performance evaluation cost

8/3/2019 Performance Evaluation COST...

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INTRODUCTION

Performance Evaluation is the basis of a management control system. Periodic comparisons of

actual costs, revenues and investments with the budgeted costs, revenues and investments canhelp management in taking decisions about future allocations. Performance evaluation should be

done in respect of all responsibility centres to ascertain their level of performance. The best wayto encourage managers to achieve the desired level of performance is to measure theirperformance in comparison to budgeted results. Performance Evaluation of employees is used to

take decisions about their salaries, promotions and training required for future assignments.

Performance evaluation is made of various responsibility centres such as cost centre, profit

centre or investment centre.

PRINCIPLES OF PERFORMANCE EVALUATION

1) Managers of responsibility centers should have direct input into the process ofestablishing budget goals of their area of responsibility.

2) The evaluation of performance should be based entirely on matters that are controllableby the manager being evaluated.3) Top management should support the evaluation process.4) The evaluation process must allow managers to respond to their evaluations.5) The evaluation should identify both good and poor performance.

RESPONSIBILITY CENTRE

A Responsibility Centre is a unit or function of an organization headed by a manager having direct

responsibility for its performance. Responsibility Centre is a personalized group of cost centres under thecontrol of a responsible individual. Under responsibility centre approach, the accounting system generates

information on the basis of managerial responsibility, allowing that information to be used directly in

motivating and controlling each managers actions in charge of responsibility Centre. The purpose ofassigning costs to responsibility centres is to permit cost control which can be achieved by personalizing

responsibility for costs to the managers in charge of responsibility centres.

Types of Responsibility Centres

Generally the following types of responsibility centres are found:

1. Cost Centre

Cost Centre is a location, function or items of equipment in respect of which costs may be

ascertained and related to cost units for control purposes. Cost centres are only related to costs

and not to revenues or assets and liabilities of the organization. Cost centre is the smallestorganizational sub-unit for which separate cost allocation is attempted. It may be a personal costcentre or impersonal cost centre. A cost centre forms the basis for building up cost records for

cost measurement, budgeting and control. Managers or functional departments might be treated

as cost centres and made responsible for their costs. In other words, cost centre is an individualactivity or group of similar activities for which costs are accumulated. Cost centre managers,

therefore, have only control over costs.

From functional point of view, a cost centre may be of any of the following:


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(a) Production cost centre: - A cost centre where production is done, example: Assembly

department, Finishing Department etc.(b) Service costs centre: - A cost centre which render services to production centres, example:

Personnel accounting, Repair shop, Boiler plant etc.

(c) Ancillary manufacturing centres: - Such as those concerned with producing packing materials

etc.

2. Revenue centre

A revenue centre is a segment of the organization which is primarily responsible for generatingsales revenue. A revenue centre manager does not possess control over cost, investment in assets,

but usually has control over some of the expenses of the marketing department. The performance

of a revenue centre is evaluated by comparing the actual revenue with budgeted revenue. The

Marketing manager of a product line or an individual sales representative is examples of revenue

centres.

3. Profit Centre

A profit centre is a segment of an organization for which both revenue and costs are

accumulated. The main purpose of a profit centre is to earn profit. Profit centre managers aim at

both production and marketing of a product. The performance of a profit centre is evaluated interms of whether the centre has achieved its budgeted profit. A division of the company which

produces and markets the products may be called a profit centre. Such a divisional manager

determines the selling price, marketing programmes and production policies. Profit centres make

managers more concerned with finding ways to increase the centres revenue by increasingproduction or improving distribution methods. Profit centre are created to delegate responsibility

to individuals and measure their performance.

4. Investment Centre

It is a centre in which a manager can control not only revenues and costs but also investments.

The manager of such centre is made responsible for properly utilizing the aspects used in his

centre. He is expected to earn a requisite return on the amount employed in assets in his centre.Return on investment is used as a basis of judging and evaluating performance of an investment

centre. Performance of an investment centre is assessed not by profit alone; rather profit is

related to investment employed in the centre. The manager of an investment centre is required toearn a satisfactory return on capital employed in the centre. An investment centre may be treated

as a separate centre of business where the manager has overall responsibility of managing inputs

(i.e. expenses or costs), outputs (i.e. revenues) and investment. Managers of subsidiary

companies can be treated as investment centre managers, accountable for costs, profits and

capital employed.


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MANAGERS CONTROL OVER RESPONSIBILITY CENTRE

TYPE OF RESPONSIBILITY

CENTRE

MANAGER HAS CONTROL

OVER

PRINCIPAL PERFORMANCE

MEASUREMENT

COST CENTRE COSTS(only controllable cost items) VARIANCE ANALYSIS

EFFICIENCY MEASURES

PROFIT CENTRE COSTS(controllable costs) SALES

PRICES (including transfer prices)

OUTPUT VOLUMES

INVESTMENT IN FIXED AND

CURRENT ASSETS

PROFIT

INVESTMENT CENTRE COSTS(controllable costs) SALES

PRICES (including transfer prices)

OUTPUT VOLUMES

RETURN ON INVESTMENT

RESIDUALINCOME OTHER

FINANCIAL RATIOS

FINANCIAL RESPONSIBILITIES OF CENTRE MANAGERS

TYPE OF

CENTRE

MANAGER RESPONSIBLE FOR

COSTS REVENUES PROFIT OR LOSS INVESTMENT

COST CENTRE Yes No No No

REVENUE

CENTRE

No Yes No No

PROFIT CENTRE Yes Yes Yes No

INVESTMENT

CENTRE

Yes Yes Yes Yes

TECHNIQUES OF PERFORMANCE EVALUATION

The following financial measures can be used for the evaluation of the performance of cost

centre, profit centre and investment centres:

I. RESPONSIBILITY ACCOUNTINGResponsibility accounting refers to the accounting process that reports how well managers (of

responsibility centres) have fulfilled their responsibility. Also known as activity or profitabilityaccounting, information system that personalizes control reports by accumulating and reporting

cost and revenue information according to defined responsibility areas within a company.According to Horngreen, The responsibility accounting system recognizes various divisioncentre throughout an organization and traces costs (as well as revenue, assets and liabilities,

where relevant) to the individual managers who are primarily responsible for making decisions

about these variables.


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Objectives of Responsibility Accounting

Responsibility accounting is a method of dividing the organizational structure into various

responsibility centers to measure their performance. In other words responsibility accounting is a

device to measure divisional performance measurement may be stated as under:

1. To determine the contribution that a division as a sub-unit makes to the totalorganization.

2. To provide a basis for evaluating the quality of the divisional managers performance.3. Responsibility accounting is used to measure the performance of managers and it

therefore, influence the way the managers behave.

4. To motivate the divisional manager to operate his division in a manner consistent withthe basic goals of the organization as a whole.

Principles of Responsibility Accounting

1. A target is fixed for each responsibility centre.2. Actual performance is compared with the target.3. The variances from the budgeted plan are analyzed so as to fix the responsibility of

centres.

4. Corrective action is taken by higher management and is communicated to theresponsibility centre i.e. the individual responsible.

5. All apportioned costs and policy costs are excluded in determining the responsibility forcosts.

Basic Process in Implementation of Responsibility Accounting

The following steps/process is to be followed to successfully implement the system of

responsibility accounting:

1. Responsibility centres within the organization are identified.2. A plan of objective is set up in terms of a target, budget, standard or estimate. The plan is

broken up for allocation of each responsibility area of centre and is communicated to the

concerned level of management.

3. For each responsibility centre the extent of responsibility is defined.4. Controllable and non-controllable activities at various levels of responsibility are

specified.

5. Accounting system of accumulate information by areas of responsibility is specified.6. Performance reports are prepared to provide information to those who will use them.7. The performance is evaluated i.e. the results of actual operation by each responsibility

area or centre. The variances are reported to higher management.

8. Corrective action is taken and communicated to the individual responsible.9. Offer incentive as inducement for good performance.

For successful implementation of the system the manager in charge of responsibility centre must:

Know what is expected from him to achieve. Knows the result of his performance. Be within his power to influence what is happening.


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Benefits of Responsibility Accounting

1. Sound system of control: It introduces the sound system of closer control.2. Assigning of responsibility: Every person individually accountable for their work

assigned and performed by them and everybody knows what is expected from him.

3. Helpful in cost planning: It is effective tool of cost control and cost reduction. It alsofosters a sense of cost consciousness among managers and their subordinates

4. Delegation and control: It helps the management to make an effective delegation ofauthority and required responsibility as well.

5. Improves performance: It facilitates the management to set realistic plans and budgets.It helps in improving the performance as it can be tailored according to the needs of anorganization.

6. Helpful in Decision making: It facilitates decentralization of decision making.7. It is very useful in applying budgetary control and standard costing.

Difficulties in implementing/introducing Responsibility accounting

While implementing the system of responsibility accounting, the following difficulties are likelyto be faced by the management:

1. Classification of costs: For responsibility accounting system to be effective a properclassification between controllable and non-controllable costs is a prime requisite. But

practical difficulties arise while doing so on account of the complex nature and variety of

costs.

2. Inter-departmental Conflicts: Separate departmental pursuits may lead to inter-departmental rivalry and it may be prejudicial to the interest of the enterprise as a whole.

Managers may act in the best interests of their own, but not in the best interests of the

enterprise.

3. Delay in Reporting: Responsibility reports may be delayed. Each responsibility centrecan take its own time in preparing reports.

4. Overloading of Information: Responsibility accounting reports may be overloadingwith all available information. This danger is inherent in the system but with clearinstructions by management as to the functioning of the system and preparation of

reports, etc., only relevant information flow in.

5. Complete Reliance will be deceptive: Responsibility accounting cant be relied uponcompletely as a tool of management control. It is a system just to direct the attention of

management to those areas of performance which required further investigation.

II. BUDGETARY CONTROL AND REPORTINGPreparation of budget is the first step in the budgetary control system. Implementation of budgets

is the second phase which needs continuous reporting of budget performance at short intervals.

Thus proper reporting is an essential element in budgetary control.

Budgetary Control is defined as "the establishment of budgets, relating the responsibilities of

executives to the requirements of a policy, and the continuous comparison of actual with


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budgeted results either to secure by individual action the objective of that policy or to provide a

base for its revision.

Objectives of budgetary control system

1. Definition of Goals: Portraying with precision, the overall aims of the business anddetermining targets of performance for each section or department of the business.

2. Defining Responsibilities: Laying down the responsibilities of each individual so thateveryone knows what is expected of him and how he will be judged.

3. Basis for Performance Evaluation: Providing basis for the comparison of actualperformance with the predetermined targets and investigation of deviation, if any, of

actual performance and expenses from the budgeted figures. It helps to take timely

corrective measures.

4. Optimum use of Resources: Ensuring the best use of all available resources to maximizeprofit or production, subject to the limiting factors.

5. Coordination: Coordinating the various activities of the business and centralizingcontrol, but also making a facility for the Management to decentralize responsibility and

delegate authority.6. Planned action: Engendering a spirit of careful forethought, assessment of what is

possible and an attempt at it. It leads to dynamism without recklessness. It also helps todraw up long range plans with a fair measure of accuracy.

7. Basis for policy: Providing a basis for revision of current and future policies.Importance of budgetary control system

1. Maximization of Profit: The budgetary control aims at the maximization of profits ofthe enterprise. To achieve this aim, a proper planning and co-ordination of different

functions is undertaken. There is proper control over various capital and revenue

expenditures. The resources are put to the best possible use.2. Co-ordination: The working of the different departments and sectors is properly co-

ordinate. The budgets of different departments have a bearing on one another. The co-

ordination of various executives and subordinates is necessary for achieving budgetedtargets.

3. Specific Aims: The plans, policies and goals are decided by the top management. Allefforts are put together to reach the common goal of the organization. Every departmentis given a target to be achieved. The efforts are directed towards achieving come specific

aims. If there is no definite aim then the efforts will be wasted in pursuing different aims.

4. Tool for Measuring Performance: By providing targets to various departments,budgetary control provides a tool for measuring managerial performance. The budgetedtargets are compared to actual results and deviations are determined. The performance of

each department is reported to the top management.

5. Economy: The planning of expenditure will be systematic and there will be economy inspending. The finances will be put to optimum use. The benefits derived for the concern

will ultimately extend to industry and then to national economy. The national resources

will be used economically and wastage will be eliminated.

6. Determining Weakness: The deviations in budgeted and actual performance will enablethe determination of weak spots. Efforts are concentrated on those aspects where

performance is less than the stipulated.


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7. Corrective Action: The management will be able to take corrective measures wheneverthere is a discrepancy in performance. The deviations will be regularly reported so thatnecessary action is taken at the earliest. In the absence of a budgetary control system the

deviation can determined only at the end of the financial period.

8. Consciousness: It creates budget consciousness among the employees. By fixing targetsfor the employees, they are made conscious of their responsibility. Everybody knowswhat he is expected to do and he continues with his work uninterrupted.

9. Reduces Costs: In the present day competitive world budgetary control has a significantrole to play. Every businessman tries to reduce the cost of production for increasing sales.

He tries to have those combinations of products where profitability is more.

Limitations of budgetary control system

1. Estimates: Budgets may or may not be true, as they are based on estimates. Theassumptions about future events may or may not actually happen.

2. Rigidity: Budgets are considered as rigid document. Too much emphasis on budgets mayaffect day to day operations and ignores the dynamic state of organizational functioning.

3. False Sense of Security: Mere budgeting cannot lead to profitability. Budgets cannot beexecuted automatically. It may create a false sense of security that everything has been

taken care of in the budgets.4. Lack of coordination: Staff cooperation is usually not available during Budgetary

Control exercise.

5. Time and Cost: The introduction and implementation of the system may be expensive.BUDGETARY CONTROL AND REPORTING

NAME OF REPORT FREQUENCY PURPOSE PRIMARY RECIPIENT

SALES WEEKLY DETERMINE

WHETHER SALES

GOALS ARE BEINGMET

TOP MANAGEMENT

AND SALES MANAGER

LABOUR WEEKLY CONTROL DIRECT

AND INDIRECT

LABOUR COSTS

VICE PRESIDENT OF

PRODUCTION AND

PRODUCTION

DEPARTMENT

MANAGERS

SCRAP DAILY DETERMINE

EFFICIENT USE OF

MATERIALS

PRODUCTION

MANAGER

DEPARTMENT

OVERHEAD COSTS

MONTHLY CONTROL OVERHEAD

COSTS

DEPARTMENT

MANAGER

SELLING EXPENSES MONTHLY CONTROL SELLINGEXPENSES SALES MANAGER

INCOME STATEMENT MONTHLY AND

QUATERLY

DETERMINE

WHETHER INCOME

OBJECTIVES ARE

BEING MET

TOP MANAGER


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III. VARIANCE ANALYSISVariance analysis is usually associated with explaining the difference (or variance) between

actual costs and the standard costs allowed for the good output. For example, the difference in

materials costs can be divided into a materials price variance and a materials usage variance.

Control is very important function of management. Through control management it ensures thatperformance of the organization conforms to its plans and objectives. Analysis of variance is

very helpful in controlling the performance and achieving the profits that have been planned.Variance analysis helps management to understand the present costs and then to control future

costs.

The difference between the standard cost or profit or sales and actual cost or profit or sales is

known as variance and the process by which the total difference standard cost or sales and actual

cost or sales is broken down into its different parts is known as variance analysis. When actualcost is less than standard cost or actual profit is better than standard profit, it is known as

favorable variance and such a variance is usually a sign of efficiency in the organization. On the

other hand, when actual cost or standard profit or standard sales is more than standard cost oractual profit or sales, it is called unfavorable or adverse variance and is indicator of inefficiency.

They are also known as debit and credit variance respectively.

Another way of classifying the variance may be controllable and uncontrollable. When the

variance is due to efficiency of a cost centre it is said to be controllable or otherwise

uncontrollable. Such a variance can be corrected by taking a suitable action. There are number ofreasons which give arise to variances and the analysis of variance will help to locate the reason

and person or department responsible for particular variance. The management need not pay

attention to items or departments proceeding according to standard laid down. It is only in the

case of unfavorable items that they have to exercise the control.

The deviation of total cost from total standard cost is known as total cost variance. It is a netvariance which is aggregate of all variances relating to various elements of cost.

Analysis of variance may be done in respect of each element of cost and sales like:

Direct material variance Direct labor variance Overhead variance Sales variance

Limitation of Variance Analysis

1. Time delay: The accounting staff compiles the variances at the end of the month beforeissuing the results to the management team. In a fast-paced environment, managementneeds the information much faster than once a month.

2. Variance source information: Many of the reasons for variances are not located in theaccounting records, so the accounting staff has to sort through such information as bills

of material, labor routings, and overtime records to determine the causes of problems.

3. Standard setting: Variance analysis is essentially a comparison of actual results to anarbitrary standard that may have been derived from political bargaining.


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IV. CONTRIBUTION MARGINIt can be defined as the difference between the sales and the variable cost of those sales. It

contributes towards fixed expenses and profit. A profit investment centre giving more

contribution is preferred because it will give higher figure of profit taking fixed expenses asconsultant.

Contribution is different from the profit which is net gain in activity and remains after deducting

fixed expenses from the total contribution. Contribution margin is a good technique ofperformance measurement as it helps to find out the profitability of a product, department or

division, to have better product mix, for profit planning and to maximize the profit of a firm.

The main drawback of this technique as a measure of performance is that it does not give due

consideration to fixed expenses. With the development of technology, fixed expenses have

increased and their impact on production is much more than that of variable expenses. Therefore,

a technique of performance evaluation which ignores fixed expenses is less effective because asignificant portion of the cost representing fixed expenses is not taken care of.

Another important limitation of contribution margin approach is that firms in a competitive

industry might be induced to sell at prices which cover variable cost and give contribution but

fail to earn an adequate return on investment in fixed assets. A technique of performanceevaluation should lay emphasis on the need for making an adequate return on capital employed

in a division or department.

V. RETURN ON CAPITAL EMPLOYED OR RETURN ONINVESTMENT

Return on capital employed or return on investment is an indicator of the earning capacity of thecapital employed in the business.

Return on investment means a performance measure used to evaluate the efficiency of an

investment or to compare the efficiency of a number of different investments. To calculate ROI,

the benefit (return) of an investment is divided by the cost of the investment; the result is

expressed as a percentage or a ratio.

The return on investment formula:

Or = Operating Profit x 100

Capital Employed

Return on capital employed is a ratio that indicates the efficiency and profitability of a

company's capital investments.


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The return on capital employed formula:

ROI is considered to be the most important ratio because it reflects the overall efficiency withwhich capital is used. This ratio is a helpful tool for making investment decisions. A project

yielding higher return is favored.

ROI can be improved by any of the following factors, all other factors being held constant.

i. A decrease in operating costs.ii. An increase in selling price.

iii. An increase in sales volume.iv. A reduction in amount of capital employed.

Advantages of ROI

1. Assess the companys ability to earn an adequate rate of return: Creditors andowners can compare the ROI of a company to other companies and to industry

benchmarks or norms. ROI provides information about a companys financial health.2. Provide information about the effectiveness of management: Tracking ROI over a

period of time assists in determining whether a company has capable management.

3. Project future earnings: Potential suppliers of capital assess present and futureinvestment and the return expected from that investment.

Disadvantages of ROI

1. Adverse effect on managers: A manager who is evaluated based on return oninvestment (ROI) may reject investment opportunities that are profitable for the wholecompany but that would have a negative impact on the manager's performance

evaluation.2. Change in employee behavior: It results in separation from other elements influencing

changes in employees behavior.

3. Limited time frame: The projects having large costs in the future may incorrectly appearto give a higher return because the future costs are not included in the calculation.

4. Consistency: The fact that ROI can be calculated several different ways creates aproblem of consistency. Few companies have developed a single ROI methodology, thus

making it difficult to accurately compare and evaluate the economic return of several

projects.

VI. RESIDUAL INCOMEThe amount of income that an individual has after all personal debts, including the mortgage,

have been paid. This calculation is usually made on a monthly basis, after the monthly bills and

debts are paid. Residual income is the money left after monthly payment obligations such as


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housing costs and taxes. In business, residual incomes are extra amounts of operating income

over the regular minimum of controllable operating assets.

Formula:

Residual income = Operating income{Minimum rate of return Average operating assets}

If residual income is less than zero, the company is earning less than the minimum rate ofreturn.

If residual income is exactly zero, the company is earning precisely the minimum rate ofreturn.

If residual income is greater than zero, the company is earning more than the minimumrate of return.

Advantages of Residual Income

1. It encourages managers to accept any project that earns about the minimum rate.2. Applies to dividend and non-dividend paying companies3. Can be used when cash flows are unpredictable4. It maximizes the overall value and growth of the firm as it focuses on economic value.5. It increases shareholders wealth by accepting investments which give a rate of return in

excess of cost of capital.

Disadvantages of Residual Income

1. Can encourage a short run orientation.2. Residual income is an absolute measure of profitability as it is expressed in rupees. It

does not provide proper measure for evaluation of organizational performance.

3. Direct comparison is difficult when level of investments differ.4. Uses readily available accounting data (e.g., accounting manipulations)

VII. VALUE ADDEDValue Added is the change in market value resulting from an alteration in the form, location oravailability of a product or service excluding the cost of bought-in material and services. It is the

excess of the sales revenue plus income from services over the cost of bought in goods and

services purchased from outsiders. It can also be defined as the wealth the organization has

created by people working in the business, by providers of capital and by the government whichhas a responsibility for the social and economic environment with in which the business operates

.In this sense it will be calculated by taking the total of employees costs (i.e., wages, salaries andcost of other benefits given to employees), interest on loans, dividend, government taxes,

depreciation and retained profits. Value added differs from the conventional profit depicted by

profit and loss account because conventional profits calculations deduct all costs from sales and

add other incomes whereas value added is obtained by deducting the cost of bought-in material

and services from sales and other incomes. Every effort should be made to increase the value ofproducts produced or services figure of value added is more important to measure, evaluate and

judge the performance of an enterprise than the figure of profit because it excludes those costs


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over which the firm has either no control or at best a little control. An organization may survive

without earning profit but cannot survive without adding value. Any business which is notmaking profit shall become risky but any business not generating value would be an evil and not

desirable at all form the societys point of view.

VIII. BENCH MARKINGBenchmarking is the process of identifying "best practice" in relation to both products

(including) and the processes by which those products are created and delivered. The search for

"best practice" can take place both inside a particular industry, and also in other industries.

The objective of benchmarking is to understand and evaluate the current position of a business

or organization in relation to "best practice" and to identify areas and means of performance

improvement.

The increased global competition calls for special competence of increased cost efficiency for a

company for its very survival. Bench marking is a technique which will help a company toachieve this comparative cost efficiency. Bench marking may be defined as a continuous

information sharing process, adopted by an organization internally and externally to identify its

strong or weak points against the toughest competitors, to improve the activities carried out and

services provided by it. Companies choose to bench mark excellent companies whose businessprocesses are similar to their own. A bench mark amount is the best level of performance that

can be found inside or outside the organization. The bench mark exercise has five essential steps

as given below:

a) Identifying key variables for bench markingb) Selecting comparative companies (i.e., excellent companies)c) Gathering required datad) Evaluating and interpreting the performance gape) Improving the performance to achieve world class operations.

In order to effectively bench mark, it is vital to determine the real difference between our firmand business process leader to be copied or imitated and comparison must be made at least in

following essential areas:

Cost of product/services Productivity Standard of performance achieved Attitudes/features

Bench marking is to be treated as a continuous learning process and it should result in

innovations.


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IX. RATIO ANALYSISRatio analysis is an important analytical tool for measuring performance of a firm. Ratio is the

numerical or an arithmetical relationship between two figures. It is expressed when one figure isdivided by another. Absolute figures are valuable but they standing alone convey no meaning

unless compared with another. Various types of ratios are calculated for evaluating theperformance of firm. Ratios may be classified in a number of ways keeping in view the particular

purpose. Ratios may be classified as:

PROFITABILITY RATIOS

COVERAGE RATIOS

TURNOVER RATIOS

FINANCIAL RATIOS

CONTROL RATIOS

These are discussed as follows:

(1)Profitability Ratios:Profitability ratios are of utmost importance for a concern. These ratios are calculated to

enlighten the end results of business activities which are the sole criterion of the overall

efficiency of a business concern. The following are the important profitability ratios:

Gross Profit Ratio: This ratio tells gross margin on trading and is calculated as under:Gross Profit Ratio = GROSS PROFIT

NET SALESHigher the ratio the better it i.e. low ratio indicates unfavorable trends in the form of

reduction in selling prices not accompanied by proportionate decrease in cost of goods or

expense, dividends and building up of reserves. In many industries there is more or lessrecognized gross profit ratio and an analysis of this ratio will indicate whether the ratio of

the firm being analyzed is satisfactory or not. Gross profit ratio of a firm may be

compared with that of competitors in the industry to assess its operational performance in

comparison to other players in the industry. Operating Ratio: - This ratio indicates the proportion that the cost of sales bears to sales.

Cost of sales includes direct cost of goods sold as well as other operating expenses,

administration, selling and distribution expenses which have matching relationship with

sales. It excludes income and expenses which have no bearing on production and sales,i.e., non-operating incomes and expenses as interest and dividend received on investment,

interest paid on long term loans and debentures, profit or loss on sale of fixed assets or

long term investments. It is calculated as follows:

COST OF GOODS SOLD + OPERATING EXPENSES 100

NET SALES


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Lower the ratio, the better it is. Higher the ratio the less favorable it is because it would have a

smaller margin of operating profit for the payment of dividends and the creation of reserves. Thisratio should be analyzed further to throw light on levels of efficiency prevailing in different

elements of total cost

Expenses Ratio: These are calculated to ascertain the relationship that exists betweenoperating expenses and volume of sales. The following ratios will help in analyzing

operating ratio:a. MATERIAL CONSUMED RATIO = MATERIAL CONSUMED 100

NET SALESb. CONVERSION COST RATIO =

LABOUR EXPENSES + MANUFACTURING EXPENSES 100

NET SALES

c. ADMINISTRATIVE EXPENSES RATIO = ADMINISTRATIVE EXPENSES 100NET SALES

d. SELLING AND DISTRIBUTION EXPENSES =SELLING AND DISTRIBUTION EXPENSES 100

NET SALES

Operating Profit Ratio: This ratio establishes the relationship between operating profitand sales and is calculated as follows:

Operating Profit Ratio = OPERATING PROFIT 100

NET SALES

Where Operating Profit=Net profit + Non-operating ExpensesNon Operating Incomeor =Gross profitOperating Expenses

or =Net profit before Interest and tax

Operating profit ratio can also be calculated with the help of operating ratio asfollows: - Operating Profit Ratio=100operating ratio

Higher the ratio the better it is.

Net Profit Ratio: This ratio is very useful to the proprietors and prospective investorsbecause it reveals the overall profitability of the concern. This is the ratio of net profit

after taxes to net sales and is calculated as follows:NET PROFIT RATIO = NET PROFIT AFTER INTEREST AND TAX 100

NET SALES

The ratio differs from the operating profit ratio in as much as it is calculated after

deducting non operating expenses ,such as loss on sale of fixed assets etc.,fromoperating profit and adding non-operating income like interest or dividends on

investments ,profit on sale of investments or fixed assets, etc,to such profit. Higher the

ratio ,the better it is because it gives idea of improved efficiency of the concern. Return on Capital Employed: The formula is:

o OPERATING PROFIT 100CAPITAL EMPLOYED

Return on Shareholders Fund: When it is desired to work out the profitability of thecompany from the shareholders point of view ,then it is calculated by following formula:

o NET PROFIT AFTER INTEREST AND TAX 100SHAREHOLDERS FUND


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The ratio of net profit to shareholders funds shows the extent to which profitability

objective is being achieved. Higher the ratio, the better it is. Return on Equity Shareholders Fund OR Return on Net Worth: This ratio is a

measure of the percentage of net profit to equity shareholders fund .The ratio is

expressed as follows:

RETURN ON EQUITY SHAREHOLDERS FUND =NET PROFIT AFTER TAX, INTEREST AND PREFERENCE DIVIDEND

EQUITY SHAREHOLDERS FUNDS

Here,

Equity Shareholders Fund = EQUITY SHARE CAPITAL+CAPITALRESERVE+REVENUE RESERVES+BALANCE OF PROFIT AND LOSS ACCOUNT-

FICTITIOUS ASSETS-NON BUSINESS ASSETS

Return on Total Assets: This ratio is calculated to measure the profit after tax againstthe amount invested in total assets to ascertain whether assets are being utilized properlyor not. It is calculated as under:

NET PROFIT AFTER TAX 100TOTAL ASSETS

Suppose net profit after tax is RS.20000 and total assets are RS.100000. Return on totalassets will be 20% (i.e ,Rs.20,000Rs.100,000)100). The higher the ratio the better it is

for the concern.

Earning Per Share: This helps in determining the market price of equity shares of thecompany and in estimating the companys capacity to pay dividend to its equityshareholders. It is calculated as follows:

EARNING PER SHARE=NET PROFIT AFTER TAX AND PREFERENCE DIVIDENDNUMBER OF EQUITY SHARES

Pay Out Ratio: This is determined as follows: DIVIDEND PER EQUITY SHARE

EARNING PER SHARE

Complimentary of this ratio is retained Earning ratio. It is calculated as follows: RETAINED EARNING RATIO = RETAINED EARNINGS 100TOTAL EARNINGS

This ratio indicates as to what proportion of earning per share has been used for paying

dividens and what has been retained for ploughing back. This ratio is very important from

shareholdrs point of view as it tells that if company has used whole or substantially thewhole of its earning for paing dividend and retained nothing for future growth and

expansion purpose.

(2)Coverage Ratios:These ratios indicate the extent to which the interests of the persons entitled to get a fixed

return(i.e interest or dividend)or a scheduled repayment as per agreed terms are safe.The higherthe cover,the better it is.Under this category the following ratios are calculated as under:

Fixed Interest Cover: It really measures the ability of the concern to service the debt. This ratio

is very important from lenders point of view and indicates whether the business would earn

sufficient profits to pay periodically the interest charges. It is calculated as follows:

NET PROFIT BEFORE INTEREST AND TAX

INTEREST CHARGES


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For example:- if the net profit before interest and tax is Rs.32000 and interest charges are

Rs.4000 then fixed interest cover will be 8 times(i.e Rs.32000Rs.4000).The higher the ratio ,the

more secured lenders will be in respect of their periodical interest income.

Fixed Dividend Cover: This ratio is important for preference shareholders entitled to get

dividend at a fixed rate in priority to other shareholders. It is calculated as follows:

NET PROFIT AFTER INTEREST AND TAX 100

PREFERENCE DIVIDEND

For example, if the profits after interest and tax are Rs.270000 and dividend on preference shares

is Rs.27,000, the fixed dividend cover will be 10times(i.e,Rs.270000Rs.27000)

(3)Turnover (or Performance or Activity) Ratios :These ratios are very important for a concern to judge how well facilities at the disposal of the

concern are being used or to measure the effectiness with which a concern uses its resources at

its disposal.In short these will indicate position of assets usage.These ratios are usually

calculated on the basis of sales or cost of sales and are expressed in number of times rather thanas a percentage.this ratio should be calculated separately for each type of asset.the greater ratio

more will be efficiency of asset usage.The lower ratio will reflect the under utilization ofresources available at the command of the concern.The following are the important turnover

rratios usually calculated by a concern.

Sales to Capital Employed (or Capital Turnover) Ratio: This ratio shows theefficiency of capital employed in the business by computing how many times capitalemployed is turned over in a stated period. This ratio is ascertained as follows:

SALES

CAPITAL EMPLOYED (i.e. shareholder + long term liabilities)

The higher the ratio the greater are the profits. A low capital turnover ratio should betaken to mean that sufficient sales are not being made and profits are lower.

Sales to Fixed Assets (or fixed assets turnover) Ratio: This ratio measures theefficiency of the assets use .The efficient use of assets will generate greater sales per

rupee invested in all assets of the concern. This ratio expresses the number of times fixedassets are being turnedover in a stated period. It is calculated as under:

SALESNET FIXED ASSETS (i.e. FIXED ASSETS less DEPRECIATION)

Sales to Working Capital (or Working Capital Turnover) Ratio: This ratio shows thenumber of times working capital is turned over in a stated period .It is calculated as

follows:

SALESNET WORKING CAPITAL (i.e. Current AssetsCurrent Liabilities)

Total Assets Turnover Ratio: This ratio is calculated by dividing the net sales by thevalue of total assets (i.e. NET SALESTOTAL ASSETS). A higher ratio is an indicator of

over-trading of total assets while a low ratio reveals ideal capacity .

Stock Turnover Ratio: It denotes the speed at which the inventory will be converted intosales, there by contributing for the profits of the concern. This ratio reveals the number of

times finished stock is turned over during a given accounting period. Higher the ratio the


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better it is because it shows that finished stock is rapidly turned-over. On the other hand a

low stock turnover ratio is not desirable because it reveals the accumulation of obsoletestock ,or the carrying of too much stock. This ratio is calculated as follows:

COST OF GOODS SOLD

AVERAGE STOCK HELD DURING THE PERIOD

Where,Cost of Goods Sold = OPENING STOCK+PURCHASES+MANUFACTURING EXPENSES-

CLOSING STOCK OR SALES-GROSS PROFIT.AVERAGE STOCK = OPENING STOCK+CLOSING STOCK

2

Suppose the cost of goods sold is Rs.45.000 and average stock is Rs.150,000. Then stock

turnover ratio will be 3 times i.e. (Rs.450,000Rs.150,000)

Receivable (or Debtors) Turnover Ratio: It indicates the number of times on theaverage the receivables are turn over in each year. The higher the value of ratio, the moreis a efficient management of the debtors. It is calculated as follows:

NET CREDIT SALES

AVERAGE DEBTORS

The collection period is calculated as under:Collection period= 365/DEBTORS TURNOVER RATIO

ORAVERAGE DEBTORS NO OF DAYS IN A PERIOD

NET CREDIT SALES

Creditors (or Accounts Payable) Turnover Ratio: This ratio given the average creditperiod enjoyed from the creditors and is calculated as under:

CREDIT PURCHASES

AVERAGE ACCOUNTS PAYABLE (Creditors+B/P)

Average Age of Payable = MONTHS(OR DAYS)IN A YEAR/CREDITORS TURNOVER

RATIO

ORAVERAGE ACCOUNTS PAYABLE MONTHS(or days)IN A YEAR

CREDIT PURCHASES

(4)Financial RatiosThese ratios are calculated to judge the financial position of the concern from long term as well

as short term solvency point of view. These can be divided into two categories:

o Liquidity Ratioso Stability Ratios

i. LIQUIDITY RATIOS: These ratios are used to measure the firms ability to meet shortterm obligations. They compare short term obligations to short term resources available

to meet these obligations. From these ratios, much insight can be obtained into the

presence cash solvency of the firm and the firms ability to remain solvent in the event of

adversity.

The important liquidity ratios are:


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Current Ratio (or Working Capital Ratio): This is most widely used ratio. It is theratio of current assets to current liabilities. It shows firms ability to cover its currentliabilities with current assets. It is expressed as follows:

Current Ratio = Current Asset .

Current LiabilitiesGenerally 2:`1 is considered ideal for a concern i.e. current asset should be twice of

current liabilities, as it shows that there would be no adverse effect on business

operations when the payment of current liabilities is made. If the ratio is less than 2,difficulty may be experienced in the payment of current liabilities and day to day

operations of the business may suffer. If the ratio is higher than 2, it is very comfortable

for the creditors, for the concern, it is indicator of ideal funds and a lack of enthusiasmfor work.

Liquid (Or Acid Test or Quick) Ratio: This is the ratio of liquid assets to liquidliabilities. It shows a firms ability to meet current liabilities with its most liquid assets.

1:1 is considered as an ideal ratio for a concern because it is wise to keep the liquid assets

at least equal to the liquid liabilities at all the times. Liquid assets are those assets whichare readily converted into cash and will include cash balances, bills receivables, sundry

debtors, and short term investments. It doesnt include Inventories and pre-paid expensesbecause the emphasis is on ready availability of cash and liquid liabilities include all

items except bank overdraft. It is expressed as follows:

Quick Ratio= Quick Assets .Quick Liabilities

Absolute Liquidity (or Super quick) Ratio: Though receivables are more liquid thaninventories, there may debts having doubt regarding their real stability in time. So, to het

idea about the absolute liquidity of a concern, both receivables and inventories areexcluded from current assets and only absolute liquid assets cash in hand, cash at bank

are taken into consideration. It is calculated as follows:

Cash in hand and at bank + Short term marketable securities

Current LiabilitiesThe desirable norm for this ratio is 1:2 i.e. Re. 1 worth of absolute liquid assets are

sufficient for Rest. 2 worth of current liabilities..

Ratio of inventory to working capital: In order to ascertain that there is nooverstocking, the ratio of inventory to working capital should be calculated. It is worked

out as follows:

InventoryWorking Capital

Working capital is the excess of current assets over current liabilities. Increase in the

volume of sales increase in the size of inventory. The desirable working capital ratio is

1:1.

ii. STABILITY RATIOS: These ratios help in ascertaining the long term solvency of a firmwhich depends on firms adequate resource to meet its long term funds requirements,appropriate debt equity mix to raise long term funds and earnings to pay interest and long

term loans on time (i.e. coverage ratios). The following ratios can be calculated for this

purpose:


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Fixed asset ratio: This ratio explains whether the firm has raised an adequate long termfunds to meet its fixed assets requirements and is calculated as under: -

Fixed Assets

Capital Employed

This ratio gives an idea as to what part of the capital employed has been used inpurchasing the fixed assets for the concern. If it is less than one it is good for the concern.

The ideal ratio is .67. Ratio of current assets to Fixed assets: This ratio is worked as follows

Current Assets

Fixed Assets

This ratio differs from industry to industry; therefore, no standard can be laid down. Adecrease in the ratio may mean that trading is slack or more mechanization has been put

though. An increase in the ratio may reveal that inventories debtors have unduly

increased or fixed assets have been intensively used. Increase in the ratio indicates

business is expanding.

Debt equity ratio: It measures the extent of equity covering the debt. This ratio iscalculated to measure the relative proportions of outsiders funds and shareholders funds

invested in company. This ratio is determine to ascertain the soundness of long termfinancial policies of that company and is also knows as external-internal equity ratio. It is

calculated as follows:

Debt equity ratio = Long term Debts ... (i)Shareholders Funds

Or Long term debts .... (ii)

Shareholders funds + Long term debts

Shareholders funds consists of preference share capital, equity share capital, Profit andLoss A/c (Cr. Balance) , capital reserves, revenue reserves and reserves representing

marked surplus, like reserves for contingencies, sinking funds for renewal of fixed term

assets or redemption of debentures etc.

Whether a given debt to equity ratio shows a favorable and unfavorable financial positionof the concern depends on the industry and the pattern of earning. A low ratio is generally

viewed as favorable from long term creditors point of view, because a large margin of

protection provides safety for the creditors. The same low ratio may be taken as quiteunsatisfactory by the shareholders because they find neglected opportunity for using the

low cost outsiders funds to acquire fixed assets that could earn a high return. Keeping in

view both the shareholders and long term creditors, debt to equity ratio of 2:1 in case (i)and 2:3 in case (ii) is acceptable.

Proprietary ratio: A variant of debt to equity ratio is the proprietary ratio which showsthe relationship between shareholders funds and total tangible assets, it is worked out as

follows:

Shareholders FundsTotal tangible assets

This ratio should be 1:3 i.e. one third of the assets minus current liabilities should be

acquired by shareholders funds and the other one third of the assets should be financed

by outsiders funds. It mainly focuses on the general financial strength of the firm.


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(5)Control RatiosThe following control ratios are used by the management to know whether the deviations of theactual performance from the budgeted performance are favorable or unfavorable. If the ratio is

100% or more the performance is considered as favorable and if it is less than 100% it is

considered as unsatisfactory.

Capacity ratio = Actual hours worked 100Budgeted Hours

This ratio indicated the extent to which budgeted hours of activity is actually utilized. If

the ratio is 35%, budgeted capacity is utilized up to 85% and rest of the remaining

remains unutilized.

Activity Ratio = Standard Hours for Actual production 100Budgeted standard Hours

This ratio measures the level of activity attained during the budget period.

Efficiency Ratio = Standard Hours for Actual production 100Actual Hours worked

This ratio is an indicator of the efficiency attained in production over a period. Efficiencyhas gone up by 25% if this ratio is 125%.

Calendar Ratio = Number of actual working Days in a period 100Number of working days in a period

This ratio indicated whether all the budgeted working days in a budget period have been

able in actual practice. If the ratio is more than 100%, more days have been available in

actual practice and vice versa if the ratio is less than 100%.

Importance/Advantages of Ratio Analysis

It is a process of determining and presenting the relationship of items and groups of items in thefinancial statements. It is an important technique of financial analysis. It is a way by which

financial stability and health of a concern can be judged. The following are the main importance

of ratio analysis:

1. Useful in financial position analysis: accounting ratios reveal the financial position ofthe concern. This helps the banks, insurance companies and other financial institutions in

lending and making investment decisions.

2. Useful in simplifying accounting figures: Accounting ratios simplify, summaries andsystematize the accounting figures in order to make them more understandable and inlucid form. They highlight the inter relationship which exists between various segments

of the business by accounting statements.

3. Useful in assessing the operational efficiency: Accounting ratios helps to have an ideaof the working of a concern. The efficiency of the firm becomes evident when analysis isbased on accounting ratio. They diagnose the financial health by evaluating liquidity,

solvency, profitability etc.


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4. Useful in forecasting purposes: If accounting ratios are calculated for a number ofyears, then a trend is published. The trend helps in setting up a future plans andforecasting. For example: expenses as a percentage of sales can be easily forecasted on

the basis of sales and expenses of the past years.

5. Useful in locating the weak spots of the business : Accounting ratios are of greatassistance in locating the weak points in the business even though the overallperformance may be efficient. Weakness in financial structure due to incorrect policies in

the past or present are revealed through accounting ratios.

6. Useful in comparison of performance: Through accounting ratios comparison can bemade between one departments of a firm with another of the same firm in order to

evaluate the performance of various departments in the firm. Manager is naturally

interested in such comparison in order to know the proper and smooth functioning of

such departments.

Limitations of Accounting Ratios

In spite of so many advantages, it has some limitations also which restrict its use. These

limitations should be kept in mind while making use of ratio analysis for interpreting thefinancial statements. Following are the main limitations:

1. False result if based on in correct accounting data: Accounting ratios can be correctonly if the data on which they are based upon is correct. Sometimes, the informationgiven in the financial statements is affected by window dressing i.e. showing position

better than what actually is. For an instance if inventory values are inflated or

depreciation is not charged on fixed assets, not only will one have an optimistic view of

profitability of the concern but also of its financial position.2. No idea of probable happening in future: Ratios are an attempt to make an analysis of

the past financial statements, so they are historical documents. Now a day keeping in

view the complexities of the business, it is important to have an idea of the probablehappening in future.3. Variation in accounting methods: The two firms results are comparable with the help

of accounting ratios only if they follow the same accounting method or bases.

Comparison will become difficult if the two concerns follow the different method ofproviding depreciation.

4. Price Level changes: Changes in the price levels makes comparison for various yearsdifficult. For example, the ratio of sales to total assets in 1996 would be much higher thanin 1982 due to rising prices, fixed assets being shown at cost and not a market price.

5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fractionof information needed for decision making. So, to have a comprehensive analysis of

financial statements, ratios should be used along with the other method of analysis.6. Ignores qualitative measures: Accounting ratios are the tool of quantitative analysisonly. But sometimes qualitative factors may surmount the quantitative aspects. The

calculations derived from the ratio analysis under such circumstances may get distorted.


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X. NON-FINANCIAL QUALITY PERFORMANCE MEASURESProfitability alone is inadequate to measure the performance of various centres. There is no

denying the fact that financial measures are important measures for evaluating the performanceof cost centres, profit centres and investment centres. But these measures are not fully adequate

measure for performance evaluation. Further these measures are short term measures. Divisionalmanagers to achieve their short term targets may be induced to derive short term benefits byusing these techniques at the expense of long term benefit of the firm. Therefore it is desirable to

use non-financial measures for evaluating the performance besides using financial measures. The

following non-financial measures should also be considered along with financial measures for

evaluation of performance:

i. Market share for each productii. Product leadership

iii. Product or service qualityiv. Delivery reliabilityv. Productivity

vi. Personnel Turnovervii. Personnel development

viii. Personnel satisfactionix. Customers aftersale servicex. Customer satisfaction

xi. Minimization of wastages and lossesxii. Social responsibilities.Non-financial measures are very important for the overall success of a firm. Financial measures

alone are not enough for measuring the overall performance of a firm.

performance evaluation cost

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