Break Even Point (in units) = Fixed CostSale Price – Variable Cost Per Unit

Break Even Point (in value) = Fixed Costs P/V Ratio

Margin of Safety = Actual Sales – Sales at BEP

P/V Ratio = Sales – Variable Costs = ContributionSales Sales

16.11 PROFIT VOLUME GRAPHProfit-Volume Graph is the graphical representation of the relationship between profitand volume. It shows profit or loss at different levels of output. It is also called the P/Vgraph. This type of graph may be preferred to know the profit or loss directly atdifferent levels of activity. Following steps are involved in the construction of profit-volume graph:1) Fixed Costs and profits are depicted on the y-axis or vertical axis.2) Sales are shown on the x-axis or horizontal axis.3) Area above the sales line (x-axis) is a “profit area” and below it is the “loss

area”. At zero output, the loss equals to fixed cost. Profit at a particular saleslevel is depicted on y-axis above the sales line.

4) After plotting profits and fixed costs, these two points are joined by a diagonalline which is called profit line or contribution line or fixed cost recovery line orprofit-volume line. The break even point occurs at a point where contribution lineintersects the horizontal line.

Let us see the following illustration how a P/V graph is prepared.Illustration 13Prepare a P/V graph with the help of the following data :

Output = 2,00,000 unitsSales = Rs.6,00,000FC = Rs. 1 ,00 ,000VC = Rs.4 ,00 ,000Profit = Rs.1 ,00 ,000

SolutionProfit Volume Graph

X

Y

Fixed cost

Contribution line Profit

Sales volume

BEPLoss area

0

200,000

+100,000

-100,000

58


Better P/V ratio is an index of sound financial health. P/V ratio can be improved bytaking following steps:

! Increase in Sale Price

! Decrease in variable costs

! Change in sales mix, i.e. producing more of an item where P/V ratio is high alongwith demand or droping or decrease the production of a products whose P/V ratiois very low as per situation.

Illustration 14

ABC Ltd., a multi product company, furnishes the following data:

Particulars Period I Period II

Sales (Rs) 4 5 , 0 0 0 5 0 , 0 0 0

Total Cost (Rs) 40,000 43,000

Assuming that there is no change in price and variable costs. Fixed expenses areincurred equally in the two periods. Calculate the following :

i) Profit volume ratioii) Fixed expensesiii) Break even pointiv) Percentage M/S to sales in Period IIv) Sales required to earn profit of Rs. 10 ,000vi) Profit when sales is Rs. 80 ,000 .

Solution

Sales Total Cost Profit (Rs.) (Rs.) (Rs.)

Period II 50,000 43,000 7,000

Period I 45,000 40,000 5000

Change 5000 3000 2000

i) P/V Ratio =Change in Profit

=Rs. 2000

= 0.40Change in Sales Rs. 5000

ii) Fixed expensesContribution = Sales × P/V ratio

Period I Contribution = Rs.50,000 × 0.40 = Rs. 20,000Contribution = Fixed Cost + ProfitRs. 20 ,000 = F C + Rs. 7000F C = Rs. 13 ,000

Period II Contribution = Rs.45 ,000 × 0 .40 = Rs.18 ,000F C = Contribution – Profit

= Rs.18,000 – Rs.5000 = Rs. 13000iii) Break even point

BEP (in value) =Fixed CostsP/V Ratio

= Rs.13,000

= Rs. 32,500 0.40

Break Even Analysis

59

iv) Margin of Safety (M/S) = Actual Sales --- BEP (in value)

= Rs. 50,000 – Rs. 32,500

= Rs. 17,500

% of M/S to sales =Rs.17,500 × 100Rs.50,000

= 35%

v) Sales required to earn a desired profit of Rs. 10,000

=FC + DP

P/V Ratio

=Rs.13,000 + Rs.10,000

0.40

= Rs. 57,500

vi) Profit when sales is Rs. 80,000

Contribution = Sales × P/V ratio

= Rs.80 ,000 × 0 .40

= Rs. 32,000

∴ Profit = Contribution – FC

= Rs. 32,000 --- Rs. 13,000

= Rs. 19,000

Activity 4 : Think on the following relationships:

1) An increase in selling price increases the amount of contribution resulting inhigher P/V ratio or contribution ratio and vice versa.

2) An increase in fixed cost increases the break-even point but does not affect the P/V ratio.

3) An increase in variable cost per unit reduces the contribution per unit, increasesthe break-even point and lowers the P/V ratio and vice versa.

4) Increase in P/V ratio lowers the break even point and vice versa.

16.12 ASSUMPTION IN BREAK EVEN ANALYSIS

Break even analysis is based on certain assumption, which are:

1) All costs can be segregated in two parts i.e., fixed and variable.

2) Fixed costs remains constant at various levels of activity.

3) Variable costs changes directly with production. It means variable cost per unitremains constant.

4) Selling price per unit remains constant at all various levels of activity.

5) Technological methods and efficiency of men and machines will not be changed.

6) Production and sales are perfectly synchronized i.e., no inventory exists in thebeginning or at the end of the period.

60


7) Either there is only one product or if several products are being produced and soldthen sales mix remains constant.

8) Break even analysis assumes linear relationship in total costs and total revenues.

9) Break even analysis ignores the capital employed in the business.

The above assumptions are also the limitations of this analysis e.g. selling price per unitand variable cost per unit remains constant at any level of activity. The production andsales can be increased upto the maximum plant capacity so long as contribution ispositive. This assumption is valid if it is not necessary to reduce the selling price per unitto increase the sales.

The variables cost per unit do not have a linear relationship with level of productionbecause of laws of return. In economic theory, initially total cost will increase at adecreasing rate, then at a constant rate and finally at increasing rate.

Further production and sales are not perfectly synchronized as there will be someopening and closing inventory. Technological methods and efficiency of men andmachines keeps changing. To increase the sales, price concessions are offered to thecustomers. The break even chart, therefore becomes curve-linear having the followingshape.

In curve-linear model, the optimum production level is where the total revenue exceedsthe total cost by the largest amount. There are two break-even points, one at the lowercapacity level and other at the higher capacity level. No firm would like to operate at alower level then BEP1 as it is loss zone and beyond BEP2 point which is again a losszone. The economist’s model is valid over a range of activity and it allows production,inputs costs, selling price to vary. The accountant model is valid only for a short relevantrange of activity where only quantity varies, price and cost structure is constant.

Check Your Progress

A. 1) In cost-volume-profit analysis, profit is determined by

a) Sales Revenue x P/V ratio - Fixed Cost

b) Sales units x contribution per unit - fixed costs

c) Total contribution - Fixed cost

d) All the above

Sale Revenue

Y

0

Total CostBEP2

BEP1

Sales Volume X

Cos

t/Sal

es R

even

ue

( R

s.)

→

→

Break Even Analysis

61

2) Variable costs per unit

a) Goes on increasing with production

b) Goes on decreasing with production

c) Remains constant with change in production

d) None of these

3) Variable cost are those which

a) Are directly apportioned to cost unit or cost centre

b) Varies directly with production

c) Depends upon the demand

d) Depends upon the sale

4) In accounting, marginal cost per unit goes on, __________ with increase in

production

a) Increases

b) Decreases

c) Remain constant

d) None of these

5) Which is not a fixed cost

a) Property tax

b) Power

c) Insurance premium

d) Rent

6) Fixed cost per unit _________with increase in production

a) Increases

b) Decreases

c) Remains constant

d) Can’t say

7) Semi variable cost are segregated into fixed and variable costs with the help of

a) Scatter diagram

b) Method of least square

c) High and low points method

d) All the above

8) Telephone charges is a

a) Fixed cost

b) Variable cost

c) Semi-variable cost

d) Marginal cost

62


9) The break even points in units is equal to

a) Fixed cost/PV ratio

b) Fixed cost x sales/total contribution

c) Fixed cost/contribution per unit

d) Fixed cost/total contribution

10) At the break-even point, which equation will be true.

a) Variable cost - fixed cost = contribution

b) Sales = variable cost + fixed cost

c) Sales - fixed cost = contribution

d) Sales – contribution = variable cost

11) When fixed costs increases, the break even point

a) Increases

b) Decreases

c) No effect

d) Can’t say

12) When variable costs decreases, then break even point

a) Increases

b) Decreases

c) No effect

d) Can’t say

13) When selling price decreases, then break even point

a) Increases

b) Decreases

c) No effect

d) Can’t say

14) When sales increases then break even point

a) Increases

b) Decreases

c) Remains constant

d) None of these

15) Contribution is

a) Fixed cost + profit

b) Sales - variable cost

c) Fixed cost – loss

d) All the above

Break Even Analysis

63

16) P/V ratio is

a) Profit/volume

b) Contribution/sales

c) Profit/contribution

d) Profit/sales

17) Profit - volume ratio is improved by reducing

a) Variable cost

b) Fixed cost

c) Both of them

d) None of them

18) The price reduction policy, ______ the P/V ratio and _______ the break evenpoint

a) Reduces, reduces

b) Reduces, increases

c) Increases, reduces

d) Increases, increases

19) Shut down point occurs when

a) Net profit is zero

b) Sale revenue - variable cost + fixed costs

c) Losses are greater than fixed cost


20) The break even point and shut down point are

a) Synonymous

b) Anonymous

c) Different

d) Can’t say

21) The sales of a firm is Rs. 3,00,000, fixed cost is Rs. 90,000, and variable costsare Rs. 2,00,000, the break even point will occur at

a) 2,70,000 units

b) Rs. 2,70,000

c) Rs. 3,25,000

d) 3,25,000 units

22) The financial accounts of a firm reveals the position at two time periods is asfollows:

Period Sales Rs. Profit Rs.

I 2,30,000 50,000

II 3,00,000 80,000

64


The profit volume ratio for the firm will be

a) 3/7

b) 5/8

c) 3/8

d) 13/53

23) The fixed cost of a firm is Rs. 90,000, variable cost per unit is Rs. 2 and saleprice is Rs. 3 per unit. The break even point will occur at

a) 30,000 units

b) 50,000 units

c) 90,000 units

d) Rs. 90,000

24) The sales volume in value required to earn the target profit, the formula is

a) Target profit/contribution per unit

b) (Fixed cost + Target profit) P/V ratio

c) Fixed cost + Target profit/contribution on per unit

d) (Fixed cost + Target profit) / PV ratio

25) The contribution per unit is Rs. 2 and fixed costs are Rs. 15,000 for earning aprofit of Rs. 50,000, the company must have sales of

a) Rs. 1,30,000

b) Rs. 1,00,000

c) 32,500 units

d) Rs. 32,500

26) Margin of safety is expressed as

a) Profit / P/V ratio

b) (Actual sales --- sales at BEP ) / Actual sales

c) Actual sales --- Sales at BEP

d) All of the above

27) The margin of safety point lies

a) To the left of break even point

b) To the right of break even point

c) On break even point

d) Can’t say

Break Even Analysis

65

28) The sale at a BEP for a firm is Rs. 4,80,000 and the actual sales made by thefirm Rs. 8,00,000, the margin of safety will be

a) Rs. 12,80,000

b) Rs. 3,20,000

c) Rs. 4 ,80 ,000/8 ,00,000

d) Rs. 800,000

29) The profit of a company is Rs. 30,000 by selling 10,000 units at a price of Rs.10 per unit. The variable cost to sale ratio is 60 per cent. Find margin of safetylevel.

a) Rs. 75,000

b) Rs. 30,000

c) Rs. 1,00,000

d) Rs. 12,000

30) In the above question, determine the break even point

a) Rs. 20,000

b) Rs. 25,000

c) Rs. 30,000

d) Rs. 40 ,000

B) State whether the following statement are True or False.

i) Contribution is the difference between the total sales and fixed cost [ ]

ii) At break even point contribution equals to fixed cost [ ]

iii) Profit volume graph shows profit or loss at different levels of sales [ ]

iv) Profit volume graph can also be called P/V graph [ ]

v) P/V ration can be improved by decreasing the selling price [ ]

vi) P/v ratio can be improved by reducing the fixed costs [ ]

vii) Margin of safety may be improved by increasing selling price and reducingfixed cost [ ]

viii) At break-even point sales equal to total cost [ ]

16.13 LET US SUM UPBreak even analysis helps is ascertaining the level of production where total costsequals to total revenue. Below this level of production, there are losses and above thispoint depicts the profit zone. Like marginal costing this analysis is also based on costclassification into fixed and variable costs. Break even analysis helps in measuring theeffect of charges in volume, costs, selling price and product mix on profit. In fact,break even analysis is cost-volume profit analysis.

Break even point can be determined both mathematically (equation technique andcontribution margin technique) and graphically. It is expressed in terms of units or in

66


value terms. This technique is very useful in profit planning and decision making. It canbe applied to estimate profits at a given sales volume, sales volume required to earn adesired profit, calculating sale volume required to offset price reduction, ascertaining themargin of safety, measuring the effect of changes in profit factors etc. The other tools inthis analysis are profit-volume ratio, margin of safety and angle of incidence.

There are inherent limitations in the break even analysis –classification of costs intofixed and variable costs, fixed costs remains fixed, variable cost per unit is constant,selling price per unit is constant etc. In spite of its limitation the break even point is auseful technique in decision making if it used by those who understand its limitations.

16.14 KEY WORDSBreak Even Point is the level of sales (volume or value) where total costs equals tototal revenue or no profit no loss point.

Cost-volume-Profit analysis is technique to study the effects of costs and volumevariations on profit.

Margin of Safety is the difference between actual sales and sales at break even point.It shows the amount by which sales may decrease before losses occur.

Profit Volume Ratio is a relationship between contribution to sales.

Mixed Costs are those costs which has both fixed and variable elements. These arealso known as semi-variable costs.

16.15 ANSWERS TO CHECK YOUR PROGRESSA

1 d 7 d 1 3 a 1 9 c 2 5 c

2 c 8 c 1 4 c 2 0 c 2 6 d

3 b 9 c 1 5 d 2 1 b 2 7 c

4 c 1 0 b 1 6 b 2 2 a 2 8 b

5 b 11 a 1 7 a 2 3 c 2 9 a

6 b 1 2 b 1 8 b 2 4 d 3 0 b

B) i) False ii) True iii) True iv) True v) False vi) False vii) True viii) True

16.16 TERMINAL QUESTIONS1) ‘Cost-volume profit analysis and break even point analysis are same’ Comment?

2) What are different methods of computing break even point?

3) “The break even chart is an excellent planning device” Comment.

4) Explain the significance of Profit-Volume ratio, Margin of Safety and Angle ofIncidence?

5) What is Contribution ? How does it helps the management in taking managerialdecisions?

Break Even Analysis

67

6) Describe three ways to lower down the break even point?

7) What are various ways to improve the margin of safety and P/V ratio?

8) ‘A 10 per cent increase in production and sales leads to more than 10 percentincrease in profit’ Explain

9) ABC Ltd. manufactures and sells four type of products under the brand namesof P, Q, R and S. The sale mix in value comprises of 34%, 40%, 16% and 10%of P,Q, R and S respectively. The total budgeted sales (100%) are Rs. 60,000 permonth. Operating costs are:

Variables costs ratio is (variable costs on % of sales)

P 60%

Q 65%

R 70%

S 40%

Fixed costs is Rs. 15,000 per month. Calculate the break even point for theproducts on an overall basis. (Ans BEP Rs. 39062.50)

10) Explain from the following data, how the reduction in selling price would affectthe break even point and margin of safety.Selling price per unit Rs. 20

Variable costs Material Rs. 6

Labour Rs. 4

Variable overheads Rs. 2

Fixed overheads is Rs. 8000. Full capacity of the plant is 5000 units. Reducedselling price is Rs. 16 per unit.

[Ans. BEP increase by 1000 units and M/S decrease by Rs. 32000]

11) The sales manager of a company found that with fixed cost Rs. 50,000, salesare increased from Rs. 30,000 to Rs. 4,00,000 and profit increased by Rs.40,000. Compute the profit when sales is Rs. 5,00,000.

[Ans. Rs. 1 ,50,000]

12) ABC Ltd., has a margin of safety 37.5% with an overall contribution sale ratioof 40%. The fixed cost is Rs. 5 lakhs.

Calculate the following:

i) Break even point

ii) Total Sales

iii) Total variables costs

iv) Profit

[Ans. (i) Rs. 12,50,000 (ii) Rs. 20,00,000 (iii) Rs. 12,00,000(iv) Rs. 3,00,000]

13) The P/V ratio of a concern is 50% and margin of safety is 40%. Calculate thenet profit of the sales is Rs. 1,00,000.[Ans. Profit Rs. 20,000]

68



14) X Ltd has earned a contribution of Rs. 2,00,000 and net profit of Rs. 1,50,000on sales of Rs. 8,00,000. What is the break even point and margin of safety.[Ans. Rs. 2 ,00,000 M/S is Rs. 6,00,000]

15) From the following cost information:2001 2002

Sales (Rs) 1,50,000 2,00,000

Profit (Rs.) 30,000 50,000

Calculate:

i) P/V ratio

ii) Break even point

iii) Sales required to earn a profit of Rs. 80,000

iv) Profit when sales is Rs. 2,50,000

[Ans. (i) 0.40) (ii) Rs. 75,000 (iii) Rs. 2,75,000 (iv) Rs. 70,000 ]

16.17 FURTHER READINGS

Horngren, C.T., Gary L. Sundem and Frank H. Selto, “Management Accounting”,Prentice Hall of India, New Delhi, 1994.

Kaplan, R.S., s, Engle Wood Cliffs, NJ., Prentice Hall Inc.

UNIT 17 RELEVANT COSTS FORDECISION MAKING

Structure17.0 Objectives

17.1 Introduction

17.2 Relevant Costs for Decision Making

17.2.1 Concept of Relevant Costs

17.2.2 Concept of Differential Costs

17.2.3 Decision-Making Process

17.2.4 Selling Price Decisions

17.2.5 Exploring New Markets

17.2.6 Make or Buy Decisions

17.2.7 Expand and Contract

17.2.8 Sales Mix Decisions

17.2.9 Alternative Methods of Production

17.2.10 Plant Shut Down Decisions

17.2.11 Acceptance of Special Order

17.2.12 Adding or Dropping a Product Line

17.2.13 Replacement of Machinery

17.3 Let Us Sum Up

17.4 Key Words



17.0 OBJECTIVESAfter studying this unit, you should be able to:

! distinguish between the different types of costs;

! distinguish between the nature of costs;

! present different alternatives before the decision making; and

! selection out of different alternatives.

17.1 INTRODUCTIONThe analysis of costs plays a vital role in selecting the alternatives available before themanagement. Costs could shape alternative opportunities and therefore, it influencesand shapes future profits. Management is not only interested in the historical costanalysis but it is also interested to study those costs, which are influencing the future 69

70


operations. After analyzing different types of costs according to their nature, one canbe able to select one out of the various optimal alternatives. When costs are futureoriented then only they remain important for the decision maker. In this unit you willstudy the importance of relevant costs for decision making.

17.2 RELEVANT COSTS FOR DECISION MAKINGWith different objectives the different costs concept is always there. It is pertinent touse the word relevant while providing the information about costs. When the costs arenot changing with the different alternatives and remain fixed in nature then theybecome irrelevant or sunk costs. When management wants to select any of thealternatives available before them and take decision then the relevant costs becomevery important.

17.2.1 Concept of Relevant Costs

Relevant cost is a cost of decision. You may call it decision cost, as it is alwaysrelevant with the selection of one out of different alternatives. If decision is beingtaken and any cost is increased because of the change in decision, that particular costbecomes relevant cost. Relevant cost is always for future and not for the analysis ofthe past decisions. These costs are ‘Future Costs’ and they differ to differentalternatives. We focus on the future whether it may be 10 seconds after or it may be10 years later.

Relevant costs are also known as differential costs. Relevant costs differ among thedifferent alternatives. For example, if an engineering graduate wants to start his ownwork shop and he has a choice to complete his post–graduation. Relevant costs tocontinue his studies are fees and books. Irrelevant costs are clothes and his residentialarrangements, which will incur under both the circumstances.

17.2.2 Concept of Differential Costs

Differential cost is the difference between the costs of alternatives. Difference in totalcost between the two alternatives available. It is also known as net relevant cost.Differential cost is not calculated per unit. It is calculated as total cost and then thedifference is being calculated between the two levels of production or is beingcalculated between the two alternatives. Both variable costs and fixed costs may bedifferential cost when there is a change in both these costs in response to alternativecourse of action. When a decision does not affect either the variable or fixed coststhen there is no differential costs. It is a technique of costing and not a method. Onlyrelevant costs of the option are being considered. It is normally calculated on salesbasis, which gives revenue. Decision cannot be taken only on the basis of differentialcost analysis as other factors like government policies, social and financial causes,investment and the behaviour of the workers are also the influential part of thedecision-making process. Conditions and costs of different alternatives always differ,so the differential costs once calculated cannot be used without adjustments for theother decisions. As differential costs are relevant costs for future, so irrelevant costsshould be known. The costs which do not change as a result of decision are irrelevantcosts. Fixed costs are irrelevant costs as they do not change if production is expandedupto certain level.

17.2.3 Decision-Making Process

Decision-making is a process of selecting any of the alternatives available afterevaluation of all the options. Selection of one alternative out of two or more shouldmaximize the profits of the concern. Decision-making is very much related with

Relevant Costs forDecision Making

71

future planning with a particular goal. In this process, available informationregarding the options should be analyzed properly to make a beneficial decision forthe benefit of the organization. Before taking decision firstly one should recognisethe problem, secondly identify the various alternatives, thirdly evaluate differentalternatives with helps of cost benefit analysis and finally adopt the most profitablecourse of action.

Differential cost analysis is a very useful technique to the management in formulatingpolicies and making the following decisions:

1) Selling Price Decisions

2) Exploring New Markets

3) Make or Buy Decisions

4) Expand and Contract

5) Sales Mix Decisions

6) Alternative Methods of Production

7) Plant Shut Down Decisions

8) Acceptance of Special Order

9) Adding or Dropping a Product Line

10. Replacement of Machinery

Let us study each one of these in detail.

17.2.4 Selling Price Decisions

Pricing process is different in different industries. It differs according to the nature,cost and demand of the product. Every producer accepts the different criterion forpricing his product. Effect of changes in selling price can easily be understood with thehelp of the following illustration.

Illustration 1

X Ltd. produces and markets ballpoint pens. Due to competition, the companyproposes to reduce the selling price. From the following information, examine theeffects of reduction in selling price by (a) 5%, (b) 10% and (c) 15%

Rs. Rs.

Present Sales 3,000 units ----- 3,00,000

Variable Costs 1,80,000

Fixed Costs 70,000 2,50,000

Net Profit 50,000

Indicate the number of units to be sold if the company wants to maintain the sameprofits in each of the above cases.

72


SolutionStatement of Cost and Profit

Particulars Present Price Price Priceprice Reduction Reduction Reduction

by 5% by 10% by 15%

Selling price per unit (Rs.) 100 95 90 85

Less: Variable cost (Rs.) 60 60 60 60

Contrubution (Rs.) 40 35 30 25Contribution for 3,000 units (Rs.) 1,20,000 — — —Contribution required to maintain

— 1,20,000 1,20,000 1,20,000same profit (Rs.)

Required units to be sold — 3 , 4 2 9 4 , 0 0 0 4 , 8 0 0Less: Units sold at present price — 3 , 0 0 0 3 , 0 0 0 3 , 0 0 0

Additional Units required to be soldto earn the same amount of Profit — 429 1,000 1,800

Decision: If company reduces the selling price by 5% then it requires 429 pens moreto sell to earn the same amount of profit. If it accepts the second option to reduce theprice by 10% then it requires 1,000 pens more to sell to earn the same amount, and if itaccepts the third alternate to reduce the price by 15% then it require 1,800 pens moreto sell to earn the same amount.

Working Notes:

1) It has been assumed that in all the options, fixed costs remain unchanged and toearn the same amount of profit the contribution should remain the same.

2) Calculation of Required Units to be sold to earn the same amount has beenmentioned with the use of the following formulae:

Rs. 1,20,000Required Sales = = = 3,429 units required to

Rs. 35 be sold if selling priceis being reduced by 5%

17.2.5 Exploring New Markets

Decisions regarding new market can be taken if the home market is not affected. Ifwe sell the commodity to the foreign market at lower price and they re-export to ourexisting customers at lesser price what we charge to our customers, then therecannot be a decision in favour of new market even if profit or contribution isincreased. It is advisable only when other things being remain same in the home orpresent market. To make use of the existing capacity, export and new market is thebest alternate. With the following illustration, one can understand about the newmarket decision.

Illustration 2

X Ltd. manufactures 1,000 units p.a. at a cost of Rs. 40 per unit and there is ademand of the whole production at a price of Rs. 42.5 per unit in the home market.There is a fall in the demand in the home market in the year 2003 and the wholeproduction can be sold in the home market at a selling price of Rs. 37.2 per unit.The cost analysis for 1,000 units is as follows:

Contribution per UnitRequired Contribution


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Rs.

Materials 15,000

Wages 11,000

Variable Expenses 6,000

Fixed Expenses 10,000

2,000 Units can be sold in the foreign market at a explored price of Rs. 35.5 per unit.It is also estimated that for additional 1,000 units of the product the fixed cost willincrease by 10%. Advise the management.

Solution

Statement showing the Effects of Selling Goods in the Foreign Market

Particulars Year 2002 Year 2003

Home market Home market Foreign market Total1,000 units 1,000 units 2,000 units 3,000 units

Rs. Rs. Rs. Rs.

Materials 15,000 15,000 30,000 45,000

Wages 11,000 11,000 22,000 33,000

Variable expenses 6,000 6,000 12,000 18,000

Marginal cost 32,000 32,000 64,000 96,000

Sales 42,500 37,200 71,000 1,08,200

Contribution(Sales – Marginal Cost) 10,500 5,200 7,000 12,200

Less : Fixed cost 10,000 10,000 2,000 12,000

Profit / (Loss) 500 (4,800) Loss 5,000 200

It is advisable to accept the proposal for sale in the foreign market as it converts lossof Rs. 4,800 of home market into a net profit of Rs. 200.

17.2.6 Make or Buy DecisionsDecisions about, whether a manufacturer of goods or services should produce goodsor services within the factory or purchase them from the market. This type ofdecision is needed when the concern organization is producing the item, which is alsoavailable in the market at cheaper rate. If, purchased from the open market,retrenchment of workers becomes inevitable or may not be able to reduce the fixedcosts of the factory. During the processing of the alternatives available other thancost factor should also be considered. Some of these are quality of the productavailable in the market, regularity of the supply, expected fluctuations in the demandand reliability of the supplier. The processing and designing of the item of a productshould be kept as a secret, then this cannot be purchased from the market and itshould be produced at the floor of the factory. The following example makes thisconcept easy to understand:

Illustration 3

With the help of the following data, a manufacturer seeks your advice whether to buy anitem from the market or to produce it at the floor of the factory:

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Cost Volume ProfitAnalysis Particulars Present Proposed

(Buy) (Make)

Rs. Rs.

Sales 16,00,000 16,00,000

Costs: Variable 11,20,000 10,24,000

Fixed 3 ,60 ,000 4 ,00 ,000

Capital required 8,00,000 9,00,000

Advise the management.

Solution

Statement of Cost and Profitability

Particulars Buy Make Rs. Rs.

Sales ( S ) 16,00,000 16,00,000

Less : Variable Costs 11,20,000 10,24,000

Contribution ( C ) 4,80,000 5,76,000

Less : Fixed Costs 3,60,000 4,00,000

Profit ( P ) 1,20,000 1,76,000

P/V Ratio (C/ S multiplied by 100) 30% 36%

Percentage of profit on sales (P/S multiplied by 100) 7.5% 11%

Return on capital employed (P/Capital multiplied by 100) 15% 19.6%

Decision: By describing the above statement making of the item at the floor isbetter than to buy.

Working Note: Total costs would be reduced by Rs. 56,000 and by the sameamount the profit would also increase. P/V Ratio and profit on sale increase by6 % and 3.5% respectively. Return on capital employed will also increase by4.6 %.

17.2.7 Expand and Contract

In any factory, if there is scope of expansion and there is a possibility to purchasethe same item on contract basis from the market then we would look at the totalcost of both the alternate. It can be understood easily with the following example:

Illustration 4

X Ltd. has two factories – A and B. A is running at 70% of installed capacity(Installed capacity is 12,000 units) and B Factory supplies its requirements byworking at 80% of its installed capacity. The cost structure of the B factory isgiven below:


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Materials Rs. 16,800

Labour Rs. 6,000

Apportioned Fixed Overheads Rs. 7,500

Variable Overheads Rs. 4,200

Total Rs. 34,500

The production of A factory is to be increased to 80% capacity. The componentproduced in B factory can be purchased from the market at Rs. 4.00 per unit. As thecost of B factory exceeds Rs. 4 per unit, it is proposed to obtain the additionalrequirement from the market instead of getting it from B factory. Advise themanagement.

Solution

A factory can produce 12,000 units at 100% capacity and is working at 70%capacity means it is producing 8,400 units. B factory is working at 80% capacity tofulfill the needs of A factory. B factory when working at 100% capacity canproduce 84,000 / 80% = 10,500 units, so if A factory is working at 100% capacityB factory cannot fulfill the requirement of A factory. If A factory is working at 80%capacity that is 9,600 units (80%of 12,000). B factory will be required to produce1,200 units more (9,600 – 8,400). For this analysis, the following statement isrequired:

Statement showing costs of buying and manufacturing for 1200 units

Cost of Manufacturing Cost of BuyingComponent 1,200 units 1,200 units

Rs. Rs.

Material (16,800 / 8,400) 1,200 2,400 -----

Labour (1,200 multiplied by 0.50) 600 -----

Variable overhead (4,200 / 8,400) 1,200 600 -----

Costs of buying @ Rs. 4.00 per unit ----- 4,800

Total Costs (Rs.) 3600 4,800

Decision: B factory will continue supply to A factory as manufacturing cost ofRs. 1,200 (Rs. 4800 -- Rs. 3600) less than the cost of buying. So it is advisable toexpand B factory. It is presumed that fixed cost will not change after the expansion.

17.2.8 Sales Mix Decisions

The relative contribution of quantities of products or services constitutes totalrevenues. It becomes difficult to analyze the profitability of the product when morethan one product is produced. To establish most profitable sales mix it becomesnecessary to get the most profitable sales mix by considering all the alternatives. Lookat following example.

Illustration 5

X Ltd. produces and sells four products A, B, C and D. The analysis of income fromeach product has been shown in the following statement. Which of these product lineswould you like to continue and which would you like to drop?

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Cost Volume ProfitAnalysis Income Statement

Particulars Products

A B C D TotalRs. Rs. Rs. Rs. Rs.

Sales 6,80,000 29,20,000 8,00,000 6,00,000 50,00,000

Less Variable Cost 4,00,000 5,70,000 5,50,000 5,80,000 21,00,000

Gross Contribution 2,80,000 23,50,000 2,50,000 20,000 29,00,000

Less : Variable Selling Costs:

Salesmen 50,000 7,00,000 70,000 20,000 8,40,000

Warehouse 40,000 7,00,000 60,000 10,000 8,10,000

Packing 30,000 2,00,000 50,000 2,000 2,82,000

Delivery 30,000 3,00,000 40,000 8,000 3,78,000

Total Variable Selling Costs: 1,50,000 19,00,000 2,20,000 40,000 23,10,000

Net Contribution 1,30,000 4,50,000 30,000 − 20,000 5,90,000

Less: Fixed Selling Cost − − − − 1,10,000

Contribution for FixedAdministrative Cost& Profit 4,80,000

Less: Fixed Administration Costs 1,88,000

Net Profit 2,92,000

Solution

By looking at the above statement it is concluded that selling price of the product D isnot able to recover its variable costs even, so, the production of product D should bestopped immediately. It shows the loss of Rs. 20,000 in net contribution.

Gross contribution of product Y is also not satisfactory so management can reconsiderabout the use of resources engaged in the production of Y.

17.2.9 Alternative Methods of Production

The decision to be taken is of the nature of selecting one machine out of one or moreavailable in the market for production or to purchase the ready goods for furtherprocessing from the market. In these cases, cost is considered and the decision istaken in favour of the lowest cost occurring sector. Look at illustration 6 and see howa decision will be taken out of alternative methods of production.

Illustraton 6

X Ltd. has to install a machine for the production of a part of a new product to belaunched by them. Two machines B and C are being considered. Their details aregiven below:


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Details Machine B Machine C

Cost in Rs. 2,00,000 4,40,000

Annual Capacity in units 4,000 10,000

Life in Years 10 10

Salvage value in Rs. Nil 40,000

Material per unit in Rs. 30.00 30.00

Production cost per unit (other than depreciation) 45.00 45.00

Apportioned overheads 2,000 2,000

Interest is @ 10% per annum. The part is available in the market @ Rs. 90 per unitand can be sold at a net price of Rs. 85 per unit. The company requires 6,000 units perannum. Advise the management.

Solution

Statement of cost of Depreciation and Interest per annum

Particulars Cost of Cost ofMachine B Machine C

Rs. Rs.Initial Investment needed 2,00,000 4,40,000Less Salvage Value Nil 40,000

Net Value of Machine to be depreciated 2,00,000 4,00,000

Depreciation p.a.for 10 years 20,000 40,000

Interest on initial investment @10% p.a. 20,000 44,000

Statement showing Comparative Costs in Different Alternatives

Particulars Cost, if Cost of Cost ofpurchased Machine B Machine C

Rs. Rs. Rs.

Units purchased 6,000 2,000 ----Units produced ---- 4,000 10,000Surplus units to be sold in the open market ---- ---- 4,000

Annual requirement (units) 6,000 6,000 6,000

Rs. Rs. Rs.Cost of material @ Rs. 30 per unit ---- 1,20,000 3,00,000Production cost @ Rs. 45 per unit ---- 1,80,000 4,50,000Cost of Depreciation p.a. 20,000 40,000Cost of interest @ 10% per annum ---- 20,000 44,000

Total Cost of production 3,40,000 8,34,000Add : Cost of purchases @Rs. 90 per unit 5,40,000 1,80,000 ----Less : Sale proceeds of surplus production @ Rs. 85 per unit ---- 3,40,000

Net Cost of 6,000 units Rs. 5,40,000 Rs. 5,20,000 Rs.4,94,000

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Decision: In all the above three alternatives the last alternate that is to purchase machineC is the cheapest and so company should purchase in the machine C and install it.

17.2.10 Plant Shut Down Decisions

This type of decision is being taken when the nature of business is seasonal, cut-throatcompetition and other un-favourable conditions of the market are there. While takingthe decision of ‘Shut Down’ of the going concern the behaviour of costs should beconsidered.

When one shuts down his plant, there are some avoidable, traceable or escapable fixedcosts such as salaries of temporary workers and salary of sales man, which can bestopped by this decision. Some unavoidable or un-escapable cost are : depreciation onfixed assets, rent of office and factory, insurance, interest and salaries of permanentstaff. These can not be stopped by shutting down the plant temporarily.

Some additional cost of Shut Down or Reopening Costs should be considered as the partof the unavoidable costs. Normal decisions are for maximizing the profits; but Shut Downdecision is for reducing the loss as it always considers the savings under loss. Calculationof net avoidable costs can be made through the following formulae:

Net Avoidable FC = Total FC – (Un-avoidable FC + Re-opening Costs)

If the loss by taking the decision of ‘Shut Down’ is less than the continuity of thebusiness then the decision of ‘Shut Down’ may be considered as favourable in shortterm. Some aspects other than costs should also be considered, such as utility of thegoods by the consumers, benefits of the employees, obsolescence of machinery,goodwill of the concern, objection by the labour unions and the governmentinterference. ‘Shut Down Point’ can be calculated by marginal cost method by thefollowing formulae:

Net Avoidable Fixed CostShut Down Point (in Units) =

Contribution per Unit

Net Avoidable Fixed CostShut Down Point (in Value) =

P/V Ratio

There is a great difference between the ‘Shut Down’ of a business and stopping theproduction of one type of product. If production of any type of product is stopped thenthe fixed cost of that product can be allocated to the remaining products; but when theplant is being ‘Shut Down’, the remaining fixed costs are the loss for the concern. Youmay have already learnt it in Unit 15 under the head 15.7. Managerial uses of Marginalcost.

17.2.11 Acceptance of Special Order

If any producer is not utilizing plant’s full installed capacity and he receives specialorder for the product and that will not make any adverse impact on our present salethen the offer will be accepted if it increases contribution. This can be illustrated bythe following illustration:

Illustration 7

Y Ltd. is working on 80% capacity and its Flexible Budget is as follows:

Output 60,000 units, sales value Rs. 12,00,000, material cost Rs. 30,000, wagesRs. 2,10,000, variable expenses Rs. 1,20,000, Semi-variable expenses Rs. 70,000and fixed costs Rs. 2,00,000.


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A proposal for additional sale of 7,500 units is available, if it is accepted and supplied atRs. 14.00 each. The semi-variable overheads increases by Rs. 2,500 for the additionalproduction. Advise the management.

SolutionStatement of Marginal Cost and Profitability

Particulars Production of Production of Total Units:60,000 units Additional 7,500 67,500

unitsRs. Rs. Rs.

Material @ Rs. 0.50 30,000 3,750 33,750

Wages @ Rs. 3.5 2,10,000 26,250 2,36,250

Variable Expenses @ Rs. 2 1,20,000 15,000 1,35,000

Semi-variable expenses 70,000 2,500 72,500

Marginal cost 4,30,000 47,500 4,77,500

Sales 12,00,000 1,05,000 13,05,000

Contribution = (S-V) 7,70,000 57,500 8,27,500

Less Fixed Costs 70,000 ----- 70,000

Profit 7,00,000 57,500 7,57,500

Decision: If the proposal for additional supply of 7,500 units is accepted then contributionincreases by Rs. 57,500 and profit also increases by the same amount. So it is advisableto accept the offer for additional supply. It is assumed that this supply will not affect thepresent market for its product.

17.2.12 Adding or Dropping a Product Line

It is obvious to add or drop a product line to increase the profitability of the business. Forthis purpose it is needed to analyze all the details available. Profitability should be assessedin the existing framework and then the profitability of all the alternatives should be comparedand then the decision should be taken.

Look at the following illustration :

Illustration 8

A factory manager seeks your advice whether he should drop one item from his productline and replace it with another. Present cost and production data per unit are as follows:

Product Price Variable Costs % Sales in(Rs.) (Rs.) Total Sales

Tables 60 40 50

Chairs 100 60 10

Book Stands 200 120 40

Total Fixed cost per annum Rs. 7,500

Current Sales of the year Rs. 25,000

The change under consideration consists in dropping the line of chairs and replacing itwith a line of Sofa. If this drop and add change is made the manager forecasts thefollowing data regarding cost and output:

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Cost Volume ProfitAnalysis Product Price Variable Costs % Sales in

(Rs.) (Rs.) Total Sales

Tables 60 40 30

Sofa 160 60 20Book Stands 200 120 50Total Fixed cost per annum Rs. 7,500Projected Sales of the year Rs. 26,500

Is this proposal feasible? Advise the management.

Solution

Statement of profitability for current production

Particulars Tables Chairs Book Stands Total Rs. Rs. Rs. Rs.

Selling Price 60 100 200 -----

Less Variable Cost % 40 60 120 -----

Contribution 20 40 80 -----

P/V Ratio 33.33% 40% 40% -----

Sales of Rs. 25,000 in theratio of 50%, 10% & 40% 12,500 2,500 10,000 25,000

Contribution (P/Vmultiplied by Sales) 4,167 1,000 4,000 9,167

Less Fixed Costs ----- ----- ----- 7,500

Profit ---- ----- ----- 1,667

Statement of profitability for projected production

Particulars Tables Sofa Book Stands Total Rs. Rs. Rs. Rs.

Selling Price 60 160 200 -----

Less Variable Cost 40 60 120 -----

Contribution 20 100 80 -----

P/V Ratio 33.33% or 1/3 62 ½% 40 % -----

Sales of Rs. 26,500 in theratio of 30%, 20% & 50% 7950 5300 13250 26,500

Contribution (P/Vmultiplied by Sales) 2650 3313 5300 11,263

Less Fixed Costs ----- ----- ----- 7,500

Profit ----- ----- ----- 3,763

Decision: After analyzing the above statements it is observed that if the proposal isaccepted then the profit will increase by Rs. 2,096 (i.e., Rs. 3,763 – Rs. 1,667). It ispresumed that the demand of the proposed products will remain in the market.Therefore the proposed is to be accepted.


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17.2.13 Replacement of Machinery

It becomes necessary to replace the old machinery by a new because of theobsolescence of the old one or the renovation of the old one. Objective of replacing theold machinery by a new machine is to reduce the cost of production and to increasethe revenue. While deciding the replacement of machinery factors like operating cost,technological development, return on capital, demand for the product, opportunity costof the capital, availability of raw material, labour etc, should be taken intoconsideration. The replacement of machinery is assessed either by marginal costanalysis or differential cost analysis but the later is more appropriate and is much inuse. Let us study in brief the factors to be considered for the replacement ofmachinery

i) Operating Cost: Comparative study of the operating cost of the old and the newmachinery should be done. Per unit cost of production by old machinery and thenew one can be analyzed by the comparative statement.

ii) Technological Development: New inventions are taking place every day. Thechances of new inventions should be taken into consideration before the decisionof replacement.

iii) Return On Capital: Return on capital on the new investment should be feasible.What will be the amount of loss while selling the old?

Demand for the Product: Production will be increased by the use of the newmachine and the demand for the increased production should be estimated. If theproduction at full capacity cannot be sold, then what percentage of the capacitycan be sold and at this point of utilization of the capacity would it be possible tokeep the price competitive. Market trend of the product should also be analyzed.If the nature of the product is not going to last for a greater period then thedecision regarding change of machinery is not required.

v) Assessment of the Opportunity Cost of the Capital: If the capital needed forthe replacement is being used for any other alternative would the capital yieldmore. If it is so then the decision of replacement should be dropped.

vi) Availability of Raw Material and Skilled Labour: Availability of raw materialand skilled labour to run the machinery should be studied before replacing themachine.

Illustration 9

The following facts relate to two machines:

Existing Machine New Machine

Capital cost (Rs.) 10,00,000 40,00,000

Marginal cost per unit (Rs.) 60 52

Selling price per unit (Rs.) 120 120

Fixed expenses (Rs.) 1,00,000 4,00,000

Annual output (units) 20,000 40,000

Life of machines (years) 10 10

The existing machine has worked for 5 years. Its present resale value is Rs. 4,00,000.The scrap value of the machine may be taken as nil, Advise whether new machineshould be installed if rate of interest is 10 %.

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SolutionStatement of Differential Cost And Incremental Revenue

Particulars Existing Machine New Machine Incremental

Cost Revenue Cost Revenue Cost Revenue Rs. Rs. Rs. Rs. Rs. Rs.

Sales 24,00,000 48,00,000 24,00,000

Total Marginal Cost 12,00,000 20,80,000

Total Fixed Cost 1,00,000 4,00,000

Interest on additional capital outlay on 36,00,000 @ 10 % (Rs. 40,00,000 — Rs. 4,00,000) 3,60,000

Depreciation on original cost 1,00,000 4,00,000

Loss on sale of machinery 14,00,000 1,00,000 33,40,000 19,40,000

Profit 10,00,000 14,60,000 4,60,000

Decision: It is clear from the above statement that installation of new machinery isbeneficial as incremental revenue is Rs 24,00,000 where as the differential cost isRs. 19,40,000. After installing the new machine the total increase in the revenue willbe Rs. 4,60,000.

Working Note:

1) Total cost of the machine is Rs. 10,00,000 and life is for 10 years and it hasbeen used for 5 years. The present book value of existing machine is Rs.5,00,000. So, the loss on sale of old machine is = Rs. 1,00,000. (Rs. 5,00,000-4,00,000)

2) The net amount required to install new machine is Rs. 3,60,000 i.e., afterdeducting the amount of Rs. 4,00,000 received on sale of existing machinery.

3) Loss on sale of existing machinery is to be included in the total cost of newmachinery for evaluation of new proposal.

4) Opportunity cost of the capital has not been considered.

Check Your Progress

1) What do you understand about relevant cost and irrelevant costs ? Give oneexample.

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2) Explain the concept of differential cost.

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3) What is decision making process ?

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4) List out four managerial applications of differential cost analysis .

1 ................................................................ 3. …………………………………….

2. ............................................................... 4. …………………………………….

5) State whether the following statements are True or False:

i) Relevant cost analysis is used for future decision making and not for pastdecisions

ii) Relevant costs are also known as differential costs

iii) Differential cost is always calculated per unit and not on total cost of twoalternatives

iv) Differential costs and marginal costs are the same

v) Fixed costs are not taken into account for differential cost analysis.

6) X Ltd. produces 1,000 articles at the following costs:

Components Rs. Rs.

Materials — 4,00,000

Wages — 3,60,000

Factory Overheads: Fixed 1,20,000Variable 2,00,000 3,20,000

Fixed Administrative Overhead — 1,80,000

Selling Overheads: Fixed 1,00,000Variable 1,60,000 2,60,000

Total — 15,20,000

1,000 units @ Rs. 1,550 can be consumed in home market. Foreign market canconsume 4,000 articles of this product if rate can be reduced to Rs. 1,250 per article.Is the foreign market worth trying?

7) The present volume of sales in a factory is 30,000units and the management hasinstalled modern machinery to increase the production to 6 times. The presentselling price is Rs. 24 per unit. Six successive levels with equal increments

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reaching up to 1,80,000 units are contemplated sales. The reduction in sellingprice is expected to be Rs. 2 at each higher level of sales. Fixed cost ofRs. 1,32,000 will not change Other costs at different levels are given below:

Production (units in’000) 30 60 90 120 150 180

Variable cost (in Rs. ‘000) 4.18 8.18 12.78 15.78 17.78 19.02

Semi Variable Cost (in Rs. ‘000) 1.50 1.50 1.70 1.70 2.00 2.00

Prepare a statement of differential cost and incremental revenue and give your adviceas to which level of production should be adopted to gain maximum

17.3 LET US SUM UPBefore taking a decision, one must analyze the alternatives available before him andthen one should take a decision, which is beneficial to the management. The decisionshould be in such a way that it increases the profit of the company. When we take adecision for a short period, normally we look at the contribution we receive in all theavailable alternatives and compare them and one should accept the alternate, whichprovides more contribution, as in shorter period it is presumed that fixed costs will notchange. If a decision is to be taken for a long period when the fixed costs will alsochange then one should take the decision through differential cost system. So, costsbecome relevant when decisions are being taken. In long-run variable and fixed costsnormally change. Total differential cost and incremental revenue is considered in thismethod of analyzing for longer period.

17.4 KEY WORDSAlternative: Options

Administrative Cost : A cost which relates to the enterprise as a whole

Book Value : The amount shown in books of account for an asset

Contribution Margin : Excess of sales revenue over all variable expenses

Differential analysis : Process of estimating the consequence of alternative actionswhile taking a decision by decision-makers

Differential cost : The costs which will change in response to a particular course ofaction.

Interest : The cost for using money.

Make or buy decision : A managerial decision about whether the firm shouldproduce internally or purchase it from outside

Opportunity Cost : The present value of income/costs that could be earned fromusing an asset in its best alternative uses.

Residual value : The estimated realisable value of an asset after use.

Relevant costs : Costs that are different under different alternatives

Short run : Period of time over which capacity will not be changed.

Decision: Deciding one out of the many options

Differential Cost: Change in the cost

Incremental revenue: Increase in the revenue

Semi variable costs: A cost, which has both variable and fixed elements.

Sunk Costs: Past costs which are unavoidable because they cannot be changed


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17.5 ANSWERS TO CHECK YOUR PROGRESS5) i) True ii) true iii) False iv ) False v ) False

6) Statement Showing Differential Cost And Incremental Revenue

Components Rs. Rs.

Sales of 4,000 units @ Rs.1250 (incremental revenue) — 50,00,000

Differential costs:

Materials (4,00,000/1,000)4,000 16,00,000 —

Labour (3,60,000/1,000)4,000 14,40,000 —

Factory O.H. (2,00,000/1,000)4,000 8,00,000 —

Selling O.H. (1,60,000/1,000)4,000 6,40,000 44,80,000

Net profit or incremental profit 5,20,000

Decision: It is better to accept the foreign proposal, as it will increase the profit byRs. 5,20,000. It is assumed that this acceptance will not affect the home market andthe fixed cost will remain same.

7) Statement of Differential Cost And Incremental Revenue

Production Selling Sales Variable Semi- Fixed Total Differential Incremental in Units Price per Revenue Cost Variable Cost Cost Cost Revenue (’000) Unit (Rs. (Rs. Cost (Rs . (Rs. (Rs. (Rs. ’000) (Rs. ’000)

’000) ’000) ’000) ’000) ’000)

30 24 720 4.18 1.50 132 137.68 — —

60 22 1320 8.18 1.50 132 141.68 4.00 600

90 20 1800 12.78 1.70 132 146.48 4.80 480

120 18 2160 15.78 1.70 132 149.48 3.00 360

150 16 2400 17.78 2.00 132 151.78 2.30 240

180 14 2520 19.02 2.00 132 153.02 1.24 120

Decision: Production level can be increased up to the equalization of incrementalrevenue and the differential cost. In this case both of these are equal at the level of90,000 units but the incremental revenue increases till the production level is achievedat 1,50,000 units. After this level incremental revenue is decreases so the productionfixed at 1,50,000 units will provide the optimum level of profit.

17.6 TERMINAL QUESTIONSQuestions

1) What do you understand by differential costing ? How does it differ frommanagerial costing?

2) Explain the practical applications of differential costing.

3) X Company Ltd. manufactures a product. You are required to prepare astatement showing differential cost and incremental revenue. At what volumethe company should set its level of production ?

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Cost Volume ProfitAnalysis Output Selling price Total semi-fixed Total variable Total fixed cost

(in ’000 units) Per unit cost per unit Cost per unit per unit

30 24 1.50 4.18 1.32

60 22 1.50 8.18 1.32

90 20 1.70 12.78 1.32

120 18 1.70 15.78 1.32

150 16 2.00 17.78 1.32

180 14 2.00 19.02 1.32

(Ans : Production at 1,50,000 units will provide optimum level of profit)

4) What considerations are involved in taking decision of the following :

i) Make or buy decisions

ii) Dropping a product or adding a new product

iii) Shut-down of plant

5) Golden company Ltd produces a product which is yielding a profit ofRs. 14,00,000 after charging fixed costs of Rs. 10,00,000 per annum. The sellingprice of the product is Rs. 50 per unit and has a variable cost of Rs. 20 per unit.The management wants to make changes in the selling price of the product. Thefollowing options are open to the management.

Alternatives Reduction in Selling Price Increase in quantity to be sold

1 5% 10%

2 7% 20%

3 10% 25%

Evaluate the above alternatives and advise the management which alternative yieldsmaximum profit ?

(Ans : Contribution : 1. Rs. 24 ,20 ,000 2. Rs. 25,44,000 and3. Rs. 25 ,00 ,000

Decision : Alternative 2 gives maximum profit.

6) X Company Ltd is producing 10,000 articles and its cost data is given below :Variable Cost per unit : Rs. 26Fixed overheads : Rs. 10Total Cost : Rs. 36

A manufacturer offers the same commodity for Rs. 32 per unit. The analysis ofthe cost data shows that Rs. 60,000 of fixed overheads will be incurredregardless of production.

You are requested to suggest that should company X make or buy the article ?

(Ans : Cost of making product Rs. 30, Difference of Rs. 2. is in favour ofmaking the product)

7) The total fixed cost of a company for producing a product price is Rs. 15 lakhs,the selling price per unit is Rs. 50 and the variable cost per unit is Rs. 40. Thecompany is incurring losses for the past several years due to lack of demand.The company wants to shut down the plant till the demand picks up. The


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avoidable costs are estimated at Rs. 4,00,000. Should the company discontinueproduction till the demand picks up? Advise the management.

(Ans. If the company’s sales are at least Rs. 55,00,000, it should not beshut down )

Fixed Cost – Avoidable cost Hint : Shut down sales = ———————————

P/V ratio

8) A firm manufactures and sells three products – X, Y and Z. Their cost data isgiven below:

Product : A B C

Production (Units) : 5,000 12,500 17,500

Selling Price (Rs.) 9 5 15

Variable Cost (Rs.) 8 3 11

Fixed Cost Rs. 1,05,000

There is no under utilisation of production capacity. Fixed costs are allocated onthe basis of units produced. There is no difference in the manufacturing time ofeach product. The management proposes to drop product A as it contributes aloss of Rs. 2 per unit as calculated below :

Selling price Rs. 9

Variable cost Rs. 8

Fixed cost Rs. 3(Rs. 105000 ÷ 35000 units) Rs. 11

Loss per unit Rs. 2

The management proposes to add product S in place of product A as more unitsof product S can be produced and sold in the market whose selling price andvariable cost per units is Rs. 8 and Rs. 7.75 respectively. It is estimated that12,000 units of product S can be sold if product A is dropped. You arerequested to advise the management.

(Ans : Contribution : Product A : Rs. 1. Profit would decrease byRs. 5000 if the product A is dropped.

Product S : Rs. 0.25 p. If product S is added in place ofproduct A profit will decrease by Rs. 2000)

Note : These questions will help you to understand the unit better. Try to writeanswers for them but do not submit your answers to the University. Theseare for your practice.

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UNIT 18 REPORTING TOMANAGEMENT


18.1 Introduction

18.2 Concept of Management Reporting

18.3 Objectives of Reporting

18.4 Reporting Needs at Different Managerial Levels

18.5 Types of Reports

18.6 Modes of Reporting

18.7 Essentials of Successful Reporting (Guiding Principles)

18.8 Let Us Sum Up

18.9 Key Words



18.0 OBJECTIVESAfter studying this unit, you should be able to :

! understand the report for the specific purpose;

! follow the pattern of reports and apply these to your decisions;

! prepare good reports;

! know the needs of the reports; and

! use the reports for data base.

18.1 INTRODUCTIONThe purpose of reporting is to provide the information needed by the concerned party.The value of information is determined by how the information meets the needs of theusers. This information creates an atmosphere for internal decision makers. Thecommunication of the information between two or more parties through reports isknown as reporting. Report is the essence of the management information system.Report is a statement containing facts and if they contain accounting information anddata they are called accounting reports. So, report may be known as process ofproviding accounting information to those who needs to make decisions. Report maybe for the past, present and for the future developments. In this unit you will studyabout the objectives of reporting, need of reporting at different managerial levels, typesand modes of reporting and essentials of a successful reporting.

18.2 CONCEPT OF MANAGEMENT REPORTINGReporting can be defined as communication of statements with related informationbetween the two parties. The process of providing information to the management isknown as management reporting. These reports are provided to the various levels of88

Reporting toManagement

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management on regular basis to keep the management abreast about the effectivenessof their respective responsibility. Reporting is an important function of the managementaccountant as the efficient and smooth working of the business depends upon the goodreporting. The effectiveness of reporting to management to a large extent dependsupon the form and timing of its presentation. The process of reporting to managementis concerned with proper selection of financial and operating data, arranginginformation in a proper form, analysing and interpreting the data and then reporting it tothe management through an appropriate method.

18.3 OBJECTIVES OF REPORTINGMain objectives of reporting can be divided under the following heads:

Accounting reports consist of financial statistics. Management cannot analyse allsignificant facts regarding its business especially in case of large scale productionwhere the business operations are more complex in nature. Accounting reports helpsto get full information about the its entire operative activity of the firm.

i) Providing accounting information: Accounting reports consist of financialstatistics. Management may not analyse all significant facts regarding its businessoperations especially in case of large scale production where the businessoperations are more complex in nature. Accounting reports help to get fullinformation about its entire operative activity of the firm. Thus importantobjective of the reporting is to provide accounting information to operating and toplevel management in accurate form in understandable brief manner.

ii) To take right decision: To help the management in taking the right decisionswith suitable statements provided by the management accountant.

iii) Acceptability of the decision by all: Reporting leads to motivate people,increases efficiency and boosting the morale of the people engaged in the variousaspects of the work of the enterprise.

iv) Maximizing the profits: To achieve this ultimate goal of any business reportingat the right time, at right place to the right person in right manner becomes anessential feature.

v) For better control: Abnormal events can be checked in time by obtaining thenecessary information in respect of each operating activity. Control throughreports become effective as compared to personal investigations.

18.4 REPORTING NEEDS AT DIFFERENTMANAGERIAL LEVELS

Reporting is the lifeline of the organization. It helps in planning and control and worksas a media of communication and stimulates corrective action. Accounting systembecomes useless, if the business has no system of reporting because all decisions arenormally based on reporting system.

Need of reporting differs at different management levels. This also differs to the usercommunity also. There are three levels of management and the reports can beclassified according to the needs as follows:

1) Top-Level Management Reports

2) Middle Level Management Reports

3) Lower Level Management Reports

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1) Top Management Reports

At this level reports are concerned with the following matters:

l For determining the aims of the enterprise;

l For formulation of policies and plans;

l For delegation of responsibility in successful manner to executives for the bestutlization of resources; and

l For formulating special significant plans.

It can be assumed that top brass of the business only needs reports for cost andoperational control. The report submitted to the level should be brief or we can callit a summarized statement, which provides an overall view on the subject. Previouslythese reports used to be submitted within the time framework. The time frameworkmay be monthly, quarterly or yearly. With the use of information technology and thereal time accounting, the whole time framework has been changed and now thesecan be made available online.

Reports to top level management consist of the following:

a) Reports to the Board of Directors

b) Reports to the Chief Finance Officer

c) Reports to the Chief Production officer, and

d) Reports to the Chief Executive Marketing and Sales .

Let us study these reports in brief.

a) Reports to the Board of Directors : Generally, following reports are to besubmitted to the Board of Directors and the Chief Executive Officer (C.E.O.):i) Different budgets,

ii) Machine utilization statement

iii) Work force utilization statement

iv) Cost analysis statement

v ) Fund flow statement

vi) Cash flow statement, and

vii) Balance sheet and income statement

b) Reports to the Chief Finance Officer : Following reports are to besubmitted to the Chief Finance Officer (C.F.O.) :

i) Cash flow statement,

ii) Funds flow statement,

iii) Abstract of receipts and payments and

iv) Report regarding any special problem such as make or buy,replacement of old assets or any other.

c) Reports to the Chief Production Officer: Following reports are to besubmitted to the Chief Production Officer (C.P.O.) :

i) Cost analysis statement

ii) Machine utilization report

iii) Work force utilization statement


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iv) Materials statement,

v) Production statement showing budgeted and actual with variance and

vi) Overheads cost statementd ) Report to the Chief Executive Marketing and Sales : Following reports

are to be submitted to the Chief Executive Marketing and Sales:i ) Sales summary

ii) Reports on credit collection

iii) Reports of orders received and executed and outstanding orders

iv) Report on stock of finished goods

2) Middle Level Management ReportsThe middle level management consists of the heads of various departments. Thereports at this level should show the efficiency and cost data relating to differentdepartments. At this level execution of plans formulated by the top managementis worked out and all the managers in each department are concerned with this.It is also the function of middle level management to coordinate differentactivities of different departments. The reports at middle level managementconsists of the following:a) Report to the General Manager : The following Reports are to be submitted

to the General Manager :

i) Administration budget,

ii) Cash and capital budget,

iii) Salaries statement of staff and

iv) Research and development budgetb) Report to the Finance Manager : The reports to be submitted to the Finance

Manager are:

i) Funds flow statement

ii) Cash flow statement

iii) Cash and bank reports

iv) Debtor’s collection period reports

v) Average payment period reportsc) Reports to the Purchase Manager : The following reports are to be

submitted to the Purchase Manager:

i) Stock level of raw material,

ii) Use of raw material,

iii) Raw material budget and actual purchases, and

iv) Budgeted cost and actual cost of purchasesd) Reports to the Works Manager : The reports submitted to the Works

Manager are:i) Production cost report

ii) Raw material budget and actual consumption

iii) Production budget and actual production

iv) Idle time report

v) Idle capacity report

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e) Reports to the Sales and Marketing Managers : The following reportsare to be submitted to the Sales and Marketing Manager:

i) Report of budgeted and actual sales,

ii) Report of orders booked and executed,

iii) Statement of sales ,

iv) Finished goods stock position and

v) Position of collections and debtors.

With modernization and adoption of computers in the business house, thereporting period has been reduced tremendously and the data are ready athand and these can be used to prepare reports instantly. Middle levelmanagement is connected on line with the computers within the organization,so preparation of reports has become easy.

3) Lower Level Management Reports

At this level foremen and supervisors are concerned at the floor and theyprepare their reports physically without any expert opinion. They areconcerned with the daily work and they infuse a certain amount ofcompetitive spirit among the workers by comparing the output per man perhour in a similar job. These reports include the following factors:

i) Workers efficiency report,

ii) Daily production report,

iii) Workers utilization report and

iv) Scrap report

v) Over-time report

vi) Material spoilage report

vii) Accident report etc.

18.5 TYPES OF REPORTSReports can be classified in various ways in which the different reports are presentedto the management such as :

1) Users Reports

2) Reports Based on Information

3) Reports Based on Nature

4) Functional Classification of Reports

Let us study each of them in brief.

1) Users Reports

Depending upon users, reports can be classified as follows :

i) Internal Users Report

ii) Special Reports

iii) Routine Reports

iv) Management Level Reports

v) External Users Reports


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Reports can be prepared according to the users. They can be:

i) Internal Users: Reports, which are prepared for the use of different levelsof management and for the use of the employees are known as the reports forinternal users. These are not public documents. These reports are aimed todifferent levels of management.

ii) Special Reports: These reports play a vital part in decision-making. Theyare prepared for specific reasons. While preparing this type of report the problemunder study should be clearly be defined and understood and effect of cost andincome should be considered. Comparison of cost of study and estimation ofcost and income relating to the problem should also be considered. Thesereports can be prepared for any of the problems relating to : i) market analysisii) Make or buy decisions iii) Problems of raw material iv) Technologicalchanges v) labour problems vi) Cost reduction schemes or any other problemsas discussed in Unit 18 of this course.

iii) Routine Reports: These are only control reports and they are required onlywhen a control system exists. These are prepared daily as per scheduled timeregarding activities. Production operation reports, cost reports, research anddevelopment reports, various budget reports, utilization of man, machine andmaterial reports, report regarding customer default, sales and distribution report,administration reports, income statement and balance sheet and cash flowstatement are included in this classification.

iv) Management Level Reports: Main classification of these reports havebeen provided while describing the reporting needs at different managementlevels at 18.3.3.

v) Reports for External Users: These reports are prepared for the externalusers who have interest in the enterprise. They are the shareholders,debenture holders, creditors, bankers, other financial institutions, stockexchange and the Government. They may be interested in knowing thefinancial position, progress made, future-plans and growth of the company.While preparing these reports, the information regarding the interest of allthe external users should be taken into consideration. For example, theprofit and loss account and balance sheet are prepared every year and thesestatements are to be filed with the Registrar of Companies and also stockexchange authorities.

2) Reports Based on Information

There are two types of information reports. They are : i) Operating Reports,and ii) Financial Reports.

i) Operating Reports: These reports convey the information regarding theoperations of the business at different functional levels. These reports areused to review and control the total production and to improve the inter-departmental efficiency. Operating reports can further be classified asinformation reports and the control reports.

l Information Reports: The reports prepared for this purpose should besimple and clear in respect of various operating activities. These reportsare of three types, viz., trend reports, analytical reports and activity report.In trend reports, comparative information is provided over a periodregarding the direction or trend of different activities. Analytical reportsare based on the horizontal comparison of results. This provides informationin an analytical manner about comparison of different activities for aparticular period. When reports are prepared for any particular activityof the business then they are known as activity reports. Segment reportsare also information reports.

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l Control Reports : These reports are prepared to help the managersin controlling the operations of the business. Various responsibilitycenters are established in every business to have an effective control.To know the performance of each responsibility center reports areprepared for them. First important aspect regarding the performanceof the center manager and the other is concerned with the economicperformance of the center towards the goal or the business, are themain features of these reports. These reports can be current controlreports or they can be summary control reports. Summary controlreports can be master summary control reports or these can besubsidiary summary control reports.

ii) Financial Reports : Financial reports differ from control or informationreports. They are necessary to know the success or failure of themanagement’s responsibility to shareholders through the accounting. Thesereports can be of two types viz., dynamic financial reports and staticfinancial reports. Dynamic financial reports show the changes took placeduring the year in the financial position of the business. These reportsinclude report of financial change, financial control reports and effective useof funds reports. Static financial reports provide the information regardingthe position of assets and liabilities. They include balance sheet and certainadditional statements for individual items of the balance sheet.

3) Reports Based on Nature

There are three types of reports based on nature:

i) Enterprise Reports : These are the reports, which give a detaileddescription of the various operating activities and financial position of thebusiness. They are generally meant for the external users i.e. bankers,financial institutions, shareholders and government authorities. They aregenerally regular and include annual accounts, directors’ reports, auditorsreport. It is obligatory under Companies Act to furnish these reports.

ii) Control Reports : These reports have already been discussed under thehead reports based on information.

iii) Investigative Reports : These reports are specially prepared only whento investigate a particular problem. These types of reports contain findingsand suggestions to solve the problem. These reports are helpful in taking adecision on a particular problem.

4) Functional Classification of Reports

These reports are normally for the particular function or for a particular departmentor for joint activity. They are also of two types:

i) Individual Activity Report : Report is prepared for the individual activityof a single department working under the supervision of one executive isknown as individual activity report.

ii) Joint Activity Report : This report is prepared when joint efforts aremade in performing the activity. When the details are necessary then theyshould be included in appendix. Then the results of all the joint activities areconsidered under the supervision of the main supervisor.

18.6 MODES OF REPORTINGThere are three modes of reporting:, 1) Written 2) Graphic, and 3) Oral. Thesereports are further divided as follows :


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Modes of Reporting

Written Graphic Oral

1. Financial Statements 1. Charts 1. Group meetings

2. Tabulated Information 2. Diagram and Pictures 2. Conferences andConferences and 3. Graphs Individual talksIndividual Talks

3. Accounting Ratios

1) Written Reports : Written reports are prepared in the different forms to provideinformation. These are as follows:

l Financial Statements: These statements provide the information regardingthe data of actual performance with budgeted figures and comparativestatements containing information over a period.

l Tabulated Information: Information related with expenditure, production,sales and distribution is furnished in the form of tables so that the data caneasily be analyzed.

l Accounting Ratios: Accounting ratios play a vital role for theinterpretation of accounting and financial statements. Different liquidityratios, profitability ratios, efficiency ratios and capital structure ratios may beused for this purpose

2) Graphic Reporting: Graphic reporting is very common in these days to presentinformation to the management. These reports can be submitted in the form ofgraphs, diagram, pictures and charts. They are prepared when quick action isneeded.

The common charts and diagrams usually included in a report are :

i) Line Graphs : To show, for example, cumulative actual sales againstbudget and/or against previous year’s actuals;

ii) Bar Charts : Generally used for showing comparison of month-wise salesand expenses – budgeted and actuals;

iii) Pie Charts : Commonly used to show in a circular diagram the distributionof the total sales revenue among costs, profits as also the total costs amongthe different constituent elements.

3) Oral Reporting : Oral reporting may take place in the form of (1) Groupmeeting, (2) Conferences, and (3) Individual talks. These oral meetings cannot bepart of important decisions, but they furnish a common platform to discuss theproblems genuinely. For decision- making the written reports have a upper handover all types of reports.

18.7 ESSENTIALS OF SUCCESSFUL REPORTING(GUIDING PRINCIPLES)

Business report is a media of communication that contains factual, correct and clearinformation and it should be able to add to the knowledge of the recipient. It should beeasy to understand the problem of the event reported to him. Accounting reportsbecome ideal if they follow the following guidelines:

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1) Content and the shape : While making a draft of the report the following headsshould be kept in mind:

1.1 Suitable title : Title should be short and suitable to the content.

1.2 Time : It should give time and the person for whom it is prepared.

1.3 Facts : Report should contain facts and not the opinions.

1.4 Totals : Where statistics are required, only relevant data should be providedand details may be given in appendix.

1.5 Objectives : Contents should serve the purpose for which it is prepared.

1.6 Synchronize : The contents should be in logical sequence.

2) Precise : Report should not be lengthy. It should be precise, specific and concise.It should not contain irrelevant matter. If details are necessary then they shouldbe included in appendix.

3) Accuracy : The information provided in the reports should be accurate.

4) Comparable : It should be prepared in such a manner that comparison with pastand predetermined standards can be made.

5) Simple : Report should be simple and should not contain any ambiguity.

6) Timeliness : Reports should be prepared and presented in time, so that decisionscan be taken promptly and further deviations checked.

7) Consistency : For comparison consistency is necessary. Uniform system ofcollection, classification and presentation of the information should be followed.

8) Attractiveness : The report should be eye-catching in the sense that it does notgo unheeded by the users.

9) Jargon : All technical jargon should be avoided as for possible since the readermay not understand these and, therefore, may become hostile to even the spirit ofthe report.

10) Highlighting Deviations : Report should highlight the variations and troublespots which are significant to the organisation.

11) Assumptions : Assumptions used in the preparation of reports should be statedneatly, precisely and separately.

12) Effective Communication : Report that communicates effectively to all levelsof management stimulates action and influence decisions. Detailed planning,codification and timely processing of data are the essential requisites for effectivereporting.

13) Figures and data : These should be presented is a tabular form preferably inannexure at the end of the report.

Check Your Progress

1) Define reporting to management.

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2) Explain any two objectives of reporting.

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3) What is control report?

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4) What are the types of reports, which are required by the middle level ofmanagement? Name any five.

1. ................................................... 3 ................................... 5 ...............................

2. ................................................... 4 ...................................

5) What are the different modes of reporting?

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18.8 LET US SUM UPOne should be very clear about the objective of the report before preparing it. Heshould be able to clearly define and understand the problem for which the report isgoing to be presented. Needs of report differs at different management levels. So thisshould be decided that which level of management will use the particular report. Modeof reporting is also important regarding the presentation. Report will be a users reportor information report or any other type of report. Certain guiding principles such asbrief, sequencing, consistency, comparability, timeliness, accuracy, attractiveness,simplicity, shape and contents are very important and these should be taken into mindwhile preparing a report.

18.9 KEY WORDSStatic Financial Report : Providing information about the position of assets andliabilities of the concern.

Graphic Reports : Information supplied in the form of Charts, Diagrams, Picturesetc.

Reporting : Providing information to the person concerned.

Dynamic Financial Report : The information regarding the change that took place inthe position of assets and liabilities of a firm

Operating Reports : Information regarding the operating of a business at differentfunctional levels

Accuracy: correct, right

Consistency: Uniformity

Synchronize: Clear sequence

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Cost Volume ProfitAnalysis 18.10 ANSWERS TO CHECK YOUR PROGRESS

4) Names of five reports:

1. Administrative Budget

2. Funds Flow Statement

3. Cash Flow Statement

4. Stock Level of Raw Material

5. Production Cost Report

5) Modes of Reporting:

1. Written: Financial Statements

Tabulated Information

Accounting Ratios

2. Graphic: Charts

Diagram and Pictures

Graphs

3. Oral: Group Meetings

Conferences and Individual Talks

18.11 TERMINAL QUESTIONS1) What do you mean by accounting reports? What are the different types of

reports for internal use? Discuss each of them.

2) What are the special reports? What matters may be covered by the specialreports?

3) Describe the reporting needs of different levels of management and how asystem of reporting can satisfy it?

4) What are the essentials of a good report? Describe.

5) Explain the different types of the reports that are used in an enterprise

6) “Accounting Reports are a matter of necessity for the management and not amatter of convenience” Discuss.

Note: These questions will help you to understand the unit better. Try to writeanswers for them. But do not submit your answers to the University.These are for your practice only.

UNIT 19 RECENT DEVELOPMENTSIN ACCOUNTING


19.1 Introduction

19.2 Scope and Limitation of Conventional Financial Accounting

19.3 Inflation Accounting

19.4 Human Resources Accounting

19.5 Social Accounting

19.6 Environmental Accounting

19.7 International Accounting

19.8 Strategic Cost Management

19.9 Activity Based Costing

19.10 IT Developments in Accounting

19.11 Let Us Sum Up



19.0 OBJECTIVESThe objectives of this unit are to:

! explain some of the recent developments in financial and managementaccounting;

! give an overview on special accounting issues like inflation accounting, humanresources accounting, environmental accounting and international accounting;

! give an overview on activity based costing and cost reduction methods; and

! review developments of information technology that are related to accounting.

19.1 INTRODUCTIONThe primary role of accounting is to record financial transaction and summarise thesame in a useful format. Financial accountants prepare three principal financialstatements by summarising huge volume of financial transactions namely Profit andLoss Account, Balance Sheet and Cash Flow Statement. While these three arereported in annual reports, they also prepare a number of statements for internalpurpose. Cost Accountants prepare a number of statements mainly for internalpurpose and the primary objective of the exercise is to find out the cost ofproduction. However, the world of accounting or accountant is fast changing.Modern accountants are expected to be more intelligent than doing a merecompiling job. You might have seen that even smaller companies are started usingcomputer software for accounting. With simplification in tax laws, the role of 99

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accountant in tax administration is also diminishing. Accountants are also expected toprovide more information about the non-conventional information. When machinesdominate industrial world, accountants are asked to provide more information aboutmaterial things of the firm. Today, in many firms, knowledge is asset. Since financialreports stated above are not geared to provide such information, accountants are askedto provide additional information. There is also lot of concerns about the socialbehaviour of corporate sector. Hence many are interested in knowing the firms’ efforton social responsibility and environment. Special reports are devised to address someof these issues. In this unit, we will briefly discuss some of these reports and recentdevelopments. Each item discussed here are full subject on its own and depending onyour interest, you can specialise in one or more of the subjects either taking up somespecific issue and mastering them by reading some specialised books or attendingsome courses on these topics. It is to be noted that accountants today, are expected tobe more intelligent since computers replaced conventional accountants in many firms.

Activity 1

1) It is the time for you to interact with some of your friends who are in accountingprofession. Have a general chat with them and note down what they haveobserved as recent trends in accounting profession.

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2) Take any annual report of some well known companies and find out how much ofspace they spend in providing non-financial information?

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19.2 SCOPE AND LIMITATION OFCONVENTIONAL FINANCIAL ACCOUNTING

It is interesting to know why companies are suddenly focussing on some of the reports,which we mentioned in the introduction. Alternatively, what is the wrong with theconventional accounting reports? Accounting reports such as profit and loss account,balance sheet and cash flow statements provide wealth of information but the questionis whether it is adequate to know about the current or future performance of thecompanies. Secondly, not all stakeholders are interested only in knowing the profit orincome details. Future of companies depends on current strength and such strength isnot reflected in the accounting reports. This is particularly true for new economy orknowledge based companies, which is seeing phenomenal growth in recent times.Also, many stakeholders would be interested to corporate social behaviour. Some ofthe prominent limitations are listed below:

a) The balance sheet is often based on historical value. It fails to show the truevalue of the firm in that context. Suppose a company owns 10 acres land in Delhior Mumbai, which was purchased some 40 years back at the rate of Rs. 10000per acre. Is it right on the part of the company to show the value of the land atthe same price in 2003 when the cost of land is several 100 times more than thepurchase value? The above applies to many industrial machines which are usedin the firm but are efficiently managed beyond their normal life. How to reflecttrue and fair value of such assets?

Recent Developments inAccounting

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b) Is human resource of a firm not an asset? Today, every company is proudlystating that they have so many engineers, doctors, etc. in their company. If so,what is the value of such intangible pool of expertise inside the company?Conventional accounting treat salaries and wages paid to such employees as anexpense but fails to recognise the value of human resources.

c) Can a company be focussed narrowly and always aiming to maximise profit? Is itnot fair to provide something to society particularly when they spoil naturalresources in their normal operation? Many developed nations are shifting theirhigh-pollution industries to the third world countries to have a clean air in theircountries. When these countries shift their base to third world nations, it islegitimate expectation of the citizens of these countries that these companiesspend sufficient amount to control pollution and other side effects.

d) Companies have changed the way in which it is operating business. Manyconcepts such as just in time (JIT), Total Quality Management (TQM), FlexibleManufacturing System, etc. are common today. But only very few companieshave changed their costing system. For instance, salaries and wages of manymanufacturing companies constitute an insignificant portion of the total cost butour costing system not only report the labour cost but also uses the same as costallocation basis in some cases. Is it not desirable to change our costing system toget some reliable cost data?

e) Traditionally, firms use IT only for accounting purpose and such accounting wasstandalone without any linkages to mainstream business operation. Today,accounting information is extensively used and also IT is extensively usedthroughout the organisation. Is it right or economical or efficient to havestandalone IT system for each functional area? Is it not desirable to have anintegrated accounting system or more specifically enterprise wide resourceplanning (ERP), which performs not only accounting but several other businessoperations in a total integrative manner?

Activity 2

1) We listed few reasons why accounting or accountants need to change fromconventional outlook. Can you apply these ideas into anyone of the companies orto your own company and list out your findings?

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2) Find out from your IT friend how ERP is different from that of accounting pageslike Tally.

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3) Do you feel that spending money on social and environment is wastage ofcorporate resources? What do these firms get in return by spending such amount?

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Cost Volume ProfitAnalysis 19.3 INFLATION ACCOUNTING

Inflation rate is the percentage change in the price level from the previous period. Theprimary objective of inflation accounting is to correct conventional historical costaccounts for the understatement of inventory and plant used in production, i.e. the costof goods sold and depreciation, in order to prevent erosion of capital during inflation.That is, inflation accounting is used to provide information that is useful to present andpotential investors and creditors and other users in making decisions (and) in assessingthe amounts, timing, and uncertainty of prospective cash receipts from dividends orinterest and the proceeds from the sale, redemption, or maturities of securities or loans.Inflation accounting was of interest when many developing economies were sufferinginflation rates of 25% or more. Now that rates are in single figures, the debate on theneed of inflation accounting is subdued. Some of the related objectives are:

a) To show the real profit and loss for the period under consideration as against theprofit or loss on the basis of historical cost;

b) To show the real value of the assets and liabilities instead of historical cost; and

c) To ensure that sufficient funds will be available to replace the various assetswhen the replacement becomes due.

This objective is generally achieved by the current cost method, which is also muchmore responsive to the general objectives of financial reporting. There are alternativemethods like Current Purchasing Power Method, Constant Dollar Accounting Method,etc. Under the current cost accounting method, fixed assets, stocks, stocks consumed,etc. are shown in the financial statements at their value to the business and not at thedepreciated value or original cost. Depreciation for the year is calculated on thecurrent value of the fixed assets. All these things normally leads to reduction in profitworked out under this method compared to normal historical based profit. Since thediscussion beyond this input is out of the scope of the subject, interested students areadvised to refer to Statement of Standard Accounting Practice (SSAP) 16.

There are limitations to inflation accounting and the failure to recognize them has led tounnecessary complexity in some methods. Inflation accounting cannot isolate orcondense into one earnings number all of the effects of inflation on a company. It issimply an improved system of measurement which brings financial statements intoharmony with current costs and values. Such improved statements provide afoundation for analysis of a company’s economic earnings and financial position in aninflationary environment, including any special effects of inflation.

Activity 3

1) What is the purpose of using inflation index in the preparation of accounting?

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2) Suppose a company provides inflation-adjusted accounting. In your opinion, whogains most by using such accounting statement?

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3) Identify a few old cement or fertiliser companies, which have been establishedsome 20 years back. Compare their book value and market value of the companyor price per share. Do you feel that the book value is not representative of currentmarket value? If so, do you feel that use of inflation accounting resolve suchinconsistency?

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19.4 HUMAN RESOURCES ACCOUNTINGIn the case of manufacturing firms, most of the assets are in physical form. Thesecould be easily traced and valued. Hence it’s not much difficult to find the value of thefirm. Other than the physical assets, manufacturing firms also have assets likeintangible assets like goodwill, brand value etc. are to a greater extent possible to givean approximate value. The most important is human capital, the ability of employees todo the things that ultimately make the company work and succeed, particularly in thecase of software firms, the main asset is human being. Is it possible to value humanbeing? Can we assign a value every individual in the firm? Should we have to value thehuman beings, just because they form the main asset in the IT firms? Yes it is utmostnecessary. As in most software companies though the projects are completed on ateam basis, the skills of each individual and his contribution is utmost important. Further,its not only important only for IT firms it could also be more helpful if such value isgiven to employees in manufacturing firm also, so that human beings get to know whatis the value they are contributing to the organisation and how much are they able toimprove in providing the value addition. Hence human resource accounting becameimportant. But not every company understands their contribution to the bottom line orknows how to manage them to drive even better financial results, even though theyaccount for as much as 80 per cent of the worth of a corporation.

What is needed is measurement of abilities of all employees in a company, at everylevel, to produce value from their knowledge and capability. Human ResourceAccounting (HRA) is basically an information system that tells management whatchanges are occurring over time to the human resources of the business. HRA alsoinvolves accounting for investment in people and their replacement costs, and also theeconomic value of people in an organization. The current accounting system is not ableto provide the actual value of employee capabilities and knowledge. This indirectlyaffects future investments of a company, as each year the cost on human resourcedevelopment and recruitment increases.

The information generated by HRA systems can be put to use for taking a variety ofmanagerial decisions like recruitment planning, turnover analysis, personneladvancement analysis and capital budgeting, which can help companies save a lot oftrouble in the future. In India, there are very few companies like BHEL, Infosys andReliance Industries, which have implemented HRA and some are working on it.Infosys, which started showing human resource as an asset in its balance sheet, hasbeen reaping high market valuations.

Companies can derive many benefits by going in for HRA. Not only can they measurethe return on capital employed on total organisational assets (including the humanassets), but the resources can also be planned accordingly. Once organisations realisethe actual benefit and take it as a growth process, it will only help them in increasingtheir shareholders’ value. When a company is able to assess an individual’s worth, ithelps in increasing its own worth. Basically HRA can be tracked through two

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methods: cost-based analysis and value-based analysis. The cost-based approachfocuses on the cost parameters, which may relate to historical cost, replacement cost,or opportunity cost. The value-based approach suggests that the value of humanresources depends upon their capacity to generate revenue. This approach can befurther sub-divided into two broad categories: non-monetary and monetary.

The disposition of resources can also be examined by allocating relative human assetvalues to different job grades. HRA also helps in examining expenditure on personneland in re-appraisal of expenditure on services and training. It can also serve as a keyfactor in case of mergers and takeover decisions, where the human asset valuebecomes a relevant factor. Another very significant role, which HRA can help increating, is goodwill for a company. The company can project itself in having bestpractices with superior policies in place. Experts believe that this may help theorganisation attract more investments.

Infosys in its balance sheets shows Human Resources value at Rs. 9539.15 cr. as onMarch 31, 2002. The HRA section of Infosys Annual Report states the following:

The dichotomy in accounting between human and non-human capital is fundamental. Thelatter is recognized as an asset and is therefore recorded in the books and reported in thefinancial statements, whereas the former is totally ignored by accountants. The definitionof wealth as a source of income inevitably leads to the recognition of human capital as oneof several forms of wealth such as money, securities and physical capital.

The Lev & Schwartz model has been used by Infosys to compute the value of the humanresources as on March 31, 2002. The evaluation is based on the present value of the futureearnings of the employees and on the following assumptions:

1. Employee compensation includes all direct and indirect benefits earned both in Indiaand abroad.

2. The incremental earnings based on group/age have been considered.

3. The future earnings have been discounted at 17.17% (previous year – 21.08%), thisrate being the cost of capital for Infosys. Beta has been assumed at 1.41 based on theaverage beta for software stocks in US.

While HRA as a concept has been present in India for more than a decade, withBHEL taking a lead, it is only now that the awareness is being translated intoapplication. However, in terms of awareness and acceptance, the level is still low asmany companies take little initiative to make the numbers public to shareholders,despite having the data. And there is a lack of an industry standard. This means thatevery company has to evolve its own standard, which can become a tedious process,considering that most of them are still involved in improving their business. Industrybodies like Nasscom can help set a standard.

Activity 4

1) What is HRA? How different is it from Human Resource Management.................................................................................................................................

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2) How wide is the application in the area of human resources valuation in India?Name few companies that are implementing HR valuation.................................................................................................................................

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3) What are the benefits of human resource accounting for the companies and alsofor the employees?

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19.5 SOCIAL ACCOUNTINGSocial accountability is about being answerable to the people affected by your actions.Leading organizations now engage relevant stakeholders, including employees,suppliers, consumers, regulators, NGOs and communities, in open, consequentialdialogue at all levels of business decision-making and activity. They also volunteerinformation to these stakeholders on their social performance, thereby makingthemselves accountable to these interest groups. Social and ethical accounting, auditingand reporting is still relatively new in many developing or third world nations, but isgaining acceptance internationally as the primary demonstration of socialaccountability. A social report is the result of a thorough evaluative process focused onthe social impact of a business on all its various stakeholders.

Social accounting and audit is a framework which allows an organisation to build onexisting documentation and reporting and develop a process whereby it can accountfor its social performance, report on that performance and draw up an action plan toimprove on that performance, and through which it can understand its impact on thecommunity and be accountable to its key stakeholders. The social accounting processshould be driven by a rigorous methodology that involves the collection, analysis andinterpretation of quantitative and qualitative data. The accounting systems should bestandardized to facilitate verification by a third party. A social report represents thedisclosure of the company’s social performance in the same way that the annual reportdiscloses financial performance.

Social accounting is not just a public relation exercise but a strategic intervention that,in addition to disclosing social performance, serves to steer the company in atransformation process. This strategic effect is achieved by adhering to the principle offull disclosure. Both negative and positive performances are declared in the finalreport. Consequently the corporation is compelled to perform and the social report hasa level of legitimacy that run-of-the-mill PR efforts do not have.

Effective reputational risk management contributes significantly to gaining andmaintaining a competitive advantage. Today’s informed consumers are increasinglyconcerned with the ethical characteristics of a business. And companies that havevalues closely aligned with wider societal demands are better placed to recruit andretain talented employees. A brand associated with ethical business conduct is betterprotected in the global market because it enjoys hardier loyalty. Engaging in a socialaccounting process, thoroughly and transparently, will enhance your company’scompetitive edge. Some of the social indicators are as follows:

1) Quality of Management2) Human Rights3) Environmental Performance4) Health and Safety5) Stakeholder Relationships6) Corporate Social Investment7) Employment Equity8) Products and Services

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Through dialogue with stakeholders, an organization identifies social and ethicalindicators that will objectively reflect its performance in relation to corporate valuesand objectives. The choice of indicators is based on the organization’s statement ofvalues and the standards, codes and guidelines to which the organization subscribes; onstakeholders’ perception of the organization’s performance against its values, and inrespect of their specific needs and concerns; and on best practices established insocieties that are part of the social accounting scope, weighed against the societalneeds of the South African context.

Decision-makers must consequently determine which parts of the organization, such asdivisions, departments or sites, are to be measured. The process of improving socialand ethical performance takes time and an organization may choose to limit disclosurewhile setting performance targets and goals for more comprehensive reporting overtime. These decisions should be declared in the social report if credibility is to bemaintained. Once indicators have been established and the parts of the organization tobe evaluated identified, relevant data must be collected. Initially this may provechallenging because there is seldom a system in place for deliberately measuring socialimpacts. Producing the first social performance report will educate the organization asto the nature of Social Impact Accounting Systems (SIAS) needed for rigorously andobjectively measuring performance.

Collected data is analysed and a social performance report is produced. The manner inwhich publication and distribution is addressed may be taken as indicative of theorganization’s commitment to ethical and socially responsible business practice.Consequently, the report should be afforded the care and status devoted to thetraditional annual report on financial performance. And in the same way that acompany’s financial performance is audited for assurance, social performance shouldbe submitted to the same intense scrutiny.

The core business of community and social enterprises and of community organisationsis to achieve some form of social, community or environmental benefit. Financialsustainability or profitability is essential to achieving that benefit, but subsidiary to it.The organisation and all the people associated with it or affected by it need to know ifit is achieving its objectives, if it is living up to its values and if those objectives andvalues are relevant and appropriate. That is what the social accounting process aims tofacilitate.

A full set of Social Accounts is likely to include the following:

1) A report on performance against the stated objectives (How well have we donewhat we said we would do? )

2) An assessment of the impact on the community (Can this be measured? What dopeople think?)

3) The views of stakeholders on our Objectives and Values (Are we doing the“right” things? Are we “walking our talk”?)

4) A report on environmental performance (Are we “living lightly” and minimizingresource consumption?)

5) A report on how we implement equal opportunities (Do we effectively encouragesocial inclusion?)

6) A report on our compliance with statutory and voluntary quality and proceduralstandards (Do we do what is expected of us, and more?)

Keeping social accounts gives us the information we need qualitative and quantitativeto tell us how we are performing and what people think about what we do, and howwe do it. This is a social balance sheet so that all stakeholders can decide for


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themselves whether to use, work for, support, or invest in the organisation. Through theproduction of audited social accounts the organisation can fulfil its accountability to itsstakeholders. The overarching principle of social accounting and audit is to achievecontinuously improved performance relative to the chosen social objectives and to thestated values. Six specific key principles have been identified from recent theory andpractice as underpinning the concept and good practice.

19.6 ENVIRONMENTAL ACCOUNTINGEnvironmental accounting is defined as the accountants’ contribution towardsenvironmental sensitivity in organizations. It gained prominence in the 1990s. Theemphasis on the social responsibilities of the accountancy profession is not new, havingbeen led to prominence by the social accounting debate of the 1970s. The socialconsciousness of the accountancy profession was started to receive its attention. Itfocused on extending accountability to numerous stakeholders by necessitatingdisclosure of social information in corporate annual reports. The accountability functionof accounting was believed to be fulfilled by reporting (financial and social) informationthat stakeholders would find useful in their decision making process.

This led to the appearance of environmental, employee and ethical information on avoluntary basis in modern day corporate annual reports. Unfortunately, socialaccounting as discussed in the earlier section, failed to make its way into themainstream accounting agenda, largely due to lack of mandatory standards to guide itand value judgments associated with determination of social responsibilities of anorganization. In spite of this, there has been renewed interest in social accounting inthe 1990s, triggered by the urgency associated with reducing environmental problemsthat exist today.

Practical developments of environmental accounting saw tremendous growth inresearch, with various initiatives and proposals being put forward by accountancybodies and related international organizations. In essence, environmental accountingnow plays a vital role in daily commercial undertakings, attempting to ensure thatdevelopment is not at odds with environmental protection. The potential foraccountants to make a significant contribution towards environmental consciousness inorganizations has been envisaged through their managerial, auditing and reporting skills.Increasingly, the emphasis has shifted from social accounting in general to a morespecific environmental accounting. These days, social accounting has becomesynonymous with the term social and environmental accounting (SEA), a linkage thatplaces due emphasis on the importance of environmental issues.

The fundamental premise behind environmental accounting is that organizations shouldinternalize environmental costs. Currently, these costs are externalized, which meansthat the society bears the impact of an organization’s adverse activities on theenvironment, largely due to the fact that is a “public good”. Internal environmentalaccounting mechanisms such as life cycle costing or even full cost accounting attemptto trace costs of the organization’s activities on the environment. It is believed thatonce organizations are made accountable for these costs, they would be compelled tominimize the potentially harmful effects of such activities. Further, environmentalaccounting requires organizations to forecast the potential environmental impact oftheir activities and accordingly estimate contingent liabilities and create provisions forenvironmental risk.

Accountants’ role in environmental issues extends beyond management of the internalmechanisms (environmental management accounting). They could be responsible forthe disclosure of environmental information, primarily in corporate annual reports, butalso through some other communication media. Environmental reporting providesaccountability to the wider society of the organization’s commitment to environmental

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consciousness. Disclosure could constitute monetary information such asenvironmental costs, liabilities, provisions and contingencies, coupled with quantitativeand descriptive information such as ecological data (for example, physicalmeasurement of environmental impacts), environmental policies, targets andachievements.

The Environmental Accounting was first considered a new field in accounting in during1998 by the intergovernmental work group ISAR (United Nations Inter governmentalWorking Group of Experts on International Standards of Accounting and Reporting).Jointly with this work, ISAR has been coordinating efforts with IAPC (InternationalAuditing Practices Committee) to formalize a group of audit standards for verificationof the environmental performance reported on accounting statements. This work groupbasically emphasised the need for environmental accounting to cover the followingbasic objectives: (a) assistance of professionals in other fields of knowledge; (b) givethe status of the information system of the analyzed company, as regards thepreparation of its internal controls to provide its financial accounting with relevantinformation on environmental aspects; and (c) effective contribution of variousexternal intervenors, as the consulting specialists, certification companies andindependent auditors, to grant an independent opinion on specific aspects of the report.

The concept of sustainable development catching on rapidly, corporate and industrialhouses across the world are increasingly incorporating the environmental element intheir day-to-day business operations. They are clear in their perception that along withquality, safety of the environment, too, is an important factor in making a businesssuccessful.

Activity 5

1) Take the annual report of top 5 companies in the Petrochemicals industry and findout which part of the report covers the environmental accounting if given?

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2) How efficiently companies follow the environmental accounting requirements?Do you find any deviance from what they actually practice and what they reportin their financial reports? If so, given an instance of any company violating thesame.

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19.7 INTERNATIONAL ACCOUNTINGMany Indian companies, particularly in pharmaceutical and software industry haveoverseas operations. With trade liberalisation in place, many Indian companies wouldbe future multinationals. When firms operations move international, not only onmanufacturing and marketing but also investors, accounting of different businessoperations located at different countries under one roof becomes difficult. There aretwo potential problems that an accountant faces in dealing with such consolidation.


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Accounting standards differ in several countries and investors of those countriesrequire the financial statements using their countries accounting standards to enablethem to compare the company with other company. For instance, if you are ashareholder of Hindustan Lever Ltd., or Castrol India Ltd. you would like to have thefinancial statements under Indian GAAP. Think about an investor of Unilever locatedeither in Netherlands or UK, who has majority stake in Hindustan Lever. Whileconsolidating the Hindustan Levers Ltd. financial statements with Unilever statements,the investors of Unilever expects Hindustan Levers Ltd., financial data also reflectstheir countries GAAP. The task turns complex further if the shareholders are locatedin different countries. For instance, Infosys or many other top rated Indian companiesshares are held by several FIIs whose investors are located across the globe andinvestors of ADR of these companies are also located in different parts of globe. IfInfosys prepares financial statements only on the basis of Indian GAAP, they will notbe happy. By virtue of agreement with overseas stock exchanges, Infosys may berequired to present a separate statement following the US GAAP. But what about theinvestors in Japan, who has also purchased shares of infosys either directly orindirectly through FII. Today, many companies started giving separate financialstatement using major countries GAAP to satisfy the investors of those countries.While it adds cost of compiling financial reports, it brings lot of goodwill.

Firms operating in different countries also have certain peculiar problem. For instance,your company’s overseas venture would have posted increased profit during a periodbut when you convert the profit in your currency, you might be alarmed to see thatprofit has actually come down from the previous year if there is a currencydepreciation in the country. On the other hand, the performance of overseas countrymight have actually come down but when we convert the same to our currency, theperformance might have improved if our currency appreciates during the period.Handling multi-currency business operations in consolidation is another complex task ininternational accounting.

Activity 6

1) Collect or download from the company’s website the annual report of Infosys orWipro or Asian Paints. Read the statement of significant accounting polices ofconsolidated financial statements. List down your observation/understanding?

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2) Visit http://www.icai.org and locate Accounting Standard page. Download AS 21and AS 27. Write a one page note on each accounting standard after reading thesame.

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19.8 STRATEGIC COST MANAGEMENTThe field of management accounting has also seen considerable changes in recenttimes. When industrialisation was limited and economies were closed for externalcompetition and also having restricted internal competition, managers decision makingscope was normally restricted to few operational decision making such as productionoptimisation, product mix, setting discount policies, etc. Conventional cost and financialaccounting provide adequate information for such decisions. However, over a periodof time, business environment has completely changed and internal and external

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competitions have become the order of the day. Top management of any firm, small,medium, large or multinational, are increasingly spending time on strategic decision andcost and financial data are extensively used along with input drawn from theenvironment, which includes competitors’ financial and non-financial information. Anew discipline called ‘strategic cost management’ or ‘strategic managementaccounting’ addresses these issues. The following issues are typically addressed usingcost input from strategic perspective:

a) Value Chain Analysis : Let us take an example of a product say televisionwhich we use daily in our life to understand the concept. The television setwhich you are using is giving you some value - educative or entertainment value.There are so many organisations, which are involved in the whole process ofmanufacturing and delivering the television to you. All these organisations areadding value at each stage to the product and what you get finally the collectiveamount of all value addition. The value chain analysis looks into how much ofvalue addition has taken place at each stage of the whole process. It helps theorganisations to identify the place where they need to be there to maximise thereward and at the same time using their expertise. If all organisations try toreduce the total cost of the value chain, then customers get benefit out of suchexercise. For instance, if you are manufacturing PET bottles, which are used bymany mineral water manufacturing companies you have two options in setting upyour plant. One, you can put up a centralised huge plant to achieve economies ofscale but force your customers to hold more inventory since without bottles, it isdifficult to run the plant. Alternatively, you can put up smaller plants nearmanufacturer. While this will add cost of manufacturing, but it will bring downinventory level. As PET bottle manufacturer, you need to look beyond yourcosting and see the value chain.

b) Activity-based-costing (ABC) : ABC looks into a firm as a bunch of activitiesand hence focuses more on activity analysis, cost associated in performing suchactivities and then finally ways to perform the activities better while reducing thecost. ABC provides more accurate cost data than conventional costing systemand such reliable costing is often required for strategic decision. ABC is alsouseful to identify value added and non-valued activities.

c) Customer cost analysis : Do you feel all your customers are equally importantto you? If you ask this question to MD of a large company, the answer will bemost probably ‘Yes’ since today every company wants to be customer focussedand it is immaterial whether the customer is small customer or large customer.Suppose you ask another question to the same MD - are all your customersequally profitable? The answer need not be ‘Yes’ and often the answer is ‘No’.Customers are increasingly demanding and hence the cost of providing servicesto customers significantly differ from customers to customers. How manycompanies trace the cost up to the customer level? They normally stop costingexercise upto the product level and that too with some ad hoc overheadallocation. You need reliable cost data to measure customer profitability.

d) Competitor cost analysis: Can you run a company without understandingcompetitor? The answer would be probably ‘yes’ in some 15 years back andtoday it is a strong ‘NO’. What do you want know about the competitor ?Apart from several other things, you would like to know their cost structure. Anunderstanding of their cost structure is helpful in several ways. For instance, ifthe material cost of the competitors is lower than your company, you can startlooking for alternative source of buying or changing material quality or change.

e) Target costing: Here, costing of product starts before the product gets into theproduction stage. Many experts find that the best way to reduce the cost is spendtime while products are under development. Because, once a product design is


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completed, about 80% of the costs are pre-determined. For instance, imagine youwant to construct a hotel and run profitably. The operating cost of running a hotelis relatively small compared to fixed cost. So the best way to reduce the cost isto spend more time and energy in drawing the construction plans andeconomically using the space, material and other items. This applies to manymanufactured products like watch or television or air-conditioner. Target costing isdone with the help of set of employees drawn from several functional areas, whotogether participate in the development exercise with a single goal of designing aproduct whose cost is less than target cost.

In addition to the above, there are several other strategic cost management techniqueslike life-cycle costing, capacity costing, etc. For all these techniques, activity basedcosting is used as a principle cost information. we will discuss briefly the activity basedcosting. Under 19.9 of this Unit.

Activity 7

1) How value chain analysis is different from value analysis?

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2) Indian Railways moves passengers and goods from one place to other place. Canyou perform value chain analysis for Indian Railways and find out how they canadd value to passengers and business communities, which use the freight service?

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3) Compare whether the profit changes are in line with the changes in cash flowfrom operating activities.

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4) Suppose one of the co-operative banks want to consult you in helping customercost analysis. Can you briefly tell how you can go about in helping the bank?

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19.9 ACTIVITY BASED COSTINGAccurate and relevant cost information is critical to any organisation that hopes tomaintain, or improve, its competitive position. For years, firms operated under theassumption that their cost information actually reflected the costs of their products andservices when, in reality, it did nothing of the kind. Over-generalised cost systems wereactually misleading decision makers, causing them to make decisions inconsistent withtheir organisations’ needs and goals, principally because of misallocated costs.

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Activity-based costing (ABC) is a valuable concept that can be used to correct theshortcomings in the cost systems of the past. It is a means of creating a system thatultimately directs an organisation’s costs to the products and services that require thosecosts to be incurred. ABC can be used this way because it provides a cross-functional,integrated view of the firm, its activities and its business processes.

As a result, in many organisations, ABC has evolved beyond the point of simplydeveloping more accurate and relevant product, process, service and activity costs.These organisations use ABC as a means of improving operations by managing thedrivers of the activities that cause costs to be incurred. They are using ABC to supportmajor decisions on product lines, market segments and customer relationships, as wellas to simulate the impact of process improvements. Organisations involved in TotalQuality Management processes are using both the financial and non-financialinformation of ABC as a measurement system.

The basic distinction between traditional cost accounting and ABC is as follows:traditional cost accounting techniques allocate costs to products based on attributes ofa single unit. Typical attributes include the number of direct labour hours required tomanufacture a unit, purchase cost of merchandise resold, or number of days occupied.Allocations, therefore, vary directly with the volume of units produced, cost ofmerchandise sold, or days occupied by the customer. In contrast, ABC systems focuson activities required to produce each product or provide each service based on eachproduct’s or service’s consumption of the activities.

Using ABC, overhead costs are traced to products and services by identifying theresources, activities and their costs and quantities to produce output. A unit of output(a driver) is used to calculate the cost of each activity. Cost is traced to the product orservice by determining how many units of output each activity consumed during anygiven period of time. An ABC system can be viewed in two different ways. The costassignment view provides information about resources, activities and cost objects. Theprocess view provides operational (often non-financial) information about cost drivers,activities and performance.

ABC does not only apply to manufacturing organisations, it is also appropriate forservice organisations such as financial institutions, and medical care providers andgovernment units. In fact, some banking firms have been applying the concept foryears under another name - unit costing. Unit costing is used to calculate the cost ofbanking services by determining the cost and consumption of each unit of output offunctions required to deliver the service.

Activity 8

1) How ABC is different from that of conventional costing?

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2) Can you list at least three examples where ABC gives different cost valuecompared to conventional costing?

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3) List down any three uses of ABC in strategic cost application?

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19.10 IT DEVELOPMENTS IN ACCOUNTINGAccounting is one of the earliest operation that has seen computerisation in thecommercial world. Today, we have reached a stage in which almost all accountingoperations are done through computers. What is the use of computers in accounting?Book-keeping is monotonous job and it is best done by machine than men. Further,accuracy and speed of the operation improves considerably. Most importantly,transactions are entered only once and all further operations are done by the machine.Compare this with manual operations in which someone keep basic day books,someone posts it to ledger and prepares trial balance and someone prepares financialreports. When the level of computerisation expands and includes several otherbusiness operations, the task improves considerably.

Today, many companies are using Enterprise Resource Planning (ERP) software likeSAP, Peoplesoft, etc. ERP attempts to integrate all departments and functions across acompany to create a single software program that runs off one database. For instance,if your planning is very good, the ERP system operates like this. Suppose, the inventorylevel has come down below certain level. Your ERP system immediately generatespurchase order and electronically placed the same to the pre-defined vendor. When thevendor supplies the material, you are making two entries - one at the stores level forthe receipt of the material and one at the accounts department for invoice data. Themachine compares the two and pass the bill for payment. On the due date, chequesare printed and accounting of payment is done electronically.

What is the use of such integration? It avoids duplication of systems and data entry ordata transport from system to another. Major benefit of ERP is better planning andcontrol. Suppose, you have made a plan for the next year sometime around January2003 (for the period of April 2003 to March 2004). Sometime around July you havefound that the performance of the first quarter is better than what you have expectedand hence you want to increase your target and reset the budget. While it may beeasier to change overall budget values, no one knows what will be changes required atvarious stages unless there is an integration. Planning doesn’t end with the boardroom.To translate the planning into action, changes are required every stages and peopleshould realise what kind of problems it may pose when we change the plan. Forinstance, such an upward revision may require additional working capital or identifyingnew supplier for the material or booking of additional railway wagon. ERP softwaretypically identifies all such problems and helps you to optimise using simple to advancemodelling.

19.11 LET US SUM UPAccounting primarily complies monetary transactions taken place between thecompany and others and prepares financial statements. Accounting information is usedby several users. A significant part of the accounting system is today handled bycomputers and hence requires accountants to upgrade the skills. Top management aswell as other stakeholders expect accountant to provide useful information in additionto traditional income statement and balance sheet. For instance, the profit shown underprofit and loss account is unreliable in a situation of high inflation or when the assetsare very old. The company may not have adequate funds to meet the expenditure.

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Accountants are expected to provide insight on the future growth prospects ofcompanies in an inflationary condition. Similarly, stakeholders, particularly those otherthan shareholders, would be interested to know the contribution of company to socialcauses and how it respects environmental and other issues. Though in a narrow sense,shareholders are not concerned on this issue, their interest is also affected if the firmfails to consider the interest of society. Shareholders interest of automobile companies,textile companies, tobacco companies, etc. is affected if these companies fail tocomply environmental issues. Accountants are also expected to provide information ofintangibles, which are particularly relevant for knowledge-based companies and otherservice organisations. Human Resources Accounting, Brand Valuation, etc. areimportant pieces of information that stakeholders expect to be incorporated in thebalance sheet. In addition to these inputs, accountants are expected to provide lot ofinputs that are used for strategic decision making process. For instance, accountantshave to collect the details on product-wise, geographic-wise, customer-wise, etc. andalso information pertaining to competitors. Accountant inputs are extensively used forbench marking exercises and also decision such as out-sourceing. Since thestakeholders are geographically spread all over the world, many companies areshowing accounting results under several accounting standards to satisfy the needs ofinvestors, employees, suppliers, customers and government authorities of severalcountries. Modern accountants are also expected to be computer-savvy and befamiliar to work in a computerised networking environment. Companies spendsubstantial money in IT and integrate all their operations. While on the one hand,accountants role is declining on account of computerisation, accountant contributionand involvement at high-end are increasing. For instance, today accounting processesare centralised and concepts like shared service operation are emerging. In this, theshared service operation provider maintains the accounts of several companies andgeneral many value added reports for the management. In other words, accountingprofession is as challenging as any other professions and also highly rewarding.

Interested students can refer the Shareholders Information section of the AnnualReport of Infosys Technologies Limited (page numbers (page number 137 to 162).It covers intangible assets score sheet, human resources accounting and value-addedstatement, brand valuation, balance sheet (including intangible assets), current-cost-adjusted financial statements, economic value-added (EVA) statement, ratio analysis,statutory obligations, value reporting and management structure. It gives you a real lifeperspective on current trends in accounting. You can download the report from thecompany’s website (http://infosys.com/investor/reports/annual/Infosys_AR03.pdf).

19.12 TERMINAL QUESTIONS1) When conducting a social audit, what are the things must a company do?

2) What is the benefit of companies being socially responsible?

3) For what type of industries, Human Resource Accounting is most suitable? Is itrelevant to countries like India? Explain.

4) Inflation rates have come down in the last few years in many countries includingIndia. Do you feel inflation accounting has a role? Discuss your answer.

5) Is environmental accounting PR exercise? How do you perform environmentalaccounting and auditing of fertiliser company?

6) How does activity based costing differ from traditional costing approach?

7) What is the role of cost accounting/cost data in strategic management?

8) Suppose your company wants to pursue product differentiation strategy. How as anaccountant you will be useful for this exercise?


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9) List down some of the major benefits to a company on account of computerisedaccounting system.

10) How implementation of ERP is different from computerisation of accounting function?

19.13 FURTHER READINGSBowman, E. H. and M. Haire. 1976. Social Impact Disclosure and Corporate AnnualReports. Accounting, Organizations and Society 1(1): 11-21.

Brandon, C. H. and J. P. Matoney, Jr. 1975. Social Responsibility Financial Statement.Management Accounting (November): 31-34.

Cowen, S. S., L.. B. Ferreri and L. D. Parker. 1987. The Impact of CorporateCharacteristics on Social Responsibility Disclosure: A Typology and Frequency-basedAnalysis. Accounting, Organizations and Society 12(2): 111-122.

Elias, N. and M. Epstein. 1975. Dimensions of corporate social reporting. ManagementAccounting (March): 36-40.

Geoffrey Whittington (1983), Inflation Accounting: An Introduction to the Debate,Cambridge University Press.

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