i. Ratio Analysis
Ratio analysis is a study of relationship among various financial factors in a business like sales, gross profit, net profit, stock, debtors, fixed assets etc. It is a technique of analysing the financial statements by computation of ratios. Ratio analysis acts as an important and effective control device in an organization. It is the process of establishing a significant relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a firm. Ratio analysis focuses attention on relative figures which should be significantly related. For example, figure of sales when related to the figure of gross profit will indicate gross margin earned on sales. This means both the figures in the ratio are significantly related. Ratio analysis seeks to measure the effectiveness and profitability of the various functions.
Controlling process starts when the accounting ratios are compared with theirown past ratios or with the ratios of similar firms in the same industry. For example, a Fruit Jelly manufacturer measures that his gross profit ratio for current year is 18% whereas in the immediate past year it was 22%. Thus, on comparing the gross profit ratio he finds the deviation. Now he has to take remedial action to improve the ratio.
Some of the important ratios used in controlling the affairs of a business are:
i)Return on Investments (ROI)
ii) Net profit to Sales (Net Profit Ratio)
iii) Sales to Capital employed (Capital Turnover Ratio)
iv) Gross profit to Sales (Gross Profit Ratio)
v) Sales to Working Capital Ratio (Working Capital Turnover Ratio)
vi) Stock Turnover Ratio
vii) Operating Ratio
viii) Current Ratio
ix) Debtors' Turnover Ratio
Let's now discuss these ratios.
i) Return on Investments (ROI)
This ratio shows the relationship between net profit (before interest and tax) and capital employed. It indicates how efficiently the capital employed in the business has been used. In other words it shows the firm's ability to generate profit per rupee of capital employed. It is a measure of overall profitability of an enterprise.
Higher the ratio the better it is.
Formula: Return on investment (ROI) =
Net profit (( before int erest and tax)/Capital employed))× 100
where Capital employed = Fixed assets + Working capital
For example, a company manufacturing various bakery items has earned a net profit (before interest and tax) of Rs. 4,00,000 during the current financial year.
The company has Rs. 16,00,000 as capital employed. The ROI works out to 25%. In the same industry ROI is 20%. This means the company has used its capital efficiently.
ii) Net Profit to Sales (Net profit ratio)
This ratio shows the relationship between net profit and net sales. It measures the rate of net profit on net sales. It helps in ascertaining the efficiency with which the affairs of the firm are being managed particularly its marketing. In case the ratio increases, it indicates improvement whereas if it declines, it reveals inefficiency in the management of the affairs of the firm.
Formula: Net profit Ratio=Net Sales × 100=((Net profit)/(Net Sales))*100
For example, the net profit of a firm is Rs. 1,00,000 and the net sales is Rs. 4,00,000. In this case, the Net Profit Ratio is 25% as calculated below:
Net Profit Ratio = 1,00,000/4 ,00,000 × 100 = 25% =(1,00,000/4,00,000)*=25%
In the corresponding next year, if the Net Profit Ratio works out to 30% it will show efficiency in the management of the affairs of the firm.
iii) Sales to Capital Employed (Capital Turnover Ratio)
This ratio shows the relationship between net sales and capital employed. It indicates the firm's ability to generate sales per rupee of capital employed. Higher the ratio the better it is.
Formula:
Capital Turnover Ratio =Net sales/Capital employed
where Capital employed = Fixed assets + Working capital
For example, net sales of a company is Rs. 8,00,000. The company has Rs.2,00,000 as capital employed. The Sales to Capital employed (Capital Turnover Ratio) works out to 4 times. i.e.
(8 , 00 , 000/2 , 00 , 000)=4
iv) Gross Profit to Sales (Gross Profit Ratio)
This ratio shows the relationship between gross profit and net sales. It indicates the gross margin earned on sales.
Formula: Gross Profit Ratio (GP Ratio) =(Gross profit/Net sales)× 100
For example, a spices manufacturing unit earns a gross profit of Rs. 5,00,000 during the current financial year. Its net sales (i.e. gross sales - sales returns) are Rs. 25,00,000. In this case the GP ratio works out to 20%. Higher the ratio the better it is.
v) Sales to Working Capital Ratio (Working Capital Turnover Ratio)
This ratio shows the relationship between net sales and the working capital. It indicates the efficiency with which the firm has utilised its working capital. In other words it signifies the ability of the firm to generate sales per rupee of working capital. Higher the ratio the better it is.
Formula:
Working Capital Turnover Ratio =(Net sales/Working capital)× 100
where Working capital = Current assets - Current liabilities
For example, a grocery dealer's sales during the current financial year are Rs. 18,00,000. His working capital is Rs. 6,00,000. In this case Sales to Working Capital Ratio (Working Capital Turnover Ratio) works out to 3 times.
vi) Stock Turnover Ratio
This ratio shows the relationship between cost of goods sold and the average stock. It indicates the efficiency with which the firm has utilised its stock. In other words it signifies the speed with which stock is converted into sales. Higher the ratio the better it is. Formula:
Stock Turnover Ratio =Cost of goods sold/Average stock
where (i) Cost of goods sold = Opening Stock + Purchases + Direct Expenses- Closing Stock and (ii) Average Stock = (Opening Stock + Closing Stock) / 2.
For example a flavour milk manufacturer's cost of goods sold during the current financial year amounted to Rs. 10,00,000. His average stock during this period was Rs. 2,00,000. In this case Stock Turnover Ratio works out to 5 times.
vii) Operating Ratio
This ratio measures the relationship between operating cost and net sales. It indicates the operational efficiency with which the production or purchases or selling operations are carried on. Lower the ratio the better it is.
Formula:Operating ratio =(Operating cost/Net sales)× 100
where (i) Operating Cost = Cost of goods sold + other operating expenses like administrative expenses, selling and distribution expenses etc.For example a ghee manufacturer's cost of goods sold during the current financial year amounted to Rs 10,00,000 and other operating expenses were Rs. 75,000.His sales during this period were Rs. 25,00,000 whereas sales returns were Rs.50,000. In this case the operating ratio works out to 43.88% as calculated below:Operating Ratio = 10,75,000/24,50,000*100 = 43.88%.
viii) Current Ratio
This ratio measures the relationship between current assets and current liabilities.It indicates the ability of the firm to meet its short term obligations. In other words it shows short term financial solvency of the firm. Ideal current ratio is 2:1.
Formula:Current Ratio =Current assets/Current liabilitie s
where (i) Current assets = Cash and bank balance, marketable securities, debtors,bills receivables, stock, prepaid expenses etc. and (ii) Current liabilities = creditors,bills payable, bank overdraft, short term loans etc.
For example a ghee manufacturer's current assets as on 31st March 2004 were Rs. 6,00,000 and current liabilities were Rs. 3,00,000. In this case the current ratio works out to 2:1.
ix) Debtors' Turnover Ratio
This ratio measures the relationship between net credit sales and average debtors.It indicates the ability of the firm to collect its trade debtors. In other words it shows the speed with which the debtors are collected. A high ratio indicates shorter collection period i.e. debtors are repaying promptly.
Formula:Debtors' Turnover Ratio =Net credit sales/Average debtors
Where Average Debtors = Opening Debtors (including opening bills receivable)+ Closing Debtors (including closing bills receivable) / 2.
For example a ghee manufacturer's net credit sales for the year 2004 were Rs.90,00,000 and average debtors were Rs. 15,00,000. In this case the Debtors'
Turnover Ratio works out to 6 times.ii. Cost Analysis and Control
This analysis is associated with various costs of the firm. Cost control is important because all the businessmen - whether operating on a small scale or large scale- always try to contain their all types of costs. For a successful analysis, the businessman should himself have a very clear idea of all the costs. He should also have an effective system to measure and analyse them systematically. Various costs may include - cost of production; cost of credit sales; selling and distribution costs; inventory costs; channel costs; marketing research costs; advertising costs;sales promotion costs etc.
These costs should be measured against the results produced by incurring them.The results may take the form of sales revenue generated, gross profit achieved etc. The efficiency of each product, channel, customer-class, and salesmen should be analysed by measuring their respective contribution to profit of the firm on the one hand and to the overheads on the other.Cost analysis should also include standard costing for various management functions.
It is not enough that costs should be compared with the budgeted costs only. The firm should develop standard costs for each function of market and measure actual cost with the standards set.
Cost analysis helps the businessman in the following ways:
Ratio analysis is a study of relationship among various financial factors in a business like sales, gross profit, net profit, stock, debtors, fixed assets etc. It is a technique of analysing the financial statements by computation of ratios. Ratio analysis acts as an important and effective control device in an organization. It is the process of establishing a significant relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a firm. Ratio analysis focuses attention on relative figures which should be significantly related. For example, figure of sales when related to the figure of gross profit will indicate gross margin earned on sales. This means both the figures in the ratio are significantly related. Ratio analysis seeks to measure the effectiveness and profitability of the various functions.
Controlling process starts when the accounting ratios are compared with theirown past ratios or with the ratios of similar firms in the same industry. For example, a Fruit Jelly manufacturer measures that his gross profit ratio for current year is 18% whereas in the immediate past year it was 22%. Thus, on comparing the gross profit ratio he finds the deviation. Now he has to take remedial action to improve the ratio.
Some of the important ratios used in controlling the affairs of a business are:
i)Return on Investments (ROI)
ii) Net profit to Sales (Net Profit Ratio)
iii) Sales to Capital employed (Capital Turnover Ratio)
iv) Gross profit to Sales (Gross Profit Ratio)
v) Sales to Working Capital Ratio (Working Capital Turnover Ratio)
vi) Stock Turnover Ratio
vii) Operating Ratio
viii) Current Ratio
ix) Debtors' Turnover Ratio
Let's now discuss these ratios.
i) Return on Investments (ROI)
This ratio shows the relationship between net profit (before interest and tax) and capital employed. It indicates how efficiently the capital employed in the business has been used. In other words it shows the firm's ability to generate profit per rupee of capital employed. It is a measure of overall profitability of an enterprise.
Higher the ratio the better it is.
Formula: Return on investment (ROI) =
Net profit (( before int erest and tax)/Capital employed))× 100
where Capital employed = Fixed assets + Working capital
For example, a company manufacturing various bakery items has earned a net profit (before interest and tax) of Rs. 4,00,000 during the current financial year.
The company has Rs. 16,00,000 as capital employed. The ROI works out to 25%. In the same industry ROI is 20%. This means the company has used its capital efficiently.
ii) Net Profit to Sales (Net profit ratio)
This ratio shows the relationship between net profit and net sales. It measures the rate of net profit on net sales. It helps in ascertaining the efficiency with which the affairs of the firm are being managed particularly its marketing. In case the ratio increases, it indicates improvement whereas if it declines, it reveals inefficiency in the management of the affairs of the firm.
Formula: Net profit Ratio=Net Sales × 100=((Net profit)/(Net Sales))*100
For example, the net profit of a firm is Rs. 1,00,000 and the net sales is Rs. 4,00,000. In this case, the Net Profit Ratio is 25% as calculated below:
Net Profit Ratio = 1,00,000/4 ,00,000 × 100 = 25% =(1,00,000/4,00,000)*=25%
In the corresponding next year, if the Net Profit Ratio works out to 30% it will show efficiency in the management of the affairs of the firm.
iii) Sales to Capital Employed (Capital Turnover Ratio)
This ratio shows the relationship between net sales and capital employed. It indicates the firm's ability to generate sales per rupee of capital employed. Higher the ratio the better it is.
Formula:
Capital Turnover Ratio =Net sales/Capital employed
where Capital employed = Fixed assets + Working capital
For example, net sales of a company is Rs. 8,00,000. The company has Rs.2,00,000 as capital employed. The Sales to Capital employed (Capital Turnover Ratio) works out to 4 times. i.e.
(8 , 00 , 000/2 , 00 , 000)=4
iv) Gross Profit to Sales (Gross Profit Ratio)
This ratio shows the relationship between gross profit and net sales. It indicates the gross margin earned on sales.
Formula: Gross Profit Ratio (GP Ratio) =(Gross profit/Net sales)× 100
For example, a spices manufacturing unit earns a gross profit of Rs. 5,00,000 during the current financial year. Its net sales (i.e. gross sales - sales returns) are Rs. 25,00,000. In this case the GP ratio works out to 20%. Higher the ratio the better it is.
v) Sales to Working Capital Ratio (Working Capital Turnover Ratio)
This ratio shows the relationship between net sales and the working capital. It indicates the efficiency with which the firm has utilised its working capital. In other words it signifies the ability of the firm to generate sales per rupee of working capital. Higher the ratio the better it is.
Formula:
Working Capital Turnover Ratio =(Net sales/Working capital)× 100
where Working capital = Current assets - Current liabilities
For example, a grocery dealer's sales during the current financial year are Rs. 18,00,000. His working capital is Rs. 6,00,000. In this case Sales to Working Capital Ratio (Working Capital Turnover Ratio) works out to 3 times.
vi) Stock Turnover Ratio
This ratio shows the relationship between cost of goods sold and the average stock. It indicates the efficiency with which the firm has utilised its stock. In other words it signifies the speed with which stock is converted into sales. Higher the ratio the better it is. Formula:
Stock Turnover Ratio =Cost of goods sold/Average stock
where (i) Cost of goods sold = Opening Stock + Purchases + Direct Expenses- Closing Stock and (ii) Average Stock = (Opening Stock + Closing Stock) / 2.
For example a flavour milk manufacturer's cost of goods sold during the current financial year amounted to Rs. 10,00,000. His average stock during this period was Rs. 2,00,000. In this case Stock Turnover Ratio works out to 5 times.
vii) Operating Ratio
This ratio measures the relationship between operating cost and net sales. It indicates the operational efficiency with which the production or purchases or selling operations are carried on. Lower the ratio the better it is.
Formula:Operating ratio =(Operating cost/Net sales)× 100
where (i) Operating Cost = Cost of goods sold + other operating expenses like administrative expenses, selling and distribution expenses etc.For example a ghee manufacturer's cost of goods sold during the current financial year amounted to Rs 10,00,000 and other operating expenses were Rs. 75,000.His sales during this period were Rs. 25,00,000 whereas sales returns were Rs.50,000. In this case the operating ratio works out to 43.88% as calculated below:Operating Ratio = 10,75,000/24,50,000*100 = 43.88%.
viii) Current Ratio
This ratio measures the relationship between current assets and current liabilities.It indicates the ability of the firm to meet its short term obligations. In other words it shows short term financial solvency of the firm. Ideal current ratio is 2:1.
Formula:Current Ratio =Current assets/Current liabilitie s
where (i) Current assets = Cash and bank balance, marketable securities, debtors,bills receivables, stock, prepaid expenses etc. and (ii) Current liabilities = creditors,bills payable, bank overdraft, short term loans etc.
For example a ghee manufacturer's current assets as on 31st March 2004 were Rs. 6,00,000 and current liabilities were Rs. 3,00,000. In this case the current ratio works out to 2:1.
ix) Debtors' Turnover Ratio
This ratio measures the relationship between net credit sales and average debtors.It indicates the ability of the firm to collect its trade debtors. In other words it shows the speed with which the debtors are collected. A high ratio indicates shorter collection period i.e. debtors are repaying promptly.
Formula:Debtors' Turnover Ratio =Net credit sales/Average debtors
Where Average Debtors = Opening Debtors (including opening bills receivable)+ Closing Debtors (including closing bills receivable) / 2.
For example a ghee manufacturer's net credit sales for the year 2004 were Rs.90,00,000 and average debtors were Rs. 15,00,000. In this case the Debtors'
Turnover Ratio works out to 6 times.ii. Cost Analysis and Control
This analysis is associated with various costs of the firm. Cost control is important because all the businessmen - whether operating on a small scale or large scale- always try to contain their all types of costs. For a successful analysis, the businessman should himself have a very clear idea of all the costs. He should also have an effective system to measure and analyse them systematically. Various costs may include - cost of production; cost of credit sales; selling and distribution costs; inventory costs; channel costs; marketing research costs; advertising costs;sales promotion costs etc.
These costs should be measured against the results produced by incurring them.The results may take the form of sales revenue generated, gross profit achieved etc. The efficiency of each product, channel, customer-class, and salesmen should be analysed by measuring their respective contribution to profit of the firm on the one hand and to the overheads on the other.Cost analysis should also include standard costing for various management functions.
It is not enough that costs should be compared with the budgeted costs only. The firm should develop standard costs for each function of market and measure actual cost with the standards set.
Cost analysis helps the businessman in the following ways:
- It helps to control and reduce all types of costs.
- Cost reduction leads to savings.
- It leads to alternate ways of performing functions to reduce the costs.
- Prices can be kept at competitive rates if costs are reduced.
- The businessman can drop unprofitable customers, products, dealers etc. from the list.
A businessman generally prefers to sell his goods on cash basis. It is because of the following reasons:
- No risk of bad debts.
- Less working capital required because of continuous cash generation.
- Short operating cycle.
Despite above advantages of selling goods on cash basis, the businessman may still be forced to sell goods on credit basis on instalment basis to achieve higher turnover. There may be number of problems attached to the selling of goods on credit or instalment basis like:
- Interest on money involved.
- Money blocked for longer period of time.
- Legal hassles i.e. court cases if money is not realized.
- Loss due to insolvency of debtors.
- More accounting work involved.
Despite these problems a businessman sells his goods on credit or instalmentbasis because he has to survive in the market, and higher turnover may off set losses and such sales.In case he sells his goods on credit basis, he should frame a clear credit policy.The businessman should also have a proper credit control system on the following lines:
i)Credit should be extended to the customers and dealers after a proper credit rating is made. A credit rating analysis would reveal the soundness of the customers and dealers. No-risk customers may be extended large credit limits.High-risk customers could be given credit only if bank guarantee or collateral security is made available.
ii) The businessman should also adhere to the prescribed credit limits.
iii) As a part of credit control system he should analyse the accounts receivables and bad debts. The number, type, extent and integrity of the debtors or the reason for a debt to become bad must be brought out by the analysis. The age of debtors outstanding should be determined (i.e. 15 days old debts, 30 days old debts, 45 days old debts, 180 days old debts, 365 days old debts etc.)from time to time and based on this analysis corrective action should be taken.
iv) A proper credit control system will ensure that the cost of credit is built to the price itself.
v) Strategies like offering cash rebates in lieu of credit can be thought of. Cash discounts may be offered for quick recoveries.
iv. Budgetary Control
A budget is a plan for some specific future period. It is based on objective to be attained. It is expressed in monetary or physical units. A budgetary control is a system in which all operations are forecast and planned and the actual results are compared with the forecast and the planned ones for reviewing policy are programme for the balance period or for next period.
Budgetary control can be applied to every function of the business i.e. production,finance, human resources, marketing etc. It corrects the deviations from pre-planned path through observation, research, reporting, planning and decision making.
The future activities of the business can thus, be performed in an orderly way.
The procedure of budgetary control involves the following steps:
i)Establishing the budgets.
ii) Continuous comparison of actuals with budgets by preparing control statements which will show:
i)Credit should be extended to the customers and dealers after a proper credit rating is made. A credit rating analysis would reveal the soundness of the customers and dealers. No-risk customers may be extended large credit limits.High-risk customers could be given credit only if bank guarantee or collateral security is made available.
ii) The businessman should also adhere to the prescribed credit limits.
iii) As a part of credit control system he should analyse the accounts receivables and bad debts. The number, type, extent and integrity of the debtors or the reason for a debt to become bad must be brought out by the analysis. The age of debtors outstanding should be determined (i.e. 15 days old debts, 30 days old debts, 45 days old debts, 180 days old debts, 365 days old debts etc.)from time to time and based on this analysis corrective action should be taken.
iv) A proper credit control system will ensure that the cost of credit is built to the price itself.
v) Strategies like offering cash rebates in lieu of credit can be thought of. Cash discounts may be offered for quick recoveries.
iv. Budgetary Control
A budget is a plan for some specific future period. It is based on objective to be attained. It is expressed in monetary or physical units. A budgetary control is a system in which all operations are forecast and planned and the actual results are compared with the forecast and the planned ones for reviewing policy are programme for the balance period or for next period.
Budgetary control can be applied to every function of the business i.e. production,finance, human resources, marketing etc. It corrects the deviations from pre-planned path through observation, research, reporting, planning and decision making.
The future activities of the business can thus, be performed in an orderly way.
The procedure of budgetary control involves the following steps:
i)Establishing the budgets.
ii) Continuous comparison of actuals with budgets by preparing control statements which will show:
- Budgeted figures
- Achieved figures
- Variances
iii) Placing the responsibility for failure to achieve the budgeted figures.
iv) Revision of budgets.
Advantages of budgetary control.
Following are the advantages of budgetary control:
i)It helps in bringing efficiency and economy in the working of the business enterprise.
ii) It fixes responsibility on every division or department of the enterprise.
iii) It coordinates the various divisions of a business i.e. production, marketing etc.
iv) It serves as an automatic check on the decisions of the management.
v) Credit agencies favour that organisation which operates through a well-ordered budget plan.
v. Break-even Analysis
Break-even analysis is yet another controlling device which can be used by a businessman. It is an important tool of profit planning. It is also called cost-volume-profit (CVP) analysis. It facilitates cost control by measuring operational efficiency. At break-even point the businessman neither makes profit nor incurs losses. For calculating break-even point we need to understand the following
concepts:
i) Fixed costs (FC): Fixed costs are those costs which remain constant whether there is increase or decrease in production over a given period of time. These costs are fixed in nature and are incurred as soon as the business is started. This concept of fixed costs remains valid up to a particular level of operation.
Examples of fixed costs are - rent of the premises, salaries of the employees,depreciation, interest charges on long term debts, insurance premium, property tax etc. Even if there is no production, these fixed costs will be incurred. Suppose, a flavoured milk manufacturer incurs Rs. 40,000 towards fixed costs for manufacturing sterilized flavoured milk bottles. In this case fixed costs are Rs.40,000 which shall be considered for calculating break-even point.
ii) Variable costs (VC): Variable costs are those costs which vary according to the level of production attained. They will increase if the production is increased even by one unit or decrease when there is decrease in production.
Such costs are - raw material costs, wages to the workers, water charges, oil and fuel etc.
For calculating break-even point, generally we consider variable cost per unit of production. Suppose variable cost incurred for manufacturing 10000 flavoured milk bottles is Rs. 60,000. In this case per unit variable cost works out to Rs.50,000.
Note: For the purpose of calculating total cost of production we have to add fixed cost and variable cost. Thus,
Total Cost = Fixed cost (FC) + Variable cost (VC)
iii) Selling price: Selling price is that price at which the goods are sold. Usually, we consider selling price per unit for calculating break-even point. For example, a flavoured milk bottle is priced at Rs. 10.00 It means that it will be sold to the
consumers at this price. Thus Rs. 10.00 is the selling price per unit of the product.
iv) Contribution margin: Contribution margin is the difference between selling price per unit and the variable cost per unit. In other words:
Contribution Margin = Selling Price per unit - Variable cost per unit considering the figures given above contribution margin is Rs. 5.0 (i.e. Rs. 10- Rs.6).
It may be noted that for calculating contribution margin, fixed cost is not considered.
After understanding the above concepts, we can move on to calculate break-even point (BEP) with the help of following formula:
BEP (in units) = 40,000/5 = 8,000 units
BEP (in value) = 8,000 units * Selling price per unit i.e. Rs.10.0 = Rs. 80,000.00
At the level of 8,000 units the manufacturer does not incur any loss nor earn any profit. This is verified as below:
Selling price of 8,000 units = 8,000*Rs.10 = Rs. 80,000
Variable cost of 8,000 units = 8,000*Rs.5 = Rs. 40,000
Fixed cost = Rs. 40,000
Total cost = (VC+FC) = Rs. 40,000 + Rs. 40,000 = Rs. 80,000.
The manufacturer does not earn or lose anything by selling 8,000 sterilized flavoured milk bottles because at this level both sales revenue (i.e. Rs. 80,000) and total cost (i.e. Rs. 80,000) are the same. Beyond this level he will start earning profit and below this level he will incur losses.
From controlling point of view the manufacturer has to understand whether he can operate above the level of break-even point. If he can do so in a shorter span,it is better for him. He must understand that the lower BEP denotes lesser risk.
vi. Internal Audit
Internal audit is another effective tool of managerial control. It involves appraisalof operations i.e. weighing actual results in the light of planned results. It is a regular appraisal which is done by trained staff of internal auditors of the accounting,financial and other operations of a business.
It is concerned with long term business interest. It aims at evaluating the entire system of an organisation. It can be said to be a continuous, systematic and bias free study of total efficiency of the firm. It tries to measure and evaluate the effectiveness of all other control devices employed by the firm.
Internal audit is advantageous for the departmental managers as well. They get proper advice from the internal auditors on policies and plans of the firm. The auditors also suggest solutions to managerial problems.The limiting factors for internal audit are two-fold - first, the business firm should be able to afford an internal audit and secondly, specialized persons should beavailable who can do a broad type of internal audit.
For making the internal audit successful, full support of subordinates is also required.
iv) Revision of budgets.
Advantages of budgetary control.
Following are the advantages of budgetary control:
i)It helps in bringing efficiency and economy in the working of the business enterprise.
ii) It fixes responsibility on every division or department of the enterprise.
iii) It coordinates the various divisions of a business i.e. production, marketing etc.
iv) It serves as an automatic check on the decisions of the management.
v) Credit agencies favour that organisation which operates through a well-ordered budget plan.
v. Break-even Analysis
Break-even analysis is yet another controlling device which can be used by a businessman. It is an important tool of profit planning. It is also called cost-volume-profit (CVP) analysis. It facilitates cost control by measuring operational efficiency. At break-even point the businessman neither makes profit nor incurs losses. For calculating break-even point we need to understand the following
concepts:
i) Fixed costs (FC): Fixed costs are those costs which remain constant whether there is increase or decrease in production over a given period of time. These costs are fixed in nature and are incurred as soon as the business is started. This concept of fixed costs remains valid up to a particular level of operation.
Examples of fixed costs are - rent of the premises, salaries of the employees,depreciation, interest charges on long term debts, insurance premium, property tax etc. Even if there is no production, these fixed costs will be incurred. Suppose, a flavoured milk manufacturer incurs Rs. 40,000 towards fixed costs for manufacturing sterilized flavoured milk bottles. In this case fixed costs are Rs.40,000 which shall be considered for calculating break-even point.
ii) Variable costs (VC): Variable costs are those costs which vary according to the level of production attained. They will increase if the production is increased even by one unit or decrease when there is decrease in production.
Such costs are - raw material costs, wages to the workers, water charges, oil and fuel etc.
For calculating break-even point, generally we consider variable cost per unit of production. Suppose variable cost incurred for manufacturing 10000 flavoured milk bottles is Rs. 60,000. In this case per unit variable cost works out to Rs.50,000.
Note: For the purpose of calculating total cost of production we have to add fixed cost and variable cost. Thus,
Total Cost = Fixed cost (FC) + Variable cost (VC)
iii) Selling price: Selling price is that price at which the goods are sold. Usually, we consider selling price per unit for calculating break-even point. For example, a flavoured milk bottle is priced at Rs. 10.00 It means that it will be sold to the
consumers at this price. Thus Rs. 10.00 is the selling price per unit of the product.
iv) Contribution margin: Contribution margin is the difference between selling price per unit and the variable cost per unit. In other words:
Contribution Margin = Selling Price per unit - Variable cost per unit considering the figures given above contribution margin is Rs. 5.0 (i.e. Rs. 10- Rs.6).
It may be noted that for calculating contribution margin, fixed cost is not considered.
After understanding the above concepts, we can move on to calculate break-even point (BEP) with the help of following formula:
BEP (in units) = 40,000/5 = 8,000 units
BEP (in value) = 8,000 units * Selling price per unit i.e. Rs.10.0 = Rs. 80,000.00
At the level of 8,000 units the manufacturer does not incur any loss nor earn any profit. This is verified as below:
Selling price of 8,000 units = 8,000*Rs.10 = Rs. 80,000
Variable cost of 8,000 units = 8,000*Rs.5 = Rs. 40,000
Fixed cost = Rs. 40,000
Total cost = (VC+FC) = Rs. 40,000 + Rs. 40,000 = Rs. 80,000.
The manufacturer does not earn or lose anything by selling 8,000 sterilized flavoured milk bottles because at this level both sales revenue (i.e. Rs. 80,000) and total cost (i.e. Rs. 80,000) are the same. Beyond this level he will start earning profit and below this level he will incur losses.
From controlling point of view the manufacturer has to understand whether he can operate above the level of break-even point. If he can do so in a shorter span,it is better for him. He must understand that the lower BEP denotes lesser risk.
vi. Internal Audit
Internal audit is another effective tool of managerial control. It involves appraisalof operations i.e. weighing actual results in the light of planned results. It is a regular appraisal which is done by trained staff of internal auditors of the accounting,financial and other operations of a business.
It is concerned with long term business interest. It aims at evaluating the entire system of an organisation. It can be said to be a continuous, systematic and bias free study of total efficiency of the firm. It tries to measure and evaluate the effectiveness of all other control devices employed by the firm.
Internal audit is advantageous for the departmental managers as well. They get proper advice from the internal auditors on policies and plans of the firm. The auditors also suggest solutions to managerial problems.The limiting factors for internal audit are two-fold - first, the business firm should be able to afford an internal audit and secondly, specialized persons should beavailable who can do a broad type of internal audit.
For making the internal audit successful, full support of subordinates is also required.
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