Accounting for Managers: Principles and Standards, Financial Statements and their Analysis, Cost Sheet, Marginal Costing, CVP and Variances

Ratio analysis compares within the firm over time (trend), against the industry (cross-section) and against standards, and its limits are historical data, window dressing, price-level changes, differing accounting policies and the absence of a single correct norm. Common-size statements express every item as a percentage of sales or total assets; comparative statements show absolute and percentage change; trend percentages index each year to a base year. Funds flow analysis (AS 3 before 1997) explains the change in working capital between two balance sheets: a schedule of changes in working capital is prepared from current items, and a funds flow statement lists sources (funds from operations — net profit adjusted for non-fund and non-operating items such as depreciation, goodwill written off, loss on sale of assets — issue of shares and debentures, sale of fixed assets, long-term borrowing) and applications (purchase of fixed assets, redemption, repayment of loans, dividend and tax paid); only transactions between a current and a non-current item are 'flows'. Cash flow analysis (AS 3 revised, Ind AS 7) explains the change in cash and cash equivalents under three heads — operating (from the main revenue activities, by the direct method listing cash receipts and payments or the indirect method adjusting profit before tax for non-cash items and working-capital changes), investing (purchase and sale of long-term assets and investments, interest and dividend received by a non-financial company) and financing (equity and debt raised or repaid, interest and dividend paid). Funds flow is broader and accrual-based; cash flow is narrower, cash-based and mandatory. DuPont analysis (developed at Du Pont in the 1920s by Donaldson Brown) decomposes return on equity into three drivers: ROE = net profit margin (PAT ÷ sales) × asset turnover (sales ÷ total assets) × equity multiplier (total assets ÷ equity), so profitability, efficiency and leverage can be judged separately; the five-step version splits margin into tax burden, interest burden and operating margin.

1. Prime cost = direct materials consumed (opening stock + purchases − closing stock of raw material) + direct labour + direct expenses (chargeable expenses).
2. Factory (works) cost = prime cost + factory overheads (indirect materials, indirect labour, power, depreciation of plant, factory rent) + opening work-in-progress − closing work-in-progress.
3. Cost of production = factory cost + office and administration overheads (salaries, office rent, audit fees, depreciation of office equipment).
4. Cost of goods sold = cost of production + opening stock of finished goods − closing stock of finished goods.
5. Cost of sales (total cost) = cost of goods sold + selling and distribution overheads (advertising, salesmen's commission, carriage outward, warehousing); sales = cost of sales + profit. Items excluded from cost: income tax, dividends, interest on capital, donations, goodwill written off, abnormal losses, cash discount, capital expenditure.

Costs are classified by nature (material, labour, expense), by function (production, administration, selling, distribution, research), by traceability (direct and indirect), by behaviour (fixed, variable, semi-variable, step), by controllability, by normality (normal and abnormal), by time (historical, predetermined) and for decisions (sunk, opportunity, relevant, differential, imputed, out-of-pocket, shut-down, marginal). Marginal cost is the change in total cost from one more unit — the variable cost per unit in the short run — and marginal costing (variable costing, direct costing) charges only variable costs to products and treats fixed costs as period costs written off against contribution: contribution = sales − variable cost, and contribution − fixed cost = profit. Absorption costing, by contrast, charges fixed production overhead to products, so stock carries fixed cost and profit differs between the two methods whenever production differs from sales — absorption profit is higher when stock rises. Marginal costing's decision uses: fixing selling prices (including below total cost in a recession, so long as price exceeds variable cost), make or buy, accepting a special order or export order at a lower price when spare capacity exists, product mix under a limiting (key) factor by ranking contribution per unit of the scarce resource, shut-down or continue, and choice of technique; its limits are the difficulty of separating semi-variable costs and the undervaluation of stock, which Ind AS 2 does not permit for external reporting.

Standard costing sets predetermined costs — what a unit should cost under efficient conditions — and compares them with actual costs, so that the differences, the variances, direct management's attention to where performance departed from plan: management by exception. Standards may be basic, ideal, attainable (currently attainable, the usual choice) or expected. Setting them needs technical studies of material specification and usage, time and motion studies of labour, and overhead budgets with a normal capacity. A variance is favourable when actual cost is below standard and adverse (unfavourable) when above, and each is split so that the responsibility can be located — the purchasing manager for price, the production manager for usage. Variance analysis compares budgeted profit with actual profit through cost variances (material, labour, overhead) and sales variances (price and volume); in a flexible-budget system the fixed-overhead volume variance is the part that arises from producing more or fewer units than the budget assumed. Standard costing works best in repetitive manufacturing and is criticised in lean and JIT environments for rewarding volume and hiding quality.