Variance analysis is used to observe how well a business is performing and how close actual costs are to the standard cost.

An accounting variance is defined as the difference between actual cost and standard cost. Variance analysis uses the standard versus actual amount to judge the performance. The analysis includes an explanation of the variance as well as evaluation as to why a variance may have occurred. The purpose of this detailed information is to assist the management in determining what may have gone right or wrong and to help in future decision making.

While interpreting variances, one has to understand that variance may be favorable or unfavorable. A variance is favorable when the actual results are better than standard results. This means costs were less than the standard or planned amount. An unfavorable variance also known as adverse variance occurs when actual costs are higher than standard. Consistently creating an adverse variance might result in a manager being punished or losing the job.

Decisions based on Variance Analysis

If the market price of material has gone up, it is uncontrollable or if electricity or power rates are increased by the government, a business manager cannot be responsible for the adverse variance that will result from such a situation. Similarly, if the price of the material comes down in the market, it will be creating a favorable material price variance but a manager cannot be rewarded for such a variance because it is not because of his actions.

Therefore before interpreting the variance, one has to see the exact cause of such a variance and whether it is controllable or uncontrollable. Managers can be held responsible only for controllable variance i.e. those variances which show their performance and efficiency.

Types of Variances in Variance Analysis

Material Variance

Under variance analysis, the following are the variances that constitute material variance –

Material Cost Variance

Material cost variance is the difference between the actual cost of direct material used and the standard cost of direct materials specified for the output achieved. This variance results from differences between quantities consumed and quantities of materials allowed for production and from differences between prices paid and prices predetermined.

This can be calculated by using the following formula –

Material Cost Variance = Standard Cost – Actual Cost

Material Cost Variance = (Standard Quantity X Standard Price) – (Actual Quantity X Actual Price)

Material Usage Variance

The material usage variance results when actual quantities of raw materials used in production differ from standard quantities. A material usage variance is favorable when the total actual quantity of direct materials used is less than the total standard quantity allowed for the actual output.

This can be calculated by the following formula –

Material Usage Variance = (Standard Quantity – Actual Quantity) X Standard Price

The material usage variance can be separated into material mix variance and material yield variance

Material Mix Variance

Material 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. A mix variance will result when materials are not actually placed into production in the same ratio as the standard formula.

It can be computed using the following formula –

Material Mix Variance = (Revised Quantity – Actual Quantity) X Standard Price

Revised Quantity means revised standard quantity

RQ = (Standard Quantity of Individual Item X Total Actual Quantity)/ Total standard quantity

Material Yield Variance

Material yield variance explains the remaining portion of the total materials quantity variance. It is the portion of material usage variance which is due to the difference between the actual yield obtained and standard yield specified.

Material 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. The total of material mix variance and material yield variance equals to material usage variance.

The formula for computing material yield variance is –

Material Yield Variance = (Actual Yield – Standard Yield Specified) X Standard Cost per unit

Material Price Variance

A Material variance price occurs when raw materials are purchased at a price different from the standard price. It is that portion of the direct materials which is due to the difference between the actual price paid and standard price specified and cost variance multiplied by the actual quantity.

Material price is unfavorable when the actual price exceeds the predetermined standard price. It is advisable that material price variance should be calculated for materials purchased rather than the material used.

Following is the formula for the computation for material price variance-

Material Price Variance = (Standard Price – Actual Price) X Actual Quantity

Computation of Material Variances

SQ = Standard Quantity
AQ = Actual Quantity
SP = Standard Price
AP = Actual Price
AY = Actual Yield
SY = Standard Yield
RQ = Revised Standard Quantity
SC = Standard Cost Per Unit

Answer

Revised Standard Quantity (RQ)

X = (110 X 30)/100 = 33

Y = (110 X 70)/100 = 77

Calculation of variances

Material Price Variance = (SP – AP) X AQ

X = (5 – 5) X 40 = NIL

Y = (4 – 5) X 70 = 70

MPV = ₹ 70

Material Usage Variance = (SQ – AQ) X SP

X= (30 – 40) X 5 = 50

Y= (70 – 70) X 4 = NIL

MUV = ₹ 50

Material Mix Variance = (RQ – AQ) X SP

X = (33 – 40) X 5 = 35

Y = (77 – 70) X 4= 28

MMV = ₹ 7

Material Yield Variance = (SY – AY) X SC per unit

MYV = (100 – 110) X (430/100) = ₹ 43

Material Cost Variance = SC – AC

MCV = (430 – 550) = ₹ 120

Labour Variance

Labour variances arise when actual labour cost is different from standard cost. In the analysis of labour costs, the emphasis is on labour rates and labour hours.

Under variance analysis, 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.

Following is the formula for computing labour cost variance-

Labour Cost Variance = Standard Cost – Actual Cost

Labour Cost Variance = (Actual Hours X Actual Rate) – (Standard Hours X Standard Rate)

Labour Efficiency Variance

Labour efficiency variance is also computed the same as material efficiency variance. Labour efficiency variance occurs when labour operations are more efficient or less efficient than standard performance.

Following is the formula for computing labour efficiency variance

Labour Efficiency Variance = (Actual Hours – Standard Hours) X Standard Rate per hour

Labour efficiency or usage variance can further be divided into two types

Labour Mix Variance

Manufacturing or completing a job requires different types or grades of workers and production will be completed if labour is mixed according to standard proportion. Labour mix variance is also calculated as the material mix variance.

Following is the formula for computing labour mix variance-

Labour Mix Variance = (Actual Labour Hours – Revised Standard Labour Hours) X Standard Rate per hour

Labour Yield Variance

The final product cost contains not only material costs but also labour cost. Therefore, gain or loss should take into account labour yield variance also.

Following is the formula for computing labour yield variance

Labour Yield Variance = (Actual Hours – Standard Hours) X Average Standard Labour Rate Per Unit Of Output

Labour Yield Variance = (Actual Loss Hours – Standard Loss hours) X Average Standard Labour Rate per unit of output

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 labour rate variance.

Following is the formula for computing labour rate variance –

Labour Rate Variance = (Actual Rate – Standard Rate) X Actual Hours

Idle Time Variance

Idle Time Variance forms a portion of wages efficiency variance. It is represented by the standard cost of the actual hours for which the workers remain idle due to abnormal circumstances.

Idle Time Variance = Idle Hours X Standard Rate

Computation of Labour Variances

Answer

Labour Cost Variance= (Standard Coast- Actual Cost) = 4536 – 6960 = 2424

Labour Rate Variance = (Standard Rate – Actual Rate) X Actual Hour

Skilled = (3 – 4) X 1120 = 1120

Semi-Skilled = (2 – 3) X 720 = 720

Unskilled = (1 – 2) X 160 = 160

LRV = 2000

Labour Efficiency Variance = (Standard Hours for Actual Output – Actual Hour) X Standard Rate

Skilled = (1152 – 1120) X 3 = 96

Semi-Skilled = (432-720) X 2 = 576

Unskilled = (216 – 160) X 1 = 56

LEV = 424

Labour Mix Variance = (Revised Standard Hours – Actual Hours) X Standard Rate

Skilled = (1280 – 1120) X 3 = 480

Semi Skilled = (480 – 720) X 2= 480

Unskilled = (240 – 160) X 1 =80

LMV = 80

Labour Yield Variance = (Standard Hours – Revised Standard Hours) X Standard Rate

Skilled = (1152 – 1280) X 3 = 3784

Semi-Skilled = (432 – 480) X 2 = 96

Unskilled = (216-240) X 1 = 24 LYV = 504

Also Read: CVP Analysis, Marginal Costing, Make or Buy Decisions, Standard Costing

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Cost Volume Profit Analysis is a method of accounting that looks at the impact that varying levels of costs and volume have on the operating profit of a business. It helps to understand the interrelationship between cost, volume, and profit in an organization.

There are three factors in Cost Volume Profit Analysis. These are

• Cost of production of goods
• Volume or quantity of goods which are produced and sold and
• Profit earned by the company.

Under Cost Volume Profit Analysis, we try to study the effect of change in one factor on the other factors. These factors are interdependent i.e. When there is a change in aby one factor the other factors are also changed. For example, when the cost of production changes the volume of sales will be affected and profit will also change. When volume changes cost and profit change.

Cost Volume Profit Analysis is a technique used by management for profit planning. It helps in studying “the effects on future profits with change in fixed cost, variable cost, sale price, quantity, and mix”. Cost Volume Profit Analysis is a part of the variable costing technique, which is one of the most useful techniques used by the management in decision making.

Cost Volume Profit Analysis is concerned with the effects on net operating income. Operating Income is expressed as:

Operating Income = Total Revenue – {Cost of Goods Sold + Operating Costs – Taxes}

Operating Income = Total Revenue – (Fixed Cost + Variable Cost)

Net Income = Operating Income – Taxes

Contribution Margin Analysis

The contribution margin per unit is the rupee amount contributed by the sale of one unit to fixed costs. The contribution margin ratio tells management how much of every rupee is going to contribute to covering fixed expenses up until the break-even point is reached. After the break-even point is reached, the contribution margin ratio tells management how much each rupee contributes to the company’s profit. It is calculated by subtracting the variable cost per unit from the sales price per unit.

Contribution = Sales – Variable Cost

Contribution = Sales (per unit) – Variable Cost (per unit)

Profit-Volume Ratio (PV Ratio)

Profit-volume ratio indicates the relationship between contribution and sales and is usually expressed in percentage.

The profit-volume ratio also measures the rate of change in profit due to the change in the volume of sales. It is influenced by the sales and variable or marginal cost. If the sales price increases without a corresponding increase in marginal cost, the contribution increases, and the profit-volume ratio improve. Similarly, if the marginal cost is reduced with sale price remaining the same profit-volume ratio improves. One fundamental property of the profit-volume ratio is that it remains the same at various levels of operations.

Following are some of the uses of profit volume ratio-

1. It helps in determining the break-even point.
2. It helps in determining profit at any volume of sales
3. It helps in determining the margin of safety.

It can be calculated by the following formulas –

P/V Ratio = Contribution/Sales

P/V Ratio = (Sales – Variable Cost)/Sales

P/V Ratio = 1 – (Variable Cost/Sales)

P/V Ratio = (Fixed Cost + Profit)/Sales

Break-Even Analysis

A break-even analysis is an analysis to determine the point at which revenue received equals the cost associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount by which the revenue exceeds the break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit.

Assumption of break-even analysis –

• All costs can be classified into fixed and variable cost
• Fixed costs remain fixed in the total amount
• The selling price does not change
• Variable cost varies directly in proportion to the volume of production
• General Price level does not change
• There will be no change in the productivity of workers
• Whatever is produced is sold out and there are no stocks of any type

Limitations of break-even analysis

• All cost cannot be classified into fixed and variable costs
• Fixed costs do not always remain fixed. These may change because of certain factors
• Variable cost does not always rise or fall in proportion to output
• The selling price does not remain fixed, it may change due to a change in external factors
• Labour productivity keeps on changing
• Sales and production are not always equal and generally, there are opening and closing stocks

To calculate the break-even point, first calculate the contribution margin which is calculated by subtracting the variable expenses from the company’s sales. Then divide the company’s fixed costs by the contribution margin.

Break Even Point = Total Fixed Cost / Contribution per unit

Break Even Point = Total Fixed Cost / (Selling Price per unit – Marginal Cost per unit)

Break Even Point = Fixed Cost / PV Ratio

Break Even Point = Fixed Cost x Sales / (Sales – Marginal Cost)

To calculate the level of sales required to earn a particular level of profit, the formula is:

Required Sales = (Fixed Cost + Desired Profit) / PV Ratio

Cost Volume Profit Analysis Sample Question

Total Sales = 20,000 units

Selling price = ₹ 150 per unit

Variable cost = ₹ 90 per unit

Fixed cost = ₹ 6,00,000

Desired Profit = ₹ 5,00,000

Calculate –

1. Contribution
2. PV Ratio
3. Break-Even Point
4. Margin of Safety
5. Operating Income
6. Selling price per unit if Break-Even Point is 1200 units?
7. Required sales to achieve desired profits?

Total Sales = 20000 X 150 = ₹ 30,00,000

Contribution = SP – VC = 150 – 90 = ₹ 60

PV Ratio = (S – VC)/S X 100 = (150 – 90)/150 x 100 = 40%

BEP = FC/Contribution = 600000/60 = 10000 units

MOS = Sales – BEP = 20000 – 10000 = 10000

Operating Income = TR – (FC + VC) = 3000000 – (600000 + 1800000) = ₹ 600000

When break-even point is 12000 units;

12000 = 600000/Contribution

 Contribution = 600000/12000 = ₹ 50

 Contribution = S – V i.e.  50 = S – 90

Therefore, Selling Price = 50 + 90 = ₹ 140

Required Sales = (FC + DP)/PV Ratio = (600000 + 500000) X100 /40 = ₹27,50,000

Also Read: Variance Analysis, Marginal Costing, Make or Buy Decision, Angle of Incidence

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In a break-even chart, the angle of incidence is formed at the break-even point where the total cost line intersects the total sales line. This angle shows the rate of profit earning of the company.

Basically the angle of incidence forms when the company’s sales line intersects with the company’s cost line from below in a break-even chart. The angle which is created by cost and sales line is called the angle of incidence. This angle is formed from the starting of a break-even point. The angle of incidence shows the rate at which a company is making profits.

The simple rule is that the bigger the angle of incidence higher is the rate of profit. A large angle of incidence indicates a company is making a profit at a higher rate similarly, a small angle of incidence shows that a company is making a profit at a lower rate. A small angle of incidence also shows that a company is incurring more variable costs. The best situation for a company is to have a big angle of incidence.

For a better understanding angle of incidence, we need to understand –

• Break-even Point   
• Break-even Chart
• Margin of Safety

BREAK-EVEN POINT

Break-even point is the production level when the company’s revenues for a product are equal to the company’s expenses.

Break-even point shows the level of production where a business will run at “no profit, no loss”. It is very important for all businesses to achieve a break-even point for any project.

It can easily be calculated by subtracting the margin of safety from actual sales. Or it can be calculated by dividing the fixed costs of production by the price per unit minus the variable cost of production.

In investing, the break-even point is said to be achieved when the market price of an asset is the same as its original cost.

Benefits of calculating break-even point –

• It helps in the measurement of profit and losses at different levels of production and sales.
• It helps in forecasting the possible effect of changes in selling price
• It coordinates the relationship between fixed and variable costs.

Disadvantages of calculating break-even point –

• It could be time-consuming to estimate the break-even point.
• It is only applicable to a single product or a single mix of products.
• It assumes sales prices are constant at all levels.

Let’s take an example to understand break-even point:

A company has Rs. 100000 in fixed costs and a gross margin of 25%. The break-even point for the company would be 400000 (100000/0.25).

This means the company needs to generate 400000 of revenues in order to meet their fixed and variable costs. If they generate more than that, the company will have profit and if they generate less than that, the company will have a loss.

BREAK-EVEN CHART

A break-even chart is a graphical representation of the relationship between costs, volume, and profit. It depicts the break-even point in a graphical manner. A Break-even chart is a very important tool for profit planning of any business.

Let’s have a look on steps for constructing break-even chart-

• First step is to plot sales or production in units on the horizontal axis.
• Second step is to plot costs and revenues on the vertical axis.
• After that, we need to draw a fixed cost line parallel to the horizontal axis.
• Next step is to draw a line from the point of fixed costs line which is starting from the vertical axis.
• Last step is to draw a line starting from point zero and finish at the maximum point of the scale.

Now, as said above break-even point is the point where both cost and sales line intersect, and angle of incidence is the angle made from the intersection of both cost and sales line. It represents the whole area between the two lines.

MARGIN OF SAFETY

Margin of safety is the difference between actual sales and break-even point. It can be expressed as –

Margin of safety = Actual Sales – Break-Even Point

In simple words margin of safety measures the business risk. Larger the margin of safety more sound is the condition of business in respect of profit earning. A large margin of safety indicates a larger amount of profit and a lower or smaller margin of safety indicates lower profits. Margin of safety is directly related to profit. It can be shown by the following formula-

Profit = Margin of safety X P/V Ratio

Basically margin of safety is the limit to which the actual or estimated sales exceed the break-even sales.

Conclusion

At last, we can say that if the break-even sales are low and the angle of incidence is large, it means the margin of safety is high which reflects that a business is stable. If the break-even sales are higher, the angle of incidence would be narrow and the margin of safety would be low, which shows instability in a business.

Also Read: Marginal Costing and Absorption Costing, Standard Costing, Marginal Costing and Decision Making

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Standard costing is a technique of costing which is used to compare the costs and revenues associated with a product with the actual results and determining the variances. It analyses the productivity of an organization.

Standard costing focuses on measuring the performance, controlling the deviations, inventory valuation, and deciding the selling price of the product.

Need for Standard Costing

• Standard costing helps in estimating the future costs for the company because it is prepared after considering all the possibilities that may arise in the future. It also tells whether a company should undertake a project or not.
• It helps in doing a performance check of the work. It helps in comparing the performance with actual results.
• Standard costs help in preparing a budget and evaluate the performance on the basis of this budget.

Process of Standard Costing

Following are the steps which are to be taken while doing standard costing-

1. Establishing Standards – The first step is to set the standards on the basis of management’s estimation. Basically standards are set considering the past data, future trends, and production plan.
2. Determination of Actual Costs – When the standards are set the second step is to determine the costs for each element like material, labor, and overhead.
3. Comparison of Actual Costs and Standard Cost – The next step is to compare the standard cost with the actual cost to determine the variances.
4. Determination of Causes – Once the comparison is done, the next step is to find out the reason for the variance so that corrective measures can be taken.
5. Disposition of Variances – The last step involves the disposition of variances by transferring it to the profit and loss account.

Difference between Standard Cost and Estimated Cost

Establishing Standard Costing System

Establishing a standard costing system requires the following requisites for accomplishing the desired results.

• Acceptance of the system – The standard costing systems only give desired results when it is acceptable by both management and the workers. Both parties should take enough interest in the system to make it effective.
• The judicious setting of standards – The standards should be fixed after a careful study of all technical processes and operations of a business. They should be fixed judiciously and they should neither be too high nor be too low. It should be achievable.
• Reasonable size – The system can prove to be an advantage in businesses that are of reasonable size. The system may not be suitable for small businesses since in their case careful scheduling of production may not be possible.
• Competent staff – The successful operation of the technique requires the existence of well-qualified staff for fixing the standards and measuring performance and reporting variances at different levels.
• Existing of budgetary control system – Existence of budgetary control system is a prerequisite for the standard costing system. The Budget sets the targets which the executive has to achieve. They create a sense of discipline among all the employees.
• Proper delegation of authority – Standard costing system requires proper delegation of authority and responsibility at different levels. This can be done by drawing an organization chart clearly dictating the responsibilities and authority of all the employees.

Read Next: Variance Analysis, CVP Analysis

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Marginal Costing is a very useful decision-making technique. It helps management to set prices, compare alternative production methods, set production activity level, close production lines, and choose which of a range of potential products to manufacture.

Following are some techniques which highlight the application of marginal costing in decision making-

PROFIT PLANNING

Profit planning is the planning of future operations to attain maximum profit. Under this technique, the contribution ratio indicates the relative profitability of the different products of the business wherever there is any change in the volume of sales, total fixed costs, selling price, etc.

PRICING OF PRODUCTS

This is one of the most important techniques in marginal costing and decision making. Generally, prices are determined by demand and supply of products or services. But under special market conditions, marginal costing is helpful in deciding the price at which the management should sell.

These special market conditions are following-

• Selling in the foreign market i.e. export prices may have to be decided. The export price may be lower than the price at which the product is selling in the domestic market.
• In times of cutthroat competition, the market price of products may fall below total cost. The management should be compelled to sell at a price which is below total cost. But the price should not be below the variable cost.

MAKE OR BUY DECISION

Under this technique, the company has to decide whether they should make the product or they should buy the product from outside sources. For making such a make or buy decision, a comparison should be made between the variable cost of manufacture of the product and the supplier’s price for it.

It will be advantageous to make a product than to purchase it if the variable cost is lower than the purchase price provided, as the decision to manufacture does not result in the substantial increase in the fixed costs and that the existing manufacturing facilities can be utilized more profitably. If the decision to manufacture involves an increase in fixed cost, it should also be added to the marginal cost for the purpose of comparison with the purchase price of the product.

So, the decision will be to purchase if the marginal cost of the manufacturer plus fixed costs plus loss of contribution is more than the purchase price.

Example Question

Question – XYZ. Ltd produces a variety of products each having a number of components parts. Product B takes 5 hours to produce on a particular machine, which is working at full capacity. B has a selling price of ₹ 100 and a variable cost of ₹ 60 per unit. A component part Z could be made on the same machine in two hours at a variable cost of ₹ 10 per unit. The suppliers’ price for the component is ₹ 25 per unit. You are required to advise whether the company should buy the component Z. If necessary make a suitable assumption.

Answer

Selling price of B = ₹ 100

Variable cost of B = ₹ 60

Contribution from B = ₹ 100 – ₹ 60 = ₹ 40

Contribution of B per hour = ₹ 40/5 = ₹ 8

Variable cost of Z Component = ₹ 10

Loss of contribution from B if Z is manufactured = ₹ 8 X 2 HRS = ₹ 16

Total cost of Z, if manufactured = ₹ 10 + ₹ 16 = ₹ 26

Supplier price = ₹ 25

As the supplier price is lower than own cost. It is advisable to buy the component from the supplier. It is given that the company is already working 100% capacity.

EXPLORING NEW MARKETS

Companies make a constant effort in exploring new markets to sell more and more so that they can fully utilize their plant capacity. The marginal costing technique helps in deciding the minimum price at which to sell in the foreign markets or home markets and widening their area of operation in various markets.

DETERMINING PRIORITY OF PRODUCTS

In those businesses, which manufacture more than one product, there arises a problem of determining the priority of products to be manufactured. In such a situation the management is faced with the problem of which product should be manufacture in large quantities as compared to other products. This is because the cost-profit relation of various products differs and products should be produced in large quantities which makes a larger contribution per unit. Thus, the data required for determining the priority of products is that which is required for calculating contribution.

In other words analysis of cost into fixed and variable and data regarding selling price is needed to determine the most profitable product mix. From such data, one can compute contribution and thus determine the priority of products. Apart from these cost factors, certain non-cost factors, or qualitative factors like the continuity of supply, the quantity of products, terms of supply, no price change in the near future should also be considered.

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Marginal Costing is the process of ascertaining marginal cost, by differentiating between fixed cost and variable cost, and of the effect on profit of changes in volume or type of output.

In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred.

Features of Marginal Costing

The main features of marginal costing are as follows-

• This technique is used to ascertain the marginal cost and to know the impact of variable cost on the value of output.
• All the costs are classified into fixed cost and variable costs. Semi-variable costs are segregated into fixed and variable costs.
• The stock of finished goods and work-in-progress are valued on the basis of variable costs.
• Two integral parts of this analysis are break-even analysis and cost-volume-profit analysis.
• The relative profitability of products or departments is based on the contribution made available by each department or product.

Advantages of Marginal Costing

• The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs.
• Marginal cost provides all the related and useful data for managerial decision making.
• There is no problem of over or under absorption of overheads.
• This technique can be used along with other techniques such as budgetary control and standard costing.
• It establishes a clear relationship between cost, sales, output, and break-even analysis.
• It shows the relative contribution to profit and where the sales effort should be concentrated.

Disadvantages of Marginal Costing

•  The separation of costs into fixed and variable elements includes considerable technical difficulty.
• It ignores fixed costs to products as if they are not important to production.
• The value of a stock cannot be accepted by taxation authorities since it deflates profit.
• The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable.
• This technique is less effective when there is an increase in the use of automatic machinery because it will increase the fixed costs but marginal costing increase the fixed costs.
• Pricing decisions cannot be based on contribution alone.

Absorption Costing

Absorption costing is the oldest and widely used method of ascertaining cost. Under this technique of costing, the cost is made up of direct costs plus overhead costs absorbed on some suitable basis.

It is the practice of charging both variable and fixed costs to operations, processes, and products. Under this technique cost per unit remains the same only when the level of output remains the same.

Absorption coating is useful if there is only one product, there is no inventory and overhead recovery rate is based on normal capacity instead of the actual level of activity.

Advantages of Absorption Costing

• It suitably recognizes the importance of including fixed manufacturing costs in product cost determination and framing a suitable policy.
• It shows correct profit calculation in a case where a product is manufactured to have sales in the future as compared to variable costing.
• It avoids the separation of costs into fixed and variable elements which cannot be done easily.
• It helps to calculate the net profit and gross profit separately in the income statement.
• It helps to make the managers more responsible for the costs and services provided to their departments.

Limitations of Absorption Costing

• Absorption costing makes comparison and control of cost difficult because it is dependent on the level of output; so different unit costs are obtained for different levels of output. An increase in the output normally results in reduced unit cost and a reduction in the output result in an increased cost per unit due to the existence of fixed expenses.
• Absorption costing is not very helpful in taking managerial decisions such as a selection of suitable product mix, choice of alternatives, and the number of units to be sold to earn the desired profit, etc.
• In absorption costing no distinction is made between the fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.
• In absorption costing, costs are vitiated because of fixed costs included in inventory valuation.

Difference between Marginal Costing and Absorption Costing

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Fund flow statement is a statement which shows the sources and uses of funds for a period of time. It is a method by which we study changes in the financial position of a business enterprise between the beginning and ending financial statement dates.

According to Anthony “the fund flow statement describes the sources from which additional funds were derived and the use to which these sources were put.”

The basic purpose of a fund flow statement is to reveal the changes in the working capital on the two balance sheet dates. It also describes the sources from which additional working capital has been financed and the uses to which working capital has been applied.

USES OF FUND FLOW STATEMENT

Following are the uses of fund flow statement –

• Helps in the analysis of financial operations – The fund flow statement discloses the causes for changes in the assets and liabilities between two different points of time and also the effect of these changes on the liquidity position of the company. Sometimes a concern may operate profitability and yet its cash position may become worse. The fund flow statement gives a clear answer to such a situation explaining what has happened to the profits of the firm.
• Helps in the formation of realistic dividend policy – A fund flow statement helps in the formation of realistic dividend policy in those cases when sometimes a firm has sufficient profits available for distribution as dividend but yet it may not be advisable to distribute a dividend for lack of liquid or cash resources.
• Helps in proper allocation of resources – A projected fund flow statement made for the future helps in making managerial decisions regarding the best use of resources. The firm can plan the expansion of these resources and allocate them among various applications.
• Future guide – Fund flow statement also acts as a future guide to the management. The firm’s future needs of funds can be projected well in advance and also the timing of these needs. The firm can arrange to finance these needs more effectively and avoid future problems.
• Helps in knowing the creditworthiness of a firm – All financial institutions ask for a fund flow statement before granting loans to know the creditworthiness and paying capacity of the firm. So if a firm seeking financial assistance from these institutions has no other option than to prepare a financial statement.

LIMITATIONS OF FUND FLOW STATEMENT

Fund flow statement has a number of limitations as well and those are as follows:

• Fund flow statement is not a substitute for an income statement or a balance sheet. It only provides additional information regarding changes in working capital.
• It is historic in nature which means they provide data on the basis of past records and it cannot be much accurate.
• It does not have that much importance than cash flow statements as it only shows the changes in working capital.
• It cannot reveal continuous changes.
• Fund flow statement is not an original statement but simply a rearrangement of the data given in the financial statements.

SOURCES OF FUNDS

Some of the most important sources of funds for a business are as follows-

FUNDS FROM OPERATIONS OR TRADING PROFITS

Funds from operations are one of the main sources of funds. Sales are the main source of inflow of funds as they increase the current assets. The net effect of operations will be a source of funds if inflow from sales exceeds the outflow for expenses and the cost of goods sold and vice-versa. It should be noted that the funds from operations do not necessarily mean the profit as shown by the profit and loss account.

There are two methods of calculating funds from operations-

1. The first method is to prepare the profit and loss account considering only fund and operational items which involve funds and are related to the normal operations of the business.

2. The second and most used method is to proceed from the figure of net profit or net loss as arrived at from the profit and loss account already prepared.

FUNDS FROM THE ISSUE OF SHARE CAPITAL

When there is an increase in the share capital, whether preference or equity, it means capital has been raised during the year. The issue of shares is a source of funds as it shows the inflow of funds.

Net proceeds from the issue of share capital are also a source of funds.

Although the following should be considered –

• Making of partly paid shares as fully paid out of profits in the form of bonus shares is not a source of funds.
• Issues of shares for other than current assets such as against purchase of land, machine, etc. do not amount to an inflow of funds.
• Conversion of debentures or loans into shares also does not amount to an inflow of funds

ISSUE OF DEBENTURES AND RAISING OF LOANS

The issue of debentures and raising of loans results in the flow of funds into the business. However, loans raised for consideration other than a current asset, such as for the purchase of a building, will not constitute inflow of funds because in that case, the accounts involved are only fixed non-current.

SALE OF FIXED ASSETS AND LONG TERM OR TRADE INVESTMENTS

When any fixed or non-current assets like land, building, plant, etc. are sold it generates funds and becomes a source of funds. But when one fixed asset is exchanged for other fixed assets than it cannot be considered as inflow of funds.

NON TRADING RECEIPTS

Any non-trading receipt like dividend received, refund tax, rent received, etc. also increases funds and is treated as a source of funds because such an income is not included in the funds from

DECREASE IN WORKING CAPITAL

If the working capital decreases during the current period as compared to the previous period, it means that there has been a release of funds from working capital and it constitutes a source of funds.

FUND FLOW ANALYSIS

Fund flow analysis is the analysis of the flow of funds from current assets to fixed assets or current assets to long term liabilities or vice-versa. Fund flow statement analysis is one of the basic tools for stock analysis. Fung flow statement analysis helps investors in identifying the key areas of utilization of funds for the company during any period along with the key sources of funds.

Funds flow analysis provides great help to investors in finding companies, which are giving loans to promoters/ related parties, etc. The movement of funds in the company’s balance sheet can be assessed by doing a comparative assessment of different sections of the balance sheet. It should be prepared by comparing the change in the value of their previous year and the current year.

• Equities and liabilities – Any increase in the liabilities section mean that the company has received funds and vice-versa when there is a decrease in the liabilities section.
• Assets – Any increase in the asset section means outflow of funds and vice-versa when there is a decrease in the asset section.

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Cash flow analysis is the evaluation of a company’s cash inflows and outflows from operating, financing and investing activities.

It shows how the company is generating its money, where it is coming from, and what it means about the overall value of the company.

Cash flow analysis should be done at least once a month to ensure your company has a healthy cash budget. For, a small business owner, performing a cash flow analysis regularly is essential for success. After all, running short of cash is one of the most common causes of small business failure. The good news: regular analysis of your cash flow can help you avoid this pitfall and manage your business more effectively.

BASICS OF CASH FLOW ANALYSIS

Monitoring cash flow is key to a healthy business. A cash flow statement is a deep dive into your business’s financial health and is a way to inspect your cash flow in and out throughout a given period of time.

It can help you better understand where your money is going and how much cash you have at any given time.

IMPORTANCE OF CASH FLOW ANALYSIS –

Creating a cash flow statement is a great first step, but if you don’t know how to read or analyze it, it is not incredibly useful. A cash flow analysis gives you a well-rounded picture of your business’s financial health. Just as keeping an eye on your personal checkbook balance tells you whether you can afford certain personal expenses.

Regularly analyzing your business cash flow will tell you whether you’ll be able to make payroll, pay your suppliers, and buy the materials to fulfill orders, or carry out expansion plans.

If your cash flow statement shows you are running short of cash to meet expenses, you can plan ways to cut costs, obtain short term financing, or take steps to accelerate income. If your cash flow analysis shows you have extra cash on hand, consider whether to invest it in new equipment or save for future slow periods.

HOW TO CONDUCT A CASH FLOW ANALYSIS

The first step of cash flow analysis is, of course, creating a cash flow statement.

Start creating a cash flow statement by taking your company’s total cash balance at the beginning of the chosen time period and entering it into your spreadsheet.

Next, fill in the blanks by adding cash inflows (money coming in) and outflows (money going out) in three categories: operating activities, investment activities, and financing activities. Inflows are to be marked as positive (+) and outflows are to be marked as negative (-).

• Operating activities: operating inflows include money received from sales/paid receivables. Operating outflow includes money paid to suppliers, employee payroll, any taxes not related to investing or financing and depreciation or amortization of business assets.

• Investing activities: money spent on purchasing assets should be marked as outflow; money gained from selling or renting them out is considered inflow.

• Financing activities: getting a loan for business would be recorded as an inflow; however each payment made on the loan would be recorded as outflow.

Once all the relevant transactions on the cash flow statement are recorded add everything up to arrive at the closing balance (the amount left at the end of the cash flow statement period). If the closing balance is higher than the opening balance than the cash flow is positive. If it is lower than the cash flow is negative.

By examining the cash flow statement a company can figure out possible ways to remedy the problem. To cover the shortfall, they can either cut the costs or increase income.

Read next: Fund Flow Analysis, Financial Statement Analysis

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Meaning of Ratio Analysis

Ratio analysis is the process of analysis and interpretation of the figures appearing in the financial statement (i.e. profit and loss account, balance sheet, and fund flow statement etc.)

It is a very important tool useful for measuring the performance of an organization. It enables users like shareholders, investors, creditors, government, and analysts, etc. to get a better understanding of financial statements.

Advantages of Ratio Analysis

• Decision making – Ratio analysis helps in validating the financial, investment and operating decisions of the firm. They summarize the financial statement into comparative figures thus helping the management to compare and evaluate the financial position of the firm and help them in taking the right decisions.
• Simplifies complex accounting – Ratio analysis helps in simplifying the complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long term positions, etc.
• Identify problem areas – Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the pinpoint such problems.
• Comparative – it allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons, etc. this will help the organization better understand its fiscal position in the economy.
• Easy to understand – Ratio analysis makes it easy to understand the data because it represents the data in a plain form. A user can decide an enterprise by just looking at a few numbers rather than understanding the complete financial statement.

Limitations of Ratio Analysis

• Window dressing – The firm can make some yearly changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.
• Ignores price level changes – Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.
• Quantitative only – Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects.
• Different accounting policies – different accounting policies regarding the valuation of inventories, charging depreciation, etc. make the accounting data and accounting ratios of two firms non-comparable.
• Casual relationship is a must – Proper care should be taken to study only such figures as have a cause and effect relationship otherwise ratios will only be misleading.

Classification of Ratios

Profitability Ratios

This type of ratio analysis suggests the returns that are generated from the business with the capital invested.

Profitability ratios can be further divided into four categories-

GROSS PROFIT RATIO – It represents the operating profit of the company after adjusting the cost of the goods that are been sold. Higher the gross profit ratio, lower the cost of goods sold and greater the satisfaction of the management.

Gross profit ratio = Gross profit/Net profit X 100

NET PROFIT RATIO – It represents the overall profitability of the company after deducting all the cash and cash expenses. Higher the net profit ratio higher the net worth and stronger the balance sheet.

Net Profit after tax/Net Sales X 100

OPERATING PROFIT RATIO- It represents the soundness of the company and the ability to pay off its debt obligations.

Operating profit ratio = Earnings before interest and tax/Net sales X 100

RETURN ON CAPITAL EMPLOYED – Return capital employed represents the profitability of the company with the capital invested in the business.

Return on capital employed = Earnings before interest and tax/capital employed

Solvency ratios

These ratio analysis types suggest whether the company is solvent and is able to pay off the debts of the lenders or not.

Solvency ratio can be divided into two types-

DEBT-EQUITY RATIO – This ratio represents the leverage of the company. A low debt-equity ratio means that the company has a lesser amount of debt on its books and is more equity diluted. The ideal debt-equity ratio of any company should be 2:1.

Debt equity ratio= Total debt/ Shareholders fund

Where,

Total debt = Long term debt + Short term debt + Other fixed payments

Shareholders fund = Equity share capital+ Reserves+ Preference share capital – fictitious assets

INTEREST COVERAGE RATIO – It represents how many times the company’s profits are capable of covering its interest expenses. It also signifies the solvency of the company in the near future. Higher the ratio of more comfort to the shareholders and lenders for the smooth functioning of the business operations.

Interest coverage ratio = Earnings before interest and tax/Interest expenses

 

Liquidity ratio

This ratio represents whether the company has enough liquidity to meet its short term obligations or not. Higher the ratio more cash-rich the company.

Liquidity ratio can be divided into two categories –

QUICK RATIO – It represents how cash rich the company is to pay off its immediate liabilities in the short term.

Quick ratio = Quick Assets (cash and cash equivalents + marketable securities + accounts receivable) / Current liabilities

CURRENT RATIO – It represents the liquidity of the company in order to meet its obligations in the next 12 months. Higher the current ratio, stronger the company to pay its current liabilities.

Current ratio = Current assets/Current liabilities

 

Turnover ratio

These ratios signify how efficiently the assets and liabilities of the company are been used to generate revenues.

Turnover ratio can be divided into three categories-

INVENTORY TURNOVER RATIO – It represents how fast the company is able to convert its inventory into sales.

Inventory turnover ratio = Cost of goods sold/ Average inventories

RECEIVABLES TURNOVER RATIO – This ratio reflects the efficiency of the company to collect its receivables. It signifies how many times the receivables are converted into cash.

Receivables turnover ratio = Net credit sales/ average receivables

FIXED ASSET TURNOVER RATIO – It represents the efficiency of the company to generate revenue from its assets. It is a return on investment in fixed assets.

Fixed assets turnover ratio = net sales/ average fixed assets

 

Earning ratios

This ratio analysis type speaks about the returns that the company generates for its shareholders and investors.

Earning ratio can be divided into three categories-

P/E RATIO – This ratio represents the earnings multiple of the company. A high P/E ratio is a positive sign for the company since it gets a high valuation in the market.

P/E Ratio = Market price per share/ earnings per share

EARNINGS PER SHARE – It represents the monetary value of the earnings of each shareholder. It is one of the major components looked at by analysts while investing in the equity market.

Earnings per share= (net income – preferred dividends)/(weighted average of shares outstanding)

RETURN ON NET WORTH – This ratio represents how much profit the company generated with the invested capital from equity and preference shareholders both.

Return on net worth = net profit/ equity shareholders fund

Where,

Equity shareholders fund = equity+ preference+ reserves – fictitious assets

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