Elucidate various bases of Cost Classification

Costs are classified in different ways to answer different questions asked by the management. Management wants different kinds of information for different purposes. Hence, costs must be classified and arranged to serve the purpose of the management.

Classification is the process of grouping costs according to their common characteristics. There are various ways of classifying costs. Each classification is for a particular purpose. The important bases of cost classification are the following.

1. Nature of Elements

2. Traceability

3. Functions or Operations

4. Variability or Behaviour

5. Controllability

6. Normality

7. Managerial Purposes

1. Nature of Elements:

In a manufacturing concern, the total cost of a product is made of three elements viz., material cost, labour cost and expenses material cost is defined as the cost of commodities supplied to in undertaking. Labour cost means the cost of remuneration of the employees of an undertaking. The expenses are the cost of services provided to an undertaking and the notional cost of the use of owned assets.

2. Traceability:

On the basis of traceability or indentifiability, costs are classified as direct costs and indirect costs. Costs which are clearly, conceniently and economically identifiable to a costing centre or cost unit are called direct costs. Eg. material and labour costs are clearly traceable to particular product because they are common to several products Eg. rent of the factory cannot be traced to a single product, since it is incurred for all products manufactured in the factory.

3. Functions or Operations:

Costs are classified by functions as manufacturing (production) cost, administration cost, selling and distribution cost. Manufacturing costs are incurred to manufacture the products, including direct material, direct labour and indirect production costs.

4. Variability or Behaviour

Costs can be classified in terms of changes in activity or volume as fixed, variable and semi-fixed (or semi variable) costs.

Fixed Costs:

Fixed cost is a cost which does not change in total amount for a given period of time in spite of changes in quantity of output or volume of activity. It is to be incurred irrespective of changes in output or turnover or level of activity.

Fixed cost depends on passage of time. Hence it is also known as period cost, capacity cost or stand by cost. Examples of fixed cost are rent, rates, insurances, salary etc.

Explain the various steps involved in preparing a Cash Flow Statement

Cash plays a very important role in the entire economic life of a business. Cash Flow Statement is a statement like Fund Flow Statement. A Cash Flow Statement concentrates to transactions that have a direct impact on cash. It deals with the inflow and outflow of cash between two Balance Sheet. That is, it explains the changes in cash position between the two period. Cash Flow mean inflow and outflow of cash during accounting period. From the beginning of the year up to the end of the year cash is received from various sources and spent on various heads. Incoming and outgoing of cash is termed as cash flow. The term cash here stands for cash and bank balances.

When the management is interested to know about the movement of cash and the availability of cash, the cash flow analysis provides this information. Cash Flow Statement is a Statement of recording systematically all inflows and outflows of cash of the accounting period. Thus it shows the sources (inflow) of cash receipts and the purpose for which payments (outflow) are made. It is like a receipts and payments account in a summary form.

Steps in Preparing Cash Flow Statement:

1. Opening of Accounts for Non-current Items (To find out the hidden information).
2. Preparation of adjusted P & L Account ( to find out cash from operation or profit, and cash lot in operation or loss).
3. Comparison of current items (to find out inflow or outflow of cash).
4. Preparation of Cash Flow Statement.

To prepare Account for all non-current items is easier for preparing items is easier for preparing Cash Flow Statement.

Cash from operation can be prepared by this formula also:

	Decrease in Current Assets	Increase in Current Assets
Net Profit +	Increase in Current -	Decrease in
	Liabilities	Current Liabilities

Cash Flow Statement can be prepared in statement form or account form.

A Specimen Cash Flow Statement

Account form of cash flow statement is normally followed by all.

Cash Flow Statement:

Inflow of Cash		Outflow of Cash
Opening Cash Balance	xxx	Redemption of Pref. Shares	xxx
Cash from Operation	xxx	Redemption of Debentures	xxx
Sales of Assets	xxx	Repayment of Loans	xxx
Issue of Debentures	xxx	Payment of Dividends	xxx
Raising of Loans	xxx	Pay of Tax	xxx
Collection from Debentures	xxx	Cash Lost in Operations	xxx
Refund of tax	Xxx		Xxx

Cash from operation can be calculated in two ways.

1. Cash Sales Method:

Cash Sales – (Cash Purchases + Cash Operations Expenses)

2. Net Profit Method:

It can be prepared in statement form or by Adjusted Profit and Loss Account.

Explain the various steps involved in preparing a Cash Flow Statement

Cash plays a very important role in the entire economic life of a business. Cash Flow Statement is a statement like Fund Flow Statement. A Cash Flow Statement concentrates to transactions that have a direct impact on cash. It deals with the inflow and outflow of cash between two Balance Sheet. That is, it explains the changes in cash position between the two period. Cash Flow mean inflow and outflow of cash during accounting period. From the beginning of the year up to the end of the year cash is received from various sources and spent on various heads. Incoming and outgoing of cash is termed as cash flow. The term cash here stands for cash and bank balances.

When the management is interested to know about the movement of cash and the availability of cash, the cash flow analysis provides this information. Cash Flow Statement is a Statement of recording systematically all inflows and outflows of cash of the accounting period. Thus it shows the sources (inflow) of cash receipts and the purpose for which payments (outflow) are made. It is like a receipts and payments account in a summary form.

Steps in Preparing Cash Flow Statement:

1. Opening of Accounts for Non-current Items (To find out the hidden information).
2. Preparation of adjusted P & L Account ( to find out cash from operation or profit, and cash lot in operation or loss).
3. Comparison of current items (to find out inflow or outflow of cash).
4. Preparation of Cash Flow Statement.

To prepare Account for all non-current items is easier for preparing items is easier for preparing Cash Flow Statement.

Cash from operation can be prepared by this formula also:

	Decrease in Current Assets	Increase in Current Assets
Net Profit +	Increase in Current -	Decrease in
	Liabilities	Current Liabilities

Cash Flow Statement can be prepared in statement form or account form.

A Specimen Cash Flow Statement

Account form of cash flow statement is normally followed by all.

Cash Flow Statement:

Inflow of Cash		Outflow of Cash
Opening Cash Balance	xxx	Redemption of Pref. Shares	xxx
Cash from Operation	xxx	Redemption of Debentures	xxx
Sales of Assets	xxx	Repayment of Loans	xxx
Issue of Debentures	xxx	Payment of Dividends	xxx
Raising of Loans	xxx	Pay of Tax	xxx
Collection from Debentures	xxx	Cash Lost in Operations	xxx
Refund of tax	Xxx		Xxx

Cash from operation can be calculated in two ways.

1. Cash Sales Method:

Cash Sales – (Cash Purchases + Cash Operations Expenses)

2. Net Profit Method:

It can be prepared in statement form or by Adjusted Profit and Loss Account.

Elaborate on Objective of Fund Flow Statement

Fund Flow Statement is a widely used tool in the hands of financial executives for analyzing the financial performance of a concern. Funds keep on moving in a business which itself is based on a going concern concept. In a narrow sense, it means cash only and a funds flow statements prepared on this basis is called as Cash Flow Statement. Such a statement enumerates net effects of the various business transactions on cash and takes into account receipts and disbursements of cash. In a broader sense, the term “Fund” refers to money values in what ever form it may exist. Here “Funds” means all financial resources in the form of men, Materials, Money, Machinery etc. But in a popular sense, the term “Funds”, means working capital, i.e. the excess of current assets over current liabilities. When the funds move inwards or outwards, they cause a flow or rotation of funds. The word “Fund” here means net working capital.

Objective of Fund Flow Statement:

The main purposes of Fund Flow Statement are:

1. To help to understand the changes in assets and assets sources which are not readily evident in the income statement of financial statement.

2. To inform as to how the loans to the business have been used.

3. to point out the financial strengths and weakness of the business.

Format of Fund Flow Statement

Sources		Applications
Fund from operation	-	Fund lost in operations
Non-trading incomes		Non-operating expenses
Issues of shares		Redemption of redeemable preference share
Issue of debentures		Redemption of debentures
Borrowing of loans		Repayment of loans
Acceptance of deposits		Repayment of deposits
Sale of investments		Purchase of long term instruments

Write a note on three Important Profitability Ratios

Profitability ratios reflect the overall performance of the business. Profit must be compared with other information to evaluate the firm’s profitability. There are 2 types of profitability ratios –

Profit margin ratios, which indicate the relationship between profit and sales. The important profit margin ratios are: -

ü Gross profit margin ratio

ü Net profit margin ratio

Rate of return ratios, which examine the relationship between profit and investment. The important rate of return ratios are: -

ü Return on total assets

ü Earning power

ü Return on equity

Gross profit margin ratio:

This ratio computes the margin earned by the firm after incurring manufacturing costs. It measures the efficiency of the production process and pricing policy of the firm. It is calculated as –

Gross Profit x 100 %
Net sales

Where

Gross profit is the difference between Net Sales and Cost of Goods Sold

The cost of goods sold takes into account costs of labour, material and manufacturing overheads.

Net profit margin ratio :

The net profit margin ratio gives the earnings available for shareholders as a percentage of net sales. It is calculated as –

Net profit x 100 %
Net sales

It measures the overall efficiency of the firm in relation to production, administration, selling, financing, pricing and tax management.

The gross and net profit margin ratios taken together provide an understanding of the firm’s cost and profit structure. It also helps identify the sources of the firm’s efficiency or inefficiency.

Return on total assets :

This ratio measures the degree to which capital is efficiently employed by the firm. It is calculated as –

Net Income (profit)

Average Total Assets

Earning power:

Earning power is a measure of operating profitability. It is calculated as –

Earnings Before Interest And Tax
Average Total Assets

It measures the business performance, which is not affected by interest charges and tax payments and thus focuses on operating performance.

Return on equity:

The return on equity measures the earnings from shareholders’ investment and is calculated as –

Equity Earning
Average Net Worth

Equity earnings refers to profit after tax less preference dividends.

Average net worth refers to (paid-up capital+ reserves and surplus).

Also known as the return on net worth, this measure is an important indicator of profitability. It indicates the productivity of the owners’ capital employed. The return on equity is influenced by the firm’s earning power, debt-equity ratio, average cost of debt to the firm and the tax rate.

Differentiate between Management Accounting and Financial Accounting

Financial accountancy (or financial accounting) is the field of accountancy concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, government agencies, owners, and other stakeholders. The fundamental need for financial accounting is to reduce principal-agent problem by measuring and monitoring agents' performance and reporting the results to interested users.

Financial accountancy is used to prepare accounting information for people outside the organization or not involved in the day to day running of the company. Managerial accounting provides accounting information to help managers make decisions to manage the business.

Financial accountancy is governed by both local and international accounting standards.

Management accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis in making informed business decisions that would allow them to be better equipped in their management and control functions. Unlike financial accountancy information (which, for public companies, is public information), management accounting information is used within an organization (typically for decision-making) and is usually confidential and its access available only to a select few.

According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non management groups such as shareholders, creditors, regulatory agencies and tax authorities" (CIMA Official Terminology).

The distinctions between financial accounting and management accounting may be summarized as follows:

1. In most of the big business houses, financial accounting is the responsibility within the management accounting. It is the duty of financial accounting to process the mass of unwieldy data and make free the management accountant from the details. The management accounting, in its turn, sorts out the significant figures and channels them for the use in management process. Management accounting offers figures as facts having managerial significance.

2. Financial accounting is more confined to the preparation of accounts from the point of view of outside parties (Eg. Debenture-holders, creditors and shareholders) while management accounting used the information for internal use of management.

3. Financial accounting tries to present statements according to standards laid down by the outside parties while management accounting tries to measure up to the standards laid down by the management which may be much higher than that laid by the outsiders.

4. Financial accounting is made compulsory by law but management accounting is adopted to increase the efficiency without and legal force.

5. Financial accounting lays emphasis on the past while management accounting stresses the future.

6. Financial accounting deals with the whole of the business while management accounting takes up only those divisions of the business which are vital and significant in business activities.

Marginal Costing Vs CVP Analysis

Marginal Costing

Marginal cost means the same thing as variable cost. The term is not a new one. The accountants concept of marginal cost differs from economists concept of marginal cost Economists define marginal cost as the additional cost of production one additional unit. This shall include an element of fixed cost also. Moreover, the economists marginal cost per unit cannot be uniform with the additional production since the law of diminishing or increasing returns is applicable; whereas the accountants marginal cost shall be constant per unit of output with the additional production.

The Institute of Cost and Works Accountants of India defined marginal cost as, :The amount at any given volume of output by which aggregate costs are changed, if the volume of output is increased of decreased by one unit”. Here a unit may be a single article, a batch of articles, an order, a stage of production capacity, a process or department. To ascertain the marginal cost, we need the following element of cost.

ü Direct Materials

ü Direct Labour

ü Other Direct Expensed, and

ü Total Variable overheads.

That is Marginal Cost = Prime Cost + Total Variable overheads

Or

Marginal Cost = Total Cost – Fixed Cost

Marginal Cost = Increase in total cost

Increase in total units

Fixed costs remain fixed within a frange of production. They are not directly linked to product units. Rather, they are spent on elapse of time. Some portion of the fixed costs may be discretionary, which the management spends on availability of adequate profit. Other portion of fixed costs in non-discretionary which the management cannot avoid in the short run.

So in the short run decisions only incremental to fixed costs are considered. Decisions are based on marginal cost and contribution. Cost, volume and profit (C.V.P.) relationship provides important information to aid decision – making.

Also, managerial decisions are affected by product’s life cycle. This means the various stages through which a product passes, from conception and development through introduction into the market through maturation and finally, withdrawal from market.

Marginal Costing is defined by the ICWA as, the ascertainment by differentiating between fixed costs, and variable costs, of marginal costs and of the effect on profit of change in volume of type of output”. According to Dr. Joseph, “Marginal Costing is a technique of determining the amount of change in the aggregate costs due to an increase of one unit over the existing level of production. As such, it arises from the production of additional increments of output.

Batty defines Marginal Costing as a “Technique of Cost accounting which pays special attention to the behavior of costs with changes in the volume of output”.

Example:

RS.

Variable cost 8,000 @ Rs. 5 40,000/-

Fixed cost 10,000/-

-----------

50,000/-

ii. Standard Costing Vs Variance Analysis:

Standards are set for various activities with reference to resource, time and values on the basis of normally available working facilities and capability of an average employee and machine. Similarly, sales standard is set on the basis of appropriate market survey.

Budgets may be set after deciding upon the standards. In actual circumstances, after budgets are set on the basis of past experience and given resources ignoring the standard requirements.

Standards are nothing but a control device. Deviation from the standards is called variance. Analysis of variances is an effective means of control.