Management Accounting

Management Accounting

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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 “Journal” or subsidiary books. The number of subsidiary
books to be maintained will be according to the nature and size of the business.
2. Classifying: Classification 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 book called “Ledger”. The Ledger contains different pages of
individual account heads under which all financial transactions of similar nature
are collected. For example the expenses may be classified under various heads
like Travelling, Communication, Printing and Stationery, Advertisement etc. All
the entries in the Ledger shall flow based on the entries passed in the Journal.
The Ledger accounts will help in knowing the total expenditure under various
heads for a given period.
3. Summarizing: This involves presenting the classified data in a manner which is
understandable and useful to the internal as well as external end-users of
financial statements. This process involves preparation of a) Trial Balance b)
Income Statement c) Balance Sheet.
4. Deals 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 books of
accounts. For example a company, which has a team of employees with sound
technological knowledge, cannot expressed in terms of financial numbers and
hence will not be recorded in the books of accounts of the company.
5. Interpretation: This is the final function of the accounting. The recorded financial
data is interpreted in a manner that the end-users can make a meaningful
judgement 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 executing such plans.

Objectives of Accounting

The following are the main objectives of the accounting:

1. To keep systematic records: Accounting is done to keep 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.

2. To protect business properties: Accounting provides protection to business

properties from unjustified and unwanted use. This is possible by providing
information the following information to the management:
(i) The amount of owner’s fund invested in the business;

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(ii) How much the business owes to others;

(iii) How much the business has to recover from others;
(iv) How much business owns the assets;

The information helps the management in ensuring that the assets do not
remain idle of under-utilized.
3. 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 expenses for a particular period.
4. To ascertain the financial position of the business: The profit and loss
accounts reflect the performance of the business during a particular period.
However, it is also necessary to know the financial position i.e. where do we
stand. What we owe and what we own. The objective is met by Balance
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.
5. To help rational decision – making: Accounting these days has taken upon
itself the task of collection, analysis and reporting of information at the
required points of time to the required level of authority in order to facilitate
rational decision-making.

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Q5. What do you man by Bank Reconciliation Statement? Why is it

prepared? Give a standard format of Bank reconciliation statement.

Answer. A form that allows individuals to compare their personal bank account
records to their account balance according to the bank in order to uncover any
possible discrepancies.
Since there are timing differences between when data is entered in the banks
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.
Need for Bank Reconciliation Statement

‘Reconciliation’ between the cashbook and the bank statement final balance simply
means an explanation of the differences. This explanation takes the form of a written
calculation (see page xx for an example). The process can be seen as follows:

Differences between the cashbook and the bank statement can arise from:

 Timing of the recording of the transactions

 Errors made by the business, or by the bank

PREPARING THE BANK RECONCILIATION STATEMENT

When a bank statement has been received, reconciliation of the two balances is
carried out in the following way:
Step 1 The cashier will tick off the items that appear in both the cashbook and the
bank statement.
Step 2 The unticked items on the bank statement are entered into the bank columns
of the cashbook to bring it up to date.
Step 3 The bank columns of the cashbook are now balanced to find the revised
figure.
Step 4 The remaining unticked items from the cashbook will be the timing
differences.
Step 5 The timing differences are used to prepare the bank reconciliation statement

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Management Accounting

Custome
r Banks'
Accounts Accounts
Current
"Customer
Account
" Account
with the
Bank

Debit
Credit
Details Debit Credit
Balance to
reconciliatio
n date,
30.6.xx 1,000 1,500
Amounts
appearing
only on the
Bank
Statement
30.6.xx
Credit:
Interest 50
30.6.xx
Debit: Bank
charges 10
27.6.xx
Credit: Error 300
Amounts
that
appear
only in our
accounts
30.6.xx
Check to
supplier, Not
yet
presented to
bank 160
1050 10 460 1,500
Adjusted
Balance as
at 30.6.xx 1,040 1,040
Debit

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Q 14. Write Short notes on any three :

Answer.

Cash budget

A forecast of estimated cash receipts and disbursements for a specified period of

time.
A cash budget is extremely important, especially for small businesses because it
allows a company to determine how much credit can be extended to customers
before they begin to have liquidity problems.
A cash flow budget is a projection of your business's 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. However, a
cash flow budget could predict the cash inflows and outflows on a weekly or daily
basis. Because of the uncertainty involved in the cash flow budget, trying to project
too far into the future may prove to be less than worthwhile. At the same time, a cash
flow budget that doesn't look far enough into the future will not predict future events
early enough for you to take corrective action in your cash flow.
A six-month cash flow budget minimizes the amount of uncertainty involved in the
budget. It also predicts future events early enough for you to take corrective action.
However, if you're applying for a loan, you may need to create a cash flow budget
that extends 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 business's ability
to take in more cash than it pays out. This will give you some indication of your
business's ability to create the resources necessary for expansion, or its ability to
support you, the business owner. The cash flow budget can also predict your
business's cash flow gaps — periods when cash outflows exceed cash inflows when
combined with your cash reserves. You can take 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 looking to outside sources of cash, such as a short-term loan, to fill the
cash flow gaps.

Flexible Budget

A set of revenue and expense projections at various production or sales volumes. The
cost allowances for each expense are able to vary as sales or production vary.
A flexible budget is developed using budgeted revenues or cost amounts based on
the level of output actually achieved in the budget period. A key difference between a
flexible budget and a static budget is the use of the actual output level in the flexible
budget.

Steps in developing a Flexible Budget –

Step 1: Determine budgeted selling price, budgeted variable cost per unit, and
budgeted fixed cost.
Step 2: Determine the actual quantity of output.
Step 3: Determine the flexible budget for revenues based on budgeted selling price
and actual quantity of output.
Step 4: Determine the flexible budget for costs based on budgeted variable costs per
output unit, actual quantity of output, and the budgeted fixed costs.

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Under Absorption and Over Absorption of Overheads

In Cost 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:

Total overheads of the cost center

Overhead absorption Rate = _____________________
Total quantum of base

The base (denominator) is selected on the basis of type of the cost center and its
contribution to the products or services, for example, machine hours, labour
hours, quantity produced etc.

Overhead absorbed = Overhead absorption rate x units of base in product or

service

A pre-determined rate may be used on a provisional basis for internal

management decision-making such as cost estimates for quotation, fixation of
selling price etc. These rates are to be calculated for each cost center for a
particular period. Budgeted overheads for the respective cost centers for the
period concerned are to be taken as numerator and budgeted normal base for
the period as denominator for determining the rate.
Budgeted Overheads for
the period
Pre-determined overhead Rate = _______________________________
Budgeted 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.
Overheads shall be analysed into variable overheads and fixed overheads.

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The variable production overheads shall be absorbed to products or services based

on actual capacity utilisation.

The fixed production overheads and other similar item of fixed costs such as quality
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-absorption of overheads shall be

adjusted with Costing Profit & Loss Account. In case of higher production than normal,
the over-absorption of overheads shall also be adjusted with Costing Profit & Loss
Account.

Q3) Write an essay on “Depreciation”.

Ans 3) Depreciation is the part of the value of fixed 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 fixed assets due to normal wear and tear, obsolescence of
the efflux ion of time, the literal meaning of depreciation is reduction of value.
International Accounting Standard(IAS)-4 defined depreciation as – “The
allocation of the depreciable amount of an asset over its estimated useful life.”
According to Indian Accounting Standard (AS)-6 – “Depreciation is a measure
of the wearing out, consumption or other loss of value of depreciable asset arising
from use, efflux ion of time or obsolescence through technology or market 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 fixed assets that left after the end of its
lifetime is assumed as the value consumed up between the date of acquisition and
the and the date of exhaustion.
The object 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 expected to be received from an asset in
each accounting period.
The time horizon or the expected useful life period of each fixed asset as well
as its salvage value at the end of that period can be anticipated.
Depreciation 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 :
By the opinion of Committee on concepts and standards on Depreciation of
AICPA in 1957 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. B) Consumption 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 fixed asset in each accounting period within its life time, whereas in
service potential concepts the consumed up portion of the total service receivable

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from a fixed asset in each accounting period within its life time is treated as
depreciation.
III) Provision for maintenance of capital :
Depreciation is also regarded as a means of recovery of capital invested in
fixed assets and it is needed for maintaining capital intact. The capital outlay for fixed
asset is gradually and continuously used up or consumed in different accounting
periods within the life time of the fixed assets.
The Financial Accounting Standard Board (FASB) and the American Accounting
Association (AAA) of USA gave the recognition to this maintenance of capital
concepts of depreciation. The committee on Concepts and Standards-Long 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 (ARS) NO. 3 published by the AICPA
sprouse and Mootinz 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 drawback of this concept lies in the difficulty in measurement of
current cost or replacement cost of fixed assets. Due to technological development it
is difficult to replace the old asset by an exactly similar asset.

• Causes of Depreciation :
Permanent fall in the value of any fixed asset or depreciation takes 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 exhaustion of the potential utility of the asset as a result of continuous use.
Careless handling of asset is also responsible for quick loss of its value.
II) Wasting asset :
Stock of wasting assets gets depleted in a normal process due to extraction or
use of the same. The continuous extractions of mineral or oil reduces their stock and
ultimately over the time the said stock gets fully exhausted.
III) Efflux of time :
Assets like leasehold property, patent right, copyright. Etc. get exhausted not
due to use but on account of efflux of time.
IV) Accident or abnormality :
Happening any abnormal event like 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) Inadequacy :
Sometimes an asset, even it has the productive value, may be replaced by
another more productive asset. Such ineffectiveness of asset is caused by its
inadequacy to cope up with the changed situation.

• Characteristic of depreciation :
The following are the character tics of depreciation :
I) Related to tangible fixed assets
Depreciation is charged only on tangible fixed asset like building, plant,
furniture etc. It is not provided on current assets or non tangible fixed assets.
II) Charge against profit :
Depreciation is a charge against profit, it is not allocation of profit. Before
ascertaining income depreciation is matched against revenue as a cost.
III) Permanent and gradual loss of utility :

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Depreciation indicates permanent and gradual loss of service rendering

capacity of fixed assets that cannot be received back.
IV) Effective within the working life :
At the end of the useful economic life of a fixed asset it is assumed to be fully
exhausted with no service rendering capacity. So the value of any fixed asset is
charged in each accounting period within its working life.
V) Assumption based :
Charging of depreciation is always based on a number of assumptions
regarding the economic life of fixed assets, stability of market price etc.

• Measurement of depreciation :
Depreciation must be properly measured. It is an extremely important job of the
accountants.
I) Cost of asset :
Cost price of asset includes its gross value. Cost may be taken as historical
value, current market price or replacement cost. In conventional accounting system
cost is assumed as historical cost.
II) Incidental expense :
Legal expenses, commission, inward freight, import duty, carrying cost etc.
paid in connection with acquisition of assets are taken as incidental expenses and
treated as capitalized cost of assets.
III) Other factors :
Some factors are consideration for the purpose of measuring of depreciation.
(a) Cost of extension or improvement of fixed assets.
(b) Replacement cost involved.
(c) Efficiency with which the asset is used.
(d) Interest expected in case the amount spent for purchase of fixed assets
were invested outside the business in securities.
(e) Legal restrictions particularly the provisions of Income Tax Act regarding
depreciation, etc.
• Problems of measurement of depreciation :

The problem that may creep on while measuring depreciation are as follows :
I) Assessment of working life :
It is really difficult to measure the correct assessment of the working life of the asset.
Instead of exact working life only the probable useful period may be assumed.
Usually such assessment is made on the basis of quality of the assets, past
experience and expert’s opinion.
II) Unexpected changes :
A fixed asset may become obsolete or loses its value due to partial
obsolescence if there is any change in customers’ choice or behavior or any new
technology is innovated.
III) Uneven use :
For measuring depreciation on the basis of use of the asset it is required t
assess its use properly. There is every possibility that the asset is not use evenly in
different accounting periods. Efficiency in use of the asset may also vary.

• Methods of depreciations :
Methods of depreciation are as follows :
I) Methods based on costs allocation concept
(a) Time based method
(a.i) Fixed installment method.
(a.ii) Diminishing balance method.
(a.iii) Double declining balance method.

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(a.iv) Sum of the years’ digit method.

(b) Use based method
(b.i) Working hours method.
(b.ii) Production unit method.
(b.iii) Mileage method.

II) Methods based on capital maintenance concept

(a) Sinking fund method.
(b) Annuity method.
(c) Insurance policy method.

III) Other methods

(a) Revolution method.
(b) Depletion method.
Composite or group method.
Q7) Explain step-by-step procedure of identifying the direct material cost
with the individual cost center. Give the formats of various documents
which are prepared in the process.

Ans7) Direct 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 objective of cost accounting i.e ascertainment of cost and control
of cost is equally applicable to material cost as well. However, 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. Procurement of materials.
b. Storing the material till it is required for consumption.
c. Issue of the material for consumption.
d.
(a) Procurement of materials :
(b)
Though the practices may differ from organization to organization, normally the
process of purchasing the materials involves the following stages.

(1) Purchase requisition :

(2)
It is an indication to the purchase department to purchase certain material. It is
issued by storekeeper or by production department. Followings particulars must
appear in purchase requisition.
(i) Material to be purchased : It should clearly specified with the specific
code number. To make it more specific, addition to the description of
the material required.
(ii) When it is required : Unless the material is required for regular
production purposes, purchase requisition should mention the last date
by which the material is required.
(iii) How much to be purchased : Purchase requisition should mentioned
clearly the quantity of the material required. Before deciding the exact
quantity this should be remembered of overstocking of material as
both these situations involve costs.

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A standard form of purchase requisition is shown below :

Purchase Requisition
To : Purchase Department From : Department
No :
Date :

Please purchase the material stated below.

Sr. No Description Code No. Quantity Required Quantity on hand Remarks

Signed by : Approved by :

For the use of Purchase Department Only

Date P.O. No. Name Of Supplier Delivery Date Remarks

Signed : Purchase Manager

(2) Selection of source of supply : Purchase department call the quotations from the
prospective suppliers of a certain type of material. Followings types of quotations
may be called for :
(i) Single Tender.
(ii) Limited Tender.
(iii) Open tender.
(iv) Global tender.

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(3) Purchase 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 :
(i) Material to be supplied.
(ii) Quantity to be supplied.
(iii) Price and other specific terms (If any).
(iv) Cash and trade discount.
(v) Instruction in respect of delivery
(vi) Guarantee clause.
(vii) Escalation clause.
(viii) Inspection clause.
(ix) Methods of settlement or disputes.
(x) Details in respect of letters of credit, import license etc.
(xi) Details in respect of interest payable in the event of late payment of dues.
Purchase order are distributed on some terms which are as follows :
o One to supplier.
o One to user department.
o One to stores department.
o One to accounts/costing department.
o One with Purchase department.

A Standard Form of Purchase Order is as shown below :

Purchase Order
No :
Date :

Requisition No :
Date :
Please supply the following material on such terms and conditions as stated therein :

Description Code No Quantity Rate Rs. Value Rs. Delivery Date Remar
ks

Delivery : Goods to be delivered at -

Extra as applicable -

Excise Duty

Sales Tax
Packing Charges

Insurance
For -------------------- (Purchasing Company)
Terms of payment
Purchase Manager
(4) Receipt and Inspection : After material is received from the supplier, the
quantity r

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received actually, is compared with quantity ordered. Excess material received may
be dealt with in any of the following ways :
(i) Accept all the material received.
(ii) Accept the material ordered and return the excess to the supplier.

(5) Checking invoice and accounting for purchases : The supplier’s invoice received
for the supply of material is subjected to security before a voucher is passed for the
same for making the entry in the books of accounts. For this purpose, the supplier’s
invoice may be compared along with the following documents.
(i) Purchase order.
(ii) Goods Received Note.
(iii) Inspection Report.
(c) Storing 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 required for
use by production departments and issuing the same whenever required.
(i) Receipt of material.
(ii) Issue of material.
(iii) Return of material from production department to stores department.
(iv) Transfer of material.

GOODS RECEIVED NOTE

No :
Date :

S.No Description Code Qty. Recd. Qty. Accepted Qty. Rejected Remarks

Prepared By Received by Inspected by Store Keeper

Material Receipt : The material physically received when compared with material
ordered as per the purchase order may reveal certain discrepancies which may take
any of the following forms :
(i) Quantity received in excess.
(ii) Quantity received in short.
(iii) Quantity received of different quality.

Excess quantity received may be retained an accepted. If required it is returned to

the supplier with Goods Returned Note which is shown here :

GOODS RETURNED NOTE

To : No :
Date :

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Following material supplied by you vide your D.C No.____________ and invoice
No._______________ against our purchase Order No._____________ is being returned to you for
the reasons stated below :
Description Quantity Reasons

(C) Issue of material :

Signature

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
Material Requisition Note which contents are :
(i) Number and Date.
(ii) Department demanding the material.
(iii) Quantity of material demanded.
(iv) Signature of authority approving the demand.
(v) Signature of the person receiving the material.
Material Requisition forms are shown as follows :

MATERIAL REQUISITION SLIP

Production/Job Order No. No.
Bill of Materials No. Date.
Department :

Description Code Qty Unit Cost (for costing dept. only)

Rate per unit Amount Rs.

Authorized by Issued by Received by Entered and valued by

Material is returned back if it is in excess in quantity. So, this is the final stage to
complete the procedure.
Q11) With the help of a Simple Break Even Chart and Contribution Break
Even Chart, Explain the significance and method of calculation of the
following terms –
a. Contribution
b. Profit Volume Ratio
c. Break Even Point
d. Margin of Safety
e. Angle of Incidence.

Ans 11) Cost volume profit relationship can expressed in the form of visual like
graphs and charts. There are various types of chart and graphs are available. Here is

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a detail of the above terms by the help of break-even chart. This are the followings
where the terms are described in short.

a) Contribution : The term contribution can be expressed in two ways basically :

I ) Sales – Variable Cost
II ) Fixed Cost + Profit
In the short period, Fixed 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.
Further, 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 fixed cost to different products. This is due
to the fact that marginal costing ignores the fixed costs.

b) Profit Volume Ratio : This ratio indicates the contribution earned with respect to
one rupees of sales. It is expressed as followings :

In the short run Rs. 10 per unit, variable cost is Rs. 6 Per unit, and fixed cost are Rs.
300, we observe that for 100 and 150 units , P/V ratio work out as followings.
100 Units 150 Units
Rs. Rs.
Sales --- 1000 1500
Variable Cost --- 600 900
------------------ ------------------
Contribution --- 400 600
Fixed Cost --- 300 300
------------------- -------------------
Profit --- 100 300

Hence, P / V Ratio is :
Contribution 400 600
------------------ * 100 = --------------- * 100 = --------------- * 100
Sales 1,000 1,500

Or i.e 40 % = 40 %

Increase in Profits 200

------------------------- * 100 i.e ----------- * 100 = 40 %
Increase of Sales 500

The fundamental concept of P/V ratio is that it remains constant remains at all levels
of activities, provided per unit sales price and variable cost remains constant. A high
P/V ratio indicates that slight increase in sales without corresponding increase in fixed
cost will result in higher profits and vice-versa while a low ratio indicates low
profitability.
So, the basic expression of P/V ratio i.e contribution/sales may lead to other useful
conclusions as -
(a) Sales * P/V Ratio = Contribution
(b) Contribution
----------------- = Sales
P/V Ratio

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C) Break 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 just enough to cover the
fixed costs i.e contribution = Fixed Cost. It also means that contribution generated by
all sales beyond Break Even point will directly result into profits. As such, it will be
intention of every business to reach the Break Even point, as early as possible. It can
expressed in two ways such as,

Fixed Costs
(a) In terms of quantity = --------------------------------
Contribution per unit
Fixed Cost
(b) In term of amount = --------------------------------
P / V ratio

d) Margin of Safety : These are the sales beyond Break Even Point. A business will
looking like 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 break even point is much below the actual sales and even if
there is reduction in sales, business will still in profits. But a low margin of safety
accompanied by high fixed cost and high P/V ratio that indicates more efforts are
required to be made for reducing the fixed cost or increasing sales volume. Margin of
safety may expressed by the following way :

Margin Of Safety = Sales - Break Even Sales

Fixed Cost
= Sales - --------------------
P / V Ratio
Sales * P/V Ratio - Fixed cost
Margin Of Safety = -----------------------------------------------
P/V Ratio
Contribution - Fixed Cost
= -----------------------------------------------
P/V Ratio
Profit
= ------------------------------
P/V Ratio

Margin of safety may be expressed as a ratio or as a percentage.

Sales - Break Even point

--------------------------------------------- * 100
Sales
i.e. 1.00.000 - 60,000 40,000
------------------------------------------- * 100 = ------------ *
100
1,00,000 1,00,000
i.e. 40 % of sales.

f) Angle of Incidence : 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 break-even chart. Contribution break-even chats are as follows :

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Contribution break even chart:

TS = Total Sales Line FC = Fixed Cost

TC = Total Cost Line VC = Variable Cost
BEP = Break Even Point MOS = Margin Of Safety
SL = Selected Level Of Activity Angel a = Angle Of
Incidence
C = Contribution

This is a chart where the COST – VOLUME – PROFIT relationship expressed more
clearly and specifically compared to simple break-even chart. Contribution break-
even chats are as follows :

Simple break even chart :

TS = Total States Line FC = Fixed Cost

TC = Total Cost Line BEP = Break Even
Point MOS = Margin Of Safety Angel a = Angle
Of Incidence
SL = Selected Level Of Activity

The limitation of simple Break Even Chart is that contribution cannot be shown
separately. The above Break Even Chart may be prepared i.e Contribution Break Even
Chart.

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