Management Accounting Unit 1 for B.Com(Hons)/BCom/BBA.pdf

Management Accounting B.Com (Hons) Semester 4th
1 | Page Prepared by UMA KANT (Research Scholar “LU”, JRF(Commerce), UGC NET(Management), M.Com, MBA
Management Accounting
B.Com (Hons) Semester - 4th
Unit -1
University of Lucknow,
Lucknow
Meaning of Management Accounting:
The term Management Accounting consists of two words “Management” and
“Accounting”. It is the study of managerial aspects of accounting. It is a tool
in the hands of management to exercise decision making. The emphasis of
management accounting is to redesign accounting in a manner which is
helpful to the management in framing the policies and control of their
execution.
Management accounting is of recent origin. The term was first used in 1950
by a team of accountants visiting U.S.A. under the auspices of Anglo-
American Council on productivity. The terminology of cost accounting had
no reference to the word „management accountancy‟ before the visit by this

study group. Intensive competitions, large scale production, dynamic
developments in technology, and complexities of modern business have led
to the development of management accounting-to solve many of the
problems.
“Management accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy and in the day-
to-day operations of an undertaking”. I.C.M.A. – the definition recently
incorporated into the terminology.
Characteristics of Management Accounting:
The objective of Management accounting is to record, analyse and present
financial data to the Management in such a way that it becomes useful and
helpful in planning and running business operations systematically and
effectively.
The following are the main characteristics of management
accounting:
1) Providing Financial Information:
The main emphasis of management accounting is to provide financial
information to management. The information is provided in a manner
suitable to various levels of management for reviewing policies and decision
making.
2) Cause and Effect Analysis:

Financial accounting confines itself to presentation of P&L account and
Balance Sheet. Management accounting analyses the cause and effect of the
facts and figures thereon. If there is loss causes for the losses are investigated.
If there is profit the variable affecting the profit are also analysed. The
amount of profit is compared with expenditure, sales, capital employed, etc.,
to draw appropriate conclusions relating to the effect of those items on profit.
3) Use of Special Techniques and Concepts:
Management accounting employs special techniques like standard costing,
budgetary control, marginal costing, fund flow, cash flow, ratio analysis,
responsibility accounting, etc. to make accounting data more useful and
helpful to the management. Each of these techniques or concepts is a useful
tool for specific purpose in analysis and interpretation of data, establishing
control over operations, etc.
4) Decision Making:
Main objective of management accounting is to provide relevant information-
to management to take various important decisions. Historical information
provides a base on which the future impact is predicted, alternatives are
developed and decisions are made to select to select the most beneficial
course of action.
5) No Fixed Conventions:
Financial accounting has various established principles and rules in preparing
the financial accounts. Management accounting has no such fixed rules. The

tools or techniques applied by the management accounting are same but
application of these techniques various from concern to concern and situation
to situation.
6) Achievement of Objectives:
Management accounting is helpful in realising the enterprise objectives.
Based on the historicalinformation and with adjustments for predicate future
changes, objectives are laid down. Actual performance is recorded.
Comparison of actual with predetermined results is made. If there are
deviations of actual from the predetermined results, corrective action is taken
and predicted objectives are achieved. This becomes possible with the help
of management accounting techniques of standard costing and budgetary
control.
7) Improving Efficiency:
The purpose of accounting is to provide information to increase efficiency.
The efficiency of departments, and divisions can be improved by fixation of
targets or goals for a specific period. The actual performance is compared
with that of targets. Positive deviations are reviewed. Thenegative deviations
are probed to ascertain the causes. The ways and means to tackle the causes
are analysed and targets are achieved. The process of fixing and achieving
the targets leads to gradual improvement in overall efficiency.
8) Forecasting:

Management accounting is concerned with taking decisions for future
implementation. This involves prediction and forecasting of future. It is
helpful in planning and laying down of objectives.
9) Providing of Information and not Decisions:
Management accounting provides financial information and not the
decisions. That is why it issaid that management accounting depends on the
efficiency of the management in using information and taking effective
decisions.
Objectives and Functions of Management Accounting:
Main objective of management accounting is to help the management in
performing its functions efficiently. The major functions of management are
planning, organising, directing and controlling. Management accounting
helps the management in performing these functions effectively.
1) Presentation of Data:
Traditional Profit and Loss Account and the Balance Sheet are not analytical
for decisionmaking. Management accounting modifies and rearranges data as
per the requirementsfor decision making through various techniques.
2) Aid of Planning and Forecasting:
Management accounting is helpful to the management in the process of
planning through the techniques of budgetary control and standard costing.
Forecasting is extensively used inpreparing budgets and setting standards.
3) Help in Organising:

Organising is concerned with establishment of relationships among different
individuals in the firm. It includes delegation of authority and fixing
responsibility. Management Accounting aims at aiding the Management in
organising through establishment of cost centres, profit centres,
responsibility centres, Budget preparation etc. AH these activities are helpful
in setting up an effective organisational frame work.
4) Decision Making:
Management accounting provides comparative data for analysis and
interpretation foreffective decision making and policy formulation.
5) Reporting to Management of Different levels:
One of the Major objectives of Management accounting is to keep the
Management informed about the performance, adherence to plans and
progress of various sections of the organisation.
6) Communication of Management Policies:
Management accounting conveys the policies of the management downward
to the personal effectively for proper implementation.
7) Effective Control:
Standard costing and budgetary control are integral part of management
accounting. These techniques lay-down targets, compare actuals will
standards and budgets to evaluate the performance and control the

deviations.
8) Incorporation of Non-Financial Information:
Management accounting considers both financial and non-financial
information for developing alternative courses of action which leads to
effective and accurate decisions.
9) Coordination:
The targets of different departments are communicated to them and their
performance is reported to the management from time to time. This continual
reporting helps the managementin coordinating various activities to improve
the overall performance.
10)Motivating Employees:
Budgets, standards and other programmers are to be implemented in practice
by the employees. A major objective of Management accounting is to
determine the targets in the form of budgets, standards and programmer in
such a way that the employees feel motivated to achieve them. Thisis usually
accomplished by making the targets practicable and offering suitable
monetary and Non-Monetary incentives to achieve them.

Tools and Techniques of Management Accounting:
The tools and techniques used in management accounting are
explained below:
1) Financial Policy and Accounting:
Every business concern ha sot plan for its sources of funds. The fund can be
raised out of different sources. Utilising a particular source depends on cost of
servicing the source, terms of repayment in case of borrowings, etc. The
amount of share capital raised, the statutory obligations for repayment are to
be considered. The capital mix, i.e., the proportion of share capital and
borrowing has to be decided to have an optimum capital structure.
Management accounting provides capital budgeting techniques for financial
planning.
2) Analysis of Financial Statement:
Analysis of financial statements is means to classify and present the data in a
manner useful to the management. The significance of information provided is
explained in a nontechnical language in the form of ratio analysis, funds flow and
cash flow techniques.
3) Historical Cost Accounting:
Costs are recorded after being incurred for comparison with predetermined
targets to evaluate performance.
4) Budgetary Control:

Budgets are used as a tool for planning and control. The expenditure and
revenue are predetermined. The actuals are compared with budgets to reveal
deviations and individuals responsible for the same. Corrective actions are
initiated to eliminate the negative deviations infuture.
5) Standard Costing:
Standard costing is an important technique of cost control. In Standard
costing the costs are determined in advance by systematic analysis. The
actual costs are compared with standards.The variances are analysed to find
the causes and action is taken for removal of the same to increase efficiency.
Generally, standard costing is used along with budgetary
control for effective control of operations.
6) Marginal Costing:
Under marginal costing, the cost of products is divided into fixed and
variable portions. While the variable costs are taken for decision making,
fixed costs are treated as period costs to be charged to costing Profit and Loss
account. Marginal costing is helpful to management in taking various
important decisions etc.
7) Other Tools of Management Accounting are:
a. Decision Accounting:
Here alternatives are evaluated for selection in decision situation.
b. Revaluation Accounting:
This is applied in replacement of fixed assets whose prices go

up from period. The effect of inflation on the fixer assets is
tackled here.
c. Control Accounting:
In control accounting, internal check, internal audit and statutory audit
are used.
Advantages/ Merits/ Uses of Management Accounting:
Management Accounting is of immense value and utility for the management
of any firm and it has been considered as indispensable, particularly in large
organisations where the task of Management iscomplex.
The following can be listed as the benefits or uses of Management
Accounting:
1) Increase in Efficiency:
Management accounting contributes significantly towards increasing
efficiency in operations of a firm. Budgets, standards, reports etc., usually
elevate the level of performance.
2) Effective Planning:
Policy formulation and planning of operations become more effective through
the „decision data‟provided by Management Accounting.
3) Performance Evaluation:
Evaluating performance of employees, departments, etc., is facilitated by
Management accounting through Variance Analysis, control ratios etc.
4) Profit Maximisation:

Management accounting is helpful in profit planning to pursue decisions
which can optimise profits.
5) Reliability:
The Tools used by Management accounting usually make the data supplied
to Management accurate and reliable.
6) Elimination of Wastages:
Standard costs, Budgets, cost control techniques, etc.,
contribute towards elimination of wastages, production of
defectives etc.
7) Effective Communication:
Regular and systematic reporting ensures constant flow of information about
operations to various levels of Management.
8) Employee Morale:
Morale of employees can be created and sustained through attainable
standards, practical budgets and incentive schemes.
9) Control and Co-ordination:
Control on costs and coordination in the efforts of different segments of an
organisation can be achieved through performance reporting, variance
analysis and follow up action etc.
Limitations of Management Accounting:
Like any other discipline Management Accounting has its own Limitations.
Though it is considered as an indispensable tool for Managerial decision
making, its recent origin and several external factors limitits effectiveness.

These factors are explained below:
1) Dependence for Basic Records:
Management Accounting rarely maintains basic and primary records of
operations, expenses and revenues. It derives all of its Primary data from
Financial Accounting, cost Accounting and other relevant records. So, the
accuracy .and reliability of the conclusions derived by Management
Accounting is limited to the reliability of its sources of data, so, it suffers
from several of the limitations of Finance Accounts and cost Accounts.
2) Personal Bias:
Analysis and interpretation of financial information depends upon the
capability of the analyst and interpreter. Personal Judgement and usage of
discretion become necessary in several areas of Management accounting.
Personal „Prejudices‟ and „Bias‟ of individuals can affect theobjectivity and
effectiveness of the conclusions and recommendations.
3) Management Accounting is only a Tool:
Management accounting cannot be considered as an alternative or substitute
to Management.Management accountant acts as an adviser and facilitator for
decision making by management.The actual decisions, their implementation
and follow up action are the prerogative of the Management.
4) Management Accounting provides only Data:
The Main function of Management Accounting is to provide data in the form
of „Alternatives‟ to the Management. It is for Management to make suitable
choice among the alternatives or even discard all of them. So, Management
Accounting can „only Inform and not prescribe‟.

5) Broad Based Scope:
The scope of Management accounting is very wide and broad based. It uses
information from varied disciplines like Financial Accounting, economics,
Statistics, Cost Accounts, engineering etc. It considers Monetary and Non-
Monetary Transaction of the firm. Limitations of the knowledge and
experience of the Management Accountant in such diverse fields can make
thedata unreliable and undependable.
6) Resistance to Change:
Installation of Management accounting involves basic changes in the
organisational set up and Traditional accounting practices. The personnel
concerned may resist such change unless they are taken into confidence and
convinced of the need for such changes.
7) Costly to Install:
Installation of Management Accounting involves huge expenditure because
of the elaborate organisation needed and the large number of changes in
procedures, forms and rules. So, small firms may not be able to afford the
cost. Only big organisations can afford to Maintain Management accounting
as a department or aid to management.
8) Evolutionary Stage:
Management accenting is of-recent-origin, as a discipline and it is still in
development stage. So, its concepts are fluid, Techniques are still evolving
and analytical tools imperfect. There are several experts who are skeptical of
the utility of Management accounting because of such an important
limitation.

Difference between Financial Accounting and Management Accounting
Basis Financial Accounting
Management
Accounting
Meaning
An accounting system
that helps in classifying,
analysing, summarising,
and recording a
company‟s financial
transactions.
An accounting system
that helps in collecting,
analysing, and
understanding the
financial, qualitative, and
statistical information
ultimately helps the
management in making
effective decisions
regarding the business.
Application
It helps in showing a true
and fair picture of the
financial position of an
organisation.
It helps the management
in making meaningful
decisions and strategizes
accordingly.
Objective
Its objective is to create
periodical reports.
Its objective is to assist
the internal management

Management
Accounting
of an organisation in
making decisions.
Users
There are both internal
(employees,
management, etc.) and
external (customers,
creditors, etc.) users of
financial accounting.
There are only internal
users (management, etc.)
of management
accounting.
Nature of the Statements
prepared
The statements under
financial accounting are
prepared for general-
purpose.
The statements or reports
under management
accounting are prepared
for specific-purpose.
Statutory Requirement
It is mandatory to
prepare the financial
statements of a company.
There is no statutory
requirement for
management accounting.
Scope
The scope of financial
accounting is pervasive.
The scope of
management accounting
is broader than financial
accounting.

Management
Accounting
Rules
Financial accounting
strictly follows the rules
of GAAP.
There are no fixed rules
while preparing reports
through management
accounting.
Time Span
Financial statements
under this accounting
system are prepared for a
fixed time period; i.e.,
one year.
Reports under this
accounting system are
prepared according to
their need.
Basis of Decision-
making
Historical information is
used as the basis of
decision-making.
Historical and estimated
(predictive) information
is used as the basis of
decision-making.
Verifiable
The information
presented in the financial
statements is verifiable.
The information
presented in the reports is
predictive; hence, not
immediately verifiable.
Format
There is a specific format
for presenting and
recording information
There is no specific
format for presenting
information in

Management
Accounting
through financial
accounting.
management accounting.
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Role of Management Accountant
1. Preparing Financial Reports: Gathering financial data, recording transactions,
grouping them into relevant categories, and preparing financial reports such as
balance sheets, income statements, and cash flow statements. These reports are
essential for investors, creditors, and regulatory bodies.
2. Conducting Financial Analysis: Using gathered financial information to conduct
thorough analysis, identify trends, compare actual results against expected results,
analyze profitability of products/services, and assess company performance.
3. Measuring Financial Performance: Utilizing profitability ratios, conducting
comparative analysis, budget variance analysis, cash flow analysis, and
formulating key metrics to evaluate financial performance and progress towards
business goals.
4. Assisting in Forecasting and Budgeting: Employing financial modeling
techniques to create scenarios, preparing company budgets, conducting variance
analysis, and formulating metrics to track progress towards goals.

5. Managing and Controlling Costs: Gathering detailed information about cost
drivers, establishing spending limits, identifying cost reduction opportunities,
estimating pricing for products/services, and developing key performance
indicators related to costs.
6. Assessing Risk: Conducting risk analysis, categorizing risks, assessing severity,
conducting root cause analysis, building risk analysis frameworks, and mitigating
financial risks.
7. Ensuring Compliance: Assisting in internal audits, preparing internal controls,
staying updated on regulations, accounting standards, and tax laws, and ensuring
adherence to legal obligations and regulatory guidelines.
Management Accountant Skills
1. Knowledge of Financial Software: Proficiency in using financial software for
tasks such as financial analysis, budgeting, cost tracking, compliance, and data
management. Understanding various financial tools and their features enables
adaptability to different software platforms.
2. Business Acumen: Ability to analyze financial data, recognize trends, identify
opportunities, and assess risks to generate business value. Understanding of
business processes and strategies aids in effective decision-making and
supporting senior management.
3. Attention to Detail: Strong focus on accuracy and precision in financial
reporting, data analysis, and documentation. Attention to detail helps in
identifying discrepancies, detecting fraud, and maintaining the integrity of
financial information, leading to improved decision-making.

4. Communication Skills: Effective communication with financial professionals,
managers, auditors, vendors, and operations teams is essential. Clear and
concise communication facilitates collaboration, supports decision-making
processes, and fosters a positive work environment conducive to achieving
financial goals.
Responsibility Accounting
Responsibility Accounting is management accounting where all the company‟s
management, budgeting, and internal accounting are held responsible. The primary
objective of responsibility accounting is to hold responsible all the concerned
departments of any particular function.
In this type of accounting system, responsibility is assigned on the basis of the
knowledge and skills of the individuals. The basic motive of responsibility
accounting is to decrease the overall cost and increase the overall profit. If the
motives do not get fulfilled, the concerned people are held accountable and
answerable. Accountability is clearly defined under responsibility accounting, so
concerned people work more carefully as they are made answerable to their
seniors, management, and board of directors.
Responsibility accounting often entails the creation of monthly and annual budgets
for each responsibility centre. It also keeps track of a company‟s costs and
revenues, with reports compiled monthly or annually and sent to the appropriate
manager for review. The focus of responsibility accounting is mostly
on Responsibility Centers.

Responsibility Centers
A responsibility center is a functional business entity that has definite objectives
and goals, dedicated personnel, procedures, and policies as well as the duty of
generating a financial report. Different types of responsibility centers are being
set up under responsibility accounting and every responsibility center has
different goals assigned to them that they have to fulfill in order to contribute to
the overall growth of the organization. Some basic responsibility centers that all
organisations generally need are Cost center, Profit center, Revenue Center and
Investment Center.
Types of Responsibility Centers
1. Cost Center
A cost center is responsible for cost control. The main objective of the cost center
is to minimize cost. The cost center‟s prime work is to check the cost of an
organisation and to limit the unwanted expenditure that the company may
acquire. Costs, in this respect, are basically classified as controllable costs and
non-controllable costs. Controllable costs are the costs that can be controlled by
the organization. Uncontrollable costs are the cost that the organization can not
control. The concerned center is made responsible and accountable for only
controllable expenses. So, it is important to distinguish between controllable costs
and non-controllable costs. The performance evaluation is done on the basis of
the actual cost that occurred and the targeted cost.
Some types of costs centers are:
 Production Cost Center
 Personal Cost Center

 Service Cost Center
 Impersonal Cost Center
 Process Cost Center
 Operation Cost Center
2. Revenue Center
This center is basically inclined towards the generation of leads and subsequently
increasing the overall revenue of the firm. Company‟s sales team is mainly held
responsible for this. A revenue center is judged solely on its ability to generate
sales; it is not judged on the amount of costs incurred. Revenue centers are
employed in organisations that are heavily sales focused. Sales team are trained
to generate more leads and convert them. Trainings are set up for them and
evaluation of the personnel is made on the basis of the conversion rates.
3. Profit Center
A profit center refers to a center whose performance is measured in cost and
revenue both. It contributes to both revenue and expenses, resulting in profit and
loss. Profit occurs when revenues are more than costs and loss occurs when costs
are more than profits. The profit center is accountable for all the actions
associated with the sale of goods and production. The principle objective of a
profit center is to generate and maximize profit by minimising the cost incurred
and increasing sales. The accomplishment of a profit center is estimated in terms
of profit growth during a definite period.
4. Investment Center
This center is held responsible for using the company‟s assets in the most
efficient way and investing them in the best opportunities in order to increase

returns. Companies evaluate the performance of an investment center according
to the revenues it brings in through investments in capital assets. An investment
center is sometimes called an investment division. Investment centers are
increasingly important for firms as financialization leads companies to seek
profits from investment and lending activities in addition to core production.
Features of Responsibility Accounting
1. Inputs and Outputs: Responsibility accounting majorly covers two most
important aspects of business i.e. costs and revenue. Costs can be identified as
inputs and revenue can be identified as outputs. Cost and revenue are the essence
of the business and need a close watch.
2. Use of Budgeting: Budgeting involves planning and controlling inputs and
outputs. Costs can be identified as inputs and revenue can be identified as
outputs. Under budgeting process, planned stats of cost and revenue are set up
and then compare with the actual cost and revenue and offset the deviations.
3. Performance Reporting: Performance reports of all the responsibility centers
are made properly and reported to seniors for evaluation. Corrective measures are
taken in case of deviations.
4. Identification of Responsibility Centers: Under responsibility accounting,
various types of responsibility centers are identified and operated to ensure the
smooth running of various functions of the organisation.
Objectives of Responsibility Accounting
1. Accountability: Responsibility Accounting makes concerned people
accountable for the results. Division needs to prepare the reports and send them to

the manager. In this way, personnel takes care of all the necessary things, as they
know they have to give proper reports to the managing authorities.
2. More Responsible Personnel: Responsibility Accounting makes the
company‟s personnel more responsible for the organisation‟s performance.
Responsibility accounting ensures better results, growth, proper documentation,
effective and efficient personnel, and more accountable and responsible
employees.
3. Minimisation of Costs: Responsibility Accounting ensures the minimisation
of costs at various levels in order to avoid wastage of resources. A cost center
ensures a cut in costs and makes the overall cost system effective.
4. Maximisation of Profits: Under Responsibility Accounting, the main goal of
the profit center is to increase the profits of the organization over different
periods of time, which improves the overall financial position of the company.
5. Decentralisation: Responsibility Accounting decentralises power so that
personnel will have a sense of responsibility and belongingness to the
organisation.
Advantages of Responsibility Accounting
1. System of Control: Responsibility Accounting sets up a system of control in a
way that concerned people are held responsible for their work and they are
accountable to their seniors and management regarding their performances.
2. Awareness: Responsibility accounting creates awareness in the workplace as
the personnel has to explain the deviation of their assigned responsibility center.

3. Better Results: As actual numbers are compared with the target numbers over
the years, management will know the reasons for the constant deviation and they
can take corrective measures carefully according to the needs of the organization.
4. Efficiency: Responsibility Accounting creates a sense of efficiency within
individual employees as their work and achievements will be reviewed.
5. Effective communication: Individual and company goals are established and
communicated in the best way.
Steps in Responsibility Accounting Process
Responsibility Accounting involves the following steps:
1. Identification of responsibility sectors correctly.
2. Setting goals and assigning responsibilities to the various responsibility
centers.
3. Keeping an eye on their actual performance.
4. Comparison of actual performance to the target.
5. Finding the reasons for deviations, if any.
6. Taking corrective measures.

Unit - 2
Budgetary control
Budgetary control is the process by which budgets are prepared for the future
period and are compared with the actual performance for finding out variances, if
any. The comparison of budgeted figures with actual figures will help the
management to find out variances and take corrective actions without any delay.
The comparison of budgeted and actual figures will enable the management to find
out discrepancies and take remedial measures at a proper time. The budgetary
control is a continuous process which helps in planning and co-ordination. It
provides a method of control too. A budget is a means and budgetary control is the
end-result.
Objectives of Budgetary Control
The main objectives of budgetary control are given below:
1) Defining the objectives of the enterprise.
2) Providing plans for achieving the objectives so defined.
3) Coordinating the activities of various departments.
4) Operating various departments and cost centres economically and
efficiently.
5) :5. Increasing the profitability by eliminating waste.
6) Centralizing the control system.
7) Correcting variances from sit standards.
8) Fixing the responsibility of various individuals in the enterprise.

Essentials of Successful Budgetary Control:
The following are the essential requisites for implementing budgetary control
successfully:
1) Clearly Defined Organisational Structure:- The authority and
responsibilities are to be properly defined to pin-point the responsibility of
specific individuals in key positions.
2) Efficient Accounting System: - The accounting system should provide
the required information in time.
3) Reporting of Deviations:- Efficient system has to be devised to reduce
the differences between the budgets and actual performance.
4) Motivation: - Staff are to be appraised of the budgets and benefits they
are going to derive directly and indirectly.
5) Realistic Targets: - The targets set should be realistic so that they are
achievable and budgets should not frustrate the workers by fixing
unrealistic targets.
6) Participation of All Departments Concerned: - Budgets are to be set for
all the departments so that their participation in implementation will be
effective.
7) Flexibility: - Budgets are prepared on the basis of certain conditions. If
there is change in conditions budgets also should be adjusted to
accommodate the changes.

8) Top Management Support: - The budgetary control system should have
continuous support of top management which can ensure its all-round
acceptance.
Advantages of Budgetary Control
Some of the advantages of budgetary control are:
1) Budgetary control fixes targets. Each and every department is forced to work
efficiently to reach the target. Thus, it is an effective method of controlling
the activities of various departments of a business unit.
2) It secures better co-ordination among various departments.
3) In case the performance is below expectation, budgetary control helps the
management in finding up the responsibility.
4) It helps in reducing the cost of production by eliminating the wasteful
expenditure.
5) By promoting cost consciousness among the employees, budgetary control
brings in efficiency and economy.
6) Budgetary control facilitates centralized control with decentralized
activity.
7) As everything is planned and provided in advance, it helps in smooth
running of business enterprise.
8) It tells the management as to where action is required for solving problems
without delay.
Disadvantages or Limitations of Budgetary Control

The following are the limitations of budgetary control:
1) Budget involves a heavy expenditure which small business concerns cannot
afford.
2) Budgets are prepared for the future period which is always uncertain. In
future, conditions may change which will upset the budgets. Thus, future
uncertainties minimize the utility of budgetary control system.
3) Budgetary control is only a management tool. It cannot replace management
in decision-making because it is not a substitute for management.
4) The success of budgetary control depends upon the support of the top
management. If there is lack of support from top management, then this will
fail.
5) It is really difficult to prepare the budgets accurately under inflationary
conditions.
Types of Budget in Management Accounting
Type # 1. Sales Budget:-
Many of the other budgets are based on the sales budget. It is taken to be the
critical starting point to which all other budgets are adjusted. Its preparation begins
with the prediction of units of each product that will be sold at specific prices. The
work starts with the examination of sales analysis for the current year.
Type # 2. Production Budget:-
The production budget shows the estimates of production planned for the
immediate future period. The production budget should indicate, apart from other

things, targets of production for each product, each department and by each month.
Generally, the production budget is based on the sales budget.
 The production budget is prepared into two parts, namely:
 Production volume budget- It shows the physical units of the product to be
manufactured; and
 Cost of production or manufacturing cost budget- It gives details of the
budgeted cost under material, labour and factory overheads.
The following steps are involved in the preparation of production budget:
1) Production Planning – Production planning plays very important part in
the preparation of production budget. Production planning on sound lines
takes into consideration optimum utilisation of plant capacity by
elimination or reduction of limiting factors and both bottlenecks in
production like shortage of material, labour etc. Proper planning of
production levels out seasonal fluctuations of sales so that optimum
inventory of finished goods, components and work-in-progress is
maintained.
2) Consideration of Plant Capacity – The total quantities of each of the
products or group of products which the firm is capable of producing is
determined. This requires coordination of production budget with plant
utilization budget.
3) Co-ordination with the Sales Budget – Proper coordination between
production and sales budget is necessary to avoid imbalances of sales and
production.

4) Inventory Policy Considerations – The extent to which inventory of
finished goods is to be carried depends upon several factors such as future
sales potential, availability of storage facilities, the risk and cost of stock-
out and cost of carrying inventory.
 The budgeted quantity of production is computed as follows:
 Units to be produced = Desired closing stock of finished goods +
Budgeted sales – Opening stock of finished goods.
5) Policy of the Management – Management policy as to whether certain
components or parts should be produced or procured from outside should
also be taken before finally setting the budget.
Type # 3. Production Cost Budget:
This is the quantity of products to be manufactured expressed in terms of cost.
Basically, there are three element of cost, namely, direct material, direct labour and
overheads. Separate budgets for each of these elements have to be prepared.
1) Direct Materials Budget:- Standard costing greatly facilitates the preparation
of a materials budget. When standard cost records are not available, the details
have to be adjusted to the period when manufacture takes place. Materials are
controlled on the basis of price and usage after allowing for normal wastage.
Technical experts decide on the best and most economical material to use for
each purpose.
2) Direct Labour Budget:- A similar procedure to the above applies to direct
labour. The hours shown in the production budget are used with the wage

rates which are likely to apply during the period of production. Wages are
controlled according to the rates paid and the efficiency of the operator.
3) Overheads Budget:- Overheads budget has to be assembled from a large
amount of detailed information from past records. It has to be updated to
allow for changes in future costs and related activity. It is compiled on the
basis of department overhead expense budgets and cost centre budgets. The
overheads may relate to factory, general administration, selling and
distribution functions. Accordingly, separate budgets are prepared for factory
overheads, administrative overheads and selling and distribution overheads.
o Factory Overheads Budget:
o Administrative Overheads Budget:
o Selling and Distribution Overheads Budget:
Type # 4. Purchase Budget:-
The purchase budget states the purchases which must be made to achieve the
complete budget plan. These include the requirements of direct and indirect
material, and of purchased services as set out in the sales, production cost, capital
expenditure and research and development budgets adjusted in respect of-
o Inventory policy of the firm,
o Purchase orders already placed,
o Materials to be manufactured within the business as distinct from
those to be purchased from outside.
Type # 5. Cash Budget:

The cash budget is a summary of the firm‟s expected cash inflows and outflows
over a particular period of time. In other words, cash budget involves a projection
of future cash receipts and cash disbursements over various time intervals. There
must be a balance between cash and the cash demanding activities/operations,
capital expenditure and so on. Very often, the need for additional cash is not
realised until the situation becomes critical.
The cash budget consists of two parts:
 The projected cash receipts (inflows) and;
 The planned cash disbursements (outflows).
 Cash receipts include collection from debtors, cash sales, dividends
received, sale of assets, loans received and issues of shares and
debentures. Payments include wages and salaries, payment to
creditors and suppliers, rent and rates, taxes, capital expenditure,
dividend payable, commission payable and repayment of loans and
debentures.
Type # 6. Master Budget:
A master budget is a master plan for the entire firm. It is the summary of final plan
for the forthcoming year. When all detailed functional budgets have been
completed, they are integrated into a master budget. According to the Chartered
Institute of Management Accounts, London, Terminology, a master budget is
defined as “The summary budget which is finally approved, adopted and
employed”.

Type # 7. Fixed and Flexible Budgeting:
In the real world, one seldom finds stable operating conditions. Future can never be
predicted with certainty. A fixed or static budget is satisfactory only when a
company‟s activities can be estimated within close limits. According to The
Chartered Institute of Management Accountants, London, Terminology, a fixed
budget is defined as a “budget designed to remain unchanged irrespective of the
level of activity actually attained”.
Standard Costing
Meaning of Standard Costing:
It is a method of costing by which standard costs are employed. According to
ICMA, London, Standard Costing is “the preparation and use of standard costs,
their comparison with actual cost and the analysis of variances to their causes
and points of incidence”.
Standard Costing involves:
a) Ascertainment and use of Standard Costs;
b) Recording the actual costs;
c) Comparison of actual costs with standard costs in order to find out the
variance;
d) Analysis of variance; and
e) After analysing the variance, appropriate action may be taken where
necessary.

Process of Standard Costing
1) Establishing Standards: First and foremost, the standards are to be set on
the basis of management‟s estimation, wherein the production engineer
anticipates the cost. In general, while fixing the standard cost, more weight
is given to the past data, the current plan of production and future trends.
Further, the standard is fixed in both quantity and costs.
2) Determination of Actual Cost: After standards are set, the actual cost for
each element, i.e. material, labour and overheads is determined, from
invoices, wage sheets, account books and so forth.
3) Comparison of Actual Costs and Standard Cost: Next step to the process,
is to compare the standard cost with the actual figures, so as to ascertain the
variance.
4) Determination of Causes: Once the comparison is done, the next step is to
find out the reason for the variances, to take corrective actions and also to
evaluate the overall performance.
5) Disposition of Variances: The last step to this process, is the disposition of
variances by transferring it to the costing profit and loss account.

Objectives of Standard Costing:
1) It helps to implement budgetary control system in operation;
2) It helps to ascertain performance evaluation.
3) It supplies the ways to utilise properly material, labour and also overhead
which will be economic in character.
4) It also helps to motivate the employees of a firm to improve their
performance by setting up a „standard‟.
5) It also helps the management to supply necessary data relating to cost
element to submit quotations or to fix up the selling price of a firm.
6) It also helps the management to make proper valuations of inventory (viz.,
Work-in- progress, and finished products).
7) It acts as a control device to the management.
8) It also helps the management to take various corrective decisions viz.,
fixation of price, make-or-buy decisions etc. which will be more
beneficial to the firm.
Advantages of Standard Costing:
The following advantages may be derived from Standard Costing:
1) Standard Costing serves as a guide to the management in several
management functions while formulating prices and production policies
etc.
2) More effective cost control is possible under standard costing if the same
is reviewed and analyzed at regular intervals.

3) Analysis of variance and its measurement helps to detect inefficiencies
and mistakes which enable the management to investigate the reasons.
4) Since standard costs are predetermined costs they are very useful for
planning and budgeting.
5) Once the Standard Costing System is implemented it will lead to saving
cost since most of the costing work can be eliminated.
6) Delegation of authority and responsibility becomes effective by setting up
standards for each cost centre as the supervisors or executives of each cost
centre will know the standard which they have to maintain.
7) Standard costing is also used for inventory valuation purposes. Stock can
be valued at standard cost which can reduce the fluctuation of profit for
different methods of valuation for the same.
8) Efficiency of labour is promoted.
Disadvantages of Standard Costing:
1) Since Standard Costing involves high degree of technical skill, it is,
therefore, costly.
2) The executives are liable for those variances that are found from actions
which are actually controllable by them.
3) Standards are always changing since conditions of the business are equally
changing. So, standards are to be revised in order to make them comparable
with actual results.
4) Standards are either too liberal or rigid since the same are based on average
past results, attainable good performance or theoretical maximum efficiency.

Material Variance:
The following variances constitute materials variances:
Material Cost Variance
The difference between the standard cost of direct materials specified for
production and the actual cost of direct materials used in production is known as
Direct Material Cost Variance. Material Cost Variance gives an idea of how much
more or less cost has been incurred when compared with the standard cost. Thus,
Variance Analysis is an important tool to keep a tab on the deviations from the
standard set by a company.
 Material Cost Variance = (Standard Cost – Actual Cost)
Material Price Variance

Material Price Variance is the difference between the standard price and the actual
price for the actual quantity of materials used for production. The cause for
material price variance can be many including changes in prices, poor purchasing
procedures, deficiencies in price negotiation, etc.
 MPV = (Standard Price – Actual Price) x Actual Quantity
Let us understand this formula with the help of an example.
Standard Actual
Price $ 10 per kg. $ 8 per kg.
Quantity 200 kgs. 150 kgs.
Here, the Material Price Variance can be calculated as follows:
MPV = (10 – 8) x 150
= 300 (F)
Reasons of direct materials price variance:
A favorable or unfavorable material price variance may occur due to one or more
of the following reasons:
1) Order size: Some suppliers allow discount on large orders. The materials
purchased in large quantities may reduce the the unit price and a favorable
price variance may occur.
2) Rise in price: The rise in the general price level may increase the input costs
of the vendor and as a result vendor may increase the price of the materials.
3) Urgent needs: If production department does not indicate the need of
materials on time, the purchasing department may have to order on urgent

basis that may increase the price of materials and other expenses associated
with the order.
4) Quality: A favorable price variance may be the result of purchasing low
quality materials and an unfavorable variance may be the result of
purchasing high quality materials.
5) Inefficient standard setting: Inefficiencies in terms of forecasting and
environmental scanning during standard setting process can be a reason of
huge variances.
6) Transportation: Transportation is a part of total direct materials cost. Any
change in the transportation expenses can change the total and per unit cost
of direct material.
7) Inefficient or unreliable suppliers: A deviation from standard material
costs may be the result of inefficient or unreliable vendors.
Material Usage Variance
Material Usage Variance is the difference between the standard quantity specified
for actual production and the actual quantity used at the standard purchase price.
There can be many reasons for material usage variance including the use of sub-
standard or defective products, pilferage, wastage, the differences in material
quality, etc.
 MUV = (Standard Quantity – Actual Quantity) x Standard Price
With the help of the above example, let us now calculate Material Usage Variance.
MUV = (200 – 150) x 10
= 500 (F)

Causes for Direct Material Usage Variance.
1) Negligence in use of materials.
2) More wastage of materials by untrained workers.
3) Adopting defective or wring or improper production process.
4) Loss due to pilferage.
5) Use of material mix other than the standard mix.
6) Using of poor or bad quality of materials.
7) Carelessness and inefficiency of workers.
8) More or less yield from materials than the standard set.
9) Lack of skill of the employee‟s leads to more consumption of materials.
10) Defective production necessitating the use of additional materials.
11) Improper condition of Plant and Equipment.
12) Bad maintenance and upkeep of plant lead to more scraping materials.
13) Lack of proper inspection and supervision of materials lead to more
consumption of materials.
The materials usage or quantity variance can be separated into mix variance and
yield variance.
For certain products and processing operations, material mix is an important
operating variable, specific grades of materials and quantity are determined before
production begins. A mix variance will result when materials are not actually
placed into production in the same ratio as the standard formula.

Material mix variance is usually found in industries, such as textiles, rubber and
chemicals, etc. A mix variance may arise because of attempts to achieve cost
savings, effective resources utilisation and when the needed raw materials
quantities may not be available at the required time.
a) Materials mix variance
Materials mix variance is that portion of the materials quantity variance which is
due to the difference between the actual composition of a mixture and the standard
mixture.
 MMV= Standard price * (Revised standard quantity-Actual quantity)
(b) Materials Yield Variance:
Materials yield variance explains the remaining portion of the total materials
quantity variance. It is that portion of materials usage variance which is due to the
difference between the actual yield obtained and standard yield specified (in terms
of actual inputs). In other words, yield variance occurs when the output of the final
product does not correspond with the output that could have been obtained by
using the actual inputs. In some industries like sugar, chemicals, steel, etc. actual
yield may differ from expected yield based on actual input resulting into yield
variance.
The formula for computing yield variance is as follows:
 MYV = Standard cost per unit x(Actual yield – Standard Yield specified)
Relationship between the Material variances:

 MCV= MPV + MUV
 MCV= MPV + (MMV+ MYV) Or MPV + (MMV + MRUV/MSUV)
 MUV= (MMV+ MRUV/MSUV) Or MUV= (MMV+ MYV)
 MPV= MCV- MUV
 MUV= MCV- MPV
 MPV=MCV-(MMV+MYV)
Where,
MCV= material cost variance
MPV= Material Price variance
MUV= Material Usage variance
MMV= Material Mix variance
MRUV= Material Revised usage variance
MSUV= Material Sub- usage variance
MYV= Material Yield variance
Labour Variances:
Direct labour variances arise when actual labour costs are different from standard
labour costs. In analysis of labour costs, the emphasis is on labour rates and labour
hours.
Labour variances constitute the following:

Labour Cost Variance:
Labour cost variance denotes the difference between the actual direct wages paid
and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (SH x SR) – (AH x AR)
Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate
1. Labour Efficiency Variance:
The calculation of labour efficiency or usage variance follows the same pattern as
the computation of materials usage variance. Labour efficiency variance occurs
when labour operations are more efficient or less efficient than standard
performance. If actual direct labour hours required to complete a job differ from
the number of standard hours specified, a labour efficiency variance results; it is

the difference between actual hours expended and standard labour hours specified
multiplied by the standard labour rate per hour.
Labour efficiency variance = Std. rate per hour x(Standard hours for the actual
output- Actual hours)
(i) Labour Mix Variance:
Labour mix variance is computed in the same manner as materials mix variance.
Manufacturing or completing a job requires different types or grades of workers
and production will be complete if labour is mixed according to standard
proportion. Standard labour mix may not be adhered to under some circumstances
and substitution will have to be made. There may be changes in the wage rates of
some workers; there may be a need to use more skilled or expensive types of
labour, e.g., employment of men instead of women; sometimes workers and
operators may be absent.
These lead to the emergence of a labour mix variance which is calculated by using
the following formula:
Labour mix variance = (Actual labour mix – Revised standard labour mix in
terms of actual total hours) x Standard rate per hour
Take an example, suppose the following were the standard labour cost data per unit
in a factory:

In a period, many class B workers were absent and it was necessary to substitute
class B workers. Since the class A workers were less experienced with the job,
more labour hours were used.
The recorded costs of a unit were:
Labour mix variance will be calculated as follows:
Labour mix variance = (Actual proportion – Revised standard proportion of actual
total hours) x standard rate per hour
Revised standard proportion:
(ii) Labour Yield Variance:
The final product cost contains not only material cost but also labour cost.
Therefore, gain or loss (higher or lower output than the standard output) should
take into account labour yield variance also. A lower output simply means that
final output does not correspond with the production units that should have been
produced from the hours expended on the inputs.

It can be computed by applying the following formula:
Labour yield variance = (Actual output – Standard output based on actual hours) x
Av. Std. Labour Rate per unit of output.
Or
Labour yield variance = (Actual loss – Standard loss on actual hours) x Average
standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which is
computed in terms of inputs, i.e., standard labour hours and revised labour hours
mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:
Labour efficiency sub-variance = (Revised standard mix – standard mix) x
Standard rate
2. Labour Rate Variance:
Labour rate variance is computed in the same manner as materials price variance.
When actual direct labour hour rates differ from standard rates, the result is a
labour rate variance. It is that portion of the direct wages variance which is due to
the difference between actual rate paid and standard rate of pay specified.
The formula for its calculation is:
Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs 25,250,
i.e.,

Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250
(unfavourable)
The number of actual hours worked is used in place of the number of the standard
hours specified because the objective is to know the cost difference due to change
in labour hour rates, and not hours worked. Favourable rate variances arise
whenever actual rates are less than standard rates; unfavourable variances occur
when actual rates exceed standard rates.
3. Idle Time Variance:
Idle time variance occurs when workers are not able to do the work due to some
reason during the hours for which they are paid. Idle time can be divided according
to causes responsible for creating idle time, e.g., idle time due to breakdown, lack
of materials or power failures. Idle time variance will be equivalent to the standard
labour cost of the hours during which no work has been done but for which
workers have been paid for unproductive time.
Suppose, in a factory 2,000 workers were idle because of a power failure. As a
result of this, a loss of production of 4,000 units of product A and 8,000 units of
product B occurred. Each employee was paid his normal wage (a rate of? 20 per
hour). A single standard hour is needed to manufacture four units of product A and
eight units of product B.
Idle time variance will be computed in the following manner:
Standard hours lost:
Product A = 4, 000/ 4 = 1,000 hr.
Product B = 8, 000 / 8 = 1,000 hr.

Total hours lost = 2,000 hr.
Idle time variance (power failure)
2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)
Unit -3
Marginal Costing
Definition: Marginal Costing is a costing technique wherein the marginal cost, i.e.
variable cost is charged to units of cost, while the fixed cost for the period is
completely written off against the contribution.
The term marginal cost implies the additional cost involved in producing an
extra unit of output, which can be reckoned by total variable cost assigned to one
unit. It can be calculated as:
Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable
Overheads
Characteristics of Marginal Costing
1) Classification into Fixed and Variable Cost: Costs are bifurcated, on the basis
of variability into fixed cost and variable costs. In the same way, semi variable
cost is separated.
2) Valuation of Stock: While valuing the finished goods and work in progress,
only variable cost are taken into account. However, the variable selling and
distribution overheads are not included in the valuation of inventory.

3) Determination of Price: The prices are determined on the basis of marginal
cost and marginal contribution.
4) Profitability: The ascertainment of departmental and product‟s profitability is
based on the contribution margin.
Features of Marginal Costing
1) Marginal Costing is a technique of decision making.
2) The total cost is classified into fixed and variable cost.
3) Fixed cost are ascertained separately and excluded from cost of production.
The fixed costs are charged to Profit and loss account.
4) The stock of work in Progress and finished goods are valued at variable cost.
Fixed cost will not be included in valuation of the stock.
5) Contribution is ascertained by reducing the variable cost from the selling
price.
6) The profitability of products or process is determined on the basis of
contribution.
7) Profit is ascertained by reducing the fixed cost from the contribution of all the
products or departments or process or division etc.
8) The profitability of various levels of activity is ascertained by calculating cost
volume profit relationship.
Facts Concerning Marginal Costing

1) Cost Ascertainment: The basis for ascertaining cost in marginal costing is
the nature of cost, which gives an idea of the cost behavior, that has a great
impact on the profitability of the firm.
2) Special technique: It is not a unique method of costing, like contract
costing, process costing, batch costing. But, marginal costing is a different
type of technique, used by the managers for the purpose of decision making.
It provides a basis for understanding cost data so as to gauge the profitability
of various products, processes and cost centers.
3) Decision Making: It has a great role to play, in the field of decision making,
as the changes in the level of activity pose a serious problem to the
management of the undertaking.
Various Decisions under Marginal Costing
1) Fixation of Selling Price:- Price is one of the most significant factor that
determines themarket for the products as well as the volume of profit for the
organization. Under, normal circumstances, the price of a product mustcover
the total costs of the product plus a margin of profit.
2) Accepting Bulk Orders (or) Foreign Market Orders Some bulk orders may
be received from local dealers (or) foreign dealers asking for a price which is
below the market price. This calls for a decision to accept (or) reject the order
3) Make (or) Buy Decision In a make (or) buy decision, the price quoted by the
outside suppliers should be compared with the marginal cost of producing the

component parts. If the outside price of the component is lower than the
marginal cost of producing it, it is worth buying. On the other hand, if the
outside price is higher than the marginal cost, making the component in the
factory may be preferred.
4) Selection of Suitable Product Mix When a factory manufacturers more than
one product, a problem is faced by the management as to which product will
give maximum profits. The solution is the products which give the maximum
contribution are to be retained and their production should be increased
5) Maintaining a Desired Level of Profit Management may be interested in
maintaining a desired level of profits. The sales required to earn a desired level
of profits can be ascertained by the marginal costing techniques.
6) Determination of Optimum Level of Activity The technique of marginal
costing helps the management indetermination the optimum level of activity. To
make such a decision, contribution at different levels of activity can be found.
The level of activity which gives the highest contribution will be the optimum
level. The level of production can be raised till the marginal cost does not
exceed the selling price.
7) Profit Planning Profit planning is a plan for future operation (or) or
planningbudget to attain the given objective or to attain the maximum profit.
Thevolume of sale required to maintain a desired profit can be ascertained.

8) Introduction of a New Product A production firm may add additional
products with the available facility. The new product is sold in the market at a
reasonable price, inorder to sell it in large quantities. It may become popular. If
favourable, the sales can be increased. Thus, the total cost comes down and
contributes some amount towards fixed costs and profits.
9) Closure of a Department or Discontinuing a Product Marginal costing
technique shows the contribution of each product to fixed costs and profit. If a
department or a product contributes the least amount, then the department can
be closed (or) its production can be discountinued. It means the product which
gives a higher amount of contribution may be chosen and the rest should be
discontinued.
10) Introduction of New Product (or) Product Line The technique to assess
the profitability of a line extension products the incremental contribution
estimates. The same technique of contribution analysis would be followed in
assessing the profitability
Unit - 4
Financial Statement Analysis:
The term ‗financial analysis‘, also known as analysis and interpretation of financial
statements‘, refersto the process of determining financial strengths and weaknesses of the
firm by establishing strategicrelationship between the items of the balance sheet, profit
and loss account and other operative data. ―Analyzing financial statements,‖ according
to Metcalf and Titard, ―is a process of evaluating therelationship between component
parts of a financial statement to obtain a better understanding of afirm‘s position and
performance.‖

In the words of Myers, ―Financial statement analysis is largely a study of relationship
among the various financial factors in a business as disclosed by a single set-of
statements and a study of the trend of these factors as shown in a series of statements.‖
Objectives and Importance of Financial Statement Analysis:
The primary objective of financial statement analysis is to understand and diagnose the
information contained in financial statement with a view to judge the profitability and
financial soundness of the firm, and to make forecast about future prospects of the firm.
The purpose of analysis depends upon the person interested in such analysis and his
object.
However, the following purposes or objectives of financial statements
analysis may be stated to bring out the significance of such analysis:
1) To assess the earning capacity or profitability of the firm.
2) To assess the operational efficiency and managerial effectiveness.
3) To assess the short term as well as long term solvency position of the firm.
4) To identify the reasons for change in profitability and financial position of the firm.
5) To make inter-firm comparison.
6) To make forecasts about future prospects of the firm.
7) To assess the progress of the firm over a period of time.
8) To help in decision making and control.
9) To guide or determine the dividend action.
10) To provide important information for granting credit.
Parties Interested in Financial Analysis:
The following parties are interested in the analysis of financial statements:
1) Investors or potential investors.
2) Management.
3) Creditors or suppliers.
4) Bankers and financial institutions.
5) Employees.
6) Government.
7) Trade associations.
8) Stock exchanges.
9) Economists and researchers.
10) Taxation authorities
Limitations of Financial Statement Analysis:
Some of the important limitations of financial analysis are, however, summed up
as below:
1) It is only a study of interim reports
2) Financial analysis is based upon only monetary information and non-

monetary factors areignored.
3) It does not consider changes in price levels.
4) As the financial statements are prepared on the basis of a going concern, it
does not give exact position. Thus accounting concepts and conventions cause
a serious limitation to financial analysis.
5) Changes in accounting procedure by a firm may often make financial analysis
misleading.
6) Analysis is only a means and not an end in itself. The analyst has to make
interpretation and draw his own conclusions. Different people may interpret the
same analysis in different ways.
Tools or Techniques of Financial Statement Analysis
1) Comparative Statement or Comparative Financial and Operating Statements.
2) Common Size Statements.
3) Trend Ratios or Trend Analysis.
4) Average Analysis.
5) Statement of Changes in Working Capital.
6) Fund Flow Analysis.
7) Cash Flow Analysis.
8) Ratio Analysis.
9) Cost Volume Profit Analysis
A brief explanation of the tools or techniques of financial statement analysis presented below.
1) Comparative Statements
Comparative statements deal with the comparison of different items of the Profit
and Loss Account and Balance Sheets of two or more periods. Separate
comparative statements are prepared for Profit and Loss Account as
Comparative Income Statement and for Balance Sheets.
As a rule, any financial statement can be presented in the form of comparative
statement such as comparative balance sheet, comparative profit and loss
account, comparative cost of production statement, comparative statement of
working capital and the like.
2) Comparative Income Statement
Three important information are obtained from the Comparative Income
Statement. They are Gross Profit, Operating Profit and Net Profit. The changes
or the improvement in the profitabilityof the business concern is find out over a
period of time. If the changes or improvement is not satisfactory, the
management can find out the reasons for it and some corrective action can be
taken.
3) Comparative Balance Sheet
The financial condition of the business concern can be find out by preparing
comparative balance sheet. The various items of Balance sheet for two different
periods are used. The assets are classified as current assets and fixed assets for
comparison. Likewise, the liabilitiesare classified as current liabilities, long term
liabilities and shareholders‘ net worth. The term shareholders‘ net worth
includes Equity Share Capital, Preference Share Capital, Reserves and Surplus

and the like.
4) Common Size Statements
A vertical presentation of financial information is followed for preparing
common-size statements. Besides, the rupee value of financial statement contents
are not taken into consideration. But, only percentage is considered for
preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items
are comparedto the total assets, total liabilities or sales in terms of percentage.
Thus, a common size statement shows the relation of each component to the
whole. Separate common size statement is prepared for profit and loss account
as Common Size Income Statement and for balance sheet as Common Size
Balance Sheet.
5) Trend Analysis
The ratios of different items for various periods are find out and then compared
under this analysis. The analysis of the ratios over a period of years gives an idea
of whether the businessconcern is trending upward or downward. This analysis is
otherwise called as Pyramid Method.
6) Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are
compared with industry average. These both trends can be presented on the
graph paper also in the shape of curves. This presentation of facts in the shape of
pictures makes the analysis and comparison more comprehensive and
impressive.
7) Statement of Changes in Working Capital
The extent of increase or decrease of working capital is identified by preparing
the statement ofchanges in working capital. The amount of net working capital is
calculated by subtracting the sum of current liabilities from the sum of current
assets. It does not detail the reasons for changes in working capital.
8) Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds of the
business concernfor a specific period. It indicates where funds come from and
how they are used during the period under review. It highlights the changes in the
financial structure of the company.
9) Cash Flow Analysis
Cash flow analysis is based on the movement of cash and bank balances. In other
words, the movement of cash instead of movement of working capital would be
considered in the cash flow analysis. There are two types of cash flows. They are
actual cash flows and notional cashflows.
10) Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship between
individual items (or group of items) in the balance sheet or profit and loss
account. Ratio analysis is not only useful to internal parties of business
concern but also useful to external parties. Ratio analysis
highlights the liquidity, solvency, profitability and capital gearing.
11) Cost Volume Profit Analysis
This analysis discloses the prevailing relationship among sales, cost and profit.
The cost is divided into two. They are fixed cost and variable cost. There is a

constant relationship betweensales and variable cost. Cost analysis enables the
management for better profit planning.
Funds Flow Statement:
Funds flow statement is a statement which discloses the analytical information about the
different sources of a fund and the application of the same in an accounting cycle. It deals
with the transactions which change either the amount of current assets and current
liabilities (in the form of decrease or increase in working capital) or fixed assets, long-
term loans including ownership fund.
It gives a clear picture about the movement of funds between the opening and closing
dates of the Balance Sheet. It is also called the Statement of Sources and Applications of
Funds, Movement of Funds Statement; Where Got—Where Gone Statement: Inflow and
Outflow of Fund Statement, etc. No doubt, Funds Flow Statement is an important
indicator of financial analysis and control. It is valuable and also helps to determine how
the funds are financed. The financial analyst can evaluate the future flows of a firm on
the basis of past data.
This statement supplies an efficient method for the financial manager in order to assess the:
a. Growth of the firm,
b. Its resulting financial needs, and
c. To determine the best way to finance those needs.
Objective of Preparing a Fund Flow Statement:
The main purpose of preparing a Funds Flow Statement is that it reveals clearly the
important items relating to sources and applications of funds of fixed assets, long-term
loans including capital. It also informs how far the assets derived from normal activities
of business are being utilized properly with adequate consideration.
Secondly, it also reveals how much out of the total funds is being collected by disposing of
fixed assets,how much from issuing shares or debentures, how much from long-term or
short-term loans, and howmuch from normal operational activities of the business.
Thirdly, it also provides the information about the specific utilization of such funds, i.e.
how much has been applied for acquiring fixed assets, how much for repayment of long-
term or short-term loans as well as for payment of tax and dividend etc.
Lastly, it helps the management to prepare budgets and formulate the policies that will
be adopted forfuture operational activities.
The significance and importance of Funds Flow Statements may be summarized as:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet,
exhibit the result of the operation and financial position of a firm. Balance Sheet presents
a static view about the resources and how the said resources have been utilized at a
particular date with recording the changes in financial activities. But Funds Flow
Statement can do so, i.e., it explains the causes of changes so made and effect of such
change in the firm accordingly.

(b)Highlighting Answers to Various Perplexing Questions:
Funds Flow Statement highlights answers of the following questions:
a. Causes of changes in Working Capital;
b. Whether the firm sells any Non-Current Asset; if sold, how were the proceeds
utilized?
c. Why smaller amount of dividend is paid in spite of sufficient profit?
d. Where did the net profit go?
e. Was it possible to pay more dividend than the present one?
f. Did the firm pay-off its scheduled debts? If so, how, and from what sources?
g. Sources of increased Working Capital, etc.
(c)Realistic Dividend Policy:
Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay
dividend due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow
Statement helps the firm to take decision about a sound dividend policy which is very
helpful to the management.
(d)Proper Allocation of Resources:
Resources are always limited. So, it is the duty of the management to make its proper use.
A projectedFunds Flow Statement helps the management to take proper decision about
the proper allocation of business resources in a best possible manner since it highlights
the future.
(e)As a Future Guide:
A projected Funds Flow Statement acts as a business guide. It helps the management to
make provision for the future for the necessary funds to be required on the basis of the
problem faced. In other words, the future needs of the fund for various purposes can be
known well in advance which is avery helpful guide to the management. In short, a firm
may arrange funds on the basis of thisstatement in order to avoid the financial problem
that may arise in future.
(f)Appraising of the Working Capital:
A projected Funds Flow Statement, no doubt, helps the management to know about how
the working capital has been efficiently used and, at the same time, also suggests how to
improve the working capital position for the future on the basis of the present problem
faced by it, if any.
Comparison Chart
BASIS
FO
R
COMPARISON
CASH FLOW FUND FLOW
Meaning A cash flow statement is a statementshowing
the inflows and outflows of cash and cash
equivalents over a period.
A fund flow statement is a statement
showing the changes in the financial
position of the entity in different
accounting years.

Purpose of
Preparation
To show the reasons for movements in the
cash at the beginning and at the end of the
accounting period.
To show the reasons for the changes in
the financial position, with respect to
previous year and current accounting
year.
Basis Cash Basis of Accounting. Accrual Basis of Accounting.
Analysis Short Term Analysis of cash planning. Long Term Analysis of financial
planning
Discloses Inflows and Outflows of Cash Sources and applications of funds
Opening and
closing balance
Contains opening and closing balance ofcash
and cash equivalents.
Does not contains opening balanceof
cash and cash equivalents.
Part of Financial
Statement
Yes No
Cash Flow Statement
A cash flow statement provides information about the changes in cash and cash
equivalents of a business by classifying cash flows into operating, investing and financing
activities. It is a key report tobe prepared for each accounting period for which financial
statements are presented by an enterprise.
Monitoring the cash situation of any business is the key. The income statement would
reflect the profits but does not give any indication of the cash components. The important
information of what the business has been doing with the cash is provided by the cash
flow statement. Like the other financial statements, the cash flow statement is also
usually drawn up annually, but can be drawn up more often. It is noteworthy that cash
flow statement covers the flows of cash over a period of time (unlike the balance sheet
that provides a snapshot of the business at a particular date). Also, the cash flow
statement can be drawn up in a budget form and later compared to actual figures.
Objectives of preparing Cash Flow Statement
1) Cash flow statement shows inflow and outflow of cash and cash equivalents from
various activities of a company during a specific period under the main heads
i.e., operating activities, investing activities and financing activities.
2) Information through the Cash Flow statement is useful in assessing the ability of
any enterprise to generate cash and cash equivalents and the needs of the
enterprise to utilize those cash flows.
3) Taking economic decisions requires an evaluation of the ability of an enterprise
to generate cash and cash equivalents, which is provided by the cash flow
statement

Cash and cash equivalents generally consist of the following:
o Cash in hand
o Cash at bank
o Short term investments that are highly liquid
o Bank overdrafts comprise an integral element of the organization‘s treasury management
CLASSIFICATION OF ACTIVITIES:
Cash flow activities are to be classified into three categories
:This is done to show separately the cash flows generated / used by
these activities, thereby helpingto assess the impact of these activities
on the financial position and cash and cashequivalents of an enterprise.
1) Operating activities
2) Investing activities
3) Financing activities
Cash from Operating Activities:
Operating activities are the activities that comprise of the primary / main activities of an
enterprise during an accounting period. For example, for a garment manufacturing
company, operating activities include procurement of raw material, sale of garments,
incurrence of manufacturing expenses, etc. These are the principal revenue generating
activities of the enterprise.
Profit before tax as presented in the income statement could be used as a starting point
to calculate the cash flows from operating activities.
Cash Inflows from operating activities:
o Cash receipts from sale of goods and rendering services.
o Cash receipts from fees, royalties, commissions and other revenues.
Cash Outflows from operating activities:
o Cash payments to suppliers for goods and services.
o Cash payments of income taxes unless they can be specifically identified with
financing and investing activities.
Following adjustments are required to be made to the profit
before tax to arriveat the cash flow from operations:
o Elimination of non cash expenses (e.g. depreciation, amortization,
impairment losses, bad debts written off, etc)
o Removal of expenses to be classified elsewhere in the cash flow

statement (e.g. interest expense should be classified under financing
activities)
o Removal of income to be presented elsewhere in the cash flow
statement (e.g. dividend income and interest income should be classified
under investing activities unless in case of forexample an investment bank)
o Elimination of non cash income (e.g. gain on revaluation of investments)
o The amount of cash from operations indicates the internal solvency
level of the company. It is
a key indicator of the extent to which the operations of the enterprise have
generated sufficientcash flows to maintain its operating potential.
Cash from Investing Activities:
Cash flow from investing activities includes the movement in cash flows owing to the
purchase and sale of assets. It relates to purchase and sale of long-term assets or fixed
assets such as machinery, furniture, land and building, etc.
a) Cash Outflows from investing activities
b) Cash payments to acquire fixed assets including intangibles and capitalized R&D.
c) Cash advances and loans made to third party (other than advances and loans
made by a financial enterprise wherein it is operating activities).
d) Cash payments to acquire shares, warrants or debt instruments of other
enterprises other thanthe instruments those held for trading purposes.
Cash Inflows from investing activities
a) Cash receipt from disposal of fixed assets including intangibles.
b) Cash receipt from the repayment of advances or loans made to third parties
(except in case offinancial enterprise).
c) Dividend received from investments in other enterprises.
d) Cash receipt from disposal of shares, warrants or debt instruments of other
enterprises exceptthose held for trading purposes.
Cash from Financing Activities:
It includes financing activities related to long-term funds or capital of an enterprise.
Financing activitiesare activities that result in changes in the size and composition of the
owners‘ capital and borrowings of the enterprise.
e.g., cash proceeds from issue of equity shares, debentures, raising long-term loans,
repayment of bank loans, etc.
Cash Inflows from financing activities
o Cash proceeds from issuing shares (equity / preference).
o Cash proceeds from issuing debentures, loans, bonds and other short/ long-term
borrowings.

Cash Outflows from financing activities:
o Cash repayments of amounts borrowed.
o Interest paid on debentures and long-term loans and advances.
o Dividends paid on equity and preference capital.
Main heads of Cash Flow statement:
Cash Flow Statement (Main heads only)
(A) Cash flows from operating activities xxx
(B) Cash flows from investing activities xxx
(C) Cash flows from financing activities xxx
Net increase (decrease) in cash and cash xxx equivalents (A + B + C) + Cash and cash
equivalents atthe beginning xxx = Cash and cash equivalents at the end xxxx
Methods of preparing the Cash Flow Statements
Operating activities are the main source of revenues and expenditures, thereby cash
flow from thesame needs to be ascertained. The cash flow can be reported through two
ways:
Direct method that discloses the major classes of gross cash receipts and cash
payments andIndirect method that has the net profit or loss adjusted for effects of
1) transactions of a non-cash nature,
2) any deferrals or accruals of past/future operating cash receipts and
3) items of income or expenses associated with investing or financing cash flows.
DIRECT METHOD:
In the direct method, the major heads of cash inflows and outflows (such as cash received from
tradereceivables, employee benefits, expenses paid, etc.) are to be considered.
As the different line items are recorded on accrual basis in statement of profit and loss,
certainadjustments are to be made to convert them into cash basis such as the following:
1) Cash receipts from customers = Revenue from operations + Trade receivables in the
beginning
– Trade receivables in the end.
2)
Cash payments to suppliers = Purchases + Trade Payables in the beginning –
Trade Payables inthe end.
3)
Purchases = Cost of Revenue from Operations – Opening Inventory + Closing Inventory.
4) Cash expenses = Expenses on accrual basis + Prepaid expenses in the beginning
and Outstanding expenses in the end – Prepaid expenses in the end and
Outstanding expenses in the beginning.

Purpose & Importance of Cash Flow Statements
1) Statement of cash flows provides important insights about the liquidity and
solvency of a company which are vital for survival and growth of any
organization.
2) It enables analysts to use the information about historic cash flows for
projections of future cash flows of an entity on which to base their economic
decisions.
3) By summarizing key changes in financial position during a period, cash flow
statement serves to highlight priorities of management.
4) Comparison of cash flows of different entities helps reveal the relative quality of
their earnings since cash flow information is more objective as opposed to the
financial performance reflected in income statement.
Advantages of Cash Flow Statement
1) Cash Flow Statements help in knowing the liquidity / actual cash position of the
company whichfunds flow and P&L are unable to specify.
2) As the liquidity position is known, any shortfalls can be arranged for or excess
can be used forthe growth of the business
3) Any discrepancy in the financial reporting can be gauged through the cash flow
statement bycomparing the cash position of both.
4) Cash is the basis of all financial operations. Therefore, a projected cash flow
statement willenable the management to plan and control the financial
operations properly.
5) Cash Flow analysis together with the ratio analysis helps measure the
profitability and financialposition of business.
6) Cash flow statement helps in internal financial management as it is useful in
formulation offinancial plans.
Disadvantages of Cash Flow Statement
1) Through the cash flow statement alone, it is not possible to arrive at actual P&L
of the company as it shows only the cash position. It has limited usage and in
isolation it is of no use and requires BL, P&L for its projections. Cash flow
statement does not disclose net income from operations. Therefore, it cannot be a
substitute for income statement
2) The cash balance as shown by the cash flow statement may not represent the real
liquidity position of the business because it can be easily influenced by
postponing the purchases and other payments
3) Cash flow statement cannot replace the funds flow statement. Each of the two has
a separate function to perform.

Management Accounting Unit 1 for B.Com(Hons)/BCom/BBA.pdf

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Management Accounting Unit 1 for B.Com(Hons)/BCom/BBA.pdf