Вы находитесь на странице: 1из 19

Management Accounting

Management Accounting

Page 1

Management Accounting

Q.1 Explain the term Accounting. What are the different streams of accounting? How are they related to each other? Ans. Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money transactions, and events, which are part, at least, of a financial character and interpreting the results thereof. The analysis of above definition brings out the following functions of accounting: 1. Recording: This is the basic function of accounting. It is essentially concerned with not only ensuring that all business transactions of financial character are recorded but also that they are recorded in an orderly manner. Recording of transactions is done in ournal! or subsidiary boo"s. The number of subsidiary boo"s to be maintained will be according to the nature and size of the business. #lassifying: #lassification is concerned with the systematic analysis of recorded facts, with a view to group transactions or entries of one nature at one place. This is done in the boo" called $edger!. The $edger contains different pages of individual account heads under which all financial transactions of similar nature are collected. %or e&ample the e&penses may be classified under various heads li"e Travelling, #ommunication, 'rinting and (tationery, Advertisement etc. All the entries in the $edger shall flow based on the entries passed in the ournal. The $edger accounts will help in "nowing the total e&penditure under various heads for a given period. (ummarizing: This involves presenting the classified data in a manner which is understandable and useful to the internal as well as e&ternal end)users of financial statements. This process involves preparation of a* Trial +alance b* Income (tatement c* +alance (heet. ,eals with financial transactions: Accounting records only those transactions and events in terms of money, which are of a financial nature. In other words the transaction which are not of financial nature are not recorded in the boo"s of accounts. %or e&ample a company, which has a team of employees with sound technological "nowledge, cannot e&pressed in terms of financial numbers and hence will not be recorded in the boo"s of accounts of the company. Interpretation: This is the final function of the accounting. The recorded financial data is interpreted in a manner that the end)users can ma"e a meaningful -udgement about the financial condition and profitability of the business operations. The data is also used for preparing the future plans and framing of policies for e&ecuting such plans.

2.

3.

4.

5.

O !ecti"es of Accounting The following are the main ob-ectives of the accounting: .. To "eep systematic records: Accounting is done to "eep systematic records of financial transactions. In absence of a scientific method of accounting, there would have been tremendous burden on the human memory, which in most cases would have been impossible to bear. To protect business properties: Accounting provides protection to business properties from un-ustified and unwanted use. This is possible by providing information the following information to the management: 0i* The amount of owner1s fund invested in the business2

/.

Page 2

Management Accounting 0ii* 0iii* 0iv* 3ow much the business owes to others2 3ow much the business has to recover from others2 3ow much business owns the assets2

The information helps the management in ensuring that the assets do not remain idle of under)utilized. 4. To ascertain the operational profit or loss: Accounting helps in ascertaining the net profit or loss carrying on the business. This is done by maintaining the proper record of revenues and e&penses for a particular period. 5. To ascertain the financial position of the business: The profit and loss accounts reflect the performance of the business during a particular period. 3owever, it is also necessary to "now the financial position i.e. where do we stand. 6hat we owe and what we own. The ob-ective is met by +alance sheet, which shows the state of affairs of assets and liabilities as on a given date. It serves as barometer for ascertaining the financial health of the business. 7. To help rational decision 8 ma"ing: Accounting these days has ta"en upon itself the tas" of collection, analysis and reporting of information at the re9uired points of time to the re9uired level of authority in order to facilitate rational decision)ma"ing.

Page 3

Management Accounting Q#. What do you man y $an% &econciliation 'tatement? Why is it prepared? (i"e a standard format of $an% reconciliation statement. Answer. A form that allows individuals to compare their personal ban" account records to their account balance according to the ban" in order to uncover any possible discrepancies. (ince there are timing differences between when data is entered in the ban"s systems and data is entered in the individuals system, there is sometimes a normal discrepancy between account balances. The goal of reconciliation is to determine if the discrepancy is due to error rather than timing. )eed for $an% &econciliation 'tatement :Reconciliation1 between the cashboo" and the ban" statement final balance simply means an e&planation of the differences. This e&planation ta"es the form of a written calculation 0see page && for an e&ample*. The process can be seen as follows:

,ifferences between the cashboo" and the ban" statement can arise from: Timing of the recording of the transactions ;rrors made by the business, or by the ban"

*&E*A&+)( ,HE $A)- &E.O).+/+A,+O) ',A,EME), 6hen a ban" statement has been received, reconciliation of the two balances is carried out in the following way: 'tep 1 The cashier will tic" off the items that appear in both the cashboo" and the ban" statement. 'tep 0 The untic"ed items on the ban" statement are entered into the ban" columns of the cashboo" to bring it up to date. 'tep 1 The ban" columns of the cashboo" are now balanced to find the revised figure. 'tep 2 The remaining untic"ed items from the cashboo" will be the timing differences. 'tep # The timing differences are used to prepare the ban" reconciliation statement

Page 4

Management Accounting

.ustome r Accounts #urrent Account with the +an" 3e it 3etails +alance to reconciliatio n date, 4=.>.&& Amounts appearing only on the $an% 'tatement 4=.>.&& #redit: Interest 4=.>.&& ,ebit: +an" charges /?.>.&& #redit: ;rror Amounts that appear only in our accounts 4=.>.&& #hec" to supplier, @ot yet presented to ban" Ad-usted +alance as at 4=.>.&& .redit

$an%s4 Accounts <#ustomer < Account

3e it

.redit

.,===

.,7==

7= .= 4==

.=7= .,=5=

.=

.>= 5>=

.,7== .,=5= ,ebit

Page 5

Management Accounting

Q 12. Write 'hort notes on any three 5 Answer. .ash udget

A forecast of estimated cash receipts and disbursements for a specified period of time. A cash budget is e&tremely important, especially for small businesses because it allows a company to determine how much credit can be e&tended to customers before they begin to have li9uidity problems. A cash flow budget is a pro-ection of your businessAs cash inflows and outflows over a certain period of time. A typical cash flow budget predicts the anticipated cash receipts and disbursements of a business on a month)to)month basis. 3owever, a cash flow budget could predict the cash inflows and outflows on a wee"ly or daily basis. +ecause of the uncertainty involved in the cash flow budget, trying to pro-ect too far into the future may prove to be less than worthwhile. At the same time, a cash flow budget that doesnAt loo" far enough into the future will not predict future events early enough for you to ta"e corrective action in your cash flow. A si&)month cash flow budget minimizes the amount of uncertainty involved in the budget. It also predicts future events early enough for you to ta"e corrective action. 3owever, if youAre applying for a loan, you may need to create a cash flow budget that e&tends for several years into the future, as part of the application process. The primary purpose of using a cash flow budget is to predict your businessAs ability to ta"e in more cash than it pays out. This will give you some indication of your businessAs ability to create the resources necessary for e&pansion, or its ability to support you, the business owner. The cash flow budget can also predict your businessAs cash flow gaps B periods when cash outflows e&ceed cash inflows when combined with your cash reserves. Cou can ta"e cash flow management steps to ensure that the gaps are closed, or at least narrowed, when they are predicted early. These steps might include lowering your investment in accounts receivable or inventory, or loo"ing to outside sources of cash, such as a short)term loan, to fill the cash flow gaps. 6lexi le $udget A set of revenue and e&pense pro-ections at various production or sales volumes. The cost allowances for each e&pense are able to vary as sales or production vary. A fle&ible budget is developed using budgeted revenues or cost amounts based on the level of output actually achieved in the budget period. A "ey difference between a fle&ible budget and a static budget is the use of the actual output level in the fle&ible budget. (teps in developing a %le&ible +udget 8 (tep .: ,etermine budgeted selling price, budgeted variable cost per unit, and budgeted fi&ed cost. (tep /: ,etermine the actual 9uantity of output. (tep 4: ,etermine the fle&ible budget for revenues based on budgeted selling price and actual 9uantity of output. (tep 5: ,etermine the fle&ible budget for costs based on budgeted variable costs per output unit, actual 9uantity of output, and the budgeted fi&ed costs.

Page 6

Management Accounting

7nder A sorption and O"er A sorption of O"erheads In #ost Accounting the analysis and collection of overheads, their allocation and apportionment to different cost centers and absorption to products or services plays an important role in determination of cost as well as control purposes. A system of better distribution of overheads can only ensure greater accuracy in determination of cost of products or services. It is, therefore, necessary to follow standard practices for allocation, apportionment and absorption of overheads for preparation of cost statements. Absorption of overheads - Absorption of overheads is charging of overheads from cost centers to products or services by means of absorption rates for each cost center, which is calculated as follows: Dverhead absorption Rate Total overheads of the cost center 8 999999999999999999999 Total 9uantum of base

The base 0denominator* is selected on the basis of type of the cost center and its contribution to the products or services, for e&ample, machine hours, labour hours, 9uantity produced etc. Dverhead absorbed E Dverhead absorption rate & units of base in product or service A pre)determined rate may be used on a provisional basis for internal management decision)ma"ing such as cost estimates for 9uotation, fi&ation of selling price etc. These rates are to be calculated for each cost center for a particular period. +udgeted overheads for the respective cost centers for the period concerned are to be ta"en as numerator and budgeted normal base for the period as denominator for determining the rate. +udgeted Dverheads for the period 're)determined overhead Rate E FFFFFFFFFFFFFFFFFFFFFFFFFFFFFFF +udgeted normal base for the period The amount of total overheads absorbed by a product, service or activity will be the sum total of the overheads absorbed from individual cost centers on pre) determined basis. The difference between overheads absorbed on pre) determined basis and the actual overheads incurred is the under) or over) absorption of overheads. The under) or over) absorption of overheads is mainly due to variation between the estimation and actual. Dverheads shall be analysed into variable overheads and fi&ed overheads.

Page 7

Management Accounting The variable production overheads shall be absorbed to products or services based on actual capacity utilisation. The fi&ed production overheads and other similar item of fi&ed costs such as 9uality control cost shall be absorbed in the production cost on the basis of the normal capacity or actual capacity utilization of the plant, whichever is higher. In case of less production than normal, under:a sorption of o"erheads shall be ad-usted with #osting 'rofit G $oss Account. In case of higher production than normal, the over)absorption of overheads shall also be ad-usted with #osting 'rofit G $oss Account.

Q1; Write an essay on <3epreciation=. Ans 3) ,epreciation is the part of the value of fi&ed assets which is used up in revenue earning process in the current accounting period and recovered from the revenue earned said period. It may also be defined as gradual and permanent diminution in the value of fi&ed assets due to normal wear and tear, obsolescence of the efflu& ion of time, the literal meaning of depreciation is reduction of value. International Accounting (tandard0IA(*)5 defined depreciation as 8 The allocation of the depreciable amount of an asset over its estimated useful life.! According to Indian Accounting (tandard 0A(*)> 8 ,epreciation is a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, efflu& ion of time or obsolescence through technology or mar"et changes.! Nature of Depreciation : There are different concepts as to the nature of depreciation, which are as follows : I) Process of allocation : The unrecoverable part of the cost of fi&ed assets that left after the end of its lifetime is assumed as the value consumed up between the date of ac9uisition and the and the date of e&haustion. The ob-ect of charging depreciation is to measure the value of the benefits the asset has provided or the services it has rendered during a particular accounting period. It is not meant for measuring the value of an asset at any specific point of time. It is possible to estimate the benefits e&pected to be received from an asset in each accounting period. The time horizon or the e&pected useful life period of each fi&ed asset as well as its salvage value at the end of that period can be anticipated. ,epreciation is not charged for raising fund for replacement of asset rather it helps the firms to recover its lost capital and maintain the original capital intact. II) Decline in service potential : +y the opinion of #ommittee on concepts and standards on ,epreciation of AI#'A in .H7? is any decline in the service potential of plant and other long term asset should be recognized in the accounts in periods in which such decline occurs.! According to them service potential of assets may decline due to any of the following reasons such as ) a* gradual or abrupt physical deterioration. +* #onsumption of services and c* economic deterioration. As a result of obsolescence or change in consumer demand!. In allocation concepts depreciation represents the allocated portion of the total cost of a fi&ed asset in each accounting period within its life time, whereas in service potential concepts the consumed up portion of the total service receivable

Page 8

Management Accounting from a fi&ed asset in each accounting period within its life time is treated as depreciation. III) Provision for maintenance of capital : ,epreciation is also regarded as a means of recovery of capital invested in fi&ed assets and it is needed for maintaining capital intact. The capital outlay for fi&ed asset is gradually and continuously used up or consumed in different accounting periods within the life time of the fi&ed assets. The %inancial Accounting (tandard +oard 0%A(+* and the American Accounting Association 0AAA* of I(A gave the recognition to this maintenance of capital concepts of depreciation. The committee on #oncepts and (tandards)$ong lived Assets of AAA directly recognized the capital maintenance concepts. In its opinion depreciation must be based on current cost of restoring the service potential consumed during the period.! IV) Current cost of service consumed : According to accounting research study 0AR(* @D. 4 published by the AI#'A sprouse and Jootinz depreciation represent an allocation of current costs and the depreciation charge for a period is the current costs of services consumed is that period. This concept is an improvement over other concepts in the sense that is overcomes the problem of replacement at times of inflation. The main drawbac" of this concept lies in the difficulty in measurement of current cost or replacement cost of fi&ed assets. ,ue to technological development it is difficult to replace the old asset by an e&actly similar asset. Causes of Depreciation : 'ermanent fall in the value of any fi&ed asset or depreciation ta"es place due to the following causes : I) Uses of natural wear and tear : The more an asset is used the fast it loses its value. This loss of value is due to the e&haustion of the potential utility of the asset as a result of continuous use. #areless handling of asset is also responsible for 9uic" loss of its value. II) Wasting asset : (toc" of wasting assets gets depleted in a normal process due to e&traction or use of the same. The continuous e&tractions of mineral or oil reduces their stoc" and ultimately over the time the said stoc" gets fully e&hausted. III) Efflu of time : Assets li"e leasehold property, patent right, copyright. ;tc. get e&hausted not due to use but on account of efflu& of time. IV) !ccident or a"normalit# : 3appening any abnormal event li"e accident due to natural or any other reasons may cause the assets to lose their value partly or completely and they may become less effective or ineffective. V) Inade$uac# : (ometimes an asset, even it has the productive value, may be replaced by another more productive asset. (uch ineffectiveness of asset is caused by its inade9uacy to cope up with the changed situation. C%aracteristic of depreciation : The following are the character tics of depreciation : I) &elated to tangi"le fi ed assets ,epreciation is charged only on tangible fi&ed asset li"e building, plant, furniture etc. It is not provided on current assets or non tangible fi&ed assets. II) C%arge against profit : ,epreciation is a charge against profit, it is not allocation of profit. +efore ascertaining income depreciation is matched against revenue as a cost. III) Permanent and gradual loss of utilit# :

Page 9

Management Accounting ,epreciation indicates permanent and gradual loss of service rendering capacity of fi&ed assets that cannot be received bac". IV) Effective wit%in t%e wor'ing life : At the end of the useful economic life of a fi&ed asset it is assumed to be fully e&hausted with no service rendering capacity. (o the value of any fi&ed asset is charged in each accounting period within its wor"ing life. V) !ssumption "ased : #harging of depreciation is always based on a number of assumptions regarding the economic life of fi&ed assets, stability of mar"et price etc. (easurement of depreciation : ,epreciation must be properly measured. It is an e&tremely important -ob of the accountants. I) Cost of asset : #ost price of asset includes its gross value. #ost may be ta"en as historical value, current mar"et price or replacement cost. In conventional accounting system cost is assumed as historical cost. II) Incidental e pense : $egal e&penses, commission, inward freight, import duty, carrying cost etc. paid in connection with ac9uisition of assets are ta"en as incidental e&penses and treated as capitalized cost of assets. III) )t%er factors : (ome factors are consideration for the purpose of measuring of depreciation. 0a* #ost of e&tension or improvement of fi&ed assets. 0b* Replacement cost involved. 0c* ;fficiency with which the asset is used. 0d* Interest e&pected in case the amount spent for purchase of fi&ed assets were invested outside the business in securities. 0e* $egal restrictions particularly the provisions of Income Ta& Act regarding depreciation, etc. Pro"lems of measurement of depreciation : The problem that may creep on while measuring depreciation are as follows : I) !ssessment of wor'ing life : It is really difficult to measure the correct assessment of the wor"ing life of the asset. Instead of e&act wor"ing life only the probable useful period may be assumed. Isually such assessment is made on the basis of 9uality of the assets, past e&perience and e&pert1s opinion. II) Une pected c%anges : A fi&ed asset may become obsolete or loses its value due to partial obsolescence if there is any change in customers1 choice or behavior or any new technology is innovated. III) Uneven use : %or measuring depreciation on the basis of use of the asset it is re9uired t assess its use properly. There is every possibility that the asset is not use evenly in different accounting periods. ;fficiency in use of the asset may also vary. (et%ods of depreciations : Jethods of depreciation are as follows : +; Methods ased on costs allocation concept *a) Time based method 0a.i* %i&ed installment method. 0a.ii* ,iminishing balance method. 0a.iii* ,ouble declining balance method.

Page 10

Management Accounting 0a.iv* (um of the years1 digit method. *") Ise based method 0b.i* 6or"ing hours method. 0b.ii* 'roduction unit method. 0b.iii* Jileage method. II* Jethods based on capital maintenance concept 0a* (in"ing fund method. 0b* Annuity method. 0c* Insurance policy method. III) Other methods 0a* Revolution method. 0b* ,epletion method. #omposite or group method. Q7) Explain step-by-step procedure of identifying the direct material cost ith the individual cost center! "ive the formats of various documents hich are prepared in the process! !ns+* ,irect material cost indicates that the material which can be identified with the individual cost center and which becomes an integral part of the finished goods. It basically consists of all raw materials, either purchased from outside or manufactured in house. The basic ob-ective of cost accounting i.e ascertainment of cost and control of cost is e9ually applicable to material cost as well. 3owever, a whole lot of organizational procedures are also involved in the process, which effect the material cost, either directly or indirectly. The movement of direct material cost may involve the following main steps which are as follows : a. 'rocurement of materials. b. (toring the material till it is re9uired for consumption. c. Issue of the material for consumption. d. *a) Procurement of materials : *") Though the practices may differ from organization to organization, normally the process of purchasing the materials involves the following stages.

(1) Purc%ase re$uisition :


*,) It is an indication to the purchase department to purchase certain material. It is issued by store"eeper or by production department. %ollowings particulars must appear in purchase re9uisition. 0i* Jaterial to be purchased : It should clearly specified with the specific code number. To ma"e it more specific, addition to the description of the material re9uired. 0ii* 6hen it is re9uired : Inless the material is re9uired for regular production purposes, purchase re9uisition should mention the last date by which the material is re9uired. 0iii* 3ow much to be purchased : 'urchase re9uisition should mentioned clearly the 9uantity of the material re9uired. +efore deciding the e&act 9uantity this should be remembered of overstoc"ing of material as both these situations involve costs.

Page 11

Management Accounting

A standard form of purchase re9uisition is shown below :

Purchase Requisition
To : Purcha e !e"artment #rom : !e"artment $o !ate P%ea e "urcha e the materia% tate& 'e%o(. : :

)r. $o

!e cri"tion

*o&e $o.

+uantit, -e.uire&

+uantit, on han&

-emar/

)igne& ', :

A""ro2e& ', :

For the use of Purchase Department Only


!ate P.0. $o. $ame 01 )u""%ier !e%i2er, !ate -emar/

)igne& : Purcha e Manager *,) -election of source of suppl# : 'urchase department call the 9uotations from the prospective suppliers of a certain type of material. %ollowings types of 9uotations may be called for : 0i* (ingle Tender. 0ii* $imited Tender. 0iii* Dpen tender. 0iv* Klobal tender.

Page 12

Management Accounting *.) Purc%ase order : The contractual obligation in between the supplier and purchase starts from purchase order. It is drawn in favor of the supplier by the purchase department which specifies some facts which are as follows : 0i* Jaterial to be supplied. 0ii* Luantity to be supplied. 0iii* 'rice and other specific terms 0If any*. 0iv* #ash and trade discount. 0v* Instruction in respect of delivery 0vi* Kuarantee clause. 0vii* ;scalation clause. 0viii* Inspection clause. 0i&* Jethods of settlement or disputes. 0&* ,etails in respect of letters of credit, import license etc. 0&i* ,etails in respect of interest payable in the event of late payment of dues. 'urchase order are distributed on some terms which are as follows : o Dne to supplier. o Dne to user department. o Dne to stores department. o Dne to accountsMcosting department. o Dne with 'urchase department. A (tandard %orm of 'urchase Drder is as shown below :

Purcha e 0r&er

$o : !ate : -e.ui ition $o :

!ate : P%ea e u""%, the 1o%%o(ing materia% on uch term an& con&ition a tate& therein : !e cri"tion *o&e $o +uantit, -ate - . 3a%ue - . !e%i2er, !ate -emar /

!e%i2er, : 4oo& to 'e &e%i2ere& at 5 67tra a a""%ica'%e 5 67ci e !ut, )a%e Ta7 Pac/ing *harge 8n urance Term o1 "a,ment #or 55555555555555555555 (Purcha ing *om"an,)

Purcha e Manager #$) %eceipt and Inspection 5 After material is recei"ed from the supplier> the ?uantity r

Page 13

Management Accounting received actually, is compared with 9uantity ordered. ;&cess material received may be dealt with in any of the following ways : 0i* Accept all the material received. 0ii* Accept the material ordered and return the e&cess to the supplier. 07* C%ec'ing invoice and accounting for purc%ases : The supplier1s invoice received for the supply of material is sub-ected to security before a voucher is passed for the same for ma"ing the entry in the boo"s of accounts. %or this purpose, the supplier1s invoice may be compared along with the following documents. 0i* 'urchase order. 0ii* Koods Received @ote. 0iii* Inspection Report. *c) -toring and issue of materials : After the material received, inspected and approved the process of storing comes into operation which deals with storing the material in good condition till it is re9uired for use by production departments and issuing the same whenever re9uired. 0i* Receipt of material. 0ii* Issue of material. 0iii* Return of material from production department to stores department. 0iv* Transfer of material.

GOODS RECEIVED NOTE


$o : !ate :

).$o !e cri"tion

*o&e

+t,. -ec&.

+t,. Acce"te&

+t,. -e9ecte&

-emar/

Pre"are& :,

-ecei2e& ',

8n "ecte& ',

)tore ;ee"er

(aterial &eceipt : The material physically received when compared with material ordered as per the purchase order may reveal certain discrepancies which may ta"e any of the following forms : 0i* Luantity received in e&cess. 0ii* Luantity received in short. 0iii* Luantity received of different 9uality. ;&cess 9uantity received may be retained an accepted. If re9uired it is returned to the supplier with Koods Returned @ote which is shown here :

400!) -6T<-$6! $0T6


To : $o : !ate : Page 14

Management Accounting

#o%%o(ing materia% u""%ie& ', ,ou 2i&e ,our !.* $o.============ an& in2oice $o.=============== again t our "urcha e 0r&er $o.============= i 'eing returne& to ,ou 1or the rea on tate& 'e%o( : !e cri"tion +uantit, -ea on

*C) Issue of material : )ignature The issue of material refers to issue of material from stores department to production department. The material should not be issued from the stores unless a proper authority in writing is produced before the stores department which is in the form of Jaterial Re9uisition @ote which contents are : 0i* @umber and ,ate. 0ii* ,epartment demanding the material. 0iii* Luantity of material demanded. 0iv* (ignature of authority approving the demand. 0v* (ignature of the person receiving the material. Jaterial Re9uisition forms are shown as follows :

!TERI!" RE#$ISITION S"IP


Pro&uction>?o' 0r&er $o. :i%% o1 Materia% $o. $o. !ate. !e"artment : !e cri"tion *o&e +t, <nit *o t (1or co ting &e"t. on%,) -ate "er unit Amount - .

Authori@e& ',

8 ue& ',

-ecei2e& ',

6ntere& an& 2a%ue& ',

Jaterial is returned bac" if it is in e&cess in 9uantity. (o, this is the final stage to complete the procedure. Q11; With the help of a 'imple $rea% E"en .hart and .ontri ution $rea% E"en .hart> Explain the significance and method of calculation of the following terms @ a. .ontri ution . *rofit Aolume &atio c. $rea% E"en *oint d. Margin of 'afety e. Angle of +ncidence. Ans &&) #ost volume profit relationship can e&pressed in the form of visual li"e graphs and charts. There are various types of chart and graphs are available. 3ere is

Page 15

Management Accounting a detail of the above terms by the help of brea")even chart. This are the followings where the terms are described in short. a; 'ontribution 5 The term contribution can be e&pressed in two ways basically : I * (ales 8 Nariable #ost II * %i&ed #ost O 'rofit In the short period, %i&ed cost are ineffective due to their stagnant nature, variable cost becomes the most important cost in deciding the profitability. As such, the situation, which generates contribution, is treated as profitable situation. %urther, the term contribution plays an important role in a situation where there are more than one product and the profits on individual products cannot be ascertained due to the problems of apportionment of fi&ed cost to different products. This is due to the fact that marginal costing ignores the fi&ed costs. ; (rofit )olume %atio 5 This ratio indicates the contribution earned with respect to one rupees of sales. It is e&pressed as followings :

In the short run Rs. .= per unit, variable cost is Rs. > 'er unit, and fi&ed cost are Rs. 4==, we observe that for .== and .7= units , 'MN ratio wor" out as followings. .== Inits .7= Inits Rs. Rs. (ales ))) .=== .7== Nariable #ost ))) >== H== )))))))))))))))))) )))))))))))))))))) #ontribution ))) 5== >== %i&ed #ost ))) 4== 4== ))))))))))))))))))) ))))))))))))))))))) 'rofit ))) .== 4== 3ence, ' M N Ratio is : #ontribution )))))))))))))))))) P .== E (ales 5== ))))))))))))))) P .== .,=== Dr i.e Increase in 'rofits ))))))))))))))))))))))))) Increase of (ales P .== 5= Q i.e >== ))))))))))))))) P .== .,7== 5= Q P .== E 5= Q

E E

/== ))))))))))) 7==

The fundamental concept of 'MN ratio is that it remains constant remains at all levels of activities, provided per unit sales price and variable cost remains constant. A high 'MN ratio indicates that slight increase in sales without corresponding increase in fi&ed cost will result in higher profits and vice)versa while a low ratio indicates low profitability. (o, the basic e&pression of 'MN ratio i.e contributionMsales may lead to other useful conclusions as ) 0a* (ales P 'MN Ratio E #ontribution 0b* #ontribution ))))))))))))))))) E (ales 'MN Ratio

Page 16

Management Accounting #* /rea' Even Point : This is a situation of no profit no loss means it is a situation of neutral in business point of view. In this stage contribution is -ust enough to cover the fi&ed costs i.e contribution E %i&ed #ost. It also means that contribution generated by all sales beyond +rea" ;ven point will directly result into profits. As such, it will be intention of every business to reach the +rea" ;ven point, as early as possible. It can e&pressed in two ways such as, 0a* 0b* In terms of 9uantity E In term of amount E %i&ed #osts )))))))))))))))))))))))))))))))) #ontribution per unit %i&ed #ost )))))))))))))))))))))))))))))))) ' M N ratio

d; *argin of +afety , These are the sales beyond +rea" ;ven 'oint. A business will loo"ing li"e smart and profitable when the amount of sales generates profit. As such the soundness of business is indicated by the margin of safety. A high margin of safety indicates that the brea" even point is much below the actual sales and even if there is reduction in sales, business will still in profits. +ut a low margin of safety accompanied by high fi&ed cost and high 'MN ratio that indicates more efforts are re9uired to be made for reducing the fi&ed cost or increasing sales volume. Jargin of safety may e&pressed by the following way : Jargin Df (afety E E Jargin Df (afety E E E (ales ) +rea" ;ven (ales %i&ed #ost (ales ) )))))))))))))))))))) ' M N Ratio (ales P 'MN Ratio ) %i&ed cost ))))))))))))))))))))))))))))))))))))))))))))))) 'MN Ratio #ontribution ) %i&ed #ost ))))))))))))))))))))))))))))))))))))))))))))))) 'MN Ratio 'rofit )))))))))))))))))))))))))))))) 'MN Ratio

Jargin of safety may be e&pressed as a ratio or as a percentage. (ales ) +rea" ;ven point ))))))))))))))))))))))))))))))))))))))))))))) (ales ..==.=== ) >=,=== ))))))))))))))))))))))))))))))))))))))))))) .,==,=== 5= Q of sales. P .== P .== E 5=,=== )))))))))))) P

i.e. .== i.e.

.,==,===

f; Angle of Incidence 5 The angle formed by total sales line and total cost line is termed as Angle of Incidence. As the difference between total sales and total costs is in the form of profits, higher the angle of incidence better will be the situation. This is a chart where the contribution is shown more clearly and specifically compared to simple brea")even chart. #ontribution brea")even chats are as follows :

Page 17

Management Accounting 'ontribution brea- even chart,

T( T# +;' ($ Incidence #

E E E E E

Total (ales $ine Total #ost $ine +rea" ;ven 'oint (elected $evel Df Activity #ontribution

%# N# JD( E Angel a

E %i&ed #ost E Nariable #ost Jargin Df (afety E Angle Df

This is a chart where the #D(T 8 ND$IJ; 8 'RD%IT relationship e&pressed more clearly and specifically compared to simple brea")even chart. #ontribution brea") even chats are as follows : -imple "rea' even c%art :

T( T#

'oint Df Incidence ($ E

E E JD(

Total (tates $ine Total #ost $ine E Jargin Df (afety (elected $evel Df Activity

%#

E %i&ed #ost +;' E +rea" ;ven Angel a E Angle

The limitation of simple +rea" ;ven #hart is that contribution cannot be shown separately. The above +rea" ;ven #hart may be prepared i.e #ontribution +rea" ;ven #hart.

Page 18

Management Accounting

Page 19