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GNDU Question Paper-2024
B.Com 5
th
Semester
MANAGEMENT ACCOUNTING
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. Give scope of management accounting. How is it different from financial accounting?
2. The following are the ratios relating to the activities of AB Traders Ltd:
Stock velocity 6 months
Creditors velocity = 2 months
Debtors velocity = 3 months
Gross profit ratio = 25%
Gross Profit for the year ended 31st December 2021 amounts to Rs. 5,00,000. Closing
Stock of the year is Rs. 20,000 above the Opening Stock. Bills Receivable amount to Rs.
30,000 and Bills Payable Rs. 20,000.
Find out:
(1) Sales
(2) Closing Stock
(3) Purchases
(4) Sundry Creditors
(5) Sundry Debtors.
SECTION-B
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3. What is Fund Flow Statement? How is it prepared? How is it different from
Cash Flow Statement?
4. Given below are the comparative Balance Sheets of a company as on 31st December
2017 and 2018.
2017 (Rs.)
2018 (Rs.)
Liabilities
Equity Share Capital
1,00,000
1,25,000
General Reserve
25,000
30,000
Bank Loan (Long Term)
35,000
—
Sundry Creditors
75,000
67,600
Provision for taxation
15,000
17,500
Surplus account
15,250
15,300
2,65,250
2,55,400
2017 (Rs.)
2018 (Rs.)
Assets
Plant and Machinery
75,000
85,500
Land and Building
1,00,000
95,000
Stock
50,000
37,000
Debtors
40,000
32,100
Cash in hand
250
300
Cash at bank
—
4,000
Goodwill at cost
—
1,500
2,65,250
2,55,400
Additional information :
During the year ended 31st December, 2018 :
(1) Dividend of Rs. 11,500 was paid. (2) Depreciation charged on Land and Building Rs.
5,000. (3) Machinery was further purchased for Rs. 19,000. (4) Depreciation written off on
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machinery Rs. 8,000. (5) Income tax paid during the year Rs. 16,500. (6) Loss on sale of
machinery Rs. 100 was written off to General Reserve.
Prepare a Cash Flow Statement.
SECTION-C
6. What is CVP Analysis ? Discuss various tools of CVP Analysis.
From the following data plot a break-even chart and showing : (a) Break-even point (b)
Margin of safety and profit (c) Number of units to be sold for a profit of Rs. 2,000.
Rs.
Selling price
5 per unit
Variable cost
3 per unit
Fixed cost
3000
Total number of units sold = 2000 units.
Show mathematical computations to verify your calculations.
SECTION-D
7. What is Transfer Pricing ? Explain various methods of transfer pricing.
8. Write notes on :
(a) Activity Based Costing.
(b) Responsibility Centers.
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GNDU Answer Paper-2024
B.Com 5
th
Semester
MANAGEMENT ACCOUNTING
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. Give scope of management accounting. How is it different from financial accounting?
Ans: Imagine a company as a massive ship sailing across the business ocean. To navigate
safely, it needs a strong captain, a reliable crew, and the right tools to chart the course. In
the corporate world, management accounting plays the role of the navigation system and
the strategic compass, while financial accounting acts more like the logbook, recording
where the ship has travelled. Both are essential, but they serve very different purposes.
Let’s explore this story in detail.
The Role and Scope of Management Accounting
Management accounting is like the wise advisor to the ship’s captain. Its primary purpose is
to provide timely, relevant, and forward-looking information to managers, helping them
make smart decisions for the company’s future. Unlike financial accounting, which looks
backward, management accounting looks forward. It’s all about planning, controlling, and
decision-making.
Let’s break the scope of management accounting into tangible areas so it feels like a real-
life guide on a ship:
1. Financial Planning and Budgeting
Think of the ship preparing for a long journey. The captain needs to know how much
fuel, food, and resources will be required. Similarly, management accounting helps
organizations prepare budgets and financial plans. It predicts income, estimates
costs, and forecasts cash flows. This allows managers to plan their journey wisely,
ensuring that the company doesn’t run out of resources mid-course.
2. Cost Control and Cost Analysis
Every ship has limited supplies. Management accounting is like monitoring fuel
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consumption and rationing supplies efficiently. It analyzes cost behavior, cost
allocation, and cost reduction techniques, helping management control
unnecessary expenditures and maximize efficiency. Techniques like standard
costing, marginal costing, and variance analysis help managers detect deviations
from the plan and take corrective action.
3. Decision-Making Support
Imagine encountering a storm at sea. Should the ship take a longer but safer route,
or risk a shortcut to save time? Management accounting provides decision-support
information to answer such questions in business. Tools like break-even analysis,
pricing decisions, product mix analysis, and capital investment appraisal give
managers clear insights into which choice will yield the best outcome.
4. Performance Measurement and Evaluation
After the journey, a captain reviews how well the crew performed and whether the
ship stayed on course. Management accounting does something similar with
performance evaluation. It measures the efficiency and effectiveness of
departments, projects, or products. Metrics like return on investment (ROI), profit
margins, and key performance indicators (KPIs) allow managers to see what
worked, what didn’t, and why.
5. Risk Management
Sailing the business ocean comes with storms—economic changes, competition, or
operational hiccups. Management accounting helps identify potential risks, assess
their impact, and develop strategies to mitigate them. Techniques like sensitivity
analysis and scenario planning allow businesses to prepare for uncertainties before
they become disasters.
6. Strategic Planning
The captain needs a long-term vision, not just day-to-day navigation. Management
accounting provides insights for strategic decisions, like entering new markets,
launching new products, mergers and acquisitions, and expansion plans. It ensures
that the company doesn’t just survive, but thrives in the competitive environment.
7. Internal Communication Tool
Imagine the ship’s crew working in sync. Management accounting acts as an internal
communication bridge, providing detailed reports to various managers about
budgets, expenses, and forecasts. Unlike financial accounting, which speaks mainly
to outsiders, management accounting ensures that every department understands
its role and responsibilities in achieving organizational goals.
8. Support for Motivation and Control
Management accounting is not just about numbers—it’s about people. By providing
relevant data, it helps set targets, allocate resources efficiently, and design
incentive systems for employees. Managers can motivate their teams by showing
progress, comparing performance against targets, and rewarding excellence.
How Management Accounting Differs from Financial Accounting
Now, let’s imagine another scenario. A historian on the ship wants to document everything
that happened during the voyage—the storms, victories, and the treasures found. This
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historian represents financial accounting. It focuses on historical recording, providing
information primarily for external stakeholders like investors, creditors, regulators, and tax
authorities.
Let’s compare the two in a detailed, side-by-side story form:
Aspect
Management Accounting
Purpose
To aid internal decision-making,
planning, and control.
Focus
Future-oriented; helps in planning and
controlling.
Users
Internal users like managers,
department heads, and executives.
Reports
Flexible, detailed, and can be prepared
as per managerial requirements (e.g.,
budgets, variance reports).
Regulations
Not legally required; tailored to
organizational needs.
Scope of
Information
Broader, including financial and non-
financial information (e.g., employee
productivity, market trends, production
efficiency).
Level of
Detail
Highly detailed and specific to
departments, projects, or products.
Flexibility
Highly flexible; reports can be produced
as needed.
Time Horizon
Short-term and long-term planning.
In simpler terms, financial accounting tells you what has already happened, like the
historian documenting the journey. Management accounting tells you what to do next, like
a seasoned captain plotting the route to reach the treasure safely and efficiently.
Real-Life Example to Humanize the Concept
Let’s take a small company, “Sweet Treats Bakery.” The bakery makes cakes and pastries
and wants to expand its business. Here’s how management and financial accounting come
into play:
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• Financial Accounting: At the end of the year, the bakery prepares financial
statements showing total sales, profits, expenses, and assets. Investors see that the
bakery made a profit of ₹5,00,000. This satisfies shareholders and tax authorities.
• Management Accounting: The bakery’s manager uses management accounting to
decide which cake flavors are most profitable, which ingredients are being wasted,
and which new branches are feasible. They prepare a budget for the next year,
analyze cost per cake, calculate breakeven points, and predict which strategies will
maximize profit.
Notice how financial accounting reports the past (profits made), while management
accounting directs future actions (how to increase profit and control costs).
Bringing It Together: Why Management Accounting Matters
If you ask why management accounting is critical, here’s the story in one sentence: it’s the
compass, map, and speedometer of a company, guiding it safely through the unpredictable
ocean of business. It provides insights, foresight, and control, helping managers make
informed decisions, reduce waste, improve efficiency, and achieve strategic goals.
While financial accounting ensures compliance and transparency, management accounting
ensures growth, efficiency, and strategic success. Both are indispensable, but they serve
different purposes for different users.
In a world where competition is fierce and resources are limited, companies that ignore
management accounting are like ships sailing blind—vulnerable to storms, unable to
navigate efficiently, and at risk of losing their way. On the other hand, companies that
embrace management accounting can predict challenges, seize opportunities, and steer
confidently toward success.
Conclusion
To summarize in a story-like way:
• Management accounting = the captain’s strategic guide, future-focused, flexible,
detailed, and internally oriented.
• Financial accounting = the historian’s logbook, past-focused, standardized, legally
required, and externally oriented.
The scope of management accounting spans financial planning, cost control, decision
support, performance evaluation, risk management, strategic planning, and internal
communication. Its goal is not merely to record numbers but to empower managers with
actionable insights, ensuring the company sails smoothly through calm seas and storms
alike.
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In essence, management accounting transforms raw data into meaningful stories,
actionable plans, and informed decisions, making it one of the most crucial tools for any
organization’s survival and growth.
2. The following are the ratios relating to the activities of AB Traders Ltd:
Stock velocity 6 months
Creditors velocity = 2 months
Debtors velocity = 3 months
Gross profit ratio = 25%
Gross Profit for the year ended 31st December 2021 amounts to Rs. 5,00,000. Closing
Stock of the year is Rs. 20,000 above the Opening Stock. Bills Receivable amount to Rs.
30,000 and Bills Payable Rs. 20,000.
Find out:
(1) Sales
(2) Closing Stock
(3) Purchases
(4) Sundry Creditors
(5) Sundry Debtors.
Ans: You’re handed a handful of clues about AB Traders Ltd.—not ledgers or invoices, just
four velocities and a profit ratio. It’s the end of the year, the lights are low, and you’re asked
to reconstruct the business story: How much did they sell? What’s the closing stock? What
did they purchase? How much do they owe suppliers? How much do customers owe them?
Each ratio is a breadcrumb. Follow them carefully and the entire picture appears, crisp and
complete.
We’ll move through the puzzle step by step, using only the given ratios and a few sensible
assumptions that accountants apply in such exam-style problems.
Given information
• Stock velocity = 6 months
• Creditors velocity = 2 months
• Debtors velocity = 3 months
• Gross profit ratio = 25%
• Gross profit for the year ended 31 Dec 2021 = Rs. 5,00,000
• Closing stock is Rs. 20,000 above opening stock
• Bills Receivable = Rs. 30,000
• Bills Payable = Rs. 20,000
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Required:
• Sales
• Closing stock
• Purchases
• Sundry creditors
• Sundry debtors
Assumptions typically used unless stated otherwise:
• All sales are credit sales and all purchases are credit purchases.
• Velocity in months means the average balance relative to the annual flow, scaled to
12 months.
Decoding the ratios in plain language
• Gross profit ratio 25% tells you that gross profit is 25% of sales. With the gross profit
amount given, you can back-calculate sales directly.
• Stock velocity 6 months means the average stock sits for 6 months before turning
over. In formula terms, average stock equals half of cost of goods sold.
• Debtors velocity 3 months means average or total receivables (including bills
receivable, unless specified otherwise) equal one quarter of the annual credit sales.
• Creditors velocity 2 months means total payables (including bills payable, unless
specified otherwise) equal one sixth of the annual credit purchases.
These are classic, exam-friendly interpretations used to reconstruct the missing figures.
Step 1: Find sales from the gross profit ratio
Gross profit ratio is 25%, and gross profit is Rs. 5,00,000. Let sales be 𝑆.
Gross profit ratio =
Gross profit
Sales
× 100
25 =
5,00,000
𝑆
× 100 ⇒ 𝑆 =
5,00,000
0.25
= 20,00,000
• Sales: Rs. 20,00,000
Now compute cost of goods sold (COGS):
COGS = Sales × (1 − GP ratio) = 20,00,000 × 0.75 = 15,00,000
• COGS: Rs. 15,00,000
Step 2: Use stock velocity to find opening and closing stock
Stock velocity 6 months means:
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Stock holding period (months) =
Average stock
COGS
× 12
6 =
Average stock
15,00,000
× 12
Average stock = 15,00,000 ×
6
12
=
15,00,000
2
= 7,50,000
Average stock is the average of opening and closing stock. Given that closing stock is Rs.
20,000 above opening stock:
Let opening stock be 𝑂. Then closing stock is 𝑂 + 20,000.
Average stock =
𝑂 + (𝑂 + 20,000)
2
=
2𝑂 + 20,000
2
= 𝑂 + 10,000
𝑂 + 10,000 = 7,50,000 ⇒ 𝑂 = 7,40,000
Closing stock = 𝑂 + 20,000 = 7,60,000
• Opening stock: Rs. 7,40,000
• Closing stock: Rs. 7,60,000
Step 3: Compute purchases from COGS reconciliation
For a merchandising firm (no manufacturing adjustments provided), the basic reconciliation
holds:
COGS = Opening stock + Purchases − Closing stock
15,00,000 = 7,40,000 + Purchases − 7,60,000
Purchases = 15,00,000 − 7,40,000 + 7,60,000 = 15,20,000
• Purchases: Rs. 15,20,000
Step 4: Use creditors velocity to find sundry creditors
Creditors velocity 2 months indicates that the total payables (sundry creditors plus bills
payable) equate to two months’ worth of credit purchases:
Average creditors (incl. BP) = Credit purchases ×
2
12
Assuming all purchases are on credit:
Total creditors (incl. BP) = 15,20,000 ×
2
12
= 15,20,000 ×
1
6
= 2,53,333. 3
‾
Given Bills Payable = Rs. 20,000:
Sundry creditors = Total creditors − Bills payable = 2,53,333. 3
‾
− 20,000 = 2,33,333. 3
‾
• Sundry creditors: Rs. 2,33,333.33 (approx.)
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Step 5: Use debtors velocity to find sundry debtors
Debtors velocity 3 months means the total receivables (sundry debtors plus bills receivable)
equate to three months’ worth of credit sales:
Total debtors (incl. BR) = Credit sales ×
3
12
Assuming all sales are credit sales:
Total debtors (incl. BR) = 20,00,000 ×
3
12
= 20,00,000 ×
1
4
= 5,00,000
Given Bills Receivable = Rs. 30,000:
Sundry debtors = Total debtors − Bills receivable = 5,00,000 − 30,000 = 4,70,000
• Sundry debtors: Rs. 4,70,000
A compact table of final answers
Item
Figure
Sales
Rs. 20,00,000
Closing stock
Rs. 7,60,000
Purchases
Rs. 15,20,000
Sundry creditors
Rs. 2,33,333.33 (approx.)
Sundry debtors
Rs. 4,70,000
Why each step works (short, examiner-friendly insights)
• Sales from GP ratio: With gross profit known and the ratio given, sales is simply the
base that makes 25% equal to Rs. 5,00,000.
• COGS from sales and GP%: COGS is the complement of the gross margin in sales.
• Stock velocity (6 months): A 6-month holding period means average stock equals
half of COGS. The closing stock being higher than opening by a known amount allows
precise opening and closing extraction from the average.
• Purchases via stock reconciliation: The timeless formula COGS = 𝑂 + 𝑃 − 𝐶anchors
purchases between opening and closing stock.
• Payables from creditors velocity: Two months of purchases sit unpaid on average;
include bills payable in the total, then back out sundry creditors.
• Receivables from debtors velocity: Three months of sales sit in receivables; include
bills receivable in total, then back out sundry debtors.
Each move is grounded in a standard ratio definition, ensuring your path is logically sound
and easy to audit.
The story behind the numbers
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• Balanced operations: A 6-month stock velocity suggests AB Traders turns inventory
roughly twice a year—steady but not hyper-fast. The large stock figures indicate a
capital-intensive assortment or longer lead times.
• Margins: A 25% gross margin is healthy for a trading firm; with Rs. 20 lakh in sales,
Rs. 5 lakh in gross profit feels aligned with a middle-tier operation.
• Working capital profile: Debtors at Rs. 4.7 lakh and creditors at about Rs. 2.33 lakh
reflect a common pattern: receivables outweigh payables, consistent with a trader
extending credit to customers more than suppliers do to them.
• Bills as part of the ecosystem: Including Bills Receivable and Bills Payable in velocity
calculations respects reality—promissory instruments are integral to trade credit and
are rightly included in totals for ratios expressed in months.
SECTION-B
3. What is Fund Flow Statement? How is it prepared? How is it different from
Cash Flow Statement?
Ans: Imagine a small business named “BrightStar Traders.” This company deals in
electronics and has been growing steadily over the past few years. The owner, Mr. Sharma,
is keen to understand not just whether his company is making a profit, but how the financial
resources of the business are moving—where the money is coming from and where it is
going. This is where a Fund Flow Statement comes into the picture.
What is a Fund Flow Statement?
Think of a Fund Flow Statement as a storybook of financial movement. While a Profit &
Loss account tells you whether the business made a profit or loss, it doesn’t explain how the
resources (funds) were used. Similarly, the balance sheet gives a snapshot of assets and
liabilities at a point in time but does not show the changes between two periods.
The Fund Flow Statement (FFS) acts like a bridge between two balance sheets. It explains:
• Where the company got its funds from (sources of funds)
• Where the company used those funds (application of funds)
In simple terms, it answers questions like:
“How did BrightStar Traders finance its new machinery?”
“Why did the company’s working capital decrease even though it earned a profit?”
A Fund Flow Statement focuses on working capital—which is the difference between
current assets and current liabilities. It gives management and investors an idea about the
movement of long-term and short-term funds within the business.
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The Story of Funds: Sources and Uses
Let’s return to Mr. Sharma. In the last year, BrightStar Traders decided to expand. They:
• Purchased new computers for inventory management
• Took a small long-term loan for expansion
• Paid off some of their old debts
Now, Mr. Sharma wants to understand how these changes affected his funds. Here’s how a
Fund Flow Statement helps:
Sources of Funds
A source of fund is anything that brings money into the company. It’s like receiving gifts or
allowances in your personal life. In business terms, sources include:
• Profit from operations: If BrightStar Traders earned a net profit, it increased funds.
• Sale of fixed assets: Selling old machinery or vehicles provides cash that can be used
elsewhere.
• Long-term borrowings: Loans from banks or issuing debentures add funds.
• Reduction in assets: For example, if the company reduces its inventory or
receivables, it frees up funds.
In our story, the company received funds from a bank loan and profit from operations, and
it also sold some old furniture that was no longer in use.
Uses of Funds
A use of fund is anything that consumes money or reduces the company’s funds. Think of it
as spending your pocket money on books, snacks, or movies. In business:
• Purchase of fixed assets: Buying computers or machinery uses funds.
• Repayment of loans: Paying back bank loans decreases funds.
• Increase in current assets: If the company buys more inventory or gives credit to
customers, it uses funds.
• Dividend payments: Money paid to shareholders is also a use of funds.
For BrightStar Traders, the purchase of new machinery and the repayment of an old loan
were major uses of funds.
How is a Fund Flow Statement Prepared?
Now let’s turn the story into a practical lesson. Preparing a Fund Flow Statement is like
investigating the journey of funds from one point to another. Here’s a step-by-step
method:
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Step 1: Determine the Period and Collect Financial Statements
The first step is to decide the period for which the statement is to be prepared, usually a
year. You then collect:
• Balance Sheet of the current year
• Balance Sheet of the previous year
• Profit & Loss Account
For example, BrightStar Traders has balance sheets for 2023 and 2024. Comparing them will
show what changed.
Step 2: Calculate Changes in Working Capital
Working capital = Current Assets – Current Liabilities
By comparing the working capital of the two years, you can determine whether it has
increased or decreased.
• Increase in working capital: More funds are tied up in current assets, which is a use
of funds.
• Decrease in working capital: It releases funds, which is a source of funds.
In our story, BrightStar Traders increased its inventory and receivables, which meant more
funds were used.
Step 3: Identify Sources and Uses of Funds
Next, classify all changes in assets and liabilities into sources and uses.
• Sources of Funds might include:
o Net profit after tax
o Decrease in assets (like selling old furniture)
o Increase in long-term liabilities (bank loans)
• Uses of Funds might include:
o Purchase of fixed assets
o Payment of dividends
o Repayment of loans
o Increase in current assets
Step 4: Prepare a Statement
Finally, the Fund Flow Statement is prepared in two columns:
Sources of Funds
Amount
Uses of Funds
Amount
Profit from Operations
50,000
Purchase of Machinery
40,000
Sale of Furniture
10,000
Increase in Inventory
15,000
Bank Loan
20,000
Loan Repayment
25,000
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Total
80,000
Total
80,000
Notice that total sources = total uses, which ensures the statement is balanced.
Difference Between Fund Flow Statement and Cash Flow Statement
Now, many students get confused between Fund Flow Statement and Cash Flow
Statement. Let’s clear it with a story.
Think of Mr. Sharma’s business like a river:
• The Fund Flow Statement is like a map of the river system, showing where water
comes from and where it goes, including all tributaries (funds tied in assets, loans,
and liabilities).
• The Cash Flow Statement is like looking at the current water in the main river—how
much cash is physically present at any moment.
Here are the main differences:
Feature
Fund Flow Statement
Cash Flow Statement
Focus
Movement of funds (working
capital)
Movement of cash (actual cash in
hand/bank)
Basis
Changes in Balance Sheet accounts
Changes in Cash & Cash Equivalents
Components
Sources & Uses of Funds
Operating, Investing, and Financing
Activities
Includes
All current assets & liabilities
Only cash or cash equivalents
Objective
Shows how resources are
generated and used
Shows cash inflow and outflow
Timing
Long-term and short-term resources
Immediate liquidity position
In BrightStar Traders’ case:
• The Fund Flow Statement will show that funds were raised through loans and profits,
then used to buy machinery and pay off debt.
• The Cash Flow Statement will focus only on the actual cash received and paid,
ignoring non-cash items like depreciation or inventory changes.
Why Fund Flow Statement is Important
1. Decision-making: Mr. Sharma can see whether he needs to raise more funds or
reduce expenditure.
2. Financial planning: Helps in planning expansion or debt repayment.
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3. Analyzing performance: Even if profit is high, increasing working capital may indicate
that cash is tied up in inventory or receivables.
4. Investor confidence: Investors and banks love to see how a business manages its
resources.
A Simple Analogy to Remember
Think of your own monthly budget:
• Your salary is like a source of funds.
• Paying rent, buying groceries, or repaying debts are uses of funds.
• Even if you earn a lot, if most of your money is tied up in unpaid bills or loan
installments, your funds are not effectively used.
• Similarly, a Fund Flow Statement helps a company keep track of the story of money
in and out.
Conclusion
To summarize:
A Fund Flow Statement tells the story of where a company’s funds came from and how
they were used, focusing on working capital changes. It is prepared by comparing two
balance sheets, calculating changes in assets and liabilities, identifying sources and uses of
funds, and presenting them in a clear, two-column statement.
It differs from a Cash Flow Statement, which focuses only on cash inflows and outflows,
ignoring other forms of funds. Both statements are crucial: one for understanding funds
management, the other for liquidity position.
For Mr. Sharma, preparing the Fund Flow Statement was like reading the diary of BrightStar
Traders’ financial life. It gave him clarity, helped plan expansion, and ensured that every
rupee was accounted for wisely.
4. Given below are the comparative Balance Sheets of a company as on 31st December
2017 and 2018.
2017 (Rs.)
2018 (Rs.)
Liabilities
Equity Share Capital
1,00,000
1,25,000
General Reserve
25,000
30,000
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Bank Loan (Long Term)
35,000
—
Sundry Creditors
75,000
67,600
Provision for taxation
15,000
17,500
Surplus account
15,250
15,300
2,65,250
2,55,400
2017 (Rs.)
2018 (Rs.)
Assets
Plant and Machinery
75,000
85,500
Land and Building
1,00,000
95,000
Stock
50,000
37,000
Debtors
40,000
32,100
Cash in hand
250
300
Cash at bank
—
4,000
Goodwill at cost
—
1,500
2,65,250
2,55,400
Additional information :
During the year ended 31st December, 2018 :
(1) Dividend of Rs. 11,500 was paid. (2) Depreciation charged on Land and Building Rs.
5,000. (3) Machinery was further purchased for Rs. 19,000. (4) Depreciation written off on
machinery Rs. 8,000. (5) Income tax paid during the year Rs. 16,500. (6) Loss on sale of
machinery Rs. 100 was written off to General Reserve.
Prepare a Cash Flow Statement.
Ans: Imagine you’re asked to tell the “cash story” of a company using just two snapshots:
the balance sheet at the end of 2017 and the end of 2018, plus a handful of clues about
what happened during the year. It’s like piecing together a film from the opening and
closing frames and a director’s note about key scenes: dividends paid, taxes settled,
machinery bought and sold, depreciation charged, and a bank loan repaid. Your goal is to
turn those frames into a flowing narrative—the Cash Flow Statement—showing exactly how
cash moved through the business in 2018.
Let’s walk through it calmly, step by step, and end with a neat, examiner-friendly statement
that reconciles perfectly with the change in cash on the balance sheets.
The comparative balance sheets and clues
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Liabilities
• Equity Share Capital: 1,00,000 (2017) → 1,25,000 (2018)
• General Reserve: 25,000 → 30,000
• Bank Loan (Long Term): 35,000 → —
• Sundry Creditors: 75,000 → 67,600
• Provision for Taxation: 15,000 → 17,500
• Surplus Account: 15,250 → 15,300
• Total Liabilities: 2,65,250 (2017) → 2,55,400 (2018)
Assets
• Plant and Machinery: 75,000 → 85,500
• Land and Building: 1,00,000 → 95,000
• Stock: 50,000 → 37,000
• Debtors: 40,000 → 32,100
• Cash in hand: 250 → 300
• Cash at bank: — → 4,000
• Goodwill at cost: — → 1,500
• Total Assets: 2,65,250 (2017) → 2,55,400 (2018)
Additional information (year ended 31 Dec 2018)
• Dividend paid: Rs. 11,500
• Depreciation on Land and Building: Rs. 5,000
• Machinery purchased: Rs. 19,000
• Depreciation on Machinery: Rs. 8,000
• Income tax paid: Rs. 16,500
• Loss on sale of machinery: Rs. 100 written off to General Reserve
We will prepare the Cash Flow Statement using the indirect method (start from profit,
adjust non-cash and working capital, then add investing and financing flows).
Key working notes (the detective’s notebook)
1) Provision for tax: find the charge for the year
Provision T-account logic:
• Closing Provision = Opening Provision + Provision made during year − Tax paid
Numbers:
• Closing = 17,500, Opening = 15,000, Tax paid = 16,500
• Provision made = 17,500 − 15,000 + 16,500 = 19,000
So, the income tax expense (charge to P&L) for 2018 is Rs. 19,000.
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2) Plant and machinery: identify sale proceeds
We have:
• Opening P&M = 75,000
• Additions = 19,000
• Depreciation = 8,000
• Closing P&M = 85,500
• Loss on sale = 100 (charged to General Reserve)
Reconcile to find book value of asset sold:
• Opening + Additions − Depreciation − Book value sold = Closing
• 75,000 + 19,000 − 8,000 − Book value sold = 85,500
• 86,000 − Book value sold = 85,500 ⇒ Book value sold = 500
Given loss on sale is 100, sale proceeds must be:
• Proceeds = Book value − Loss = 500 − 100 = 400
Therefore:
• Cash inflow from sale of machinery = Rs. 400
3) Goodwill
Goodwill at cost appears at 1,500 in 2018; it was nil in 2017.
• This is a purchase (investing outflow): Rs. 1,500
4) Change in cash and cash equivalents (for reconciliation)
• Cash in hand: 250 → 300, increase = 50
• Cash at bank: — → 4,000, increase = 4,000
• Net increase in cash and cash equivalents = 4,050
Our final cash flow statement must produce +4,050 as the net increase.
Funds from operations (profit for the year) via adjusted surplus
We’ll extract the year’s profit by tracking movements in reserves/surplus and
appropriations:
• Closing Surplus (2018): 15,300
• Add: Dividend paid (appropriation): 11,500
• Add: Transfer to General Reserve: note the reserve increased by 5,000 despite a 100
loss charged to it; hence transfer from profits must be 5,100 (to net +5,000 after
−100 loss)
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• Add: Provision for taxation (charge for the year): 19,000
• Less: Opening Surplus (2017): 15,250
Compute:
• Total added: 15,300 + 11,500 + 5,100 + 19,000 = 50,900
• Profit for the year = 50,900 − 15,250 = 35,650
This figure (35,650) represents profit before tax (since we added back the tax provision)
under the indirect method’s starting point.
Operating profit before working capital changes
Add back non-cash/non-operating items:
• Depreciation on Land & Building: +5,000
• Depreciation on Machinery: +8,000
• Loss on sale of machinery was charged to General Reserve, not P&L; so no add-back
needed here.
Operating profit before working capital changes:
• 35,650 + 5,000 + 8,000 = 48,650
Working capital adjustments
• Stock: 50,000 → 37,000, decrease = +13,000 (decrease in inventory releases cash)
• Debtors: 40,000 → 32,100, decrease = +7,900
• Sundry Creditors: 75,000 → 67,600, decrease = −7,400 (decrease in payables uses
cash)
Net change:
• +13,000 + 7,900 − 7,400 = +13,500
Cash generated from operations (before tax):
• 48,650 + 13,500 = 62,150
Less: Income tax paid (actual cash): −16,500
Net cash from operating activities:
• 62,150 − 16,500 = 45,650
Cash flows from investing activities
• Purchase of machinery: −19,000
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• Sale of machinery (proceeds): +400
• Purchase of goodwill: −1,500
• Land & Building: only depreciation adjustment (non-cash), no purchase/sale
mentioned.
Net cash used in investing:
• −19,000 + 400 − 1,500 = −20,100
Cash flows from financing activities
• Issue of share capital (increase): +25,000
• Repayment of long-term bank loan (decrease): −35,000
• Dividend paid: −11,500
Net cash used in financing:
• 25,000 − 35,000 − 11,500 = −21,500
Reconcile the net change in cash
• Net cash from operating: +45,650
• Net cash from investing: −20,100
• Net cash from financing: −21,500
Net increase in cash and cash equivalents:
• 45,650 − 20,100 − 21,500 = +4,050
This matches the balance sheet change: cash in hand up by 50 and cash at bank up by 4,000
(total +4,050). Perfect reconciliation.
Cash flow statement for the year ended 31 December 2018 (indirect method)
Cash flows from operating activities
• Profit before tax (derived via adjusted surplus): 35,650
• Add: Non-cash/non-operating adjustments
o Depreciation on Land & Building: 5,000
o Depreciation on Machinery: 8,000
• Operating profit before working capital changes: 48,650
• Adjustments for working capital
o Decrease in stock: 13,000
o Decrease in debtors: 7,900
o Decrease in sundry creditors: −7,400
• Cash generated from operations: 62,150
• Less: Income tax paid: −16,500
• Net cash from operating activities: 45,650
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Cash flows from investing activities
• Purchase of machinery: −19,000
• Proceeds from sale of machinery: 400
• Purchase of goodwill: −1,500
• Net cash used in investing activities: −20,100
Cash flows from financing activities
• Proceeds from issue of share capital: 25,000
• Repayment of long-term bank loan: −35,000
• Dividend paid: −11,500
• Net cash used in financing activities: −21,500
Net increase in cash and cash equivalents
• Operating + Investing + Financing: 45,650 − 20,100 − 21,500 = 4,050
• Add: Cash and cash equivalents at beginning of year: 250 (hand) + 0 (bank) = 250
• Cash and cash equivalents at end of year: 300 (hand) + 4,000 (bank) = 4,300
• Net increase: 4,300 − 250 = 4,050 (reconciles)
Why the numbers tell a coherent story
• Strong operating inflow (45,650): The company generated positive cash from
operations even after paying taxes. Decreases in stock and debtors helped unlock
cash.
• Modest investing outflow (20,100): New machinery and goodwill purchases indicate
investment in productive capacity and intangible value; sale of an old machine
brought minor cash in.
• Financing outflow (21,500): Repayment of a long-term bank loan and dividend
payment exceeded the equity raised, reducing cash from financing overall.
• Net increase in cash (4,050): Despite paying down debt and investing, operations
produced enough liquidity to grow the cash balance, precisely matching the balance
sheet changes.
SECTION-C
5. What is CVP Analysis ? Discuss various tools of CVP Analysis.
Ans: Imagine you are the owner of a small chocolate factory. You make delicious chocolates
that everyone loves. But, like every business owner, you have to keep a careful eye on your
costs, prices, and sales. You need to know: “If I sell 1000 chocolates, will I make a profit?
What if sales drop to 500? Or increase to 2000?” This is exactly where Cost-Volume-Profit
Analysis, or CVP Analysis, comes into the picture. Think of it as a magical pair of glasses that
lets you see the future of your business based on costs, sales, and profits.
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What is CVP Analysis?
At its core, CVP Analysis is a managerial accounting tool that helps businesses understand
the relationship between costs, sales volume, and profit. In simple terms, it answers
questions like:
• How many units do I need to sell to break even?
• How will my profit change if I increase the selling price or reduce costs?
• What is the impact of changing production levels on my profit?
CVP Analysis is essentially the backbone of business planning. Without it, a business is like
sailing a ship in a storm without a compass—you might get somewhere, but you have no
idea if it’s the right place!
The Basics of CVP Analysis
CVP Analysis relies on a few simple building blocks:
1. Fixed Costs: These are costs that stay the same no matter how many chocolates you
make—like rent for your factory, salaries of permanent staff, or machinery
depreciation.
2. Variable Costs: These costs change with production volume. For chocolates, variable
costs include cocoa, sugar, milk, packaging, and direct labor. If you make more
chocolates, these costs rise.
3. Sales Price per Unit: The amount you charge for one chocolate.
4. Sales Volume: The number of chocolates sold.
5. Profit: The leftover money after subtracting all costs from total revenue.
Using these elements, CVP Analysis helps in understanding the break-even point, margin of
safety, and profit planning.
Why is CVP Analysis Important?
Imagine you are preparing for a big festival season, like Diwali, and you expect chocolate
sales to soar. But there’s a problem—you’re unsure how much to produce. Produce too
little, and you lose sales; produce too much, and unsold stock will rot. Here, CVP Analysis
acts like your financial GPS:
• It guides decision-making about pricing, production, and sales targets.
• It helps in profit planning by showing how changes in costs, prices, or volume affect
profit.
• It reduces risk by highlighting the minimum sales needed to avoid losses.
In short, CVP Analysis transforms guesswork into smart, data-backed decisions.
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Tools of CVP Analysis
To make CVP Analysis practical, managers use several tools. Let’s explore each one as if we
are walking through the chocolate factory step by step.
1. Break-Even Analysis
The first and most crucial tool is the Break-Even Analysis (BEP). The break-even point is the
level of sales at which total revenue equals total costs—meaning, you neither make a profit
nor incur a loss.
Formula for Break-Even Point in Units:
BEP (units) =
Fixed Costs
Selling Price per Unit – Variable Cost per Unit
Example Story:
Suppose your fixed costs (factory rent, salaries) are ₹50,000 per month, the selling price of a
chocolate is ₹50, and the variable cost is ₹30 per chocolate.
𝐵𝐸𝑃 =
50,000
50 − 30
=
50,000
20
= 2,500 chocolates
So, you need to sell 2,500 chocolates to cover all costs. Sell more, and you make a profit;
sell less, and you incur a loss. Simple, right?
Graphical BEP: Many businesses draw a break-even chart, plotting costs and revenue
against units sold. Where the total cost line intersects the total revenue line is the break-
even point. It’s visually satisfying because it clearly shows risk and opportunity.
2. Contribution Margin Analysis
The contribution margin (CM) is the amount that each unit contributes toward covering
fixed costs and generating profit. It is calculated as:
Contribution Margin per Unit = Selling Price per Unit – Variable Cost per Unit
In our chocolate example, the CM per chocolate is ₹50 – ₹30 = ₹20.
The contribution margin ratio is the CM expressed as a percentage of sales:
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CM Ratio =
CM per Unit
Selling Price per Unit
× 100
Here, CM ratio = 20/50 × 100 = 40%.
Why is this important? The CM tells you how much of each sale actually contributes to
profit, helping in pricing and sales strategies.
3. Margin of Safety
The Margin of Safety (MOS) tells you how much sales can drop before you start making a
loss. It’s a safety net for your business.
Margin of Safety = Actual Sales – Break-Even Sales
Story Example:
If you sell 4,000 chocolates but the break-even is 2,500, then:
𝑀𝑂𝑆 = 4,000 − 2,500 = 1,500 chocolates
You have a comfortable buffer. Even if 1,000 chocolates don’t sell, you are still safe.
4. Profit-Volume (P/V) Ratio
The P/V ratio is a powerful tool to understand the relationship between profit and sales. It
is calculated as:
𝑃/𝑉𝑅𝑎𝑡𝑖𝑜 =
Contribution Margin
Sales
× 100
This ratio tells you the percentage of each sales rupee that contributes to profit. For
example, if your P/V ratio is 40%, then ₹40 of every ₹100 sale goes toward covering fixed
costs and profit.
Managers use this ratio to estimate profits at different sales levels quickly without
recalculating costs for each scenario.
5. CVP Graphs and Charts
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Visual tools make CVP Analysis even more understandable:
• Break-even chart: Shows the intersection of costs and revenue.
• Profit-volume graph: Shows how profits increase with sales beyond the break-even
point.
• Cost-volume graph: Illustrates fixed, variable, and total costs relative to production
volume.
Graphs make it easy to explain business plans to stakeholders who might not love numbers
as much as accountants do.
6. Target Profit Analysis
Sometimes, you don’t just want to break even—you want to achieve a specific profit. CVP
Analysis helps in calculating the required sales volume to hit that target.
Required Sales (units) =
Fixed Costs + Target Profit
Selling Price – Variable Cost
Example Story:
If you aim for a profit of ₹30,000 on top of covering your fixed costs of ₹50,000:
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝑆𝑎𝑙𝑒𝑠 =
50,000 + 30,000
20
=
80,000
20
= 4,000 chocolates
Now you know exactly how many chocolates to produce and sell.
Assumptions of CVP Analysis
For CVP Analysis to work smoothly, some assumptions are made:
1. Costs can be neatly divided into fixed and variable.
2. Selling price per unit is constant.
3. All units produced are sold—no inventory buildup.
4. Total fixed costs remain constant, and variable cost per unit is stable.
5. The analysis typically applies to single-product or simplified product mixes.
While these assumptions may not always perfectly match reality, CVP Analysis still gives a
very close approximation for planning purposes.
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Real-Life Example to Tie It Together
Imagine Diwali season arrives, and you want to maximize chocolate sales. Using CVP tools:
• You calculate break-even and know minimum sales needed.
• Contribution margin analysis tells you which chocolate varieties are most profitable.
• Margin of safety shows how much sales can fall without causing a loss.
• P/V ratio helps decide whether to offer discounts or increase prices.
• Target profit analysis guides production planning to hit desired profit goals.
CVP Analysis turns overwhelming questions like “How many chocolates should I make?” into
clear, actionable answers.
Conclusion
In essence, CVP Analysis is the financial storyteller of your business. It takes numbers and
turns them into an understandable narrative about how costs, volume, and profit interact.
By using tools like break-even analysis, contribution margin, margin of safety, P/V ratio,
and target profit analysis, managers gain insight and confidence in decision-making.
It’s like having a roadmap in a dense forest—you still need to navigate carefully, but you
have guidance to reach your destination safely and profitably. For any business,
understanding CVP is not just helpful—it’s essential.
6.From the following data plot a break-even chart and showing : (a) Break-even point (b)
Margin of safety and profit (c) Number of units to be sold for a profit of Rs. 2,000.
Rs.
Selling price
5 per unit
Variable cost
3 per unit
Fixed cost
3000
Total number of units sold = 2000 units.
Show mathematical computations to verify your calculations.
Ans: Imagine you’re the captain of a small factory ship. Every unit you sell is a wave that
brings money in; every unit you produce is a wave that takes money out. You want to know
the exact point where the inflow catches up with the outflow — the moment your ship
stops just floating and starts sailing profitably. That moment is the break-even point. Once
you know it, you can chart the seas of margin of safety and steer toward a target profit.
Let’s turn the numbers you’ve been given into a clear, visual and mathematical story.
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Data and core ideas
• Selling price per unit: Rs. 5
• Variable cost per unit: Rs. 3
• Fixed cost: Rs. 3,000
• Total units sold: 2,000
Key definitions:
• Contribution per unit is the money left after covering variable cost:
Contribution per unit = Selling price − Variable cost = 5 − 3 = 2
• Profit equals total contribution minus fixed costs:
Profit = (Contribution per unit ⋅ Units) − Fixed cost
• Break-even point (BEP) occurs when profit is zero:
BEP units =
Fixed cost
Contribution per unit
Step 1: Break-even point
Compute BEP in units:
BEP units =
3000
2
= 1500 units
Compute BEP in sales value:
BEP sales = BEP units ⋅ Selling price = 1500 ⋅ 5 = Rs. 7500
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Interpretation:
• At 1,500 units (or Rs. 7,500 in sales), total revenue and total cost are equal. Beyond
this, every extra unit contributes Rs. 2 directly to profit.
Step 2: Profit at 2,000 units and margin of safety
Profit at actual volume (2,000 units):
Profit at 2000 units = (2 ⋅ 2000) − 3000 = 4000 − 3000 = Rs. 1000
Margin of safety (MOS) in units:
MOS units = Actual units − BEP units = 2000 − 1500 = 500 units
Margin of safety in value:
MOS value = MOS units ⋅ Selling price = 500 ⋅ 5 = Rs. 2500
Margin of safety as a percentage of sales volume:
MOS % =
MOS units
Actual units
× 100 =
500
2000
× 100 = 25%
Interpretation:
• The business is operating safely at 2,000 units, with a 25% cushion above break-
even. If sales fall by more than 500 units, profit would vanish and losses would begin.
Step 3: Units needed for a profit of Rs. 2,000
Target profit calculation:
Required units =
Fixed cost + Target profit
Contribution per unit
=
3000 + 2000
2
=
5000
2
= 2500 units
Check the profit at 2,500 units:
Profit = (2 ⋅ 2500) − 3000 = 5000 − 3000 = Rs. 2000
Interpretation:
• To earn Rs. 2,000 profit, the firm must sell 2,500 units. Each unit beyond break-even
adds Rs. 2 to profit, so an extra 1,000 contribution is generated by 500 more units
beyond the current 2,000-unit level.
Break-even chart: how to plot and read it
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To visualize the story, draw a simple graph:
• Horizontal axis: Units (from 0 to, say, 2,500).
• Vertical axis: Amount in rupees.
Plot two lines:
• Total Cost line: starts at Rs. 3,000 (fixed cost) and rises by Rs. 3 per unit.
Total Cost = 3000 + 3𝑥
• Total Revenue line: starts at 0 and rises by Rs. 5 per unit.
Total Revenue = 5𝑥
Mark key points:
• Break-even point is at the intersection of the two lines. Solve:
5𝑥 = 3000 + 3𝑥 ⇒ 2𝑥 = 3000 ⇒ 𝑥 = 1500
Coordinates: (1500,7500), since:
5 ⋅ 1500 = 7500,3000 + 3 ⋅ 1500 = 7500
• Actual performance point at 2,000 units:
o Revenue: 5 ⋅ 2000 = Rs. 10000
o Cost: 3000 + 3 ⋅ 2000 = 3000 + 6000 = Rs. 9000
o Profit visually is the vertical gap between revenue and cost lines at 2,000
units: 10000 − 9000 = Rs. 1000
• Target profit point at 2,500 units:
o Revenue: 5 ⋅ 2500 = Rs. 12500
o Cost: 3000 + 3 ⋅ 2500 = 3000 + 7500 = Rs. 10500
o Profit: 12500 − 10500 = Rs. 2000
Shade regions:
• Loss area: left of break-even (cost line above revenue line).
• Profit area: right of break-even (revenue line above cost line).
• Margin of safety: the horizontal distance from BEP (1,500 units) to actual sales
(2,000 units), i.e., 500 units.
Reading the chart:
• The slope of the revenue line (5) is steeper than the cost line’s variable slope (3),
which guarantees profit beyond the point where fixed cost is covered.
• The distance between lines at any unit level is the profit at that level.
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Full mathematical verification
1. Break-even point in units:
BEP units =
3000
2
= 1500
2. Profit at 2,000 units:
Profit = (2 ⋅ 2000) − 3000 = 4000 − 3000 = 1000
3. Margin of safety in units:
MOS units = 2000 − 1500 = 500
Margin of safety in value:
MOS value = 500 ⋅ 5 = 2500
Margin of safety percentage:
MOS % =
500
2000
⋅ 100 = 25%
4. Units required for Rs. 2,000 profit:
Required units =
3000 + 2000
2
= 2500
Profit check at 2,500 units:
(2 ⋅ 2500) − 3000 = 5000 − 3000 = 2000
All computations are consistent and self-reinforcing.
Intuition and insights the examiner will enjoy
• The contribution per unit is your “fuel efficiency.” At Rs. 2 per unit, every extra unit
sold beyond break-even adds Rs. 2 to profit. This is why target profit calculations are
so straightforward: divide the desired profit by contribution per unit, and add the
break-even units.
• The break-even point is fundamentally about covering fixed costs. If fixed cost rises
or contribution per unit falls, the BEP moves right — you need more units to cross
into profit.
• The margin of safety tells you how much sales can drop before you start losing
money. It’s a measure of risk comfort. Here, at 25%, you have a healthy cushion,
though not enormous.
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• Visually, the break-even chart stitches all these ideas into a single picture: two lines,
one intersection, and clear zones of loss and profit. It’s the simplest, most powerful
performance map you can draw for a single-product setup.
SECTION-D
7. What is Transfer Pricing ? Explain various methods of transfer pricing.
Ans: Imagine a huge multinational company, let’s call it GlobalTech Inc., with offices and
factories spread across the world—India, USA, Germany, and Brazil. Each branch is like a
separate little kingdom with its own managers, profits, and challenges. Now, suppose the
Indian branch manufactures high-quality microchips and sells them to the German branch,
which uses these chips to assemble smartphones. The question arises: At what price should
the Indian branch sell these microchips to the German branch? This is where the concept
of transfer pricing enters the story.
What is Transfer Pricing?
In simple words, transfer pricing refers to the pricing of goods, services, or intangible assets
(like patents or brand rights) when they are transferred between different divisions,
subsidiaries, or related companies within the same organization. Since these entities are
under common ownership, the price at which they trade is called a transfer price.
Transfer pricing becomes crucial because it affects:
1. Profits of each division – A higher transfer price may make the seller division look
more profitable, while the buyer division seems less profitable.
2. Taxation – Tax authorities in different countries can be affected depending on where
the profits are reported. For instance, if the Indian branch sells at a low price to
Germany, more profit may appear in Germany, which could have a lower tax rate.
3. Performance evaluation – Companies often evaluate managers based on the
profitability of their divisions. Transfer pricing ensures fairness in assessing
performance.
Think of it like this: if siblings are sharing a cake, transfer pricing is the method they use to
decide how much each sibling gets from the cake they bake together. Too much for one, too
little for another, and everyone might feel unfairly treated.
Why Transfer Pricing is Important
Let’s continue with GlobalTech Inc.. The stakes are high.
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1. Internal Decision Making: Suppose the German branch has to decide whether to
produce chips locally or import from India. The transfer price will directly influence
this decision. A higher price may push them to make chips themselves, while a lower
price encourages buying from India.
2. Profit Allocation Across Countries: Companies often operate in countries with
different tax rates. By setting transfer prices strategically, they can reduce overall tax
liability. This is why tax authorities closely monitor transfer pricing to prevent profit
shifting.
3. Performance Measurement: If the Indian branch shows massive profits because it
charges a very high transfer price, its manager may get incentives, but the German
branch may report losses. Transfer pricing ensures that performance metrics remain
fair.
4. Regulatory Compliance: Most countries, including India and the USA, have strict
rules on transfer pricing to prevent tax avoidance. Incorrect transfer pricing can lead
to penalties, audits, or legal disputes.
So, in essence, transfer pricing is not just an accounting concept—it is a strategic tool, a tax
planning mechanism, and a management tool all rolled into one.
Methods of Transfer Pricing
Now that we understand what transfer pricing is and why it matters, let’s dive into the
methods that companies use to determine these prices. Imagine GlobalTech’s finance team
sitting around a table, thinking: "How do we set a fair price for our inter-branch trades?"
Here are the main methods they consider:
1. Market-Based or Comparable Uncontrolled Price (CUP) Method
This method looks at the price of similar transactions between unrelated parties in the
open market.
• Story analogy: Imagine you’re selling apples to your cousin. If the local market sells
apples for ₹50 per kg, you wouldn’t want to charge your cousin ₹200 per kg—that
would be unfair. You’d likely charge around ₹50, just like in the market.
• Pros: Reflects real market conditions; simple if market prices are available.
• Cons: Hard to find exact comparables; adjustments may be needed for differences in
quality or terms.
2. Cost-Based Method
Here, the transfer price is determined based on the cost of production plus a markup for
profit. There are three sub-types:
1. Cost Plus Method: Transfer price = Cost + Standard Profit Margin.
o Example: Indian branch produces chips at ₹500 each and adds 20% profit. So,
transfer price = ₹500 + (20% of ₹500) = ₹600.
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2. Resale Price Method: Transfer price = Resale Price – Normal Profit Margin.
o Example: German branch plans to sell smartphones for ₹1000. The normal
profit margin is ₹200. Then, the transfer price for chips = ₹1000 – ₹200 =
₹800.
• Pros: Useful when market prices are unavailable.
• Cons: Determining the correct cost and markup can be subjective.
3. Profit Split Method
In this method, the total profit from a transaction is split between the divisions based on a
pre-agreed formula.
• Story analogy: Think of two friends starting a lemonade stand. One provides lemons,
the other provides sugar. They decide to split profits 60-40 based on who
contributed more. Similarly, divisions share profits based on their contribution.
• Pros: Fair allocation when both divisions contribute significantly.
• Cons: Complex to calculate; requires detailed financial data.
4. Transactional Net Margin Method (TNMM)
Here, the transfer price is set so that the profit margin of the transaction is in line with
similar independent transactions.
• Example: If independent companies in similar businesses earn 10% profit on sales,
the internal transfer should also aim for a 10% margin.
• Pros: Flexible; aligns with international standards.
• Cons: Requires careful selection of comparable companies.
5. Other Methods
Some companies also use arbitrary or negotiated methods, especially for intangible assets
like brand value or patents. However, these are often scrutinized by tax authorities.
Challenges in Transfer Pricing
While transfer pricing sounds straightforward, it comes with challenges:
1. Finding Comparables: Not all products have a market price, especially unique or
specialized items.
2. Tax Disputes: Tax authorities in different countries may have conflicting views,
leading to audits or penalties.
3. Currency Fluctuations: Prices between countries must account for exchange rates,
which can affect profits.
4. Intangibles: Patents, trademarks, and know-how are difficult to value accurately.
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Imagine GlobalTech trying to price a new AI chip. No exact market comparables exist, and
the cost of research is massive. Setting a fair transfer price becomes tricky, and mistakes can
lead to a financial headache.
Key Principles in Transfer Pricing
To make the process fair and compliant, companies follow some guiding principles:
1. Arm’s Length Principle: The transfer price should be the same as if the two divisions
were independent parties. This is the core principle recommended by the OECD
(Organisation for Economic Co-operation and Development).
2. Documentation: Companies must maintain detailed records of how prices were set.
3. Consistency: Methods should be applied consistently across similar transactions.
4. Transparency: Clear reporting to tax authorities avoids penalties.
Real-Life Example
Let’s see a simplified example of GlobalTech Inc.:
• Indian branch produces microchips at ₹500 each.
• German branch assembles smartphones using these chips.
• Market price of similar chips = ₹550.
• Indian branch sells 1,000 chips to Germany.
Option 1: CUP Method: Transfer price = ₹550 → Indian branch profit = ₹50,000.
Option 2: Cost Plus Method (20% markup): Transfer price = ₹600 → Indian branch profit =
₹100,000.
Option 3: TNMM (profit margin 10% on cost): Transfer price = ₹550 → same as CUP.
Depending on the method chosen, profits shift between branches and even between
countries for tax purposes. Hence, choosing the right method is critical.
Conclusion
Transfer pricing is more than just numbers on a ledger—it’s a strategic balancing act.
Companies must consider internal fairness, tax regulations, global business strategy, and
managerial incentives. By understanding different methods like the CUP method, cost-
based methods, profit split, and TNMM, managers can ensure that divisions are treated
fairly, tax compliance is maintained, and corporate objectives are met.
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Think of it as a story of brothers sharing the same cake: everyone wants a fair slice, and
transfer pricing is the recipe that ensures no one feels cheated. Done right, it keeps the
company happy, regulators satisfied, and managers motivated—a true win-win situation!
8. Write notes on :
(a) Activity Based Costing.
(b) Responsibility Centers.
Ans: Imagine you walk into a large factory. Machines are humming, workers are moving,
and products are rolling off the line. At first glance, you might think costs are simply
“materials + wages + overhead.” But then you notice something deeper: some products
require extra testing, some need special packaging, others demand more machine setups.
Suddenly, you realize not all products consume resources equally. This is where Activity
Based Costing (ABC) comes in—it’s like putting on a pair of glasses that lets you see exactly
which activities are driving costs.
Now, shift the scene. You’re in the head office of the same company. The CEO is not just
interested in costs but also in accountability. Who is responsible for controlling costs? Who
ensures revenue targets are met? Who manages investments? This is where the concept of
Responsibility Centers enters—a way of dividing the organization into smaller units, each
with its own manager accountable for specific results.
Let’s explore both concepts in detail, weaving them into a story that is easy to follow,
examiner-friendly, and rich with examples.
(a) Activity Based Costing (ABC)
󷈷󷈸󷈹󷈺󷈻󷈼 The Traditional Problem
In traditional costing systems, overheads are often allocated using a single base—like
machine hours or labor hours. This works fine when products are simple and similar. But in
modern industries, where products vary widely, this method distorts costs.
For example:
• Product A is mass-produced, requires little supervision, and runs smoothly on
machines.
• Product B is custom-made, requires frequent setups, special engineering, and quality
checks.
If overhead is allocated only on machine hours, Product A may appear more expensive than
it really is, while Product B looks cheaper. This misleads managers into wrong pricing and
profitability decisions.
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󷈷󷈸󷈹󷈺󷈻󷈼 The ABC Solution
Activity Based Costing solves this by recognizing that activities consume resources, and
products consume activities.
Steps in ABC:
1. Identify activities: e.g., machine setup, quality inspection, material handling,
packaging.
2. Assign costs to activity cost pools: e.g., total cost of all setups in a year.
3. Identify cost drivers: measurable factors that cause the cost of an activity, e.g.,
number of setups, number of inspections, orders processed.
4. Calculate cost driver rates:
Cost driver rate =
Total cost of activity
Total number of cost driver units
5. Assign costs to products: Multiply the cost driver rate by the number of cost driver
units consumed by each product.
󷈷󷈸󷈹󷈺󷈻󷈼 Example Story
Suppose a company makes two products: X and Y.
• Overhead activities:
o Machine setups: Rs. 1,00,000 (100 setups in total)
o Quality inspections: Rs. 50,000 (500 inspections in total)
• Cost driver rates:
o Setup cost per setup = 1,00,000 ÷ 100 = Rs. 1,000
o Inspection cost per inspection = 50,000 ÷ 500 = Rs. 100
• Consumption by products:
o Product X: 20 setups, 100 inspections
o Product Y: 80 setups, 400 inspections
• Overhead assigned:
o Product X: (20 × 1,000) + (100 × 100) = 20,000 + 10,000 = Rs. 30,000
o Product Y: (80 × 1,000) + (400 × 100) = 80,000 + 40,000 = Rs. 1,20,000
Now, overhead is allocated fairly. Product Y, which consumes more setups and inspections,
bears more cost.
󷈷󷈸󷈹󷈺󷈻󷈼 Advantages of ABC
• Accuracy: Provides more realistic product costs.
• Better pricing: Helps managers set prices based on true costs.
• Identifies cost drivers: Shows which activities are expensive and need efficiency
improvements.
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• Supports decision-making: Useful for product mix, outsourcing, and process
improvement decisions.
󷈷󷈸󷈹󷈺󷈻󷈼 Limitations of ABC
• Complexity: Requires detailed data collection.
• Costly to implement: More time and resources needed.
• Not always necessary: For simple businesses, traditional costing may suffice.
󷈷󷈸󷈹󷈺󷈻󷈼 Examiner-Friendly Summary
Activity Based Costing is a modern costing method that assigns overheads based on
activities and cost drivers, rather than a single base. It improves accuracy, highlights
inefficiencies, and supports better decisions, though it can be complex and costly to
implement.
(b) Responsibility Centers
󷈷󷈸󷈹󷈺󷈻󷈼 The Idea of Accountability
In large organizations, it’s impossible for top management to control every detail. Instead,
the company is divided into responsibility centers, each headed by a manager who is
accountable for specific results. This creates clarity: who is responsible for costs, who for
revenues, who for investments.
󷈷󷈸󷈹󷈺󷈻󷈼 Types of Responsibility Centers
1. Cost Centers
o Focus: Control of costs.
o Manager is responsible only for costs, not revenues.
o Example: Maintenance department, HR department.
o Performance measure: Actual cost vs. budgeted cost.
2. Revenue Centers
o Focus: Generating revenue.
o Manager is responsible for sales, not costs.
o Example: Sales department, marketing division.
o Performance measure: Actual sales vs. targets.
3. Profit Centers
o Focus: Both costs and revenues.
o Manager is responsible for profit (Revenue − Cost).
o Example: A branch office, a product division.
o Performance measure: Actual profit vs. budgeted profit.
4. Investment Centers
o Focus: Costs, revenues, and investments in assets.
o Manager is responsible for return on investment (ROI).
o Example: A subsidiary company, a strategic business unit.
o Performance measure: ROI, residual income, economic value added.
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󷈷󷈸󷈹󷈺󷈻󷈼 Example Story
Imagine a retail chain with multiple stores:
• The store manager of one outlet is a profit center head—responsible for both sales
and expenses of that store.
• The regional manager overseeing several stores is an investment center head—
responsible not only for profits but also for decisions like opening new outlets or
investing in technology.
• The HR department at headquarters is a cost center—its job is to manage
recruitment and training within budget.
• The sales team is a revenue center—their performance is judged by how much
revenue they bring in.
This structure ensures accountability at every level.
󷈷󷈸󷈹󷈺󷈻󷈼 Advantages of Responsibility Centers
• Clarity of accountability: Each manager knows what they are responsible for.
• Performance measurement: Easy to compare actual vs. budgeted results.
• Motivation: Managers feel ownership of their results.
• Decentralization: Top management can focus on strategy while operational
decisions are delegated.
󷈷󷈸󷈹󷈺󷈻󷈼 Limitations of Responsibility Centers
• Conflict of interest: Managers may focus only on their own center, ignoring overall
company goals.
• Measurement difficulties: Some costs and revenues are hard to allocate fairly.
• Short-term focus: Managers may prioritize immediate results over long-term
benefits.
󷈷󷈸󷈹󷈺󷈻󷈼 Examiner-Friendly Summary
Responsibility Centers divide an organization into smaller units where managers are
accountable for specific results. They can be cost centers, revenue centers, profit centers, or
investment centers. This system improves accountability, performance measurement, and
motivation, though it may create conflicts and measurement challenges.
󽆪󽆫󽆬 Bringing It All Together
• Activity Based Costing is about accuracy in cost allocation: tracing costs to activities
and then to products. It answers: “Which product or service is really consuming our
resources?”
• Responsibility Centers are about accountability in management: dividing the
organization into units with clear responsibilities. It answers: “Who is responsible for
controlling costs, generating revenue, or managing investments?”
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Together, they form a powerful duo: ABC ensures costs are understood correctly, while
responsibility centers ensure managers are held accountable for those costs and revenues.
󹶓󹶔󹶕󹶖󹶗󹶘 Conclusion
Think of a company as a play. Activity Based Costing is like the stage lighting—it shines on
each activity, showing which ones consume resources and how much. Responsibility
Centers are like the cast and crew—each with a defined role, accountable for their part in
the performance. When both are in place, the play runs smoothly, costs are transparent,
and accountability is clear.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”