CA Intermediate

Budget and Budgetary Control – CA Inter Cost and Management Accounting Study Material is designed strictly as per the latest syllabus and exam pattern.

Budget and Budgetary Control – CA Inter Costing Study Material

1. Budgetary Control: It is the system of management control and accounting in which all the operations are forecasted and planned in advance to the: extent possible and the actual results compared with the forecasted and planned results.

2. Types of Budget:

• Capacity wise – Fixed Budget, Flexible Budget,
• Functions wise – Sales Budget, Production Budget, Plant Utilisation Budget, Direct Material Usage Budget, Direct Material Purchase Budget/etc.,
• Master Budget,
• Period wise – Long Term Budgets, Short Term Budgets, Current Budgets.

3. Budget Ratios: It provide information about the performance level, i.e., the extent of deviation of actual performance from budgeted performance: and whether the actual performance is favourable or unfavourable.
Ratio is 100% or more – Favourable performance
Ratio is less than 100% – Unfavourable performance

Theory Questions

Question 1.
What are the essential characteristics of budget [CA Inter Nov. 2011, 2 Marks]
Answer:
Essential characteristics of budget:

• It is concerned for a definite future period.
• It is a detailed plan of all economic activities of a business.
• It is a mean to achieve business objectives and it is not an end in itself.
• It helps in planning, co-ordination and control.
• It acts as a business barometer.
• It is usually prepared in the light of past experiences.

Question 2.
What are the objectives of Budgetary Control System? [ICAI Module]
Answer:

• Portraying with precision the overall aims of the business and determining targets of performance for each section or department of the business.
• Providing a basis for the comparison of actual performance with the predetermined targets and investigation of deviation, if any, of actual performance and expenses from the budgeted figures.
• Ensuring optimum use of available resources to maximise profit or production, subject to the limiting factors.
• Co-ordinating various activities of the business, and centralising control and yet enabling management to decentralise responsibility and delegate authority in the overall interest of the business.
• Providing a basis for revision of current and future policies.
• Drawing up long range plans with a fair measure of accuracy.

Question 3.
Describe the steps involved in establishing good budgeting control system [CA Inter Nov. 2013, 4 Marks]
Answer:
The following steps are necessary for establishing a good budgetary control system:

• Determining the objectives to be achieved, over the budget period, and the policy or policies that might be adopted for the achievement of these objectives.
• Determining the activities that should be undertaken for the achievement of objectives.
• Drawing up a plan or a scheme of operation in respect of each class of activity, in quantitative as well as monetary terms for the budget period.
• Laying out a system of comparison of actual performance by each person, or department with the relevant budget and determination of causes for the variation, if any.
• Ensuring that corrective action will be taken where the plan has not been achieved and, if that is not possible, for the revision of the plan.

Question 4.
What are the advantages of Budgetary Control System? [ICAI Module]
Answer:

Points	Description
1. Efficiency	The use of budgetary control system enables the management to conduct its business activities in an efficient manner.
2. Control on expenditure	It is a powerful instrument used by business entity for the control of their expenditure. It provides a yardstick for measuring and evaluating the performance of individuals and their departments.
3. Finding deviations	Budget reveals the deviations of the actual from the budgeted figures after making a comparison and communicating the deviation to management.
4. Effective utilisation of resources	Effective utilisation of various resources like men, material, machinery and money, is made possible, as the production is planned after taking these into account.
5. Revision of plans	Budget helps in the review of current trends and framing of future policies.
6. Cost Consciousness	Budgetary control system encourages cost consciousness and maximum utilisation of available resources.

Question 5.
What is ‘Budgetary Control System’ and discuss the components of the same. [CA Inter Dec. 2021, May 2009, 5 Marks]
Answer:
It is the system of management control and accounting in which all the operations are forecasted and planned in advance to the extent possible and the actual results compared with the forecasted and planned results.

Components of Budgetary Control System:
The policy of a business for a defined period is represented by the master budget, the detailed components of which are given, in a number of individual budgets called functional budgets. These functional budgets are broadly grouped under the following heads:
1. Physical budgets: Those budgets which contain information in quantitative terms such as the physical units of sales, production etc. This may include quantity of sales, quantity of production, inventories, and manpower budgets are physical budgets.

2. Cost budgets: Budgets which provides cost information in respect of , manufacturing, administration, selling and distribution, etc. for example, manufacturing costs, selling costs, administration cost, and research and development cost budgets are cost budgets.

3. Profit budgets: A budget which enables the ascertainment of profit. For example, sales budget, profit and loss budget, etc.

4. Financial budgets: A budget which facilitates in ascertaining the financial position of a concern, for example, cash budgets, capital expenditure budget, budgeted balance sheet etc.

Question 6.
State the limitations of Budgetary Control System. [CA Inter January 2021, 5 Marks]
Answer:
Limitations of Budgetary Control System

Points	Description
1. Based on Estimates	Budgets are based on a series of estimates, which are based on the conditions prevalent or expected at the time budget is established. It requires revision in plan if conditions change.
2. Time factor	Budgets cannot be executed automatically. Some preliminary steps are required to be accomplished before budgets are implemented. It requires proper attention and time of management. Management must not expect too much during the initial development period.
3. Co-operation Required	Staff co-operation is usually not available during the initial budgetary control exercise. In a decentralized organisation, each unit has its own objective and these units enjoy some degree of discretion. In this type of organisation structure, coordination among different units is required. The success of the budgetary control depends upon willing co-operation and teamwork.
4. Expensive	The implementation of budget is somewhat expensive. For successful implementation of the budgetary control, proper organisation structure with responsibility is prerequisite. Budgeting process start from the collection of information to for preparing the budget and performance analysis. It consumes valuable resources (in terms of qualified manpower, equipment, etc.) for this purpose; hence, it is an expensive process.
5. Not a substitute for management.	Budget is only a managerial tool and must be intelligently applied for management to get benefited. Budgets are not a substitute for good management.
6. Rigid document	Budgets are sometime considered as rigid documents. But in reality, an organisation is exposed to various uncertain internal and external factors. Budget should be flexible enough to incorporate ongoing developments in the internal and external factors affecting the very purpose of the budget.

Question 7.
Describe the salient features of budget manual. [CA Inter RTP May 2021]
Answer:
Following are the salient features of Budget Manual:

• It contains much information which is required for effective budgetary planning.
• It is a collection of documents that contains key information for those involved in the planning process.
• It includes introductory explanation of the budgetary planning and control process, statement of the budgetary objective and desired results.
• It contains a form of organisation chart to show who is responsible for the preparation of each functional budget and the way in which the budgets are interrelated.
• In contains a timetable for the preparation of each budget.
• Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning their completion is included in Budget Manual.

Question 8.
Explain briefly the concept of ‘flexible budget’. [CA inter Nov. 2019, Nov. 2017, Nov. 2008, 2 Marks]
Answer:
Flexible Budget: A flexible budget is defined as “a budget which, by recognizing the difference between fixed, semi-variable and variable cost is designed to change in relation to the level of activity attained”. A fixed budget, on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. In a fixed budgetary control, budgets are prepared for one level of activity whereas in a flexibility budgetary control system, a series of budgets are prepared one for the each of a number of alternative production levels or volumes. Flexible budgets represent the amount of expense that is reasonably necessary to achieve each level of output specified. In other words, the allowances given under flexibility budgetary control system serve as standards of what costs should be at each level of output.

Question 9.
What are the cases when a flexible budget is found suitable? [CA Inter May 2019, 5 Marks]
Answer:
Flexible budgeting may be resorted to under following situations:

• In the case of new business venture due to its typical nature it may be difficult to forecast the demand of a product accurately.
• Where the business is dependent upon the mercy of nature e.g., a per-son dealing in wool trade may have enough market if temperature goes below the freezing point.
• In the case of labour-intensive industry where the production of the concern is dependent upon the availability of labour.

Suitability for flexible budget:

• Seasonal fluctuations in sales and/or production, for example in soft drinks industry.
• A company which keeps on introducing new products or makes changes in the design of its products frequently.
• Industries engaged in make-to-order business like ship building.
• An industry which is influenced by changes in fashion; and
• General changes in sales.

Question 10.
Distinguish between ‘Fixed and flexible budget’. [CA Inter Nov. 2011, May 2016, 4 Marks]
Answer:
Difference between fixed and flexible budgets

Fixed Budget	Flexible Budget
1. It does not change with actual volume of activity achieved. Thus it is rigid.	It can be recasted on the basis of activity level to be achieved. Thus it is not rigid.
2. It operates on one level of activity and under one set of conditions.	It consists of various budgets for different level of activity.
3. If the budgeted and actual activity levels differ significantly, then cost ascertainment and price fixation do not give a correct picture.	It facilitates the cost ascertainment and price fixation at different levels of activity.
4. Comparisons of actual and budgeted targets are meaningless particularly when there is difference between two levels.	It provided meaningful basis of comparison of actual and budgeted targets.

Question 11.
List the eight functional budgets prepared by a business. [CA Inter Nov. 2009, 3 Marks]
Answer:
The various commonly used Functional budgets are:

1. Sales Budget
2. Production Budget
3. Plant Utilisation Budget
4. Direct Material Usage Budget
5. Direct Material Purchase Budget
6. Direct Labour (Personnel) Budget
7. Factory Overhead Budget
8. Production Cost Budget.

Question 12.
State the considerations on which capital expenditure budget is prepared. [CA Inter Nov. 2012, 4 Marks]
Answer:
The preparation of Capital Expenditure Budget is based on the following considerations:

1. Overhead on production facilities of certain departments as indicated by the plant utilisation budget.
2. Future development plans to increase output by expansion of plant facilities.
3. Replacement requests from the concerned departments.
4. Factors like sales potential to absorb the increased output, possibility of price reductions, increased costs of advertising and sales promotion to absorb.increased output, etc.

Question 13.
Write a short note on ‘Zero Base Budgeting as an approach towards Productive improvement. [CA Inter Nov. 2005, 4 Marks]
Answer:
Zero Base Budgeting approach plays key role in productivity improvement.
It is beneficial in this regard in the following manner:

1. ZBB ensures that the various functions adopted by the organisation are important and critical for the achievement of its objectives and are being performed in the best possible way.
2. ZBB gives an opportunity to the management to allocate resources for different activities only after proper cost benefit analysis.
3. In this approach, ‘chances of arbitrary cuts and enhancement are thus avoided.
4. Department budgets are closely linked with corporate objectives.
5. It provides a systematic approach for the evaluation of different activities and rank them in order of preference for the allocation of scarce resources.
6. Wasteful expenditures can be easily identified and eliminated.

Question 14.
Why is ‘Zero Base Budgeting’ (ZBB) considered superior to ‘Traditional Budgeting’? Explain. [CA Inter May 2018, 5 Marks]
Answer:
Zero based budgeting is superior to traditional budgeting: Zero based budgeting is superior to traditional budgeting in the following manner:

• It provides a systematic approach for evaluation of different activities.
• It ensures that the function undertaken is critical for the achievement of the objectives.
• It provides an opportunity for management to allocate resources to various activities after a thorough – cost benefit analysis.
• It helps in the identification of wasteful expenditure and then their elimination. It facilitates the close linkage of departmental budgets with corporate objectives.
• It helps in the introduction of a system of Management by Objectives.

Question 15.
What are the advantages and limitations of zero base budgeting? [CA Final Nov. 2004, 4 Marks]
Answer:
Advantages of ZBB:

• It provides a systematic approach for the evaluation of different activities and rank them in order of preference for the allocation of scarce resources.
• It ensures that the various functions undertaken by the organization are critical for the achievement of its objectives and are being performed in the best possible way.
• It provides an opportunity to the management to allocate resources for various activities only after having a thorough cost-benefit-analysis. The chances of arbitrary cuts and enhancement are thus avoided.
• The areas of wasteful expenditure can be easily identified and eliminated.
• Departmental budgets are closely linked with corporation objectives.
• The technique can also be used for the introduction and implementation of the system of ‘management by objective.’ Thus, it cannot only be used for fulfilment of the objectives of traditional budgeting but it can also be used for a variety of other purposes.

Limitations of ZBB:

• The work involves in the creation of decision-making and their subsequent ranking has to be made on the basis of new data. This process is very tedious to management.
• The activities selected for the purpose of ZBB are on the basis of the traditional functional departments. So the consideration scheme may not be implemented properly.

Question 16.
Define Zero Base Budgeting and mention its various stages. [CA Inter Nov. 2019, 5 Marks]
Answer:
Zero-based Budgeting: (ZBB) is an emergent form of budgeting which arises to overcome the limitations of incremental (traditional) budgeting system. Zero- based Budgeting (ZBB) is defined as a method of budgeting which requires each cost element to be specifically justified, although the activities to which the budget relates are being undertaken for the first time, without approval, the budget allowance is zero’.

ZBB is an activity based budgeting system where budgets are prepared for each activities rather than functional department. Justification in the form of cost benefits for the activity is required to be given. The activities are then evaluated and prioritized by the management on the basis of factors like synchronisation with organisational objectives, availability of funds, regulatory requirement etc.

ZBB is suitable for both corporate and non-corporate entities. In case of non-corporate entities like Government department, local bodies, not for profit organisations, where these entities need to justify the benefits of expenditures on social programmes like mid-day meal, installation of street lights, provision of drinking water etc.

ZBB involves the following stages:

• Identification and description of Decision packages
• Evaluation of Decision packages
• Ranking (Prioritisation) of the Decision packages
• Allocation of resources

Question 17.
What are the important points an organization should consider if it wants to adopt Performance Budgeting? [CA Inter Nov. 2020, 5 Marks]
Answer:
For an enterprise that wants to adopt Performance Budgeting, it is thus imperative that:

• The objectives of the enterprise are spelt out in concrete terms.
• The objectives are then translated into specific functions, programmes, activities and tasks for different levels of management within the realities of fiscal constraints.
• Realistic and acceptable norms, yardsticks or standards and performance indicators should be evolved and expressed in quantifiable physical units.
• A style of management based upon decentralised responsibility structure should be adopted, and
• An accounting and reporting system should be developed to facilities monitoring, analysis and review of actual performance in relation to budgets.

Question 18.
Write short note on Budget Ratio. [ICAI Module]
Answer:
Budget ratios provide information about the performance level, i.e., the extent of deviation of actual performance from the budgeted performance and whether the actual performance is favourable or unfavorable. If the ratio is 100% or more, the performance is considered as favourable and if ratio is less than 100% the performance is considered as unfavourable.

The following ratios are usually used by the management to measure development from budget.

Practical Questions

Flexible Budget

Question 1.
G Ltd. manufactures a single product for which market demand exists for additional quantity. Present sales of ₹ 6,00,000 utilises only 60% capacity of the plant. The following data are available:
(1) Selling price : ₹ 100 per unit
(2) Variable cost : ₹ 30 per unit
(3) Semi-variable expenses : ₹ 60,000 fixed + ₹ 5 per unit
(4) Fixed expenses : ₹ 1,00,000at present level, estimated to increase by 25% at and above 80% capacity.
You are required to prepare a flexible budget so as to arrive at the operating profit at 60%, 80% and 100% levels. [ CA Inter Nov. 2020, 5 Marks]
Answer:

Note:
60% level of activity = 6,000 units (given)
80% level or activity = \(\frac{6,000 \text { units } \times 80 \%}{60 \%}\) = 8,000 units
100% level of activity = \(\frac{6,000 \text { units } \times 100 \%}{60 \%}\) = 10,000 units

Question 2.
The Cost Sheet of a company based on a budgeted volume of Sales of 3,00,000 units per quarter is as under:

	₹ per unit
Direct Materials	5.00
Direct Wages	2.00
Factory overheads (50% fixed)	6.00
S/A dm, overheads (1/3 variable)	3.00
Selling price	18.00

When the budget was discussed it was felt that the company would be able to achieve only a volume of 2,50,000 units of production and sales per quarter. The company therefore decided that an aggressive sales promotion campaign should be launched to achieve the following improved operations:

Proposal I:

• Sell 4,00,000 units per quarter by spending 2,00,000 on special advertising.
• The factory fixed costs will increase by 4,00,000 per quarter.

Proposal II:

• 5,00,000 units per quarter subject to the following conditions.
• An overall price reduction of 2 per unit is allowed on all sales.
• Variable Selling and Administration Costs will increase by 5%.
• Direct Material Costs will be reduced by 1% due to purchase price discounts.
• The fixed factory Costs will increase by 2,00,000 more.

You are required to prepare a Flexible Budget at 2,50,000, 4,00,000 and 5,00,000 units of output per quarter and calculate the Profit at each of the above levels of output. [CA Final May 2002, 9 Marks]
Answer:
Statement of flexible budget and profit per quarter at 2,50,000; 4,00,000 and 5,00,000 units of output levels per quarter

Under proposal II the factory costs were increased by 2,00,000 more over proposal I.

Question 3.
The Accountant of KPMR Ltd, has prepared the following budget for the coining year 2022 for its two products ‘AYE’ and ‘ZYF’:

Particulars	Product ‘AYE’	Product ‘ZYE’
Production and Sales (in Units)	4,000	3,000
	Amount (in ₹)	Amount (in ₹)
Selling Price per unit	200	180
Direct Material per unit	80	70
Direct Labour per unit	40	35
Variable Overhead per unit	20	25
Fixed Overhead per unit	10	10

After reviewing the above budget, the management has called the marketing team for suggesting some measures for increasing the sales. The marketing team has suggested that by promoting the products on social media, the sales quantity of both the products can be increased by 5%. Also, the selling price per unit will go up by 10%. But this will result in increase in expenditure on variable overhead and fixed overhead by 20% and 5% respectively for both the products.
You are required to prepare flexible budget for both the products:
(i) Before promotion on social media.
(ii) After promotion on social media. [CA Inter Dec. 2021, 5 Mar ks]
Answer:
(i) Flexible budget (before promotion)

(ii) Flexible budget (after promotion)

Question 4.
Tricon Co. furnishes the following information for the month of September, 2020.

During the month 10,000 kg. of materials and 3.100 direct labour hours were utilized.
Required:
(i) Prepare a flexible budge! for the month.
(ii) Deter the material usage variance and the direct labour rate variance for the actual vs the flexible budget. [CA Inter MTP]
Answer:
(i) Statement Showing “Flexible Budget for 3,200 units Activity Level”

(ii) Computation of Variances
Material Usage Variance = Standard Cost of Standard Quantity for Actual Production – Standard Cost of Actual Quantity
= (SQ – AQ) × SP
= [(3,200 units × 3 kg.) – 10,000 kg.] × ₹ 30.00
= ₹ 12,000 (A)

Labour Rate Variance = Standard Cost of Actual Time – Actual Cost
= (SR – AR) × AH
= [₹ 72 – \(\left(\frac{₹ 2,25,000}{3,100}\right)\)] × 3,100
= ₹ 2,400(A)

Question 5.
You are given the following data of a manufacturing concern:

	₹
Variable Expenses (at 50% capacity):
-Materials	48,00,000
-Labour	51,20,000
-Others	7,60,000
Semi variable expenses (at 50% capacity):
-Maintenance and Repairs	5,00,000
-Indirect Labour	19,80,000
-Sales-Dept. Salaries	5,80,000
-Sundry Administrative Expenses	5,20,000
Fixed Expenses:
-Wages & Salaries	16,80,000
-Rent, Rates and Taxes	11,20,000
-Depreciation	14,00,000
-Sundry Administrative Exp.	17,80,000

The fixed expenses remain constant for ail levels of production. Semi variable expenses remain constant between 45% and 65% of capacity whereas it increases by 10% between 65% and 80% capacity of 20% between 80% and 100% capacity.
Sales at various levels are as under:

Capacity	Sales (₹)
75%	2,40,00,000
100%	3,20,00,000

Prepare flexible budget at 75% and 100% capacity. [CA Inter May 2017, 8 Marks]
Answer:

At 75% and 100% capacity level, the semi-variable costs increased by 10% and 20% respectively.

Question 6.
Maharatna Ltd., a public sector undertaking (PSU), produces product A. The company is in process of preparing its revenue budget for the year 2022. The company has the following information which can be useful in preparing the budget:
(i) It has anticipated 12% growth in sales volume from the year 2021 of 4,20,000 tonnes.
(ii) The sales price of ₹ 23,000 per tonne will be increased by 10% provided Wholesale Price Index (WPI) increases by 5%.
(iii) To produce one tonne of product A, 2.3 tonnes of raw material are required. The raw material cost is ₹ 4,500 per tonne. The price of raw material will also increase by 10% if WPI increase by 5%.
(iv) The projected increase in WPI for 2022 is 4%.
(v) A total of 6,000 employees works for the company. The company works 26 days in a month.
(vi) 85% of employees of the company are permanent and getting salary as per 5- year wage agreement. The earnings per manshift (means an employee cost for a shift of 8 hours) is ₹ 3,000 (excluding terminal benefits). The new wage agreement will be implemented from 1st July 2022 and it is expected that a 15% increase in pay will be given.
(vii) The casual employees are getting a daily wage of ₹ 850. The wages in linked to Consumer Price Index (CPI). The present CPI is 165.17 points and it is expected to be 173.59 points in year 2022.
(viii)Power cost for the year 2021 is ₹ 42,00,000 for 7,00,000 units (1 unit = 1 Kwh). 60% of power is used for production purpose (directly related to production volume) and remaining are for employee quarters and administrative offices.
(ix) During the year 2021, the company has paid ₹ 60,00,000 for safety and maintenance works. The amount will increase in proportion to the volume of production.
(x) During the year 2021, the company has paid ₹ 1,20,000 for the purchase of diesel to be used in car hired for administrative purposes. The cost of diesel will increase by 15% in year 2022.
(xi) During the year 2021, the company has paid ₹ 6,00,000 for car hire charges (excluding fuel cost). In year 2022, the company has decided to reimburse the diesel cost to the car rental company. Doing this will attract 5% GST on Reverse Charge Mechanism (RCM) basis on which the company will not get GST input credit.
(xii) Depreciation on fixed assets for the year 2021 is ₹ 80,40,00,000 and it will be 15% lower in 2022.
Required:
From the above information prepare Revenue (Flexible) budget for the year 2022 and also show the budgeted profit/loss for the year. [CA Inter RTP May 2022]
Answer:
Revenue Budget (Flexible Budget) of Maharatna Ltd. for the Year 2022

Working Notes:
1. Calculation of Raw Material Cost:

2. Calculation of Wages and Salary Cost:

3. Calculation of Power Cost:

4. Calculation of Car Hire Charges:

Expense Budget

Question 7.
KLM Limited has prepared its expense budget for 50,000 unIts in its factory for the year 2020-2 1 as detailed below:

	₹ per unit
Direct Materials	125
Direct Labour	50
Variable Overhead	40
Direct Expenses	15
Selling Expenses (20% fixed)	25
Factory Expenses (100% fixed)	15
Administration expenses (100% fixed)	8
Distribution expenses (85% variable)	20
Total	298

Prepare an expense budget for the production of 35,000 units and 70,000 units. [CA Inter May 2013, Nov 2019, RTP]
Answer:
Expense Budget of KLM Ltd.

Selling Expenses:	Fixed cost per unit	= ₹ 25 × 20% = ₹ 5
Fixed Cost	= ₹ 5 × 50,000 units	= ₹ 2,50,000
Variable Cost Per unit	= ₹ 25 – ₹ 5	= ₹ 20
Distribution Expenses:	Fixed cost per unit	= ₹ 20 × 15% = ₹ 3
Fixed Cost	= ₹ 3 × 50,000 units	= ₹ 1,50,000
Variable cost per unit	= ₹ 20 – ₹ 3	= ₹ 17

Question 8.
RST Limited is presently operating at 50% capacity and producing 30,000 units. The entire output is sold at a price of ₹ 200 per unit. The cost structure at the 50% level of activity is as under:

	₹
Direct Material	75 per unit
Direct Wages	25 per unit
Variable Overheads	25 per unit
Direct Expenses	15 per unit
Factory Expenses (25% fixed)	20 per unit
Selling and Distribution Exp. (80% variable)	10 per unit
Office and Administrative Exp. (100% fixed)	5 per unit

The company anticipates that the variable costs will go up by 10% and fixed costs will go up by 15%.
You are required to prepare an Expense budget, on the basis of marginal cost for the company at 50% and 60% level of activity and find out the profits at respective levels. [CA Inter Nov. 2014, 8 Marks]
Answer:

Note:
50% level of activity = 30,000 units (given)
60% level of activity = \(\frac{30,000 \text { units } \times 60 \%}{50 \%}\) = 36,000 units

Functional Budget

Question 9.
A Vehicle manufacturer has prepared sales budget for the next few months, and the following draft figures are available:

Month	No. of vehicles
October	40,000
November	35,000
December	45,000
January	60,000
February	65,000

To manufacture a vehicle a standard cost of ₹ 11,42,800 is incurred and sold through dealers at a uniform selling price of ₹ 17,14,200 to customers. Dealers are paid 15% commission on selling price on sale of a vehicle.

Apart from other materials, four units of Part-X are required to manufacture a vehicle. It is a policy of the company to hold stocks of Part-X at the end of each month to cover 40% of next month’s production. 48,000 units of Part-X are in stock as on 1st October.

There are 9,500 Nos. of completed vehicles in stock as on 1st October and it is policy to have stocks at the end of each month to cover 20% of the next month’s sales.
You are required to
(i) Prepare Production budget (in Nos.) for the month of October, November, December and January.
(ii) Prepare a Purchase budget for Part-X (in units) for the months of October, November and December.
(iii) Calculate the budgeted gross profit for the quartet October to December. [CA Inter May 2020 RTP]
Answer:
(i) Preparation of Production Budget (in units)

(ii) Preparation of Purchase budget for Part-X

(iii) Budgeted Gross Profit for the Quarter October to December

Net Selling Price per unit = ₹ 17,14,200 – (15% commission on ₹ 17,14,200) = ₹ 14,57,070

Question 10.
RS Ltd. manufactures and sells a single product and has estimated sale;; revenue of ₹ 302.4 lakh during the year based on 20% profit on selling price. Each unit of product requires 6 kg of material A and 3 kg of material B and processing time of 4 hours in machine shop and 2 hours in assembly shop Factory overheads are absorbed at a blanket rate of 20% of direct labour. Variable selling & distribution overheads are ₹ 60 per unit sold and fixed selling & distribution overheads are estimated to be ₹ 69,12,000.
The other relevant details are as under:
Purchase Price:
Material A ₹ 160 per kg
Material B ₹ 100 per kg

Labour Rate:
Machine Shop ₹ 140 per hour
Assembly Shop ₹ 70 per hour

	Finished Stock	Material A	Material B
Opening Stock	2,500 units	7,500 kg	4000 kg
Closing Stock	3,000 units	8,000 kg	5,500kg

Required:
(i) Calculate number of units of product proposed to be sold and selling price per unit,
(ii) Prepare Production Budget in units, and
(iii) Prepare Material Purchase Budget in units. [CA Inter May 2021 RTP]
Answer:
Statement Showing ‘Total Variable Cost for the year’

Estimated Sales Revenue	3,02,40,000
Less: Desired Profit Margin on Sale @ 20%	60,48,000
Estimated Total Cost	2,41,92,000
Less: Fixed Selling and Distribution Overheads	69,12,000
Total Variable Cost	1,72,80,000

Statement Showing ‘Variable Cost per unit’.

(i) Calculation of number of units of product proposed to be sold and selling price per unit ?
Number of Units Sold = Total Variable Cost/Variable Cost per unit
= ₹ 1,72,80,000/₹ 2,160
= 8,000 units
Selling Price per unit = Total Sales Value/Number of Units Sold
= ₹ 3,02,40,000/8,000 units
= ₹ 3,780

(ii) Production Budget (units)

	Units
Budgeted Sales	8,000
Add: Closing Stock.	3,000
Total Requirements	11,000
Less: Opening Stock	(2,500)
Required Production	8,500

(iii) Materials Purchase Budget (kg.)

Question 11.
AK Limited produces and sells a single product. Sales budget for calendar year 2021 by a quarters is as under:

The year is expected to open with an inventory of 6,000 units of finished products and close with inventory of 8,000 units. Production is customarily scheduled to provide for 70% of the current quarter’s sales demand plus 30% of the following quarter demand. The budgeted selling price per unit is ₹ 40. The standard cost details for one unit of the product are as follows: Variable Cost ₹ 34.50 per unit.

Fixed Overheads ₹ 2 hours 30 minutes @ ₹ 2 per hour based on a budgeted production volume of 1,10,000 direct labour hours for the year. Fixed overheads are evenly distributed throughout the year.
You are required to:
(i) Prepare Quarterly Production Budget for the year.
(ii) In which quarter of the year, company expected to achieve bread-even point. [CA Inter May 2012, 5 Marks]
Answer:
(i) Production Budget for the year 2021 by Quarters

(ii) Break Even Point = Fixed Cost/ Contribution per unit
= 2,20,000/₹ 5.50 = 40,000 units
Contribution per unit = ₹ 40 – ₹ 34.50 = ₹ 5.50
Total sales in the quarter II is 40000 equal to BEP means BEP achieved in II quarter.

Question 12.
X Y Z Limited is drawing a production plan for its two products – Product ‘xml’ and ‘Product ‘yml’ for the year 2020-21. The company’s policy is to maintain closing stock of finished goods at 25% of the anticipated volume of sales of the succeeding month.
The following are the estimated data for the two products:

	xml	yml
Budgeted Production (in units)	2,00,000	1,50,000
Direct Material (per unit)	₹ 220	₹ 280
Direct Labour (per unit)	₹ 130	₹ 120
Direct Manufacturing Expenses	₹ 4,00,000	₹ 5,00,000

The estimated units to he sold in the first four months of the year 2020-21 are as under:

Prepare:
(i) Production Budget (Month wise)
(ii) Production cost Budget (for first quarter of the year) [CA Inter May 2015, 5 Marks]
Answer:
(i) Production Budget of Product ‘xml’ and ‘yml’ (month wise in units)

Opening stock of April is the closing stock of March, which is as per company’s policy 25% of next months sale.

(ii) Production Cost Budget (for first quarter of the year)

Question 13.
An electronic gadget manufacturer has prepared sales budget for the next few months. In this respect, following figures are available:

Months	Electronic gadgets’ sales
January	5000 units
February	6000 units
March	7000 units
April	7500 units
May	8000 units

To manufacture an electronic gadget, a standard cost of ₹ 1,500 is incurred l and it is sold through dealers at an uniform price of ₹ 2,000 per gadget to customers. Dealers are given a discount of 15% on selling price.
Apart from other materials, two units of batteries are required to manufacture a gadget. The company wants to hold stock of batteries at the end of each month to cover 30% of next month’s production and to hold slock of manufactured gadgets to cover 25% of the next month’s sale.
3,250 units of batteries and 1,200 units of manufactured gadgets were in stock on 1st January.

Required:
(i) Prepare production budget (in units) for the month of January, February, March and April.
(ii) Prepare purchase budget for batteries (in units) for the month of January, February and March and calculate profit for the quarter ending on March. [CA Inter Nov. 2018, 10 Marks]
Answer:
(i) Preparation of Production Budget (in Units)

(ii) Preparation of Purchase budget

Question 14.
A Company manufactures two Products A and B by making use of two types of materials, viz., X and Y. Product A requires 10 units of X and 3 units of Y. Product B requires 5 units of X and 2 units of Y. The price of X is 2 per unit and that of Y is 3 per unit. Standard hours allowed per product are 4 and 3, respectively. Budgeted wages rate is 8 per hour. Overtime premium is 50% and is payable, if a worker works for more than 40 hours a week. There are 150 workers.

The Sales Manager has estimated the sales of Product A to be 5,000 units and Product B 10,000 units. The target productivity ratio (or efficiency ratio) for the productive hours worked by the direct worker in actually manufacturing the product is 80%, in addition, the non-productive downtime is budgeted at 20% of the productive hours worked. There are twelve 5-day weeks in the budget period and it is anticipated that sales and production will occur evenly throughout the whole period.

It is anticipated that stock at the beginning of the period will be:
Product A 800 units; Product B 1,680 units. The targeted closing stock ex-pressed in terms of anticipated activity during the budget period are Product A 12 days sales; Product B 18 days sales. The opening and closing stock of raw material of X and Y will be maintained according to requirement of stock position for Products A and B.
You are required to prepare the following for the next period:
(i) Material usage and Material purchase budget in terms of quantities and values.
(ii) Production budget.
(iii) Wages budget for the direct workers. [CA Final Nov. 2004, 8 Marks]
Answer:
(i) Material Usage

(ii) Production Budget

Note: Computation of closing stock
Budgeted period (12 weeks × 5) = 60 days
Budgeted closing stock:
Product A = 12 days sales = \(\frac{5,000 \times 12}{60}\) = 1,000 units
Product B = 18 days sales = \(\frac{10,000 \times 18}{60}\) = 3,000 units

(iii) Wages Budget

Question 15.
Company is engaged in manufacturing two products ‘X’ and ‘ Y’ Product X uses one unit of component *P’ and two units of component ‘Q\ Product ‘Y’ uses two units of component ‘P’, one unit of component ‘Q’ and two units of component ‘R’. Component ‘R’ which is assembled in the factory uses one unit of component ‘O’.

Components ‘P’ and ‘Q’ are purchased from the market. The company has prepared the following forecast of sales and inventory for the next year:

	Product ‘X’	Product ‘Y’
Sales (in units)	80,000	1,50,000
At the end of the years	10,000	20,000
At the beginning of the year	30,000	50,000

The production of both the products and the assembling of the component R’ will be spread out uniformly throughout the year.

The company at present orders its inventory of ‘P’ and ‘Q’ in quantities equivalent to 3 months production. The company has compiled the following data related to two components:

	P	Q
Price per unit (₹)	20	8
Order placing cost per order (₹)	1,500	1,500
Carrying cost per annum	20%	20%

Required:
(a) Prepare a Budget of production and requirements of components during next year.
(b) Suggest the optimal order quantity of components ‘P’ and ‘Q’. [CA Final May 2006, 11 Marks]
Answer:
(a) Production Budget for products X and Y

	X units	Y units
Inventory at the end of the year Sales forecast Total requirements Less: Beginning inventory Production	10,000 80,000	20,000 1,50,000
	90,000 30,000	1,70,000 50,000
	60,000	1,20,000

Budgeted requirements of components P, Q and R

(b) Optimal order quantity:
P = \(\sqrt{\frac{2 \times 3,00,000 \times 1,500}{20 \times 20 \%}}\) = 15,000 components
Q = \(\sqrt{\frac{2 \times 4,80,000 \times 1,500}{8 \times 20 \%}}\) = 30,000 components

Question 16.
PVS Ltd. manufactures and sells a single product and estimated the following related information for the period November, 2020 to March, 2021.

Additional information:

• Closing stock of finished goods at the end of March, 2021 is 10,000 units.
• Each unit of finished output requires 2 kg. of Raw Material ‘A’ and 3kg of Raw Material ‘B’.

You are required to prepare the following budgets for the period November, 2020 to March, 2021 on monthly basis:
(i) Sales Budget (in ₹)
(ii) Production budget (in units)
(iii) Raw materials ‘A’ and ‘B’ separately (in units) [CA Inter July 2021, 5 Marks]
Answer:

Question 17.
XY Co. Ltd. manufactures two products viz., X and Y and sells them through two divisions, East and West. For the purpose of Sales Budget to the Budget Committee, following information has been made available for the year 2019-20:

Adequate market studies reveal that product X is popular but under priced. It is expected that if the price of X is increased by ₹ 1, it will, find a ready market. On the other hand, Y is overpriced and if the price of Y is reduced by x 1 it will have more demand in the market. The company management has agreed for the aforesaid price changes. On the basis of these price changes and the reports of salesmen, following estimates have been prepared by the Divisional Managers:
Percentage increase in sales over budgeted sales

Product	East Division	West Division
X	+ 10%	+ 5%
Y	+ 20%	+ 10%

With the help of intensive advertisement campaign, following additional sales (over and above the abovementioned estimated sales by Divisional Managers) are possible:

Product	East Division	West Division
X	60 units	70 units
Y	40 units	50 units

You are required to prepare Sales Budget for 2020-21 after incorporating above estimates and also show the Budgeted Sales and Actual Sales of 201920. [CA Inter Nov. 2015, 8 Marks]
Answer:
Statement Showing Sales Budget for 2020-21

Working Notes:
1. 400 × 11096 + 60 = 500 units
2. 600 × 10596 + 70 = 700 units
3. 300 × 12096 + 40 = 400 units
4. 500 × 11096 + 50 = 600 units

Statement Showing Sales Budget for 2019-20

Question 18.
Following is the sales budget for the first six months of the year 2021 in respect of FOR Ltd. :

Finished goods inventory at the end of each month is expected to be 20H» of budgeted sales quantity for the following month. Finished goods inventory was 2,700 units on January 1, 2021. There would be no work-in-progress at the end of any month.
Each unit of finished product requires two types of materials as detailed below:
Material X : 4 kgs @ ₹ 10/kg
Material Y : 6 kgs @ ₹ 15/kg
Material on hand on January 1,2021 was 19,000 kgs of material X and 29,000 kgs of material Y. Monthly closing stock of material is budgeted to be equal to half of the requirements of next month’s production.
Budgeted direct labour hour per unit of finished product is 3/4 hour.
Budgeted direct labour cost for the first quarter of the year 2021 is ₹ 10,89,000.
Actual data for the quarter one, ended on March 31, 2021 is as under:
Actual production quantity: 40,000 units
Direct material cost
(Purchase cost based on materials actually issued to production)
Material X : 1,65,000 kgs @ ₹ 10.20/kg
Material Y : 2,38,000 kgs @ ₹ 15.10/kg
Actual direct labour hours worked: 32,000 hours
Actual direct labour cost: ₹ 13,12,000
Required:
(a) Prepare the following budgets:
(i) Monthly production quantity for the quarter one.
(ii) Monthly raw material consumption quantity budget from January, 2021 to April, 2021.
(iii) Materials purchase quantity budget for the quarter one.
(b) Compute the follow ing variances :
(i) Material cost variance
(ii) Material price variance
(iii) Material usage variance
(iv) Direct labour cost variance
(v) Direct labour rate variance
(vi) Direct labour efficiency variance [ICAI Module]
Answer:
(a) (i)

Total Budgeted Output for the Quarter ended March 31, 2009
= (9,700 + 12,400 + 14,200)
= 36,300 units.

(ii) Raw Material Consumption Budget (in quantity)

(iii) Raw Materials Purchase Budget (in quantity)

(b) Computation of variances
Material variances
Calculation of Standard Quantity (SQ):
Material X = 40,000 × 4 = 1,60,000 kgs.
Material Y = 40,000 × 6 = 2,40,000 kgs.

Basic calculation

Calculation of Material Variances:
(a) Material Cost Variance = (SQ × SP) – (AQ × AP)
Material X = 16,00,000 – 16,83,000 = 83,000 (A)
Material Y = 36,00,000 – 35,93,800 = 6.200 (F)

(b) Material Price Variance = AQ (SP – AP)
Material X = 1,65,000 (10 – 10.20) = 33,000 (A)
Material Y = 2,38,000 (15 – 15.10) = 23.800 (A)

(c) Material Usage Variance = SP (SQ – AQ)
Material X = 10 (1,60,000 – 1,65,000) = 50,000 (A)
Material Y = 15 (2,40,000 – 2,38,000) = 30,000 (F)

Labour Variances:
Budgeted output for the quarter = 36,300 units
Budgeted hours = 36,300 units × 3/4 = 27,225 hours

Calculation of Labour Cost Variances:
(a) Direct Labour Cost Variance = (SH × SR) – (AH × AR)
= (30,000 × 40) – (32,000 × 41)
= 1,12,000 (A)

(b) Direct Labour Rate Variance = AH (SR – AR)
= 32,000 (40 – 41)
= 32,000 (A)

(c) Direct Labour Efficiency Variance = SR (SH – AH)
Material X = 40 (30,000 – 32,000)
Material Y = 80,000 (A)

Budget Ratios

Question 19.
Calculate Efficiency and Capacity ratio from the following figures:

Budgeted production	80 units
Actual production	60 units
Standard lime per unit	8 hours
Actual hours worked	500

[CA Inter Nov. 2007, 2 Marks]
Answer:
Standard hour for actual production = 60 units × 8 hours = 480 hours
Actual hours worked = 500 hours
Budgeted hours = 80 units × 8 hours = 640 hours
Efficiency Ratio = \(\frac{\text { Standard hours for actual production }}{\text { Actual hours worked }}\) × 100
= \(\frac{480}{500}\) × 100
= 96%
Capacity Ratio = \(\frac{\text { Actual hours worked }}{\text { Budgeted hours }}\) × 100
= \(\frac{500}{640}\) × 100
= 78.125%

Question 20.
Calculate efficiency and activity ratio from the following data:
Capacity ratio = 75%
Budgeted output = 6,000 units
Actual output = 5,000 units
Standard Time per unit = 4 hours [CA Inter Nov. 2009, 2 Marks]
Answer:

Question 21.
Following data is available for ABC Ltd:

Standard working hours	8 hours per day of 5 days per week
Maximum Capacity	60 employees
Actual working	50 employees
Actual hours expected to be worked per four week	8,000 hours
Standard hours expected to be earned per hour week	9,600 hours
Actual hours worked in the four week period	7,500 hours
Standard hours earned in the four week period	8,800 hours

The related period is of four weeks. Calculate the following Ratios:
(i) Efficiency Ratio
(ii) Activity Ratio
(iii) Standard Capacity Usage Ratio
(iv) Actual Capacity Usage Ratio
(v) Actual Usage of Budgeted Capacity Ratio [CA Inter May 2019, 5 Marks]
Answer:

Miscellaneous

Question 22.
Company prepared the following budget for a year:

After evaluating the half-yearly performance, it was observed that the Company would be able to achieve only 80% of the original budgeted sales. The revised budgeted sale as envisaged above was estimated at 1,080 lakhs after taking into account a reduction in the selling price by 10%.
You are required to prepare a statement showing the break up of the original and revised budget for the year. [CA Final May 2000, 6 Marks]
Answer:
Statement showing the break-up of the original and revised for a year:
(₹ in lakhs)

Working notes:
1. Revised budgeted sales (after taking into account 10% reduction in selling price)
If revised budgeted S.P, is ₹ 90, the original budgeted S.P. is 100
If revised budgeted S.P. is ₹ 1, the original budgeted S.P. is \(\frac{100}{90}\)
If revised budgeted sales at revised S.P. is ₹ 1080 lakhs then the revised budgeted sales at original S.P. will be \(\frac{100}{90}\) × 1080 lakhs = ₹ 1,200 lakhs

2. Original budgeted sales
If revised budgeted sales at original S.P. is ₹ 80 then the original budgeted sales at original selling price is ₹ 100.
If revised budgeted sales at original S.P. is ₹ 1 then the original sales at original selling price is \(\frac{₹ 100}{₹ 80}\).
If revised budgeted sales at original S.P. is ₹ 1,200 lakhs then the original budgeted sales at Original selling price is \(\frac{₹ 100}{₹ 80}\) × 1,200 lakhs = ₹ 1,500 Lakhs.

Question 23.
The information of Z Ltd. for the year ended 31st March, 2020 is as below:

	₹
Direct materials	17,50,000
Direct wages	12,50,000
Variable factory overhead	9,50,000
Fixed factory overhead	12,00,000
Other variable costs	6,00,000
Other fixed costs	4,00,000
Profit	8,50,000
Sales	70,00,000

During the year, the company manufactured two products X and Y, and the output and cost were:

	X	Y
Output (units)	8,000	4,000
Selling price per unit (₹)	600	550
Direct material per unit (₹)	140	157.50
Direct wages per unit (₹)	90	132.50

Variable factory overheads are absorbed as a percentage of direct wages and other variable costs are computed as:
Product X – ₹ 40 per unit and Product Y- ₹ 70 per unit
For the F,Y. 2020-21, it is expected that demand for products X and Y will fall by 20% & 10% respectively. It is also expected that direct wages cost will raise by 20% and other fixed costs by 10%. Products will be required to be sold at a discount of 20%.
You are required to:
(i) Prepare product-wise profitability statement on marginal costing method for the F.Y. 2019-20 and
(ii) Prepare a budget for the FY 2020-21. [CA Inter Nov. 2020 RTP]
Answer:
(i) Product-wise Profitability Statement for the FY 2019-20

Variable factory overhead rate = \(\frac{\text { Variable factory overhead }}{\text { Direct wages }}\) × 100 = \(\frac{9,50,000}{12,50,000}\) × 100 = 76%

(ii) Preparation of Budget for the FY 2020-21:

Question 24.
The accountant of manufacturing company provides you the following details for year 2019-20:

	₹
Direct materials	28,00,000
Direct Wages	16,00,000
Fixed factory overheads	16,00,000
Variable factory overheads	16,00,000
Other variable costs	12,80,000
Other fixed costs	12,80,000
Profit	18,40,000
Sales	1,20,00,000

During the year, the company manufactured two products A and B and the output and costs were:

	A	B
Output (units)	2,00,000	1,00,000
Selling price per unit	₹ 32.00	₹ 56.00
Direct materials per unit	₹ 8.00	₹ 12.00
Direct wages per unit	₹ 4.00	₹ 8.00

Variable factory overhead is absorbed as a percentage of direct wages. Other variable costs have been computed as:
Product A ₹ 4.00 per unit
Product B ₹ 4.80 per unit.
During 2020-21, it is expected that the demand for product A will fail by 25% and for B by 50%. It is decided to manufacture a new product C, the cost for which is estimated as follows:

	Product C
Output (units)	2,00,000
Selling price per unit	₹ 28.00
Direct materials per unit	₹ 6.40
Direct wages per unit	₹ 4.00

It is anticipated that the other variable costs per unit of Product C will be same as for product A.
Prepare a budget to present to the management, showing the current position and the position for 2020-21. Comment on the comparative results. [CA In ter RTP Nov 2021]
Answer:

Introduction of Product C is likely to increase profit by ₹ 1,60,000 (₹ 20,00,000 – ₹ 18,40,000) in 2020-21 as compared to 2019-20 even if the demand for Products A & B falls,
Therefore, introduction of product C is recommended.

Marginal Costing – CA Inter Cost and Management Accounting Study Material is designed strictly as per the latest syllabus and exam pattern.

Marginal Costing – CA Inter Costing Study Material

Marginal Costing:
It is a costing system where products or services and inventories are valued at variable costs only. It does not consider fixed costs.

• Total Contribution (C) = Sales Revenue (S) – Total Variable Cost (V)
  Contribution per unit = Sales price per unit – Variable cost per unit
• Profit = Contribution – Fixed Cost
• Marginal Cost Equation = S – V = C = F ± P
  S = Selling price per unit, V = Variable cost per unit, C = Contribution, F = Fixed Cost

Profit Volume (P/V) Ratio: It shows the proportion of sales available to cover fixed costs and profit.
P/V Ratio = \(\frac{\text { Contribution }}{\text { Sales }}\) × 100 OR \(\frac{\text { Change in Contribution or profit }}{\text { Change in Sales }}\) × 100 OR \(\frac{\text { Fixed Cost }}{\text { Breakeven Sales }}\) × 100
Sales = \(\frac{\text { Contribution }}{\text { PV Ratio }}\)
Fixed cost = Break-even sales × P/V Ratio

Break-even point: It is the point where neither profits nor losses have been made.
BEP (in units) = \(\frac{\text { Fixed Cost }}{\text { Contribution per unit }}\)
BEP (in ₹) = \(\frac{\text { Fixed Cost }}{\text { PV Ratio }}\) OR Total Sales – Margin of Safety Sales

Cash Break-even point: When break-even point is calculated only with those fixed costs which arc payable in cash. Depreciation and other- non-cash fixed costs are excluded from fixed costs.
= \(\frac{\text { Cash Fixed Costs }}{\text { Contribution per unit }}\)

Multi-product break even analysis; Break-even point needs adjustm ents when more than one product is manufactured by using a common fixed costs. Composite Contribution is calculated by taking weights for the products. VVdghty = sales:mix quantity or sales mix values,
BEP = \(\frac{\text { Common Fixed Cost }}{\text { Composite Contribution per unit }}\)

Margin of Safety = \(\frac{\text { Profit }}{\text { PV Ratio }}\) or Total sales – Break-even sales
Margin of Safety ratio = \(\) x 100

2. Absorption Costing: A method of costing in which all costs, both variable | and fixed are charged to operations, process or product.

Theory Questions

Question 1.
What are the characteristics of marginal costing? [ICAI Module]
Answer:

• All elements of cost are classified into fixed and variable components. Semi-variable costs are also analyzed into fixed and variable elements.
• The marginal or variable costs are treated as the cost of product.
• The value of finished goods and work-in-progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock of finished goods and closing WIP.
• Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred.
• Prices are determined with reference to marginal costs and contribution margin.
• Profitability of departments and products is determined with reference to their contribution margin.

Question 2.
State the advantages of marginal costing. [CA Inter May 2001, 6 Marks]
Answer:
1. Simplified Pricing Policy: The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. This help in making firm decisions on pricing policy.
2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be under-recovery or over-recovery of. This creates the problem of treatment of such under or over-recovery of overheads. Marginal costing avoids such under or over-recovery of overheads.
3. Shows Realistic Profit: Under the marginal costing, the stock of finished goods and WIP are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit of the period.
4. How much to produce: Marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.
5. More control over expenditure: Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances.
6. Helps in Decision Making: Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of particular product, replacement of machines, etc.

Question 3.
What are the limitations of marginal costing? [CA Inter May 2019, May 2001, 5 Marks]
Answer:
(i) Difficulty in classifying fixed and variable elements:
It is difficult to classify exactly the expenses into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed. For example, various amenities provided to workers may have no relation either to volume of production or time factor.

(ii) Dependence on key factors:
Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor.

(iii) Scope for Low Profitability:
Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.

(iv) Faulty valuation:
Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while valuing the work-in-progress. In order to show the correct position fixed overheads have to be included in work-in-progress.

(v) Unpredictable nature of Cost:
Some of the assumptions regarding the behaviour of various costs are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Fixed cost may change from one period to another. Also, the variable costs do not remain constant per unit of output. There may be changes in the prices of raw materials, wage rates etc. after a certain level of output has been reached.

(vi) Marginal costing ignores time factor and investment:
The marginal cost of two jobs may be the same but the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. This fact is not disclosed by marginal costing.

(vii) Understating of W-I-P:
Under marginal costing stocks and work-in-progress are understated.

Question 4.
Discuss basic assumptions of Cost Volume Profit analysis. [CA Inter May 2012, May 2003, 4 Marks]
Answer:
Assumptions of CVP Analysis:

• Changes in the levels of revenues and costs arise only because of changes in the number of products (or service) units produced and sold.
• Total cost can be separated into two components: Fixed and variable
• Graphically, the behaviour of total revenues and total cost are linear in relation to output level within a relevant range.
• Selling price, variable cost per unit and total fixed costs are known and constant.
• The proportion of different products when multiple products are sold will remain constant as the level of total units sold changes.
• All revenues and costs can be added, sub-traded and compared without taking into account the time value of money.

Question 5.
Explain and illustrate cash break-even chart. [CA Inter May 2008, May 2001, 3 Marks]
Answer:
When break-even point is calculated only with those fixed costs which are payable in cash, such a break-even point is known as cash break-even point. This means that depreciation and other non-cash fixed costs are excluded from the fixed costs in computing cash break-even point. It is computed as under:
Cash BEP (Units) = \(\frac{\text { Cash Fixed Costs }}{\text { Contribution per unit }}\)

Hence for example suppose insurance has been paid on 1st January, 2016 till 31st December, 2020 then this fixed cost will not be considered as a cash fixed cost for the period 1st January, 2018 to 31st December, 2020.

Question 6.
What is Margin of Safety? What does a large Margin of Safety indicates? How can you calculate Margin of Safety? [CA Inter July2021,5Marks]
Answer:
The margin of safety can be defined as the difference between the expected level of sale and the break-even sales. Large margin of safety indicates the high chances of making profits. The Margin of Safety can also be calculated by identifying the difference between the projected sales and break-even sales in units multiplied by sale price per unit.
Margin of Safety (in units) = \(\frac{\text { Profit }}{\text { Contribution per unit }}\)
Margin of Safety (in ₹) = \(\frac{\text { Profit }}{\text { Profit Volume Ratio }}\)

Question 7.
Write short note on Angle of Incidence. [CA Inter May 2012, 2 Marks]
Answer:
Angle of Incidence is formed by the intersection of sales line and total cost line at the break-even point. This angle shows the rate at which profits are being earned once the break-even point has been reached. The wider the angle the greater is the rate of earning profits. A large angle of incidence with a high margin of safety indicates extremely favourable position.

Question 8.
Differentiate between “Marginal and Absorption Costing”. [CA Inter Nov. 2001, Nov. 2020, 5 Marks]
Answer:
Difference between Marginal costing and Absorption costing

Marginal costing	Absorption costing
(i) Only variable costs are considered for product costing and inventory valuation.	Both fixed and variable costs are consid­ered for product costing and inventory valuation.
(ii) Fixed costs are regarded as period costs. The Profitability of different products is judged by their P/V ratio.	Fixed costs are charged to the cost of production. Each product bears a rea­sonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs.
(iii) Cost data presented highlight the total contribution of each product.	Cost data are presented in conventional pattern. Net profit of each product is de­termined after subtracting fixed cost along with their variable costs.
(iv) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production.	The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed cost.
(v) In case of marginal costing the cost per unit remains the same, irrespective of the production as it is valued at variable cost.	In case of absorption costing the cost per unit reduces, as the production increases as it is fixed cost which reduces, whereas, the variable cost remains the same per unit.

Practical Questions

Question 1.
Product Z has a profit-volume ratio of 28%. Fixed operating costs directly attributable to product Z during the quarter will be ₹ 2,80,000.
Calculate the sales revenue required to achieve a quarterly profit of ₹ 70,000. [CA Inter May 2009, 3 Marks]
Answer:
Computation of sales revenue:
P/V ratio = 28%
Quarterly fixed Cost = ₹ 2,80,000
Desired Profit = ₹ 70,000
Sales revenue required to achieve desired profit
Total contribution = Fixed Cost + Desired Profit
= ₹ 2,80,000 + ₹ 70,000
= ₹ 3,50,000 28%
= ₹ 12,50,000

Total sales revenue = \(\frac{\text { Total contribution }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{₹ 3,50,000}{28 \%}\)
= ₹ 12,50,000

Question 2.
Following information are available for the years 2020 and 2021 of PIX Limited:

Years	2020	2021
Sales	₹ 32,00,000	₹ 57,00,000
Profit/ (Loss)	(₹ 3,00,000)	₹ 7, 00,000

Calculate:
(i) P/V ratio
(ii) Total fixed cost
(iii) Sales required to earn a Profit of ₹ 12,00,000 [CA Inter Nov. 2016, May 2010, 5 Marks]
Answer:
(i) P/V Ratio

(ii) Total fixed cost = Total contribution – Profit
= (Sales × P/V ratio) – Profit
= (₹ 57,00,000 × 40%) – ₹ 7,00,000
= ₹ 22,80,000 – ₹ 7,00,000
= ₹ 15,80,000

(iii) Total contribution = \(=\frac{\text { Total contribution }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\)
= ₹ 69,50,000

Question 3.
PQR Ltd. has furnished the following data for the two years:

	2019-20	2020-21
Sales	₹	?
Profit/Volume Ratio (P/V ratio)	50%	37.5%
Margin of Safety sales as a % of total sales	40%	21.875%

There has been substantial savings in the fixed cost in the year 2020-21 due to the restructuring process. The company could maintain its sales quantity level of 2019-20 in 2020-21 by reducing selling price.
You are required to calculate the following:
(i) Sales for 2020-21 in Value,
(ii) Break-even sales for 2020-21 in Value,
(iii) Fixed cost for 2020-21 in Value. [ICAI Module]
Answer:
Total Variable cost in 2019-20 = Sales – P/V Ratio
= ₹ 8,00,000 – 50% = ₹ 4,00,000
In 2020-21, sales quantity has not changed. Thus, variable cost in 2020-21 will remain the same i.e. ₹ 4,00,000.
P/V ratio (2020-21) = 37.50%
Thus, Variable cost ratio = 10096 – 37.596 = 62.5%

(i) Thus, sales in 2020-21 = \(\frac{4,00,000}{62.5 \%}\) = ₹ 6,40,000
In 2020-21, Break-even sales = 100% – 21.875% (Margin of safety) = 78.125%

(ii) Break-even sales in 2020-21:
In 2020-21, Break-even sales = 10096 – 21.87% – 6 (Margin of safety) = 78.125%
= 6,40,000 × 78.1259c = ₹ 5,00,000

(iii) Fixed cost in 2020-21 = B.E. sales × P/V ratio
= ₹ 5,00,000 × 37.5096 = ₹ 1,87,500.

Question 4.
Following information is available for the 1st and 2nd quarter of the year 2020-21 of ABC Ltd:

	Production (in units)	Semi-variable cost (₹)
Quarter I	36,000	2,80,000
Quarter II	42,000	3,10,000

You are required to segregate the semi-variable cost and calculate:
(a) Variable cost per unit;
(b) Total fixed cost. [CA Inter May 2009, 2 Marks]
Answer:

	Production (in units)	Semi-variable cost (₹)
Quarter I	36,000	2,80,000
Quarter II	42,000	3,10,000

Variable Cost per Unit = \(\frac{\text { Change in Semi Variable Cost }}{\text { Change in Production }}\)
= \(\frac{₹ 30,000}{6000 \text { units }}\) = ₹ 5perunit
Total Fixed Cost = Semi Variable Cost – (Production × Variable Cost per Unit)
= ₹ 2,80,000 – (36,000 units × ₹ 5 per unit)
= ₹ 2,80,000 – ₹ 1,80,000
= ₹ 1,00,000

Question 5.
PQ Ltd. reports the following cost structure at two capacity levels;

	(100% capacity) 2,000 units	(75% capacity) 1,590 units
Production overhead I	₹ 3 per unit	₹ 4 per unit
Production overhead II	₹ 2 per unit	₹ 2 per unit

If the selling price, reduced by direct material and labour is ₹ 8 per unit, what would be its break-even point? [CA Inter Nov. 2008, 3 Marks]
Answer:
Computation of Break-even point in units:

	2,000 units	1,500 units
Production Overhead I: Fixed Cost (₹)	6,000 (2,000 unit × ₹ 3 per unit)	6,000 (1,500 unit × ₹ 4 per unit)
Selling price – Material and labour (₹) (A)	8	8
Production Overhead II (Variable Overhead) (B)	2	2
Contribution per unit (A)-(B)	6	. 6

Break-even point = \(\frac{\text { Fixed cost }}{\text { Contribution per unit }}=\frac{6,000}{6}\) = 1,000 units

Question 6.
A Company sells two products, J and K. The sales mix is 4 units of J and 3 units of K. The contribution margins per unit are ₹ 40 for J and ₹ 20 for K. Fixed costs are ₹ 6,16,000 per month. Compute the break-even point. [CA Inter Nov. 2009, 2 Marks]
Answer:
Let 4a = No. of units of J
Then, 3a = No. of units of K

Units Break-even point of Product J = 4 × 2,800 = 11,200 units
Break-even point of Product K = 3 × 2,800 = 8,400 units

Question 7.
PVC Ltd. sold 55,000 units of its product at ₹ 375 per unit. Variable costs are ₹ 175 per unit (manufacturing costs of ₹ 140 and selling cost ₹ 35 per unit). Fixed costs are incurred uniformly throughout the year and amount to ₹ 65,00,000 (including depreciation of ₹ 15,00,000). There is no beginning or ending inventories.
Required:
(i) Compute break even sales level quantity and cash break-even sales level quantity.
(ii) Compute the P/V ratio.
(iii) Compute the number of units that must be sold to earn an income (EBIT) of ₹ 5,00,000.
(iv) Compute the sales level achieve an after-tax income (PAT) of ? 5,00,000, assume 40% corporate tax rate. [CA Inter Nov. 2019, RTPJ
Answer:
Contribution per unit = ₹ 375 – ₹ 175 = ₹ 200

(iii) No. of units that must be sold to earn an Income (EBIT) of ₹ 2,50,000
= \(\frac{\text { Fixed cost }+ \text { Desired EBIT }}{\text { Contribution margin per unit }}\)
= \(\frac{₹ 65,00,000+₹ 5,00,000}{₹ 200}\)
= 35,000 units

(iv) After Tax Income (PAT) = ₹ 5,00,000
Tax rate = 40%
Desired level of Profit before tax = ₹ 5,00,000/60 × 100 = ₹ 8,33,333/-
= \(\frac{₹ 65,00,000+₹ 8,33,333}{53.33 \%}\)
= \(\frac{₹ 65,00,000+₹ 8,33,333}{53.33 \%}\)
= ₹ 1,37,50,859/-

Question 8.
MNP Ltd. sold 2,75,000 units of its product at ₹ 37.50 per unit. Variable costs are ₹ 17.50 per unit (manufacturing costs of ₹ 14 and selling cost ₹ 3.50 per unit). Fixed costs are incurred uniformly throughout the year and amount to ₹ 35,00,000 (including depreciation of ₹ 15,00,000). There is no beginning or ending inventories.
Required:
(i) Estimate break-even sales level quantity and cash break-even sales level quantity.
(it) Estimate the P/V ratio.
(iii) Estimate the number of units that must be sold to earn an income (EBIT) of ₹ 2,50,000.
(iv) Estimate the sales level achieve an after-tax income (PAT) of ₹ 2,50,000, Assume 40% corporate Income Tax rate. [CA Inter Nov. 2010, 8 Marks]
Answer:
Contribution per unit = ₹ 37.50 – ₹ 17.50 = ₹ 20
(i) Break-even Sales Quantity

(iii) No. of units that must be sold to earn an Income (EBIT) of ₹ 2,50,000
= \(\frac{\text { Fixed cost }+ \text { Desired EBIT }}{\text { Contribution margin per unit }}\)
= \(\frac{₹ 35,00,000+₹ 2,50,000}{₹ 20}\)
= 1,87,500 units

(iv) After Tax Income (PAT) = ₹ 2, 50,000
Tax rate = 40%
Desired level of Profit before tax = ₹ 2,50,000/60 × 100 = ₹ 4,1.6,667/-
Estimate Sales Level = \(\frac{\text { Fixed Cost }+ \text { Desired Profit }}{\mathrm{P} / \text { V ratio }}\)
= \(\frac{₹ 35,00,000+₹ 4,16,667}{53.33 \%}\)
= ₹ 73,43,750 /-

Question 9.
The P/V Ratio of Delta Ltd. is 50% and margin of safety is 40%, The company sold 500 units for ₹ 5,00,000. You are required to calculate:
(i) Break-even point, and
(ii) Sales in units to earn a profit of 10% on sales [CA Inter Nov. 2011, 5 Marks]
Answer:
(i) P/V Ratio = 50%
Margin of Safety = 40%
Calculation of Break Even Point (BEP)
Margin of Safety Ratio = \(\frac{(\text { Sales }- \text { BEP }) \times 100}{\text { Sales }}\)
40 = \(\frac{5,00,000-\mathrm{BEP}}{5,00,000}\) × 100
BEP = ₹ 3,00,000
BEP Per Unit = 3,00,000/1000 = 300 Units

(ii) Sales in units to earn a profit of 10 % on sales
Let the sales be x
Profit = 10% of x ie. 0.1x.
Sales = \(\frac{\text { Fixed Cost }+ \text { Desired Profit }}{\text { P/V ratio }}\)
x = \(\frac{1,50,000+0.1 \mathrm{x}}{50 \%}\)
or x = ₹ 3,75,000
Sales (in units) = 3,75,000/1,000
= 375 Units

Working Notes:
1. Selling Price = ₹ 5,00,000/₹ 500
= ₹ 1,000 per unit

2. Variable cost per unit = Selling Price – (Selling Price × P/V Ratio)
= 1,000 – (1,000 × 50%)
= ₹ 500

3. Profit at present level of sales
Margin of Safety = 40% of Total sales
= 40% of ₹ 5,00,000 = ₹ 2,00,000

Profit = Margin of Safety × P/V Ratio
= ₹ 2,00,000 × 50%
= ₹ 1,00,000

4. Fixed Cost = (Sales × P/V Ratio) – Profit
= (5,00,000 × 50%) – 1,00,000
= ₹ 1,50,000

Question 10.
Omega Ltd. manufactures a product, currently utilising 75% capacity with a turnover of ₹ 99,00,000 at ₹ 275 per unit. The cost data is as under:

Direct Material per unit	96
Direct wages per unit	42
Variable overhead per unit	18
Semi- variable overheads	7,32,000
P/V ratio	40%

Fixed overhead cost is ₹ 28,81,000 upto 80% level of activity, beyond this level an additional ₹ 2,38,500 will be incurred.
Required:
(i) Break even point in units and activity level at Break even point.
(ii) Number of units to be sold to earn profit of ₹ 25 per unit. [Inter CA May 2019. 5 Marks]
Answer:
Contribution per unit = ₹ 275 × 40% = ₹ 110
Total Variable cost per unit = ₹ 275 – ₹ 1 10 = ₹ 165

Semi-variable cost per unit:
= Total variable cost – (Direct Material + Direct wages + Variable Overheads)
= ₹ 165 – (96 + 42 + 18)
= ₹ 9 per unit
Total fixed cost:
= Fixed cost part of semi-variable cost + Fixed overheads
= (Semi variable overheads at 75% level – Variable cost part) + Fixed Over heads
=[₹ 7,32,000 – (₹ 9 × 36,000 units)] + ₹ 28,81,000 – ₹ 4,08,000 + ₹ 28,81,000
= ₹ 32,89,000

(i) Calculation of Break-even point
BEP (in units) = \(\frac{\text { Total fixed cost }}{\text { Contribution per unit }}=\frac{₹ 32,89,000}{₹ 110}\) = 29,900 units
Activity level = \(\frac{29,900}{48,000}\) × 100 = 62.29%

(ii) Number of units to be sold to earn profit of ₹ 25 per unit:
No.of units = \(\frac{\text { Total fixed cost at } 75 \% \text { level }}{\text { Contribution per unit }- \text { Desired profit per unit }}\)
= \(\frac{₹ 32,89,000}{₹ 110-₹ 25}\) = 38,694 units
Activity level = \(\frac{38,694}{48,000}\) × 100 = 80.61%
This is more than 80% capacity level, hence fixed overheads would increase by ₹ 2,38,500 and so the Break-even point.
BEP = \(\frac{\text { Total fixed cost beyond } 80 \% \text { level }}{\text { Contribution per unit }- \text { Desired profit per unit }}\)
= \(\frac{₹ 32,89,000+₹ 2,38,500}{₹ 110-₹ 25}\) = 41,500 units

Question 11.
ABC Limited started its operations in the year 2019 with a total production capacity of 2,00,000 units. The following information, for two years, are made available to you:

	Year 2019	Year 2020
Sales (units)	80,000	1,20,000
Total Cost (₹)	34,40,000	45,60,000

There has been no change in the cost structure and selling price and it is anticipated that it will remain unchanged in the year 2021 also.
Selling price is ₹ 40 per unit.
Calculate:
(i) Variable cost per unit.
(ii) Profit Volume Ratio.
(iii) Break-Even Point (in units)
(iv) Profit if the firm operates at 75% of the capacity. [CA Inter May 2015, May 2013, 5 Marks]
Answer:

(iii) Fixed Cost = Total Cost in 2019 – Total Variable Cost in 2019
= ₹ 34,40,000 – (₹ 28 × 80,000 units)
= ₹ 34,40,000 – ₹ 22,40,000
= ₹ 12,00,000

Break Even Point (in units) = \(\frac{\text { Fixed cost }}{\text { Contribution per unit }}\)
= \(\frac{\text { Fixed cost }}{\text { Contribution per unit }}\) = 1,00,000 units

(iv) Profit if the firm operates at 75% of the capacity:
Number of units to be produced and sold = 2,00,000 units × 75%
= 1,50,000 units
Profit = Total contribution – Fixed Cost
= (₹ 12 × 1,50,000 units) – ₹ 12,00,000
= ₹ 18,00,000 – ₹ 12,00,000
= ₹ 6,00,000

Question 12.
A company gives the following information:

Margin of Safety	₹ 3,75,000
Total Cost	₹ 3,87,500
Margin of Safety (Qty.)	15,000 units
Break Even Sales in Units	5,000 units

You are required to calculate:
(i) Selling price per unit
(ii) Profit
(iii) Profit/Volume Ratio
(iv) Break-even Sales (in Rupees)
(v) Fixed Cost [CA Inter Nov. 2019. Nov. 2015, 5 Marks]
Answer:
(i) Selling Price per unit = \(\frac{\text { Margin of Safety in Rupee value }}{\text { Margin of Safety in Quantity }}\)
= \(\frac{₹ 3,75,000}{15,000 \text { units }}\) = ₹ 25

(ii) Profit = Sales Value – Total Cost
= [Selling price per unit × (BEP units + MoS units)] – Total Cost
= [₹ 25 × (5,000 + 15,000) units] – ₹ 3,87,500
= ₹ 5,00,000 – ₹ 3,87,500
= ₹ 1,12,500

(iv) Break-even Sales (in ₹)
= BEP units × Selling Price per unit
= 5,000 units × ₹ 25 = ₹ 1,25,000

(v) Fixed Cost = Break-even Sales (in ₹) × P/V Ratio
= ₹ 1,25,000 × 30%
= ₹ 37,500

Question 13.
When volume is 4,000 units; average cost is ₹ 3.75 per unit. When volume is 5,000 units, average cost is ₹ 3.50 per unit. The Break-Even point is 6,000 units.
Calculate:
(i) Variable Cost per unit
(ii) Fixed Cost and
(iii) Profit Volume Ratio. [CA Inter Nov. 2019, 5 Marks]
Answer:

Question 14.
During a particular period ABC Ltd. has furnished the following data: Sales ₹ 10,00,000
Contribution to sales ratio 37% and Margin of safety is 25% of sales.
A decrease in selling price and decrease in the fixed cost could change the “contribution to sales ratio” to 30% and “margin of safety” to 40% of the revised sales. Calculate:
(i) Revised Fixed Cost;
(ii) Revised Sales; and
(iii) New Break-Even Point. [CA Inter Jan. 2021, 5 Marks]
Answer:
Contribution to sales ratio (P/V ratio) = 37%
Variable cost ratio = 100% – 37% = 63%
Variable cost = ₹ 10,00,000 × 63% = ₹ 6,30,000
After decrease in selling price and fixed cost, sales quantity has not changed. Thus, variable cost is ₹ 6,30,000.
Revised Contribution to sales =30%
Thus, Variable cost ratio = 100% – 30% = 70%
Revised, Break-even sales ratio = 100% – 40% (revised Margin of safety) = 60

(i) Revised fixed cost = Revised break even sales × Revised contribution to sales ratio
= (₹ 9,00,000 × 60%) × 30%
= 5,40,000 × 30%
= ₹ 1,62,000

(ii) Revised sales = ₹ 6,30,000/70%
= ₹ 9,00,000

(iii) Revised Break-even point = Revised sales × Revised break-even sales ratio
= ₹ 9,00,000 × 60%
= ₹ 5,40,000

Question 15.
AZ company has prepared its budget for the production of 2,00,000 units. The variable cost per unit is ₹ 16 and fixed cost is ₹ 4 per unit. The company fixes its selling price to fetch a profit of 20% on total cost.
You are required to calculate:
(i) Present break-even sales (in ₹ and in quantity).
(ii) Present profit-volume ratio.
(iii) Revised break-even sales in ₹ and the revised profit-volume ratio, if it reduces its selling price by 10%.
(iv) What would be revised sales in quantity and the amount, if a company desires a profit increase of 20% more than the budgeted profit and selling price is reduced by 10% as above in point (iii). [CA Inter Dec. 2021, 10 Marks]
Answer:
Total Cost = Variable cost + Fixed Cost = ₹ 16 + ₹ 4 = ₹ 20 per unit
Total Fixed Cost = 2,00,000 units × ₹ 4 per unit = ₹ 8,00,000
Profit = 2096 on total cost = ₹ 20 × 20% = ₹ 4 per unit
Selling Price = Total Cost + Profit = ₹ 20 + ₹ 4 = ₹ 24 per unit
Contribution = Selling Price – Variable cost = ₹ 24 – ₹ 16 = ₹ 8 per unit

(i) Present Break-even Sales (Quantity) = \(\frac{\text { Fixed Cost }}{\text { Contribution per unit }}\)
= \(\frac{₹ 8,00,000}{₹ 8}\) = 1,00,000
Present Break-even Sales (₹) = 1,00,000 units × ₹ 24 = ₹ 24,00,000

(ii) Present P/V ratio = \(\frac{\text { Contribution per unit }}{\text { Selling price per unit }}\) × 100
= \(\frac{₹ 8}{₹ 24}\) × 100 = 33.33%

(iii) Revised S.P ₹ 24 – 10% = ₹ 21.60 per unit
Revised Contribution = ₹ 21.60 – ₹ 16 = ₹ 5.60 per unit
Revised P/V Ratio \(\frac{₹ 5.60}{₹ 21.60}\) × 100 = 25.926%
Revised Break-even Sales (₹) = \(\frac{\text { Fixed Cost }}{\text { Revised P/V Ratio }}\)
= \(\frac{₹ 8,00,000}{25.926 \%}\)
= ₹ 30,85,705

(iv) Present Profit = ₹ 4 × 2,00,000 units = ₹ 8,00,000
Desired Profit = ₹ 8,00,000 + 20% = ₹ 9,60,000
Sales Required (units) = \(\frac{\text { Total Fixed Cost }+ \text { Desired Profit }}{\text { Contribution per unit }}\)
= \(\frac{₹ 8,00,000+₹ 9,60,000}{₹ 5.60}\)
= 3,14,286 units
Sales Required (₹) = 3,14,286 units × ₹ 21.60
= ₹ 67,88,578

Question 16.
A company produces single product which sells for ₹ 20 per unit. Variable cost is ₹ 15 per unit and Fixed overhead for the year is ₹ 6,30,000.
Required:
(a) Calculate sales value needed to earn a profit of 10% on sales.
(b) Calculate sales price per unit to bring BEP down to 1,20,000 units
(c) Calculate margin of safety sales if profit is ₹ 60,000. [CA Inter Nov. 2007, 3 Marks]
Answer:
(a) Suppose sales units are x then Sales revenue = 20x
Total contribution = (₹ 20 – ₹ 15) x = 5x
Total profit = (20 × 10%) x = 2x
P/V ratio = \(\frac{\text { Total contribution } \times 100}{\text { Sales revenue }}=\frac{5 x}{20 x}\) × 100 = 25%
Total contribution = Total fixed cost + Total profit
5x = 6,30,000 + 2x
3x = 6,30,000
∴ x = 6,30,000/3 = 2,10,000 units
Sales value = 2,10,000 × 20 = ₹ 42,00,000

(b) Sales price to down BEP = 1,20,000 units
Contribution per unit = \(\frac{\text { Total fixed cost }}{\text { Break Even Point }}\)
= \(\frac{₹ 6,30,000}{1,20,000 \text { units }}\)
= ₹ 5.25

Sales price = Variable cost per unit + Contribution per unit
= ₹ 15 + ₹ 5.25
= ₹ 20.25

(c) Margin of Safety Sales = \(\frac{\text { Profit }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{₹ 60,000}{25 \%}\)
= ₹ 2,40,000

Question 17.
A company has fixed cost of ₹ 90,000, Sales ₹ 3,00,000 and Profit of ₹ 60,000.
Required:
(i) Sales volume it’ in Ihe next period, the company suffered a loss of ₹ 30,000.
(ii) What is the margin of safety for a profit of ₹ 90,000? [CA Inter May 2008, 3 Marks]
Answer:
Total contribution = Total fixed cost + Total profit
= ₹ 90,000 + ₹ 60,000
= ₹ 1,50,000

Question 18.
SHA Limited provides the following trading results:

Year	Sale	Profit
2019-20	₹ 25,00,000	10% of sale
2020-21	₹ 20,00,000	8% of sale

You are required to calculate:
(i) Fixed Cost
(ii) Break Even Point
(iii) Amount of profit, if sale is ₹ 30,00,000
(iv) Sale, when desired profit is ₹ 4,75,000
(v) Margin of Safety at a profit of ₹ 2,70,000 [CA Inter May 2014, 5 Marks]
Answer:
Profit in year 2019-20 = ₹ 25,00,000 × 10% = ₹ 2,50,000
Profit in year 2020-21 = ₹ 20,00,000 × 8% = ₹ 1,60,000
So, P/V Ratio = \(\frac{\text { Change in profit (loss) } \times 100}{\text { Change in sales }}\)
= \(\frac{(₹ 2,50,000-₹ 1,60,000) \times 100}{(₹ 25,00,000-₹ 20,00,000)}\)
= \(\frac{₹ 90,000 \times 100}{₹ 5,00,000}\) = 18%

(i) Fixed Cost = Contribution (in year 2019-20) – Profit (in year 2019-20)
= (Sales × P/V Ratio) – ₹ 2,50,000
= (₹ 25,00,000 × 18%) – ₹ 2,50,000
= ₹ 4,50,000 – ₹ 2,50,000
= ₹ 2,00,000

(ii) Break-even Point (in Sales) = \(\frac{\text { Fixed Cost }}{\text { P V Ratio }}\)
= \(\frac{\text { Fixed Cost }}{\text { P V Ratio }}\) = ₹ 11,11,111 (Approx)

(iii) Calculation of profit, if sale is ₹ 30,00,000
Profit = Contribution – Fixed Cost
= (Sales × P/V Ratio) – Fixed Cost
= (₹ 30,00,000 × 18%) – ₹ 2,00,000
= ₹ 5,40,000 – ₹ 2,00,000 = ₹ 3,40,000
So profit is ₹ 3,40,000, if Sale is ₹ 30,00,000.

(iv) Calculation of Sale, when desired Profit is ₹ 4,75,000
Contribution Required = Desired Profit + Fixed Cost
= ₹ 4,75,000 + ₹ 2,00,000
= ₹ 6,75,000

Sales = \(\frac{\text { Contribution }}{\mathrm{P} / \mathrm{V} \text { Ratio }}\)
= \(\frac{\text { Contribution }}{\mathrm{P} / \mathrm{V} \text { Ratio }}\) = ₹ 37,50,000
Sales is ₹ 37,50,000 when desired profit is ₹ 4,75,000.

(v) Margin of Safety = \(\frac{\text { Profit }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{2,70,000}{18 \%}\) = ₹ 15,00,000

So Margin of Safety is ₹ 15,00,000 at a profit of ₹ 2,70,000

Question 19.
A company has introduced a new product and marketed 20,000 units. Variable cost of the product is ₹ 20 per units and fixed overheads are ₹ 3,20,000.
You are required to:
(i) Calculate selling price per unit to earn a profit of 10% on sales value, – BEP and Margin of Safety?
(if) If the selling price is reduced by the company by 10%, demand is expected to increase by 5,000 units, then what will be its impact on Profit, BEP and Margin of Safety?
(iii) Calculate Margin of Safety if profit is ₹ 64,000 [CA Inter Nov. 2016, 8 Marks]
Answer:
(i) Let ‘X’ be the selling price per unit:
Sales value = Variable Cost + Fixed Cost + Profit
20,000 units × X = (₹ 20 × 20,000 units) + ₹ 3,20,000 + (10% of 20,000 units × X)

Therefore, Selling price per unit = ₹ 40
Contribution per unit = Selling price per unit – variable cost per unit
= ₹ 40 – ₹ 20 = ₹ 20

P/V ratio = \(\frac{\text { Contribution per unit }}{\text { Selling price per unit }}\) × 100 = \(\frac{₹ 20}{₹ 40}\) × 100 = 50%
= (₹ 40 × 20,000 units) – (₹ 20 × 20,000 units) – 3,20,000

Break-even Point (in units) = ₹ 80,000
= \(\frac{\text { Fixed Overheads }}{\text { Contribution per unit }}\)
= \(\frac{₹ 3,20,000}{₹ 20}\)
= 16,000 units

Break – even point (in value) = \(\frac{\text { Fixed Overheads }}{\text { P / V Ratio }}\)
= \(\frac{₹ 3,20,000}{50 \%}\)
= ₹ 6,40,000

Margin of Safety = Total sales value – Break-even sale
= (₹ 40 × 20,000) – ₹ 6,40,000
= ₹ 1,60,000

(ii) Profitability Statement

	₹
Sales Value (7 36 X 25,000 units)	9,00,000
Variable Cost (7 20 X 25,000 units)	(5,00,000)
Contribution	4,00,000
Fixed overheads	(3,20,000)
Profit	80,000

Impact on Profit:
Though there is no impact on the total profit amount but the rate of profit is decreased from 10% to 8.89% (80,000/9,00,000 × 100).

Break-even Point (in units) = \(\frac{\text { Fixed Overheads }}{\text { Contribution per unit }}\)
= \(\frac{₹ 3,20,000}{₹ 36-₹ 20}\)
= 20,000 units

Break-even point (in value) = Selling price per unit × BEP
= ₹ 36 × 20,000 units
= ₹ 7,20,000

Impact on Break-even point (BEP):
The Break-even point is increased by 4,000 units (20,000 units – 16,000 units) or by 7 80,000 (7 7,20,000 – 7 6,40,000).
Impact on Margin of Safety = Total sales value – Break-even sale
= ₹ 9,00,000 – ₹ 7,20,000
= ₹ 1,80,000
Margin of safety is increased by ₹ 20,000 (₹ 1,80,000 – ₹ 160,000) or 1,000 units (5,000 units – 4,000 units)

(iii) Margin of Safety when, profit is ₹ 64,000:
= \(\frac{\text { Profit }}{\mathrm{P} / \mathrm{V} \text { ratio }}=\frac{₹ 64,000}{50 \%} .\) = ₹ 1,28,000

Question 20.
Following figures have been extracted from the books of M/s. RST Private Limited:

Financial Year’	Sales	Profit/Loss
2019-20	4,00,000	15,000 (loss)
2020-21	5,00,000	15,000 (profit)

You are required to calculate:
(i) Profit Volume Ratio
(ii) Fixed Costs
(iii) Break Even Point
(iv) Sales required to earn a profit of 45,000.
(v) Margin of Safety in Financial Year 2020-21. [CA Inter May 2018, 5 Marks]
Answer:

Year	Sales	Profit/Loss
2019-20	₹ 4,00,000	₹ (15,ooo)
2020-21	₹ 5,00,000	₹ 15,000
Difference	₹ 1,00,000	₹ 30,000

(i) Profit Volume Ratio:
P/V Ratio = \(\frac{\text { Change in profit }(\text { loss }) \times 100}{\text { Change in sales }}\)
= \(\frac{₹ 30,000 \times 100}{₹ 1,00,000}\)
= 30%

(ii) Fixed Costs:

	₹
Contribution in 2019-20 (₹ 4,00,000 × 30%)	1,20,000
Add: Loss in 2019-20	15,000
Fixed Cost	1,35,000

(iii) Break Even Point:
Break Even Point = \(\frac{\text { Fixed Cost }}{\mathrm{P} / \mathrm{V} \text { Ratio }}\)
= \(\frac{₹ 1,35,000}{30 \%}\)
= ₹ 4,50,000

(iv) Sales required to earn a profit of ₹ 45,000
Total contribution = Total fixed cost + Total profit
= ₹ 1,35,000 + ₹ 45,000
= ₹ 1,80,000

Sales revenue = \(\frac{\text { Total contribution }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{₹ 1,80,000}{30 \%}\)
= ₹ 6,00,000

(v) Margin of Safety = \(\frac{\text { Profit }}{P / \text { V ratio }}\)
= \(\frac{15,000}{30 \%}\) = ₹ 50,000

So Margin of Safety is ₹ 50,000 at a profit of ₹ 15,000

Question 21.
MFN Limited started its operation in 2019 with the total production capacity of 2,00,000 units. The following data for two years is made available to you:

	2019	2020
Sales units	80,000	1,20,000
Total Cost (₹)	34,40,000	45,60,000

There has been no change in the cost structure and selling price and it is expected to continue in 2021 as well. Selling price is ₹ 40 per unit.
You are required to calculate:
(i) Break-Even Point (in units)
(ii) Profit at 75% of the total capacity in 2021 [CA Inter May 2013, 5 Marks]
Answer:
(i) Break-even point:
Variable cost per unit = \(\frac{\text { Change in total cost }}{\text { Change in unts }}\)
= \(\frac{₹ 45,60,000-₹ 34,40,000}{1,20,000-80,000}\)
= ₹ 28 per unit

Total Fixed Cost = ₹ 45,60,000 – (1,20,000 × ₹ 28)
= ₹ 12, 00, 000

Break-even point in units = \(\frac{\text { Fixed cost }}{\text { Contribution per unit }}=\frac{₹ 12,00,000}{₹ 40-₹ 28}\)
= 1,00,000 units

(ii) Profit at 75% of the total capacity:
Capacity at 75% = 2,00,000 units × 75% = 1,50,000 units
Contribution per unit ₹ 12
Contribution (₹) 1,50,000 × ₹ 12 = ₹ 18,00,000
Fixed Cost = ₹ 12,00,000
Profit = Contribution – Fixed Cost = ₹ 18,00,000 – 12,00,000
= ₹ 6,00,000

Question 22.
A manufacturing company is producing a product ‘A’ which is sold in the market at ₹ 45 per unit. The company has the capacity to produce 40,000 units per year. The budget for the year 2020-21 projects a sale of 30,000 units.
The costs of each unit are expected as under:

	₹
Materials	12
Wages	9
Overheads	6

Margin of safety is ₹ 4,12,500.
You are required to:
(i) Calculate fixed cost and break-even point.
(ii) Calculate the volume of sales to earn profit of 20% on sales.
(iii) If management is willing to invest ₹ 10,00.000 with an expected return of 20%, calculate units to be sold to earn this profit.
(iv) Management expects additional sales if the selling price is reduced to ₹ 44. Calculate units to be sold to achieve the same profit as desired in above (iii). [CA Inter Nov 2018, 10 Marks]
Answer:
Contribution per unit = Selling price per unit – Variable cost per unit
= ₹ 45 – (₹ 12 + ₹ 9 + ₹ 6)
= ₹ 18

P/V ratio = \(\frac{\text { Contribution per unit }}{\text { Selling price per unit }}\) × 100
= \(\frac{₹ 18}{₹ 45}\) × 100 = 40%

Margin of Safety = \(\frac{\text { Profit }}{\mathrm{P} / \mathrm{V} \text { Ratio }}\)
4, 12 , 500 = \(\frac{\text { Profit }}{40 \%}\)
Profit = 4,12,500 × 40%
= 1,65,000

(i) Fixed Cost
Profit = Total contribution – Fixed Cost
Profit = (Sales × P/V Ratio) – Fixed Cost
1,65,000 = [(30,000 × 45) × 40%] – Fixed Cost
Fixed Cost = ₹ 5,40,000 – ₹ 1,65,000
= ₹ 3,75,000
Break-even Point = Total Sales – Margin of Safety
= (30,000 × ₹ 45) – ₹ 4,12,500
= ₹ 13,50,000 – ₹ 4,12,500
= ₹ 9,37,500

(ii) Volume of sales to earn profit of 20% on sales:
Let sales volume be ‘S’ units. Therefore, total sales value will be 45S and Contribution will be 18S
Contribution = Fixed Cost + Desired Profit
18S = 3,75,000 + (20% of 45S)
18S = 3,75,000 + 9S = 3,75,000
9S = 3,75,000
So, S = \(\frac{3,75,000}{9}\) = 41666.67 Units
Volume of sales = Contribution per unit × Selling price per unit
= 41666.67 Units × 45
= ₹ 18,75,000
So, ₹ 18,75,000 sales are required to earn profit on 20% of sales

(iii) Calculation of No. of units to be sold to earn 20% return on investment
Contribution = Fixed Cost + Desired Profit
18S = 3,75,000 + Return on Investment
18S = 3,75,000 + 2,00,000 (ie. ₹ 10,00,000 × 20%)
S = \(\frac{5,75,000}{18 \text { Units }}\) = 31,945 Units (approx.)
So, 31,945 Units to be sold to earn a return of ₹ 2,00,000.

(iv) When selling price reduced to ₹ 44 per unit to earn same profits as above
Revised Contribution = Fixed Cost + Desired Profit
(₹ 44 – ₹ 27)S = 3,75,000 + 2, 00,000
17S = 5,75,000
S = \(\frac{5,75,000}{17 \text { Units }}\) = 33,824 units (approx.)
Additional Sales to be sold to achieve the same profit is 33,824 Units.

Question 23.
A company is producing an identical product in two factories. The following are the details in respect of both factories:

	Factory X	Factory Y
Selling price per unit (₹)	50	50
Variable cost per unit (₹)	40	35
Fixed cost (₹)	2.00.000	3,00,000
Depreciation included in above fixed cost (₹)	40,000	30,000
Sales in units	30,000	20,000
Production capacity (units)	40,000	30,000

You are required to determine:
(i) Break Even Point (BEP) each factory individually.
(ii) Cash break even point for each factory individually.
(iii) BEP for company as a whole, assuming the present product mix is in sales ratio,
(iv) Consequence on profit and BEP if product mix is changed to 2:3 and total demand remain same. [CA Inter May 2018, 8 Marks]
Answer:

(iv) New Sales Mix
Factory X = 50,000 × \(\frac{2}{5}\) = 20,000 units
Factory Y = 50,000 × \(\frac{3}{5}\) = 30,000 units
Calculation of Composite contribution = 10 × \(\frac{2}{5}\) + 15 × \(\frac{3}{5}\)
= 4 + 9 = ₹ 13

Consequence on profit

	Existing Mix	New Mix
Contribution	6,00,000 (50,000 × 12)	6,50,000 (50,000 × 13)
Less: Fixed Cost	5,00,000	5,00,000
Profit	1,00,000	1,50,000

∴ Increase in profit = ₹ 1,50,000 – ₹ 1,00,000
= ₹ 50,000

Consequence on BEP
New BEP as a whole = \(\frac{\text { Complete Fixed Cost }}{\text { Composite Contribution }}\)
= \(\frac{5,00,000}{13}\)
= 38,462 units
So, BEP Reduced by 3,205 units (41,667 – 38,462)

Question 24.
Zed Limited sells its product at ₹ 30 per unit. During the quarter ending, it produced and sold 16,000 units and suffered a loss of ₹ 10 per unit. If the volume of sales is raised to 40,000 units, it can earn a profit of ₹ 8 per unit.
You are required to calculate:
(i) Break Even Point in Rupees.
(ii) Profit if the sale volume is 50,000 units.
(iii) Minimum level of production where the company needs not to close the production if unavoidable fixed cost is ₹ 1,50,000 [CA Inter Nov 2014, 5 Marks]
Answer:

Units sold	Sales value (₹)	Profit/(loss) (₹)
16,000 units	4,80,000 (₹ 30 × 16,000 units)	(1,60,000) (₹ 10 × 16,000 units)
40,000 units	12,00,000 (₹ 30 × 40,000 units)	3,20,000 (₹ 8 × 40,000 units)

Total Contribution in case of 40,000 units = Sales Value × P/V Ratio
= ₹ 12,00,000 × 66.67
= ₹ 8,00,000
So, Fixed cost = Contribution – Profit
= ₹ 8,00,000 – ₹ 3,20,000
= ₹ 4,80,000

(i). Break-even Point in Rupees = \(\frac{\text { FIXed cost }}{\text { Contribution per unit }}\)
= \(\frac{4,80,000}{66.67 \%}\)
= ₹ 7,20,000

(ii) If sales volume is 50,000 units, then profit = (Sales Value × P/V Ratio) – Fixed Cost
= (50,000 units × ₹ 30 × 66.67%) – ₹ 4,80,000
= ₹ 5,20,000

(iii) Minimum level of production where the company needs not to close the production, if unavoidable fixed cost is ₹ 1,50,000:

= 16,500 units.
At production level of ≥ 16,500 units, company needs not to close the production.

Question 25.
A company-manufactures radios, which are sold at ₹ 1,600 per unit. The total cost is composed of 30% for direct materials, 40% for direct w ages and 30% and in wage rates by 10% is expected in the forthcoming year, as a result of which the profit at current selling price may decrease by 40% of the present profit per unit. You are required to prepare a statement showing current and future profit at present Selling Price. How much Selling Price should be increased to maintain the present rate of profit? [CA Inter May 2001, 4 Marks]
Answer:
Let X be the cost, Y be the profit and ₹ 1,600 selling price per unit of radio manufactured by a company.
Hence,
X + Y = 1,600 ………….(i)
Statement of present and future cost of a radio

An increase in material price and wage rates resulted into a decrease in current profit by 40 per cent at present selling price; therefore we have:
1.13X + 0.6 Y= 1,600 …………(ii)
On solving (i) and (ii) we get:
X = ₹ 1,207.55
Y = ₹ 392.45
Current profit ₹ 392.45 or 32.5% of cost Future profit ₹ 235.47

Question 26.
M.K. Ltd. manufactures and sells a single product X whose selling price is ₹ 40 per unit and the variable cost is ₹ 16 per unit.
(i) If the Fixed Costs for this year are ₹ 4,80,000 and the annual sales are at 60% margin of safety, calculate the rate of net return on sales, assuming an income tax level of 40%.
(ii) For the next year, it is proposed to add another product line Y whose selling price would be ₹ 50 per unit and the variable cost ₹ 10 per unit. The total fixed costs are estimated at ₹ 6,66,600. The sales mix values of X : Y would be 7 : 3. Determine at what level of sales next year, would M.K. Ltd. break even? Give separately for both X and Y the break-even sales in rupee and quantities. [ICAIModule]
Answer:
(i) Contribution per unit = Selling price – Variable cost
= ₹40 – ₹ 16 = ₹ 24
Break-even Point = \(\frac{₹ 4,80,000}{₹ 24}\) = 20, 000 units
Margin of Safety = 60%
Therefore, break even sales will be 40%.
Total Sales = \(\frac{\text { Break-even Sales }}{40 \%}=\frac{20,000 \text { units }}{40 \%}\) = 50,000 units

	₹
Sales Value (50,000 units x ? 40)	20,00,000
Less: Variable Cost (50,000 units x ? 16)	8,00,000
Contribution	12,00,000
Less: Fixed Cost	4,80,000
Profit	7,20,000
Less: Income Tax @ 40%	2,88,000
	4,32,000

Rate of Net Return on Sales = 21.6%(\(\frac{₹ 4,32,000}{₹ 20,00,000}\) × 100)

(ii) Computation of Break even sales of product X and product Y

	X(₹)	Y (₹)
Selling Price	40	50
Less: Variable Cost	16	10
Contribution per unit	24	40

Weighted Contribution = \(\frac{24 \times 7+40 \times 3}{10}\) = ₹ 28.8 per unit
Total Break-even Point = \(\frac{\text { Total Fixed Cost }}{\text { Weighted Cost }}=\frac{6,66,600}{28.80}\) = 23,145.80 units
Break-even Point
X = \(\frac{7}{10}\) × 23,145.80 = 16,202 units
or 16,202 × ₹ 40 = ₹ 6,48,080
Y = \(\frac{3}{10}\) × 23,145.80 = 6,944 units or 6,944 × 50 = 3,47,200

Question 27.
A company has three factories situated in North, East and South with its Head Office in Mumbai. The Management has received the following summary report on the operations of each factory for a period:

Calculate the following for each factory and for the company as a whole for the period:
(i) Fixed Cost
(ii) Break-even Sales [CA Inter RTP Nov., 2021]
Answer:
Computation of Profit Volume (P/V) Ratio (₹ in ’000)

(i) Computation of Fixed Costs (₹ in ’000)

(ii) Computation of Break-Even Sales

Question 28.
Mega Company has just completed its first year of operations. The unit costs on a normal costing basis are as under:

	₹
Direct material 4 kg @ ₹ 4	16.0
Direct labour 3 hrs @ ₹ 18	54.00
Variable overhead 3 hrs @ ₹ 4	12.00
Fixed overhead 3 hrs @ ₹ 6	18.00
Selling and administrative costs:	100.00
Variable	₹ 20 per unit
Fixed During the year the company has the following activity:	₹ 7,60,000
Units produced	24,000
Units sold	21,500
Unit selling price	₹ 168
Direct labour hours worked	72,000

Actual fixed overhead was ₹ 48,000 less than the budgeted fixed overhead. Budgeted variable overhead was ₹ 20,000 less than the actual variable overhead. The company used an expected actual activity level of 72,000 direct labour hours to compute the pre-determine overhead rates.
Required:
(i) Compute the unit cost and total income under:
(a) Absorption costing
(b) Marginal costing
(ii) Under or over absorption of overhead.
(iii) Reconcile the difference between the total income under absorption and marginal costing. [CA Inter .You 2009. 13 Marks]
Answer:
(i) Computation of Unit Cost & Total Income

Unit Cost	Absorption Costing (₹)	Marginal Costing (₹)
Direct Material	16.00	16.00
Direct Labour	54.00	54.00
Variable Overhead (₹ 12 + ₹ 20,000/24,000)	12.83	12.83
Fixed Overhead	18.00	–
Unit Cost	100.83	82.83

Income Statement

(ii) Under or over absorption of overhead:

(iii) Reconciliation of Profit:
Difference in Profit = ₹ 3,02,083 – ₹ 2,57,083
= ₹ 45,000
This is due to Fixed Factory Overhead being included in Closing Stock in Absorption Costing and not in Marginal Costing.
Therefore, Difference in Profit
= Fixed Overhead Rate (Production – Sale) = ₹ 18 (24,000 -21,500)
= ₹ 45,000

Working Note: Calculation of Cost of Goods Sold

Question 29.
A dairy product company manufacturing baby food with a shelf life of one year furnishes the following information:
(i) On 1st January, 2021, the company has an opening stock of 20,000 packets whose variable cost is ₹ 180 per packet.
(ii) In 2020, production was 1,20,000 packets and the expected production in 2021 is 1,50,000 packets. Expected sales for 2021 is 1,60,000 packets.
(iii) In 2020, fixed cost per unit was ₹ 60 and it is expected to increase by 10% in 2021. The variable cost is expected to increase by 25%. Selling price for 2021 has been fixed at ₹ 300 per packet.
You are required to calculate the Break-even volume in units for 2021. [CA Inter May 2016, 5 Marks]
Answer:
Calculation of Break-even Point (in units):
Since, shelf life of the product is one year only, hence, opening stock is to be sold first.

	₹
Total Contribution required to recover total fixed cost in 2021 and to reach break-even volume.	79,20,000
Less: Contribution from opening stock (20,000 units × (₹ 300 – ₹ 180)}	24,00,000
Balance Contribution to be recovered	55,20,000

Units to be produced to get balance contribution
= \(\frac{\text { Balance Contribution to be recovered }}{\text { Contribution per unit }}\)
= \(\frac{₹ 55,20,000}{(₹ 300-₹ 225)}\)
= 73,600 packets.
Break-even volume in units for 2021

	Packets
From 2021 production	73,600
Add: Opening stock from 2020	20,000
	93,600

Working Notes:

	2020 (₹)	2021 (₹)
Fixed Cost	72,00,000 (₹ 60 × 1,20,000 units)	79,20,000 (110% of ₹ 72,00,000)
Variable Cost	180	225 (125% of ₹ 180)

Question 30.
A company, with 90% Capacity utilization, is manufacturing a product and makes a sale of ₹ 9,45,000 at ₹ 30 per unit. The cost data is as under:

Materials	₹ 9.00 per unit
Labour	₹ 7.00 per unit

Semi variable cost (including variable cost of ₹ 4.25 per unit) ₹ 2,10,000.
Fixed cost is ₹ 94,500 upto 90% level of output (capacity). Beyond this, an additional amount of ₹ 15,000 will be incurred.
You are required to calculate:
(i) Level of output at break-even point
(ii) Number of units to be sold to earn a net income of 10% of sales
(iii) Level of output needed to earn a profit of ₹ 1,41,375 [CA Inter Nov. 2017, 8 Marks]
Answer:
No. of units at 90% capacity utilization = \(\frac{\text { Sales Value }}{\text { Selling price per unit }}\)
= \(\frac{₹ 9,45,000}{₹ 30}\) = 31,500 units
Calculation of Contribution per unit:

	₹
Material	9.00
Labour cost	7.00
Variable overheads	4.25
Total Variable Cost	20.25
Selling price	30.00
Contribution per unit (Selling price – Variable Cost)	9.75

Calculation of Total Fixed Cost

	₹
Semi-variable cost	2,10,000
Less: Variable cost (31,500 units × ₹ 4.25)	1,33,875
Fixed Cost	76,125
Add: Fixed cost upto 90% level	94,500
Total Fixed Cost	1,70,625

(i) Break-even point = \(\frac{\text { Total Fixed Cost }}{\text { Contribution per unit }}\)
= \(\frac{₹ 1,70,625}{₹ 9.75}\)
= 17,500 Units
At 17,500 units, output level is 50% (17,500/31,500 × 90%). This means that at 50% activities level, this company reaches at BEP.

(ii) Number of units to be sold to earn a net income of 10% of sales
10% of sales = 10% of ₹ 30 = ₹ 3 per unit profit.
Let us assume ‘S’ is the No. of units to be sold, hence profit will be 3S
Sales (Units) = \(\frac{\text { Fixed Cost }+ \text { Profit }}{\text { Contribution per unit }}\)
S = \(\frac{₹ 1,70,625+3 S}{₹ 9.75}\)
9.75 S = ₹ 1,70,625 + 3S
S = \(\frac{₹ 1,70,625}{6.75}\) = 25,278 units.

(iii) Level of output needed to earn a profit of ₹ 1,41,375
Sales (units) = \(\frac{₹ 1,70,625+₹ 1,41,375}{₹ 9.75}\) = 32,000 units
32,000 units is beyond 90% activity level. In such case, the fixed cost will be increased by ₹ 15,000 to ₹ 3,27,000.
Then, S = \(\frac{₹ 3,27,000}{₹ 9.75}\) = 33,538 units i.e. 33,538/35,000 × 100 = 95.82% activity level.

Question 31.
J Ltd. manufactures a Product-Y. Analysis of income statement indicated a profit of ₹ 250 lakhs on a sales volume of 5,00,000 units. Fixed costs are ₹ 1,000 lakhs which appears to be high. Existing selling price is ₹ 680 per unit. The company is considering revising the profit target to ₹ 700 lakhs.
You are required to compute:
(i) Break-even point at existing levels in units and in rupees.
(ii) The number of units required to be sold to earn the target profit.
(iii) Profit with 10% increase in selling price and drop in sales volume by 10%.
(iv) Volume to be achieved to earn target profit at the revised selling price as calculated in (ii) above, if a reduction of 10% in the variable costs and ₹ 170 lakhs in the fixed cost is envisaged. [CA Inter Nov. 2020, RTP]
Answer:
Sales Volume 5,00,000 Units
Computation of existing contribution

	Per unit (₹)	Total (₹ In lakhs)
Sales (A)	680	3,400
Fixed Cost	200	1 ,000
Profit	50	250
Contribution (B)	250	1,250
Variable Cost [(A) – (B)]	430	2,150

(i) Break even sales (units) = \(\frac{\text { Cixed Cost }}{\text { Contribution per unit }}\)
= \(\frac{₹ 10,00,00,000}{₹ 250}\)
= 4,00,000 units
Break even sales (₹) = 4,00,000 units × ₹ 680
= ₹ 2,720 lakhs

(ii) Number of units sold to achieve a target profit of ₹ 700 lakhs:
Desired Contribution = Fixed Cost + Target Profit
= ₹ 1,000 lakhs + 700 lakhs
= ₹ 1,700 lakhs
Number of units to be sold = \(=\frac{\text { Desired Contribution }}{\text { Contribution per unit }}=\frac{₹ 17,00,00,000}{₹ 250}\)
= 6,80,000 units

(iii) Profit if selling price is increased by 10% and sales volume drops by 10%:
Existing Selling Price per unit = ₹ 680
= ₹ 680 × 110% – ₹ 748
= 5,00,000 units
= 5,00,000 units – (10% of 5,00,000)
= 4,50,000 units

Statement of Profit at sales volume of 4,50,000 units @ 748 per unit

(iv) Volume to be achieved to earn target profit of ₹ 700 lakhs with revised selling price and reduction of 10% in variable costs and ₹ 170 lakhs in fixed cost:
Revised selling price per unit = ₹ 748
Variable costs per unit existing = ₹ 430
Revised Variable Costs = ₹ 430 – (10% of 430)
= ₹ 430 – ₹ 43
= ₹ 387

Total Fixed Cost (existing) = ₹ 1,000 lakhs
Reduction in fixed cost = ₹ 170 lakhs
Revised fixed cost = ₹ 1,000 lakhs – ₹ 170 lakhs
= ₹ 830 lakhs

Revised Contribution (unit) = ₹ 748 – 1387 = ₹ 361
Desired Contribution = Revised Fixed Cost + Target Profit
= ₹ 830 lakhs + ₹ 700 lakhs
= ₹ 1,530 lakhs

No.of units to be sold = \(\frac{\text { Desired Contribution }}{\text { Contribution per unit }}\)
= \(\frac{₹ 15,30,00,000}{₹ 361}\) = 4,23,823 units

Question 32.
The following information was obtained from the records of a manufacturing unit:

	₹	₹
Sales 80,000 units @ ₹ 25		20,00,000
Material consumed	8,00,000
Variable Overheads	2,00,000
Labour Charges	4,00,000
Fixed Overheads	3,60,000	17,60,000
Net Profit		2,40,000

Calculate:
(i) The number of units by selling which the company will neither lose nor gain anything.
(ii) The sales needed to earn a profit of 20% on sales.
(iii) The extra units which should be sold to obtain the present profit if it is proposed to reduce the selling price by 20% and 25%.
(iv) The selling price to be fixed to bring down its Break-even Point to 10,000 units under present conditions. [CA Inter May 2017, 8 Marks]
Answer:
(i) The number of units to be sold for neither loss nor gain i.e. Break-even units:
= \(\frac{\text { Fixed Overheads }}{\text { Contribution per unit }}=\frac{₹ 3,60,000}{₹ 7.50}\) = 48,000 units

(ii) The sales needed to earn a profit of 20% on sales:
Let desired total sales be X.
Desired Sales = \(\frac{\text { Fixed Cost }+ \text { Desired Profit }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
X = \(\frac{₹ 3,60,000+0.2 \mathrm{X}}{30 \%}\)
or, 0.30X = 3,60,000
or, 0.10X = 3,60,000
or, X = ₹ 36,00,000
No. of units to be sold = \(\frac{36,00,000}{25}\) = 1,44,000 units

(iii) Calculation of extra units to be sold to earn present profit of ₹ 2,40,000 under the following proposed selling price:

(iv) Sales price to bring down BEP to 10,000 units:
B.E.P (Units) = \(\frac{\text { Fixed Cost }}{\text { Contribution per unit }}\)
Or Contribution per unit = \(\frac{₹ 3,60,000}{10,000 \text { units }}\) = ₹ 36

So, Sales Price (per unit) = Variable Cost + Contribution
= ₹ 17.5 + ₹ 36 = ₹ 53.50

Workings:
Variable cost per unit = \(\frac{₹ 8,00,000+₹ 2,00,000+₹ 4,00,000}{80,000 \text { units }}\) = ₹ 17.50
Contribution per unit = ₹ 25 – ₹ 17.50 = ₹ 7.50
P/V Ratio = \(\frac{\text { Contribution per unit }}{\text { Selling price per unit }}\) × 100 = \(\frac{7.50}{25}\) × 100 = 30%

Question 33.
LR Ltd. is considering two alternative methods to manufacture a new product it intends to market. The two methods have a maximum output of 50,000 units each and produce identical items with a selling price of ₹ 25 each. The costs are:

	Method 1 Semi-Automatic (₹)	Method 2 Fully-Automatic (₹)
Variable cost per unit	15	10
Fixed costs	1,00,000	3,00,000

You are required to calculate:
(1) Cost Indifference Point in units. Interpret your results.
(2) The Break-even Point of each method in terms of units.
Answer:

Question 34.
M/s Gaurav Private Limited is manufacturing and selling two products: ‘BLACK’ and ‘WHITE’ at selling price of ₹ 20 and ₹ 30 respectively.
The following sales strategy has been outlined for the financial year 2020-21:
(i) Sales planned for the year will be ₹ 81,00,000 in the case of ‘BLACK’ and ₹ 54,00,000 in the case of ‘WHITE’.
(ii) The selling price of ‘BLACK’ will be reduced by 10% and that of ‘WHITE’ by 20%.
(iii) Break-even is planned at 70% of the total sales of each product.
(iv) Profit for the year to be maintained at ₹ 8,26,200 in the case of ‘BLACK’ and ₹ 7,45,200 in the case of ‘WHITE’. This would be possible by- reducing the present annual fixed cost of ₹ 42,00,000 allocated as ₹ 22,00,000 to ‘BLACK’ and ₹ 20,00,000 to ‘WHITE’.
You are required to calculate:
1. Number of units to be sold of ‘BLACK’ and ‘WHITE’ to Break even
during the financial year 2020-21.
2. Amount of reduction in fixed cost product-wise to achieve desired profit mentioned at (iv) above. [CA Inter May 2019, 3 Marks]
Answer:
(i) Statement showing Break Even Sales

(ii) Statement Showing Fixed Cost Reduction

Question 35.
PH Gems Ltd. is manufacturing ready made suits. It has annual production capacity of 2,000 pieces. The Cost Accountant has presented following information for the year to the management:

	₹	₹
Sales 1,500 pieces @ ₹ 1,800 per piece		27,00,000
Direct Material	5,94,200
Direct Labour	4,42,600
Overheads (40% Fixed)	11,97,000	22,33,800
Net Profit		4,66,300

Evaluate following options:
(i) If selling price is increased by ₹ 200, the sales will come down to 60% of the total annual capacity. Should the company increase its selling price?
(ii) The company can earn a profit of 20% on sales if the company provides TIEPIN with ready-made suit. The cost of each TIEPIN is ₹ 18. Calculate the sales to earn a profit of 20% on sales. [CA Inter May 2018, 10 Marks]
Answer:
(i) Evaluation of Option (i)
Selling Price = ₹ 1800 + ₹ 200 = ₹ 2,000
Sales = 2000 × 60° = 1200 Pieces

Yes, the company should increase its selling price. As at sales of 1,500 pieces it can earn profit of ₹ 310.8 per unit and at sales of 1,200 pieces it can earn profit of ₹ 431 per unit.

(ii) Evaluation of Option (ii)

Sales required to earn a profit of 20%
Sales = \(\frac{₹ 4,78,800+0.20 \text { sales }}{34.00 \%}\)
0.34 Sales = ₹ 4,78,000 + 0.20 sales
Sales = ₹ 34,20,000 or 1,900 units (₹ 34,20,000/1800)
To earn profit 20% on sales of readymade suit (along with TIEPIN) company has to sold 1,900 units i.e. 95% of the full capacity. This sales level of 1,900 units is justified only if variable cost is constant. Any upside in variable cost would impact profitability, to achieve the desired profitability. Production has to be increased but the scope is limited to 5% only.

Question 36.
PJ Ltd. manufactures hockey sticks. It sells the products at ₹ 500 each and makes a profit of ₹ 125 on each stick. The Company is producing 5,000 sticks annually by using 50% of its machinery capacity.
The cost of each stick is as under:

Direct Material	₹ 150
Direct Wages	₹ 50
Works Overhead	₹ 125 (50% fixed)
Selling Expenses	₹ 50 (25% variable)

The anticipation for the next year is that cost will go up as under:

Fixed Charges	10%
Direct Wages	20%
Direct Material	5%

There will not be any change in selling price.
There is an additional order for 2,000 sticks in the next year.
Calculate the lowest price that can be quoted so that the Company can earn the same profit as it has earned in the current year? [CA Inlet Nor. 2019, 10 Marks]
Answer:
Selling Price = ₹ 500
Profit = ₹ 125
No. of Sticks = 5,000

Let lowest price quoted be K
Now, Sales = Target Profit + Variable Cost + Fixed Cost
(5,000 × 500) + (2,000 × K) = (5,000 units × ₹ 125) + (7,000 units × ₹ 292.50)
25,00,000 + 2,000K = 6,25,000 + 20,47,500 + 5,50,000
= ₹ 361.25
So, Lowest Price that can be quoted to earn the profit of ₹ 6,25,000 (same as current year) is ₹ 361.25.

Question 37.
A Ltd. manufacture and sales Its. product R-9. .The following figures have been collected from cost records of last year for the product R-9:

Elements of Cost	Variable Cost portion	Fixed Cost
Direct Material	30% of Cost of Goods Sold	–
Direct Labour	15% of Cost of Goods Sold	–
Factory Overhead	10% of Cos? of Goods Sold	₹ 2,30,000
Administration Overhead	2% of Cost of Goods Sold	₹ 71,000
Selling & Distribution Overhead	4% of Cost of Sales	₹ 68,000

Last Year 5,000 units were sold at ₹ 185 per unit. From the given, determine the followings:
(i) Break-even Sales (in ₹)
(ii) Profit earned during last year
(iii) Margin of safety (in %)
(iv) Profit if the sales were 10% less than the actual sales (Assume that Administration Overhead is related with production activity) [CA Inter RTF May 203,0]
Answer:
(i) Break-Even Sales
= \(\frac{\text { Fixed cost }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{₹ 3,69,000}{53.41 \%}\)
= ₹ 6,90,882

(ii) Profit earned during the last year
= (Sales – Total Variable Costs) – Total Fixed Costs
= (₹ 9,25,000 – ₹ 4,31,000) – ₹ 3,69,000
= ₹ 1,25,000

(iii) Margin of Safety (%)
= \(\frac{\text { Sales }- \text { Break-even sales }}{\text { Sales }}\) × 100
= \(\frac{₹ 9,25,000-₹ 6,90,882}{₹ 9,25,000}\) × 100
= 25.3196

(iv) Profit if the sales were 10% less than the actual sales:
Profit = 90% of (₹ 9,25,000 – ₹ 4,31,000) – ₹ 3,69,000
= ₹ 4,44,600 – ₹ 3,69,000
= ₹ 75,600

Working Notes:
1. Calculation of Cost of Goods Sold (COGS):
COGS = Direct Material + Direct Labour + Factory Overhead + Administration Overhead
COGS = [0.3 COGS + 0.15 COGS + (0.10 COGS + ₹ 2,30,000) + (0.02 COGS + ₹ 71,000)]
COGS = 0.57 COGS + ₹ 3,01,000
COGS = \(\frac{₹ 3,01,000}{0.43}\) = ₹ 7,00,000

2. Calculation of Cost of Sales (COS):
COS = COGS + Selling & Distribution Overhead
COS = COGS + (0.04 COS + ₹ 68,000)
COS = ₹ 7,00,000 + (0.04 COS + ₹ 68,000)
COS = \(\frac{₹ 7,68,000}{0.96}\) = ₹ 8,00,000

Calculation of Variable Costs:

Direct Material	(0.30 × ₹ 7,00,000)	₹ 2,10,000
Direct Labour	(0.15 × ₹ 7,00,000)	₹ 1,05,000
Factory Overhead	(0.10 × ₹ 7,00,000)	₹ 70,000
Administration OH	(0.02 × ₹ 7,00,000)	₹ 14,000
Selling & Distribution OH	(0.04 × ₹ 8,00,000)	₹ 32,000
		₹ 4,31,000

4. Calculation of total Fixed Costs:

Factory Overhead	₹ 2,30,000
Administration OH	₹ 71,000
Selling & Distribution OH	₹ 68,000
	₹ 3,69,000

5. Calculation of P/V Ratio:
P/V Ratio = \(\frac{\text { Contribution }}{\text { Sales }}\) × 100
= \(\frac{\text { Sales Variable Costs }}{\text { Sales }}\) × 100
= \(\frac{(₹ 185 \times 5,000 \text { units })-4,31,000}{₹ 185 \times 5,000 \text { units }}\) × 100
= 53.41%

Question 38.
The following figures are related to LM Limited for the year ending 31st March, 2021:
Sales – 24,000 units @ ₹ 200 per unit;
P/V Ratio 25% and Break-even Point 50% of sales.
You are required to calculate:
(i) Fixed cost for the year
(ii) Profit earned for the year
(iii) Units to be sold to earn a target net profit of ₹ 11,00,000 for a year.
(iv) Number of units to be sold to earn a net income of 25% on cost.
(v) Selling price per unit if Break-even Point is to be brought down by 4,000 units. [CA Inter Nov. 2012, 8 Marks]
Answer:
Break even point (in units) = 50% of sales = 12,000 units
Break even point (in sales value) = 12,000 units × ₹ 200 = ₹ 24,00,000
(i) Break even sales = \(\frac{\text { Fixed Cost }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
or 24,00,000 = \(\frac{\text { Fixed cost }}{25 \%}\)
or Fixed Cost = ₹ 24,00,000 × 2596 = ₹ 6,00,000
So Fixed Cost for the year is ₹ 6,00,000

(ii) Contribution for the year = Total Sales × P/V Ratio
= (24,000 units × ₹ 200) × 2596 = ₹ 12,00,000
Profit for the year = Contribution – Fixed Cost
= ₹ 12,00,000 – ₹ 6,00,000
= ₹ 6,00,000

(iii) Target net profit is ₹ 11,00,000
Contribution per unit = 25% of ₹ 200 = ₹ 50 per unit
No.of units to be sold = \(\frac{\text { Fixed Cost }+ \text { Desired Profit }}{\text { Contribution per unit }}\)
= \(\frac{₹ 6,00,000+₹ 11,00,000}{₹ 50}\) = 34,000 units

(iv) Let desired total sales be X, then desired profit is 25% on Cost or 20% on Sales i.e. 0.2X
Fixed Cost + Desired Profit
Desired Sales = \(\frac{\text { Fixed Cost }+ \text { Desired Profit }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
X = \(\frac{₹ 6,00,000+0.2 \mathrm{X}}{25 \%}\)
or, 0.25 X = 6,00,000 + 0.2X
or, 0.05 X = 6,00,000
or, X = ₹ 1,20,00,000
No. of units to be sold – \(\frac{1,20,00,000}{200}\) = 60,000 units

(v) If Break even point is to be brought down by 4,000 units, then Breakeven point will be 12,000 units – 4000 units = 8000 units .
B.E.P (Units) = \(\frac{\text { Fixed Cost }}{\text { Contribution per unit }}\)
Or, Contribution per unit = \(\frac{6,00,000}{8,000 \text { unit }}\) = ₹ 75
So, Sales Price (per unit) = Variable Cost + Contribution
= ₹ 150 + ₹ 75 = ₹ 225

Question 39.
Two manufacturing companies A and B are planning to merge. The details are as follows:

	A	B
Capacity utilisation (%)	90	60
Sales (₹)	63,00,000	48,00,000
Variable Cost (₹)	39,60,000	22,50,000
Fixed Cost (₹)	13,00,000	15,00,000

Assuming that the proposal is implemented, calculate:
(i) Break-Even sales of the merged plant and the capacity utilization at that stage,
(ii) Profitability of the merged plant at 80% capacity utilization
(iii) Sales Turnover of the merged plant to earn a profit of ₹ 60,00,000.
(iv) When the merged plant is working at a capacity to earn a profit of ₹ 60,00,000, what percentage of increase in selling price is required to sustain an increase of 5% in fixed overheads. [CA Inter January 2021, 10 Marks]
Answer:

P/V ratio of merged plant = \(\frac{\text { Contribution }}{\text { sales }}\) × 100
= \(\frac{₹ 68,50,000}{1,50,00,000}\) × 100
= 45.67%

(i) Break-even sales of merged plant = \(\frac{\text { Fixed cost }}{\mathrm{P} / \mathrm{V} \text { ratio }}\)
= \(\frac{28,00,000}{45.67 \%}\)
= ₹ 61,30,939.34 (approx.)

(ii) Profitability of the merged plant at 80% capacity utilisation
= (₹ 1,50,00,000 × 80%) × P/V ratio – fixed cost
= ₹ 1,20,00,000 × 45.67% – ₹ 28,00,000
= ₹ 26,80,400

(iii) Sales to earn a profit of ₹ 60,00,000
Desired sales = \(\frac{\text { Fixed Cost }+ \text { desired profit }}{\text { P / V Ratio }}\)
= \(\frac{₹ 28,00,000+₹ 60,00,000}{45.67 \%}\)
= ₹ 1,92,68,666 (approx.)

(iv) Increase in fixed cost = ₹ 28,00,000 × 5% = ₹ 1,40,000
Therefore, percentage increase in sales price
= \(\frac{₹ 1,40,000}{₹ 1,92,68,666}\) × 100 = 0.726% (approx)

Question 40.
XYZ Ltd. is engaged in the manufacturing of toys. It can produce 4,20,000 toys at its 70% capacity on per annum basis. Company is in the process of determining sales price for the financial year 2020-21. It has provided the following information:

Direct Material	₹ 60 per unit
Direct Labour	₹ 30 per unit
Indirect Overheads
Fixed	₹ 65,50,000 per annum
Variable	₹ 15 per unit
Semi-variable	₹ 5,00,000 per annum up to 60% capacity and ₹ 50,000 for every 5% increase in capacity or part thereof up to 80% capacity and thereafter ₹ 75,000 for every 10% increase in capacity or part thereof

Company desires to earn a profit of ₹ 25,00,000 for the year. Company has planned that the factory will operate at 50% of capacity for first six months of the year and at 75% of capacity for further three months and for the balance three months, factory will operate at full capacity.
You are required to:
(1) Determine the average selling price at which each of the toys should be sold to earn the desired profit.
(2) Given the above scenario, advise whether company should accept an offer to sell each Toy at:
(a) 1130 per Toy
(b) ₹ 129 per Toy (CA Inter January 2021, 10 MarksJ
Answer:
(1) Statement of Cost

* ₹ 5,00,000 + [3 times (from 60% to 75%) × 50,000] = ₹ 6,50,000
** ₹ 6,50,000 + [1 time (from 75% to 80%) × 50,000] + [2 times (from 80% to 100%) × 75,000] = ₹ 8,50,000
(2) Company Should accept the offer as it is above its targeted sales price of ₹ 128.45 per toy.

Question 41.
PQR Ltd. manufactures medals for winners of athletic events and other contests. Its manufacturing plant has the capacity to produce 10,000 medals each month. The company has current production and sales level of 7,500 medals per month. The current domestic market price of the medal is ₹ 150,
The cost data for the month of August 2021 is as under:

	₹
Variable costs:
Direct materials	2,62,500
Direct labour cost	3,00,000
Overhead	75,000
Fixed manufacturing costs	2,75,000
Fixed marketing costs	1,75,000
	10,87,500

PQR Ltd, has received a special one-time only order for 2,500 medals at ₹ 120 per medal.
Required:
(i) Should PQR Ltd, accept the special order? Why? Explain briefly.
(ii) Suppose the plant capacity was 9,000 medals instead of 10,000 medals each month. The special order must be taken either in full or rejected totally. Analyse whether PQR Ltd. should accept the special order or not. [ICAI Module]
Answer:

(z) Since, the offered price (₹ 120) for the additional demand of 2,500 medals is more than the variable cost per unit (₹ 85), the order will be accepted.
Increase in profit by accepting order = (₹ 120 – ₹ 85) × 2,500 medals
= ₹ 87,500

(ii) If the plant capacity is 9,000 medals, then by accepting special order of 2,500 medals, the company has to lose contribution on 1,000 medals from existing customers.

By accepting the special order at ₹ 120 per unit, the total profit of the company is increased by ₹ 22,500 (₹ 60,000 – ₹ 37,500) hence the order may be accepted, however, other qualitative factors may also be taken care-off.

Question 42.
A company using a continuous manufacturing operation achieves an output of 3 kg per hour. The selling price is ₹ 450 per kg. The raw material cost ₹ 3 25 per kg. of output and the direct labour and variable overheads amount to ₹ 316 per kg. of output. The company has provided an expenditure of ₹ 640 on maintenance and ₹ 6,400 on breakdown repairs per month in its budget. Breakdowns averaging 300 hours per month occur due to mechanical faults. These could be reduced or eliminated, if additional maintenance on the following scale were undertaken:

Breakdown Hours	Maintenance Costs (₹)	Repair Costs (₹)
0	20,480	0
60	10,240	1,920
120	5,120	2,560
180	2,560	3.840
240	1,280	5,120
300	640	6,400

Using the incremental cost and incremental revenue concept, you are required to:
(i) Determine the optimum level upto which breakdown can be reduced to increase production.
(ii) Calculate the additional profits obtainable at that level as compared to the present situation. [CA Inter May 2003, 7 Marks]
Answer:
Contribution per hour :
Contribution per kg = Selling price per kg – Variable cost per kg
= ₹ 450 – (₹ 125 material cost + ₹ 316 direct labour and overheads)
= ₹ 450 – ₹ 441
= ₹ 9

Contribution per hour = 3 kg. × Contribution per kg.
= 3 kg. × ₹ 9
= ₹ 27

(i) Optimum level upto which breakdown can be reduced to increase production

Optimal level upto which breakdown can be reduced to increase production:
Saving of 180 hours and breakdown of 120.

(ii) Additional profit at optimum level as compared to present position:
₹ 340 + ₹ 1,620 + ₹ 2,260 = ₹ 4,220

Question 43.
OPR Ltd. purchases crude vegetable oil. It does refining of the same. The refining process results in four products at the split-off point – S, P, N and A. Product ‘A’ is fully processed at the split-off point. Product S, P and N can be individually further refined into SK, PM and NL respectively. The join cost of purchasing the crude vegetable oil and processing it were ₹ 40,000 other details are as follows:

Product	Further processing cost (₹)	Sales at split-off point (₹)	Sales after further processing (₹)
S	80,000	20,000	1,20.000
P	32,000	12,000	40,000
N	36,000	28,000	48.000
A	–	20,000	–

You are required to identify the products which can be further processed for maximizing profits and make suitable suggestions. a [CA Inter July 2021, 5 Marks]
Answer:
Statement showing further processing decisions

Since the Incremental Revenue from Product S exceeds the Incremental Cost of further processing, Product S should be processed further and Products P and N should be sold at split off point.

Question 44.
The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the relevant figures are as under:

Sales	₹ 5,00,000
Direct Materials	₹ 2,50,000
Direct Labour	₹ 1,00,000
Variable Overheads	₹40,000
Capital Employed	₹ 4,00,000

The new Sales Manager who has joined the company recently estimates for next year a profit of about 23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is an increase in Selling Price of 4% and an overall cost reduction in all the elements of cost by 2%.
Required:
Find out by computing in detail the cost and profit for next year, whether the proposal of Sales Manager can be adopted. [ICAIModule]
Answer:
Present profit = Capital employed ₹ 12.5% = ₹ 4,00,000 × 12.5% = ₹ 50,000
Variable Costs = Direct Materials + Direct Labour + Variable o/h
= ₹ 2,50,000 + ₹ 1,00,000 + ₹ 40,000 = ₹ 3,90,000
Sales = Variable Costs + Fixed Cost + Profit
₹ 5,00,000 = ₹ 3,90,000 + Fixed Cost + ₹ 50,000
Fixed Cost = ₹ 60,000

Statement Showing “Cost and Profit for the Next Year”

Profit on Capital Employed = (\(\frac{₹ 92,780}{₹ 4,00,000}\) × 100) = 23.19%
Since the Profit of ₹ 92,780 is more than 23% of capital employed, the proposal of the Sales Manager can be adopted.

Question 45.
Moon Ltd. produces products ‘X’, ‘Y’ and ‘27 and has decided to analyse its production mix in respect of these three products – ‘X’, ‘Y’ and ‘Z’
You have the following information:

	X	Y	Z
Direct Materials ₹ (per unit)	160	120	80
Variable Overheads ₹ (per unit)	8	20	129

Direct labour:

From the current budget, further details are as below :

There is a constraint on supply of labour in Department-A and its manpower cannot be increased beyond its present level.
Required:
(i) Identify the best possible product mix of Moon Ltd.
(ii) Calculate the total contribution from the best possible product mix. [CA Inter Nov 2020, 5 Marks]
Answer:
(i) Statement Showing “Calculation of Contribution/ unit”

(ii) Statement Showing Total Contribution from best mix
Existing Hours = 10,000 × 6 hrs. + 12,000 × 10 hrs. + 20,000 × 5 hrs.
= 2,80,000 hrs.
Allocation of Hours on the basis of ranking:

Question 46.
Mohit Limited manufactures three different products and the following information has been collected from the books of account:

The company has currently under discussion, a proposal to discontinue the manufacture of Product U and replace it with Product M, when the following results are anticipated:

Required:
(i) Compute the PV ratio, total contribution, profit and Break-even sales for the existing product mix.
(ii) Compute the PV ratio, total contribution, profit and Break even sales for the proposed product mix. [CA Inter RTP, May 2021]
Answer:
(i) Computation of PV ratio, contribution and break-even sales for existing product mix

(ii) Computation of PV ratio, contribution and break-even sale for proposed product mix

Question 47.
X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd. facilitates production of any one spare part for a particular period of time. The following are the cost and other information for the production of the two different spare parts A and B:

	Part A	Part B
Per unit Alloy usage	1.6 kgs.	1.6 kgs.
Machine Time: Machine P	0.6 hrs	0.25 hrs.
Machine Time: Machine Q	0.5 hrs.	0.55 hrs.
Target Price (₹)	145	115

Total hours available Machine P 4,000 hours
Machine Q 4,500 hours
Alloy available is 13,000 kgs. @ ₹ 12.50 per kg.

Variable overheads per machine hours
Machine P: ₹ 80
Machine Q: ₹ 100
Required:
(i) Identify the spare part which will optimize contribution at the offered price.
(ii) If Y Ltd. reduces target price by 10% and offers ₹ 60 per hour of unutilized machine hour, calculate the total contribution from the spare part identified above? [ICAI Module]
Answer:
(i) Computation of maximum number of parts that can be manufactured

Computation of Total Contribution at maximum number of parts

(ii) Total Contribution from Spare part A when target price reduced by 10% and unutilised machine hour can be utilised (5 ₹ 60 per hour)

	Part A
Parts to be manufactured numbers	6,666
Machine P hours used	4,000
Machine Q hours used	3,333
Underutilized Machine Hours (4,500 hrs. – 3,333 hrs.)	1,167
Compensation for unutilized machine hours (1,167 hrs. × ₹ 60)	70,020

International Trade Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

International Trade Notes – CA Inter ECO Notes

1. The Mercantilists’ View of International Trade:

• Increase exports and collect precious metals in return
• More gold and silver a country accumulates, the richer it becomes
• Mercantilism advocated maximizing exports in order to bring in more “specie” (precious metals) and minimizing imports through the state imposing very high tariffs on foreign goods
• Trade is a ‘zero-sum game’
• Who win does so only at the expense of losers
• One country’s gain is equal to another country’s loss

2. The Theory of Absolute Advantage:

• Adam Smith was the first to put across the possibility that international trade is not a zero-sum game.
• Absolute cost advantage is the determinant of mutually beneficial in-ternational trade.
• In other words, exchange of goods between two countries will take place only if each of the two countries can produce one commodity at an absolutely lower production cost than the other country.
  Output per Hour of Labour

Commodity	Country A	Country B
Wheat (bushels/hour)	6	1
Cloth (yards/hour)	4	5

• Country A is more efficient than country B, or has an absolute advantage over country B in production of wheat.
• Similarly, country B is more efficient than country A, or has an absolute advantage over country A in the production of cloth.

3. The Theory of Comparative Advantage:

• David Ricardo developed the classical theory of comparative advantage in his book ‘Principles of Political Economy and Taxation’ published in 1817.
• Even if one nation is less efficient than the other nation in the production of all commodities, there is still scope for mutually beneficial trade.
• The first nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller and import the commodity in which its absolute disadvantage is greater.

Output per Hour of Labour

Commodity	Country A	Country B
Wheat (bushels/hour)	6	1
Cloth (yards/hour)	4	2

• Country A’s absolute advantage is greater in wheat
• Country B’s absolute disadvantage is smaller in cloth, so its comparative advantage lies in cloth production.

4. The Heckscher -Ohlin Theory of Trade or Factor-Endowment Theory of Trade or Modem Theory of Trade or Heckscher-Ohlin-Samuelson theorem:

• Different regions have different factor endowments (Labour, Capital).
• If a country is a capital abundant one, it will produce and export capital intensive goods.
• A labour-abundant country will produce and export labour intensive goods

5. New Trade Theory – An Introduction:

• New Trade Theory (NTT) is an economic theory that was developed in the 1970’s as a way to understand international trade patterns.
• According to NTT, two key concepts give advantages to countries that import goods to compete with products from the home country:
• Economies of Scale: If the firm serves domestic as well as foreign market instead of just one, it can reap, the benefit of large scale of production consequently the profits are likely to be higher.
• Network effects: The value of the product or service is enhanced as the number of individuals using it increases. This is also referred to as the ‘bandwagon effect’.

6. Forms of Import Tariffs:

• Specific Tariff fixed monetary tax per physical unit of the good imported
• Advalorem tariff constant percentage of the monetary value of one unit of the imported good
• Mixed Tariffs 5 percent ad valorem or ₹ 3,000 per tonne, whichever is higher
• Compound Tariff or a Compound Duty is a combination of an ad valorem and a specific tariff
• Technical/Other Tariff the duties are payable by its components or related items
• Tariff Rate Quotas imports above the quota face a much higher tariff
• Most-Favoured Nation Tariffs MFN rates are the highest (most restrictive) that WTO members charge one another
• Variable Tariff a duty typically fixed to bring the price up to the domestic support price
• Preferential Tariff a lower tariff is charged from goods imported from a country which is given preferential treatment
• Bound Tariff which a WTO member binds itself with a legal commitment not to raise it above a certain level
• Applied Tariffs duty that is actually charged on imports
• Escalated Tariff nominal tariff rates on imports of manufactured goods are higher than tariff rates on intermediate inputs and raw materials
• Prohibitive tariff so high that no imports will enter
• Import subsidies

7. Tariffs as Response to Trade Distortions:

• Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a foreign country below the sales prices in their domestic market or below their full average cost of the product. Anti-dumping duty is additional import duty so as to offset the foreign firm’s unfair price advantage.
• Countervailing Duties: Countervailing duties are tariffs that aim to offset the artificially low prices charged by exporters who enjoy export subsidies and tax concessions offered by the governments in their home country.

8. Effects of Tariffs:

• Tariff barriers create obstacles to trade, decrease the international trade
• Tariffs discourage import
• Protect domestic industries
• The price increase in the domestic market
• An increase in the output of the existing firm
• An increase in employment in the industry
• Prevent countries from enjoying gains from trade arising from compar-ative advantage.
• Tariffs increase government revenues

9. Non – Tariff Measures (NTMs):
Non-tariff measures comprise all types of measures which alter the conditions of international trade, including policies and regulations that restrict trade and those that facilitate it:

• Technical Measures
• Non-technical Measures

10. Technical Measures:

• Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to protect human, animal or plant life from risks arising from additives, pests, contaminants, toxins or disease-causing organisms and to protect biodiversity
• Technical Barriers To Trade(TBT): Mandatory ‘Standards and Technical Regulations’ that define the specific characteristics that a product should have, such as its size, shape, design, labelling/marking/packaging, functionality or performance and production methods, excluding measures covered by the SPS Agreement

11. Non – Technical Measures:

• Import Quotas
• Price Control Measures/Para Tariff Measures
• Non-automatic Licensing and Prohibitions
• Financial Measures
• Measures Affecting Competition
• Government Procurement Policies
• Trade-Related Investment Measures
• Distribution Restrictions
• Restriction on Post-sales Services
• Administrative Procedures
• Rules of origin
• Safeguard Measures
• Embargos/Total Ban

12. Export – Related Measures:

• Ban on exports
• Export Taxes
• Export Subsidies and Incentives
• Voluntary Export Restraints

13. Taxonomy of Regional Trade Agreements (RTAS):

• Unilateral trade agreements
• Bilateral Agreements
• Regional Preferential Trade Agreements
• Trading Bloc: group of countries that have a free trade agreement be-tween themselves
• Free-trade area: group of countries that eliminate all tariff barriers independence in determining their tariffs with non-members
• A customs union: group of countries that eliminate all tariffs on trade among themselves but maintain a common external tariff on trade with countries
• Common Market: free flow of factors of production labour and capital
• Economic and Monetary Union: common currency and macroeconomic policies

14. The General Agreement on Tariffs and Trade (GATT):

• GATT provided the rules for much of world trade for 47 years, from 1948 to 1994,
• It was only a multilateral instrument governing international trade or a provisional agreement
• The original intention to create an International Trade Organization (ITO) did not succeed
• The Kennedy Round in the mid-sixties, and the Tokyo Round in the 1970s led to massive reductions in bilateral tariffs, establishment of negotiation rules and procedures on dispute resolution, dumping and licensing
• The eighth, the Uruguay Round of 1986-94, was the last and most consequential of all rounds and culminated in the birth of WTO and a new set of agreements.

15. The GATT lost its relevance by 1980s because:

• It was obsolete
• International investments had expanded substantially
• Intellectual property rights and trade in services were not covered
• Liberalizing agricultural trade were not successful
• Inadequacies in institutional structure and dispute settlement system

16. The Uruguay Round and the Establishment of WTO:

• The need for a formal international organization which is more powerful and comprehensive was felt by late 1980s
• Members established 15 groups to work
• The Round started in Uruguay in September 1986
• Finally, in December 1993, the Uruguay Round was completed after seven years
• The agreement was signed by most countries on April 15, 1994, and took effect on July 1, 1995.
• It also marked the birth of the World Trade Organization (WTO)

17. The World Trade Organization (WTO):

• The most important outcome of the Uruguay Round agreement was the replacement of the GATT secretariat with the WTO in Geneva with authority not only in trade in industrial products but also in agricultural products and services.
• The objectives of the WTO Agreements include “raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand, and expanding the production of and trade in goods and services”.
• The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly and predictably

18. The Structure of the WTO:

• Secretariat located in Geneva, headed by a Director General
• It has a three-tier system of decision making
• The WTO’s top level decision-making body is the Ministerial Conference
• The next level is the General Council
• At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS) Council

19. The Guiding Principles of World Trade Organization (WTO):

• Trade without discrimination
• The National Treatment Principle (NTP)
• Free trade/”progressive liberalization”
• Predictability
• Principle of general prohibition of quantitative restrictions
• Greater competitiveness
• Tariffs as legitimate measures for the protection of domestic industries
• Transparency in Decision Making
• Market Access
• Special privileges to less developed countries
• Protection of Health & Environment
• A transparent, effective and verifiable dispute settlement mechanism

20. The Doha Round:

• The Doha Round, which is the ninth round, in November 2001
• Seeks to accomplish major modifications through lower trade barriers and revised trade rules
• The negotiations include 20 areas of trade
• The most controversial topic in the yet to conclude Doha Agenda has been agriculture trade.

21. The Exchange Rate:
Exchange rate is the rate at which the currency of one country exchanges for the currency of another country.

• A direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency. Example: ₹ 66 is needed to buy one US dollar
• An indirect quote is the number of units of a foreign currency exchange-able for one unit of local currency. Example: $ 0.0151 per rupee

22. The Exchange Rate Regimes:
It refers to the method by which the value of the domestic currency in terms of foreign currencies is determined. There are two types of exchange rate regimes:

• Floating exchange rate regime (also called a flexible exchange rate):
  The equilibrium value of the exchange rate of a country’s currency is market determined, and
• Fixed exchange rate regime/pegged exchanged rate:
  Central Bank and/or government announces what its currency will be worth in terms of either another country’s currency or a basket of currencies or another measure of value, such as gold.

23. The Main Advantages of a Fixed Rate Regime are:

• Eliminates exchange rate risks
• Enhance international trade
• Lower levels of inflation
• Stability encourages investment
• Enhance the credibility of the country’s monetary policy
• Adequate amount of foreign exchange reserves

24. The Main Advantages of a Floating Rate Regime are:

• Independent monetary policy
• Exchange rate can be used as a policy tool
• The central bank is not required to maintain a huge foreign exchange reserves

25. Nominal Versus Real Exchange Rates:

• Nominal exchange rate: how much of one currency can be traded for a unit of another currency when prices are constant.
• The ‘Real exchange rate’: describes ‘how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a foreign country. It is calculated as:

Real exchange rate = Nominal exchange rate × \(\frac{\text { Domestic Price Index }}{\text { Foreign Price Index }}\)

26. The Foreign Exchange Market:
The wide-reaching collection of markets and institutions that handle the ex-change of foreign currencies is known as the foreign exchange market.

In the foreign exchange market, there are two types of transactions:

• Current transactions which are carried out in the spot market and the exchange involves immediate delivery, and
• Contracts to buy or sell currencies for future delivery which are carried out in forward and/or futures markets.

27. Determination of Nominal Exchange Rate:
The supply of and demand for foreign exchange in the domestic foreign ex-change market determine the country’s exchange rate.

28. Devaluation (Revaluation) Vs Depreciation (Appreciation):

• Devaluation is a deliberate downward adjustment in the value of a country’s currency relative to another currency, group of currencies or standard and depreciation is a decrease in a currency’s value due to market forces.
• Revaluation is the opposite of devaluation and the term refers to a discrete raising of the otherwise fixed par value of a nation’s currency and appreciation is an increase in a currency’s value due to market forces.

29. Impacts of Exchange Rate Fluctuations on Domestic Economy:

• Changes in import spending and export revenue
• Changing the relative prices of domestically-produced and foreign-pro-duced goods and sendees
• Affect economic activity in the domestic economy
• Currency depreciation helps in increases the volume of exports and promotes trade balance.
• Increased import prices will increase firms’ cost of production, push domestic prices up and decrease real output.
• For an economy where exports are significantly high, a depreciated currency would mean a lot of gain.
• Make financial forecasting more difficult for firms
• Depreciating currency hits investor sentiments

30. Types of Foreign Capital:

• Foreign aid or assistance which may be:
  • Bilateral or direct inter government grants
  • Multilateral aid
  • Tied aid
  • Foreign grants which are voluntary transfer
• Borrowings which may take different forms such as:
  • Direct inter government loans
  • Loans from international institutions (e.g. world bank, IMF, ADB)
  • Soft loans for e.g. from affiliates of World Bank such as IDA
  • External commercial borrowing, and
  • Trade credit facilities
• Deposits from non-resident Indians (NRI)
• Investments in the form of:
  • Foreign portfolio investment (FPI) in bonds, stocks and securities, and
  • Foreign direct investment (FDI) in industrial, commercial and similar other enterprises

31. Foreign Direct Investment (FDI):
Foreign direct investment is defined as a process whereby the resident of one country (ie. home country) acquires ownership of an asset in another country (le. the host country) and such movement of capital involves ownership, control as well as management of the asset in the host country.

FDI may be categorized as horizontal, vertical or conglomerate:

• A horizontal direct investment: same type of business
• A vertical investment: different from main business activity yet in some way supplements its major activity
• A conglomerate: unrelated to its existing business in its home country

32. Modes of Foreign Direct Investment (FDI):

• Opening of a subsidiary in a foreign country,
• Equity injection into an overseas company,
• Acquiring a controlling interest in an existing foreign company,
• Mergers and acquisitions (M&A),
• Joint venture with a foreign company,
• Green field investment

33. Foreign Portfolio Investment (FPI):
Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than ‘real capital’ and does not involve ownership or control on the part of the investor.

34. Foreign Direct Investment (FDI) Fs. Foreign Portfolio Investment (FPI):

Foreign direct investment (FDI)	Foreign portfolio investment (FPI)
Investment involves creation of physical assets	Investment is only in financial assets
Has a long term interest and therefore remain invested for long	Only short term interest and generally remain invested for short periods
Relatively difficult to withdraw	Relatively easy to withdraw
Not inclined to be speculative	Speculative in nature
Often accompanied by technology transfer	Not accompanied by technology transfer
Direct impact on employment of labour and wages	No direct impact on employment of labour and wages
Enduring interest in management and control	No abiding interest in management and control
Securities are held with significant degree of influence by the investor on the management of the enterprise	Securities are held purely as a financial investment and no significant degree of influence on the management of the enterprise

35. Reasons for Foreign Direct Investment:

• The chief motive for shifting of capital between different regions or between different industries is the expectation of higher rate of return than what is possible in the home country
• Investment in a host country may be found profitable by foreign firms because of some firm-specific knowledge or’ assets

36. Benefits of Foreign Direct Investment:

• Competitive environment in the host country
• Enhance the total output
• FDI can accelerate growth and foster economic development
• Political reforms, including legal systems and macroeconomic policies
• It generates direct and indirect employment in the recipient country
• Promote relatively higher wages for skilled jobs
• Source of new tax revenue
• Better work culture and higher productivity standards

37. Foreign Direct Investment In India (FDI):

• The most important shift in investment policy occurred when India em-barked upon economic liberalisation and reforms programme in 1991 to raise its growth potential and to integrate it with the world economy.
• According to United Nations Conference on Trade and Development (UNCTAD)’s World Investment Report 2016, India ranks as the tenth highest recipient of foreign direct investment globally in 2015 receiving $44 billion of investment that year compared to $35 billion in 2014. In-dia has also moved up by one rank to become the sixth most preferred investment destination.
• India received the maximum FDI equity inflows from Mauritius (US$ 5.85 billion) followed by Singapore, Netherlands, Japan and the USA.

38. In India, Foreign Investment is Prohibited in the Following Sectors:

• Lottery business including Government/private lottery, online lotteries, etc.
• Gambling and betting including casinos etc.
• Chit funds
• Nidhi company
• Trading in Transferable Development Rights (TDRs)
• Real Estate Business or Construction of Farm Houses
• Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes.
• Atomic energy and railway operations

39. Overseas Direct Investment by Indian Companies:

• Outward Foreign Direct Investment (OFDI) from India stood at US$ 1.86 billion in the month of June, 2016.
• The overseas investments have been primarily driven by resource seek-ing, market seeking or technology seeking motives.
• Many Indian IT firms like Tata Consultancy Services, Infosys, WIPRO, and Satyam acquired global contracts and established overseas offices in developed economies to be close to their key clients.
• Overseas investments by Indian companies, especially to acquire energy resources in Australia, Indonesia and Africa.
• Indian entrepreneurs are also choosing investment destinations in countries such as Mauritius, Singapore, British Virgin Islands, and the Netherlands on account of higher tax benefits they provide.

Money Market – CA Inter Economics Study Material is designed strictly as per the latest syllabus and exam pattern.

Money Market – CA Inter Economics Study Material

Theory Questions

Question 1.
What would be the impact of each of the following on credit multiplier and money supply? (3 Marks May 2018)
(a) If Commercial Banks keep 100 percent reserves.
(b) If Commercial Banks do not keep reserves.
(c) If Commercial Banks keep excess reserves.
Answer:
Credit Multiplier = 1 ÷ required reserve ratio
(a) If commercial banks keep 100% reserves, the reserve deposit ratio is one and the value of money multiplier is one. Deposits simply substitute for the currency that is held by banks as reserves and therefore, no new money is created by banks.

(b) If commercial banks do not keep reserves and lends the entire deposits, it is a case of zero required reserve ratio and credit multiplier will be infinite and therefore money creation will also be infinite.

(c) Excess reserves are reserves over and above what banks are legally required to hold against deposits. The additional units of money that goes into ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to creation of money. The increase in banks’ excess reserves reduces the credit multiplier, causing the money supply to decline.

Question 2.
Explain the following modified equation of exchange as given by Irving Fisher: MV+M’ V’ = PT. (3 Marks May 2018)
Answer:
Modified Equation of exchange as given by Irving Fisher: MV + M’V’ = PT

This is an extended form of the original equation of exchange which Fisher gave to include demand deposits (M’) and their velocity (V’) in the total supply of money. The equation can also be rewritten as P = (MV + M’ V’) / T.

From the above equation, it is evident that the price level is determined by the following factors:
(a) Quantity of money in circulation (M),
(b) The velocity of circulation of money (V), .
(c) The volume of credit money (M’), the velocity of circulation of credit money (V’) and the volume of trade (T).

The equation of exchange further shows that the price level (P) is directly related to M, V, M’ and V’. It is, however, inversely related to T. Velocity of money in circulation (V) and the velocity of credit money (V’) remain constant. Since full employment prevails and since T is function of national income the volume of transactions T is fixed in the short run.

The total volume of transactions (T) multiplied by the price level (P) represents the demand for money. The demand for money (PT) is equal to the supply of money (MV + M’V’). In any given period, the total value of transactions made is equal to PT and the value of money flow is equal to MV+ M’V’.

Question 3.
Explain why people hold money according to Liquidity Preference Theory. (3 Marks May 2018)
Answer:
People hold money according to Liquidity Preference Theory for following three motives:
1. The transactions motive: People hold cash for current transactions for personal and business exchanges i.e. to bridge the time gap between receipt of income and planned expenditures.

2. The precautionary motive: People hold cash to make unanticipated expenditures that may occur due to unforeseen and unpredictable contingencies.

3. The speculative motive:This motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices.

Question 4.
Explain the difference between Liquidity Adjustment Facility (LAP) and Marginal Standing Facility (MSF). (3 Marks May 2018}
Answer:
Liquidity Adjustment Facility (LAF): Liquidity Adjustment Facility (LAF) which was introduced by RBI in June, 2000, is a facility extended to the scheduled commercial banks and primary dealers to avail of liquidity in case of requirement on an overnight basis against the collateral of government securities including state government securities. Its objective is to assist banks to adjust their day to day mismatches in liquidity. Currently, the RBI provides financial accommodation to the commercial banks through repos/reverse repos under LAF.

Marginal Standing Facility (MSF): Marginal Standing Facility (MSF) which was introduced by RBI in its monetary policy statements 2011-12, refers to the facility under which scheduled commercial banks can borrow additional amount of overnight money from the central bank over and above what is available to them through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.

This provides a safety valve against unexpected liquidity shocks to the banking system. The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility.

Question 5.
How do changes in Cash Reserve Ratio (CRR) impact the economy? (2 Marks May 2018)
Answer:
Impact of changes in Cash Reserve Ratio (CRR): Change in Cash Reserve Ratio is one of the important quantitative tools aiding in liquidity management. Higher the CRR with the central bank, lower will be the liquidity in the system and vice versa. In order to control credit expansion during periods of inflation, the central bank increases the CRR. With higher CRR, banks have to keep more reserves and the banks’ lendable resources get depleted leading to decrease in the volume of bank lending and contraction in credit and money supply in the economy.

During deflation, the central bank reduces the CRR in order to enable the banks to expand credit and increase the supply of money available in the economy. With more credit available in the market, economic activities get accelerated bringing the economy back to stability and economic growth.

Question 6.
Explain the role of Monetary Policy Committee (MPC) in India. (3 Marks Nov 2018)
Answer:
Role of Monetary Policy Committee (MPC) in India: Monetary Policy Committee (MPC) constituted by the Central Government is an empowered six-member committee with RBI Governor as the chairperson. Under the Monetary Policy Framework Agreement, the RBI will be responsible for price stability and for containing inflation targets at 4% (with a standard deviation of 2%) in the medium term.

The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months. MPC has complete control over monetary policy decisions to ensure economic growth and price stability. The MPC decides the changes to be made to the policy rate (repo rate) so as to contain inflation within the target level specified to it by the Central Government.

Fixing of the benchmark policy interest rate (repo rate) is made in a more consultative and participative manner and on the basis of majority vote by this panel of experts. This has added lot of value and transparency to monetary policy decisions.

Question 7.
Mention the general characteristics of Money. (2 Marks Nov 2018)
Answer:
Characteristics of money are:

1. Generally acceptable,
2. Durable or long-lasting,
3. Effortlessly recognizable, ‘
4. Difficult to counterfeit i.e. not easily reproducible by people,
5. Relatively scarce, but has elasticity of supply,
6. Portable or easily transported,
7. Possessing uniformity; and
8. Divisible into smaller parts in usable quantities or fractions without losing value.

Question 8.
Explain the different mechanism of monetary policy which influences the price level and national income. (3 Marks Nov 2018)
Answer:
Different mechanisms of monetary policy or monetary transmission mechanism are:
(1) The interest rate channel A contractionary monetary policy-induced increase in interest rates increases the cost of capital and the real cost of borrowing for firms and households with the result that they cut back on their investment expenditures and durable goods consumption expenditures respectively.

A decline in aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of capital for firms and cost of borrowing for households.

(2) The exchange rate channel The exchange rate channel works through expenditure switching between domestic and foreign goods. Appreciation of the domestic currency makes domestically produced goods more expensive compared to foreign-produced goods. This causes net exports to fall; correspondingly domestic output and employment also fall.

(3) The quantum channel (e.g., relating to money supply and credit) Two distinct credit channels: the bank lending channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate through the real economy. Credit channel operates by altering access of firms and households to bank credit.

A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest rates works to increase the payments that the firm must make to service its floating rate debts. An indirect effect sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long-lived assets.

(4) The asset price channel: Asset prices respond to monetary policy changes and consequently impact output, employment and inflation. A policy-induced increase in the short-term nominal interest rates makes debt instruments more attractive than equities in the eyes of investors leading to a fall in equity prices, erosion in household financial wealth, fall in consumption, output, and employment.

Question 9.
Explain the Monetary Policy Framework Agreement. (2 Marks Nov 2018)
Answer:
The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the Monetary Policy Framework Agreement. It is an agreement reached between the Government of India and the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability.

The amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation targeting framework’ by abandoning the ‘multiple indicator’ approach. The inflation target is to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly:

1. The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5,2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
2. The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and the forecasts of inflation for the coming period of six to eighteen months.

Question 10.
Why is the central bank referred to as a “banker’s bank”? (2 Marks May 2019)
Answer:
A central bank referred to as a ‘banker’s bank’ because:
(1) The central bank acts as a custodian of cash reserves of commercial banks in the country.

(2) The central bank provides efficient means of funds transfer for all banks. All commercial banks maintain accounts with the central bank and it enables smooth and swift clearing and settlements of inter-bank transactions and interbank payments.

(3) The central bank acts as a lender of last resort. It provides liquidity to banks when the latter face shortage of liquidity. The scheduled commercial banks can borrow from the discount window against the collateral of securities like commercial bills, government securities, treasury bills, or other eligible papers.

Question 11.
“Money has four functions: a medium, a measure, a standard and a store.” Elucidate. (2 Marks May 2019, 3 Marks Nov 2020)
Answer:
Four functions of money are:
1. Money is a convenient medium of exchange: Money is a convenient me
dium of exchange or it is an instrument that facilitates easy exchange of goods and services. Money, though not having any inherent power to directly satisfy human wants, by acting as a medium of exchange, it commands purchasing power and its possession enables us to purchase goods and services to satisfy our wants. By acting as an intermediary, money increases the ease of trade and reduces the inefficiency and transaction costs involved in a barter exchange.

By decomposing the single barter transaction into two separate transactions of sale and purchase, money eliminates the need for double coincidence of wants. Money also facilitates separation of transactions both in time and place and this in turn enables us to economize on time and efforts involved in transactions.

2. Money is a ‘common measure of value: The monetary unit is the unit of measurement in terms of which the value of all goods and services is measured and expressed. It is convenient to trade all commodities in exchange for a single commodity.

So also, it is convenient to measure the prices of all commodities in terms of a single unit, rather than record the relative price of every good in terms of every other good. A common unit of account facilitates a system of orderly pricing which is crucial for rational economic choices. Goods and services which are otherwise not comparable are made comparable through expressing the worth of each in terms of money.

3. Money serves as a unit or standard of deferred payment: Money facilitates recording of deferred promises to pay. Money is the unit in terms of which future payments are contracted or stated. However, variations in the purchasing power of money due to inflation or deflation, reduces the efficacy of money in this function.

4. Money is a store of value: People prefer to hold it as an asset, that is, as part of their stock of wealth. The splitting of purchases and sale into two transactions involves a separation in both time and space. This separation is possible because money can be used as a store of value or store of means of payment during the intervening time. Again, rather than spending one’s money at present, one can store it for use at some future time.

Thus, money functions as a temporary abode of purchasing power in order to efficiently perform its medium of exchange function. Money also functions as a permanent store of value. Money is the only asset which has perfect liquidity.

Question 12.
Describe the determinants of demand for money as identified by Milton Friedman in his restatement of Quantity Theory of demand for money. (3 Marks May 2019)
Answer:
Determinants of demand of money as per Milton Friedman’s restatement of Quantity theory of demand of money are:

1. Permanent income and
2. Relative returns on assets (which incorporate risk).

Friedman maintains that it is permanent income and not current income as in the Keynesian theory that determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present expected value of all future income. To Friedman, money is a good as any other durable consumption good and its demand is a function of a great number of factors. Friedman identified the following four determinants of the demand for money. The nominal demand for money:

(a) is a function of total wealth, which is represented by permanent income divided by the discount rate, defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds, equity, physical capital and human capital.
(b) is positively related to the price level P. If the price level rises the demand for money increases and vice versa.
(c) rises, if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and vice versa.
(d) is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby increasing the opportunity costs of money holdings.

Question 13.
Explain the open market operations conducted by RBI. (2 Marks Nov 2019)
Answer:
Open market operations conducted by RBI: Open Market Operations (0M0) is a general term used for monetary policy involving market operations conducted by the Reserve Bank of India by way of sale or purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

When the Reserve Bank of India feels that there is excess rupee liquidity in the market, it resorts to sale of government securities for absorption of the excess liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby injecting liquidity into the market.

Question 14.
Explain ‘Reverse Repo Rate’. (2 Marks Nov 2019)
Answer:
Reverse Repo Rate: ‘Reverse repo operation’ is a monetary policy instrument and in effect it absorbs the liquidity from the system. This operation takes place when the RBI borrows money from commercial banks by selling them securities (which RBI permits) with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. The interest rate paid by the RBI for such borrowings is called the “Reverse Repo Rate”. Thus, reverse repo rate is the rate of interest paid by the RBI on its borrowings from commercial banks.

Question 15.
Explain the neo-classical approach to demand for money. (3 Marks Nov 2019)
Answer:
Neo-Classical Approach: The Neo-classical Approach or the cash balance approach put forth by Cambridge economists holds that money increases utility in the following two ways:

1. for transaction motive, ie. for enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous,
2. as a temporary store of wealth ie. for a hedge against uncertainty.

Since demand for money also involves a precautionary motive in this approach and money gives utility in its store of wealth and precautionary modes, money is demanded for itself. How much money will be demanded depends:
(a) partly on income which points to transactions demand, such that higher the income, the greater the quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value to overcome transactions costs, and

(b) partly on other factors of which important ones are wealth and interest rates.
The Cambridge equation is stated as:
Md = k PY
Where,
Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for money (M) equals k proportion of the total money income. The neo-classical theory changed the focus of the quantity theory of money to money demand and hypothesized that demand for money is a function of money income.

Question 16.
What is the impact of the following on credit multiplier and money supply, if Commercial Banks keep: (2 Marks Nov 2020)
(1) Less Reserve?
(2) Excess Reserve?
Answer:
Credit Multiplier = 1 ÷ Required Reserve Ratio
(1) The impact on credit multiplier and money supply, if commercial banks keep less reserves: The Credit Multiplier describes the amount of additional money created by commercial banks through the process of lending the available money it has in excess of the central bank’s reserve requirements.

Thus the credit multiplier is inextricably tied to the bank’s reserve requirement. If reserve ratio is 40%, then credit multiplier = 1 ÷ 0.40 = 2.5. If banks need to keep only less reserve, then the credit multiplier would be high and therefore money supply would be higher. If the reserve ratio is only 20%, then the credit multiplier is 1 ÷ 0.20 = 5.

(2) The impact on credit multiplier and money supply, if commercial banks keep excess reserve: ‘Excess reserves’ refers to the positive difference between total reserves (TR) and required reserves (RR). The money that is kept as ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to creation of credit. When banks keep excess reserves, the credit multiplier would be low and it impact on money supply would be less.

Question 17.
“The deposit multiplier and the money multiplier though closely related are not identical”. Explain briefly. (2 Marks Nov 2020)
Answer:
The Deposit Multiplier and the Money Multiplier: The money multiplier denotes by ‘how much the money supply will change for a given change in high-powered money’. The deposit multiplier describes the amount of additional money created by commercial bank through the process of lending the available money it has in excess of the central bank’s reserve requirements. Though closely related they are not identical because:

(1) Generally banks do not lend out all of their available money, but instead maintain reserves at a level above the minimum required reserve. In other words, banks keep excess reserves.

(2) The public prefers to hold some cash and therefore, some of the increase in loans will not be deposited at the commercial banks, but will be kept cash. This means, that when new reserves enter the banking system they will not be multiplied entirely by the deposit multiplier into new demand deposits. Some money will leave the banking system in the form of cash. Therefore, the money supply will be raised by less than the demand deposits.

If some portion of the increase in high-powered money finds its way into currency, this portion does not undergo multiple deposit expansion. The size of the money multiplier is reduced when funds are held as cash rather than as demand deposits.

Question 18.
What is the meant by ‘Statutory Liquidity Ratio’? -In which forms this ratio is maintained? (3 Marks Nov 2020)
Answer:
The Statutory Liquidity Ratio: The Statutory Liquidity Ratio (SLR) is the ratio of a bank’s liquid assets to its net demand and time liabilities (NDTL).

As per the Banking Regulations Act, 1949, all scheduled commercial banks in India are required to maintain a stipulated percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL) in one of the following forms:

1. Cash,
2. Gold, or
3. Investments in un-encumbered Instruments that include:
   (a) Treasury-bills of the Government of India.
   (b) Dated securities including those issued by the Government of India from time to time under the market borrowings programme and the Market Stabilization Scheme (MSS).
   (c) State Development Loans (SDLs) issued by State Governments under their market borrowings programme.
   (d) Other instruments as notified by the RBI. These include mainly the securities issued by PSEs.
   The SLR requires holding of assets in one of the above three categories by the bank itself.

Question 19.
Explain the Transactions Motive for holding cash. (2 Marks Jan 2021)
Answer:
Transactions Motive for holding cash:The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for holding money arises between as there is lack of synchronization between receipts and expenditures.

The transaction motive is further classified into income motive and business motive, both of which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of income and planned expenditure. The transaction demand for money is a direct proportional and positive function of the level of Income.
Lr = KY
Where,
Lr = is the transaction demand for money
K = is the ratio of earnings which is kept for transaction purposes
Y = is the earning

Question 20.
Distinguish between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). (3 Marks Jan 2021)
Answer:
Cash Reserve ratio (CRR): Cash Reserve Ratio (CRR) refers to the average daily balance that a bank is required to maintain with the Reserve bank of India as a share of its total net demand and time liabilities (NDTL). This Percentage will be notified from time to time by Reserve bank of India. The RBI may set the ratio in keeping with the broad objective of maintaining monetary stability in the economy.

This requirement applies uniformly to all the scheduled banks in the country irrespective of its size or financial position. Higher the CRR with the RBI, lower will be the liquidity in the system and vice versa. During Slowdown in the economy, the RBI reduces the CRR in order to enable the banks to expand credit and increase the supply of money available in the economy. In order to contain credit expansion during the period of high inflation, the RBI increases the CRR.

The Statutory Liquidity Ratio: The Statutory Liquidity Ratio (SLR) is the ratio of a bank’s liquid assets to its net demand and time liabilities (NDTL).

As per the Banking Regulations Act, 1949, all scheduled commercial banks in India are required to maintain a stipulated percentage of their total Demand and Time Liabilities (DTL)/Net DTL (NDTL) in one of the following forms:

1. Cash,
2. Gold, or
3. Investments in un-encumbered Instruments that include:
   (a) Treasury-bills of the Government of India.
   (b) Dated securities including those issued by the Government of India from time to time under the market borrowings programme and the Market Stabilization Scheme (MSS).
   (c) State Development Loans (SDLs) issued by State Governments under their market borrowings programme.
   (d) Other instruments as notified by the RBI. These include mainly the securities issued by PSEs.

While CRR has to be maintained by banks as cash with the RBI, the SLR requires holding of assets in one of the above three categories by the bank itself. The Banks which fail to meet its SLR obligations are liable to be imposed penalty in the form of penal interest payable to RBI. The SLR is also a powerful tool for controlling liquidity in the domestic market by means of manipulating bank credit.

Question 21.
Discuss the role of ‘Market Stabilization Scheme* In our economy. (2 Marks Jan 2021)
Answer:
Market Stabilization Scfieme/Market Stabilization Scheme was introduced in 2004 as an Instrument for monetary management with the primary aim of aiding the sterilization operations of the RBI. (Sterilization is the process by which the monetary authority sterilizes the effects of significant foreign capital inflows on domestic liquidity by off- loading parts of the stock of government securities held by it).

Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short, dated government securities and treasury bills. Under this Scheme, the government of India borrows from the RBI (Such borrowing being additional to its normal borrowing requirements and issues treasury-bills/dated securities for absorbing excess liquidity from the market arising from large capital inflows.

Question 22.
Explain the concept of ‘Money Multiplier’. (2 Marks Jan 2021)
Answer:
Money Multiplier (m) = Money Supply ÷ Monetary Base
Money Multiplier: Money multiplier (m) is defined as a ratio that relates the changes in the money supply to a given change in the monetary base. It is the ratio of the stock of money to the stock of high-powered money. It denotes by how much the money supply will change for a given change in high powered money. It denotes by how much the money supply will change for a given change in high powered money.

The money multiplier process explains how an increase in the monetary base causes, the money supply to increase by a multiplied amount. For example, if there is an injection of ₹ 500 Crores through an open market operation by the Central Bank of the country and if it leads to an increment of ₹ 5,000 Crores of final money supply, then the money multiplier is said to be 10. Hence the multiplier indicates the change in monetary base which is transformed into money supply.

Question 23.
What do you mean by ‘Reserve Money’? (2 Marks Jan 2021)
Answer:
The Reserve Money, also known as central bank money, base money or high powered money determines the level of liquidity and the price level in the economy.
Reserve Money = Currency in Circulation + Banker’s deposits with the RBI + other deposits with the RBI.
= Net RBI credit to the government + RBI credit to the commercial sector + RBI’s claim on banks + RBI’s net foreign exchange assets + Government Currency liabilities to the Public- RBI’s net non-monetary liabilities

Practical Problems

Question 1.
The RBI published the following data as on 31st March, 2018. You are required to compute M4: (3 Marks Nov 2018)
(₹ in crores)
Currency with the public – 1,12,206.6
Demand Deposits with Banks – 1,93,300.4
Net Time Deposits with Banks – 2,67,310.2
Other Deposits of RBI – 614.8
Post Office Savings Deposits – 277.5
Post Office National Savings Certificates (NSCs) – 110.5
Answer:
M4 = Currency and coins with the people + demand deposits with the banks (Current and Saving accounts) + other deposits with the RBI + Net time deposits with the banking system + Total deposits with the Post Office Savings (excluding National Savings Certificates)
= 1,12,206.6 +1,93,300.4 + 2,67,310.2 + 614.8 + 277.5 = 5,73,709.5 Crores

Question 2.
Compute Ml supply of money from the data given below: (3 Marks May 2019)
Currency with public – ₹ 2,13,2798 Crores
Time deposits with bank – ₹ 3,45,000.7 Crores
Demand deposits with bank – ₹ 162,74.5 Crores
Post office savings deposit – ₹ 382.9 Crores
Other deposits of – ₹ 765.1 Crores
Answer:
M1 = Currency and coins with the people + demand deposits of banks (current and saving accounts) + other deposits of the RBI.
= ₹ 2,13,279.8 + ₹ 1,62,374.5 + ₹ 765.1
= ₹ 3,76,419.4 Crores

Question 3.
What will be the total credit created by the commercial banking system for an initial deposit of ₹ 3,000 at a Required Reserve Ratio (RRR) of 0.05 and 0.08 respectively? Also compute credit multiplier. (2 Marks May 2019)
Answer:
Credit Multiplier = 1 ÷Required Reserve Ratio
For RRR 0.05 : Credit Multiplier = 1/0.05 = 20
For RRR0.08 : Credit Multiplier = 1/0.08 = 12.5
Credit Creation = Initial Deposit × Credit Multiplier
For RRR 0.05 : Credit creation = ₹ 3,000 × 20 = ₹ 60,000
For RRR 0.08 : Credit creation = ₹ 3,000 × 12.5 = ₹ 37,500

Question 4.
Compute reserve money from the following data published by RBI: (3 Marks Nov 2019)

	₹ in crores
Net RBI credit to the government	8,51,651
RBI Credit to the commercial sector	2,62,115
RBI’s claim on Banks	4,10,315
Government’s Currency liabilities to the public	1,85,060
RBI’s net foreign assets	72,133
RBI’s net non-monetary liabilities	68,032

Answer:
Reserve Money = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public – RBI’s net non – monetary Liabilities.
= 8,51,651 + 2,62,115 + 4,10,315 + 72,133 + 1,85,060 – 68,032
= 17,13,242 Crores

Question 5.
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every ₹ 1,00,000 deposited in the hanking system. What will be the total credit money created by the banking system in each case? (2 Marks Nov 2019)
Answer:
(a) Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\)
For RRR 10% : Credit Multiplier = 1 / 10% = 10
For RRR 12.5% : Credit Multiplier = 1/12.5% = 8

(b) Credit creation = Initial deposits × Credit Multiplier
For RRR 10% : Credit creation = 1,00,000 × 10 = 10, 00,000
For RRR 12.5% : Credit creation = 1,00,000 × 8 = 8, 00,000

Question 6.
Compute M3 from the following data: (3 Marks Nov 2020)

Component	₹ in Crores
Currency with the public	2,23,432.6
Demand Deposits with Banks	3,40,242.4
Time Deposits with Banks	2,80,736.8
Post office savings Deposits                                                 ‘	446.7
(Excluding National Saving Certificates)
Other Deposits with RBI	392.7
(Including Government Deposits)
Post Office National Saving Certificates	83.7
Government Deposits with RBI-	102.5

Answer:
M3 = Currency with the public + Demand deposits with the banks 4- Time deposits with the banks + ‘Other’ deposits with the RBI
= 2,25,432.6 + 3,40,242.4 + 2,80,736.8 + (392.7 – 102.5)
= ₹ 8,46,702 Crores

Question 7.
Compute M2 supply of money from the following RBI data: (3 Marks Jan 2021)

Component	₹ in Crores
Currency with the public	4,35,656.6
‘Other’ deposits with RBI	12,34.2
Saving deposits with post office saving banks	647.7
Net time deposits with the banking system                                                ‘	5,14,834.3
Demand deposits with banks	2,74,254.9

Answer:
M1 = Currency Notes and Coins with the people + demand deposits with the banking system (currency and saving deposit accounts) + Other deposits with the RBI
= 4,35,656.6 + 2,74,254.9 + 1,234.2 = 7,11,145.7 Crores
M2 = M1 + Saving deposit with Post Office Saving Bank
= 7,11,145.7 + 647.7 = 7,11,793.4 Crores

Important Questions

Question 1.
(a) Calculate M if Velocity 19, Price 108.5 and Volume of transactions 120 billion.
(b) What will be the effect on money supply if velocity is 25?
Answer:
(a) MV = PT,
M × 19 = 108.5 × 120
M = 685.26 billion

(b) MV = PT,
M × 25 = 108.5 × 120
M = 520.8 billion
Effect: Money supply will decrease by 164.46 (685.26 – 520.8) billion.

Question 2.
(a) Calculate velocity of money, Money Supply 5,000 billion, Price 110 and Volume of transaction 200.
(b) What will be the outcome if volume of transaction increases to 225?
Answer:
(a) MV = PT,
5,000 × V = 110 × 200
V = 4.4

(b) MV = PT,
5,000 × V = 110 × 225
V = 4.95

Question 3.
Calculate Narrow Money (Ml) from the following data:
Currency with public : ₹ 90,000 Crores
Demand Deposits with Banking System : ₹ 2,00,000 Crores
Time Deposits with Banking System : ₹ 2,20,000 Crores
Other Deposits with RBI : ₹ 2,80,000 Crores
Saving Deposits of Post office saving banks : ₹ 60,000 Crores
Answer:
M1 = Currency with public + Demand Deposits with Banking System + Other Deposits with the RBI
= 90,000 + 2,00,000 + 2,80,000
= 5,70,000 Crores

Question 4.
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every ₹ 1,00,000 deposited in the banking system. What will be the total credit money created by the banking system in each case?
Answer:
(a) Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\)
For RRR 10% = \(\frac{1}{\text { Required Reserved Ratio }}\) = 1/10% = 10
For RRR 12.5% = \(\frac{1}{\text { Required Reserved Ratio }}\) = 1/12.5% = 8

(b) Credit creation = Initial deposits × Credit Multiplier
For RRR 10% = 1,00,000 × 10 = 10,00,000
For RRR 12.5% = 1,00,000 × 8 = 8,00,000

Question 5.
Calculate currency with the Public from the following data (₹ Crores)
Notes in Circulation – 24,96,611
Circulation of Rupee Coin – 25,572
Circulation of Small Coins – 743
Cash on Hand with Banks – 98,305
Answer:
Currency with the Public = 24,96,611 + 25,572 + 743 – 98,305 = 24,24,621

Question 6.
Calculate M2 from the following data: (₹ Crores)
Notes in Circulation – 24,20,964
Circulation of Rupee Coin – 25,572
Circulation of Small Coins – 743
Post Office Saving Bank Deposits – 1,41,786
Cash on Hand with Banks – 97,563
Deposit Money of the Public – 17,76,199
Demand Deposits with Banks – 17,37,692
‘Other’ Deposits with Reserve Bank – 38,507
Total Post Office Deposits – 14,896
Time Deposits with Banks – 1,78,694
Answer:
M2 = M1 + Post Office Saving Bank Deposits
Ml = (Notes in Circulation + Circulation of Rupee Coin + Circulation of Small Coins – Cash on Hand with Banks) + Deposit Money of the Public
= (24,20,964 + 25,572 + 743 – 97,563) + 17,76,199
= 41,25,915 Crores
M2 = M1+ Post Office Saving Bank Deposits
= 41,25,915 + 1,41,786
= 42,67,701 Crores

Question 7.
If the required reserve ratio is 10 percent, currency in circulation is ₹ 400 billion, demand deposits are ₹ 1,000 billion, and excess reserves total ₹ 1 billion, find the value of money multiplier.
Answer:
r = 10% or 0.10
Currency = 400 billion
Deposits = 1,000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1,400 billion
c = C/D
= 400 billion/1,000 billion
= 0.4 or depositors hold 40% of their money as currency
e = 1 billion /1,000 billion
= 0.001 or banks hold 0.1 % of their deposits as excess reserves
Multiplier ‘m’ = \(\frac{1+c}{r+e+c}\) = \(\frac{1+0.4}{0.1+0.001+0.4}\) = 2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.

CA Inter Costing Question Paper Nov 2022 – CA Inter Costing Study Material is designed strictly as per the latest syllabus and exam pattern.

CA Inter Nov 2022 Costing Question Paper Solution

Question 1.
Answer the following :
(a) A Ltd. is a pharmaceutical company which produces vaccines for diseases like Monkey Pox, Covid-19 and Chickenpox. A distributor has given an order for 1,600 Monkey Pox Vaccines. The company can produce 80 vaccines at a time. To process a batch of 80 Monkey Pox Vaccines, the following costs would be incurred:

	₹
Direct Materials	4,250
Direct wages	500
Lab set up cost	1,400

The Production Overheads are absorbed at a rate of 20% of direct wages and 20% of total production cost is charged in each batch for selling, distribution and administration Overheads. The company is willing to earn profit of 25% on sales value.
You are required to determine:
(i) Total Sales value for 1,600 Monkey Pox Vaccines
(ii) Selling price per unit of the Vaccine.
(b) ABC Bank is having a branch which is engaged in processing of ‘Vehicle Loan’ and ‘Education Loan’ applications in addition to other services to customers. 30% of the overhead costs of the branch are estimated to be applicable to the processing of ‘Vehicle Loan’ applications and ‘Education Loan’ applications each.
Branch is having four employees at a monthly salary of ₹ 50,000 each, exclusively for processing of Vehicle Loan applications and two employees at a monthly salary of ₹ 70,000 each, exclusively for processing of Education Loan applications.
In addition to above, following expenses are incurred by the Branch:

• Branch Manager who supervises all the activities of branch, is paid at ₹ 90,000 per month,
• Legal charges, Printing & stationery and Advertising Expenses are incurred at ₹ 30,000, ₹ 12,000 and ₹ 18,000 respectively for a month.
• Other Expenses are ₹ 10,000 per month.

You are required to:
(i) Compute the cost of processing a Vehicle Loan Application on the assumption that 496 Vehicle Loan applications are processed each month.
(ii) Find out the number of Education Loan Applications processed, if the total processing cost per Education Loan Application is same as in the Vehicle Loan Application as computed in (i) above.
(c) MM Ltd. uses 7500 valves per month which is purchased at a price of ₹ 1.50 per unit. The carrying cost is estimated to be 20% of average inventory investment on an annual basis. The cost to place an order and getting the delivery is ₹ 15. It takes a period of 1.5 months to receive a delivery from the date of placing an order and a safety stock of 3200 values is desired.
You are required to determine:
(i) The Economic Order Quantity (EOQ) and the frequency of orders,
(ii) The reorder point.
(iii) The Economic Order Quantity (EOQ) if the valve costs ₹ 4.50 each instead of ₹ 1.50 each.
(Assume a year consists of 360 days)
(d) ABC Ltd. sells its Product ‘Y’ at a price of ₹ 300 per unit and its variable cost is ₹ 180 per unit. The fixed costs are ₹ 16,80,000 per year uniformly incurred throughout the year. The Profit for the year is ₹ 7,20,000.
You are required to calculate:
(i) BEP in value (₹) and units,
(ii) Margin of Safety,
(iii) Profits made when sales are 24,000 units,
(iv) Sales in value (₹) lo be made to earn a net profit of ₹ 10,00,000 for the year. (Marks 4 × 5 = 20)
Answer:
(a) Statement of cost per batch and per order
No. of batch = 1600 units ÷ 80 units = 20 batches.

Particulars	Cost per Batch	Total cost
Direct Material cost	4,250	85,000
Direct wages	500	10,000
Lab set up cost	1,400	28,000
Production overheads (20% of direct wages)	100	2,000

Particulars	Cost per Batch	Total cost
Total Production cost Add: S&D and Administrative overheads (20% of total production cost)	6,250 1,250	1,25,000 25,000
Total cost Add: Profit (1/4 on sales i.e. 1/3 on cost)	7,500 2,500	1,50,000 50,000
Selling price	10,000	2,00,000

(i) Total sales value = 2,00,000
(ii) Selling price p.u. = \(\frac{2,00,000}{1,600}\) = ₹ 125/unit

(b)

(i) Cost of processing a vehicle loan = \(\frac{2,48,000}{496 \text { loans }}\) = ₹ 500
(ii) Given that cost of processing an education loan is same as cost of pro¬cessing a vehicle loan
∴ No of education loan processed = \(\frac{1,88,000}{500 / \text { loan }}\) = 376 loans

(c) Annual Requirement = 7500 × 12 months = 90,000 units
Ordering cost = ₹ 15
Carrying cost = ₹ 0.3 (1.5/unit × 2096)
(Per unit)

(i) Calculation of Economic Order Quantity
EOQ = \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\)
= \(\sqrt{\frac{2 \times 90,000 \times 15}{0.3}}\)
= 3000 units
Frequency of orders = \(\frac{90,000}{3,000}

(ii) EOQ when purchase cost is ₹ 4.5 each instead of ₹ 1.5 each
EOQ = [latex]\frac{\sqrt{2 \mathrm{AO}}}{\mathrm{C}}\)
= \(\frac{\sqrt{2 \times 90,000 \times 15}}{0.9}\) = 1732 units
Calculation of carrying cost ⇒ 20% of ₹ 4.5/unit = ₹ 0.9

(iii) Calculation of Re-Order Point
= Safety stock + Average lead Lime consumption
= 3,200 + [\(\frac{90,000}{360 \text { days }}\) × 45 days]
= 14,450 units.

(d)
(i) Calculation of Break Even Point:

(ii) Margin of Safety = \(\frac{\text { Current sales }- \text { Break even sales }}{\text { Current sales }}\)
= \(\frac{20,000-14,000}{20,000}\)
= 30%

(iii) Calculation of profit when sales are 24,000 units

(iv) Calculation of sales to earn net profit of ₹ 10,00,000
Total contribution = Fixed cost + Expected profit
= 16,80,000 + 10,00,000
= ₹ 26,80,000
No. of units = \(\frac{\text { Total contribution }}{\text { Contribution per unit }}\)
= \(\frac{₹ 26,80,000}{₹ 120}\)
= 22,333 units
Total Sales = 22,333.333 × ₹ 300 = ₹ 67,00,000

Question 2.
(a) USP Ltd. is the manufacturer of ‘double grip motorcycle tyres’. In the manufacturing process, it undertakes three different jobs namely, Vulcanising, Brushing and Striping. All of these jobs require the use of a special machine and also the aid of a robot when necessary. The robot is hired from outside and the hire charges paid for every six months is ₹ 2,70,000. An estimate of overhead expenses relating to the special machine is given below :

• Rent for a quarter is ₹ 18,000.
• The cost of the special machine is ₹ 19,20,000 and depreciation is charged @ 10% per annum on straight line basis.
• Other indirect expenses are recovered at 20% of direct wages.

The factory manager has informed that in the coming year, the total direct wages will be ₹ 12,00,000 which will be incurred evenly throughout the year.
During the first month of operation, the following details are available from the job book:

Number of hours the special machine was used
Jobs-Without the aid of the robot-With the aid of the robot

Vulcanising	500	400
Brushing	1000	400
Striping	–	1200

You are required to :
(i) Compute the Machine Hour Rate for the company as a whole for a month (A) when the robot is used and (B) when the robot is not used.
(ii) Compute the Machine Hour Rate for the individual jobs i.e. Vulcanising, Brushing and Striping. (10 Marks)
(b) A skilled worker, in PK Ltd. is paid a guaranteed wage rate of ₹ 15.00 per hour in a 48-hour week. The standard time to produce a unit is 18 minutes. During a week, a skilled worker – Mr. ‘A’ has produced 200 units of the product. The Company has taken a drive for cost reduction and wants to reduce its labour cost.
You are required to:
(i) Calculate wages of Mr. ‘A’ under each of the following methods :
A. Time rate,
B. Piece-rate with a guaranteed weekly wage,
C. Halsey Premium Plan,
D. Rowan Premium Plan.
(ii) Suggest which bonus plan i.e. Halsey Premium Plan or Rowan Premium Plan, the company should follow. (6 Marks)
(c) XYZ Ltd. is engaged in manufacturing two products – Express Coffee and Instant Coffee. It furnishes the following data for an year:

The annual overheads are as under:

Particulars	₹
Machine Processing costs	7,00,000
Set up related costs	7,68,000
Purchase related costs	6,80,000

You are required to :
(i) Compute the costs allocated to each product – Express Coffee and Instant Coffee from each activity on the basis of Activity-Based Costing (ABC) method.
(ii) Find out the Overhead cost per unit of each product – Express Coffee and Instant Coffee based on (i) above. (4 Marks)
Answer:
(a)
Working Notes
(i) Total special machine hours used
(500 + 1000 + 400 + 400 + 1200) = 3,500

(ii) Total special machine hrs. without aid of robot
(500 + 1000) = 1,500

(iii) Total special machine hrs. with aid of robot
(400 + 400 + 1200) = 2,000

(iv) Total overheads of special machine per month
Rent (₹ 18,000 ÷ 3 months) = 6,000
Depreciation (19,20,000 × 10% × 1/12) 16,000
Other indirect expenses
(20% of 12,00,000 × 1/12) = 20,000
Total = 42,000

(v) Robot hire changes
= (2,70,000 ÷ 6 months) – 45,000

(vi) Overheads for using special machines without robot
= \(\frac{₹ 42,000}{3,500 \text { hrs. }}\) × 1500 hrs. = 18,000

(vi) Overheads for using special machines with robot.
= \(\frac{42,000}{3,500 \mathrm{hrs}}\) × 2000 hrs. + 45,000 = ₹ 69,000

(d) Computation of machine hr. rate for the firm as a whole for the month
When the robot is used = \(\frac{₹ 69,000}{2,000}\) = ₹ 34.50
When the robot is not used = \(\frac{₹ 18,000}{1500}\) = ₹ 12

(b) Computation of machine hour rate for individual job.

(i) Calculation of wages of Mr.A
A. Time rate
48 hrs. × ₹ 15/hr = ₹ 720

B. piece – rate with a guaranteed weekly wage.
Std. units/hr. = \(=\frac{60 \text { minutes } / \mathrm{hr} .}{18 \text { minute } / \text { unit }}\) = 3.33 units/hr.
∴ Piece rate = \(\frac{₹ 15 / \mathrm{hr} .}{3.33 \text { units/hr. }}\) = ₹ 4.5/unit
Wages = 200 units × ₹ 4.5/units = ₹ 900
Therefore, Mr. A will be paid ₹ 900 as it exceeds the minimum guaranteed weekly wage of ₹ 720.

(c) Halsey premium plan
Standard time for actual output
= \(\frac{200 \text { units } \times 18 \text { minutes } / \text { unit }}{60 \text { minutes } / \mathrm{Hr} .}\)
= 60 Hrs.
∴ Time saved = Time allowed – Time taken
= 60 Hrs. – 48 Hrs.
= 12 Hrs.
Wages under Halsey premium plan
= TT × TR + 50% of TS × TR
= 48 × ₹ 15/hr. + (50% of 12 hr.) × ₹ 15/hr.
= ₹ 810

(d) Rowan premium plan
Wages under Rowan premium plan
= TT × TR + \(\frac{\mathrm{TT}}{\mathrm{TA}}\) × TS × TR
= 48 × ₹ 15/hr. + \(\frac{48}{60}\) × 12 × ₹ 15/hr.
= ₹ 864

(ii) Rowan scheme of premium bonus is a suitable incentive scheme for the company. If this scheme is adopted, the entire gains due to time saved by a worker will not pass to them.

Another feature is that a worker cannot increase his earnings or bonus by merely increasing its work speed. The reason for this is that the bonus under Rowan scheme is maximum when time taken by a worker on a job is half of the time allowed.

Lastly, Rowan scheme provides a safeguard in case of any loose function of the standards by rate-setting department.

(c)
(i) Allocation of each product on the basis of ABC

Question 3.
(a) XYZ Construction Ltd. has obtained a contract of ₹ 25,00,000 in the Financial Year 2021 -22. The work on the contract commenced immediately and it is expected that the contract will be completed by 31st March, 2023. Chief accountant of the company has provided following information related to the Contract:

Following additional information is also available:

• A part of plant costing ₹ 12,000 was scrapped and written-off in the F.Y. 2021-22.
• The value of Plant-at-Site on 31st March, 2022 was ₹ 18,000.
• Company would have to spend an additional sum of ₹ 80,000 on the plant in F.Y. 2022-23 and the residual value of the plant on the completion of contract would be ₹ 10,000.
• A part of material costing ₹ 30,000 was scrapped and sold for ₹ 20,000 in F.Y. 2021-22.
• The value of Material-at-Site on 31st March, 2022 was ₹ 17,000.
• Cash received on account till 31st March, 2022 was ₹ 13,50,000 representing 90% of the work certified.
• The cost of work uncertified on 31st March, 2022 was valued at 20% of work certified.

You are required to:
(i) Prepare a Contract Account for the year ended on 31st March, 2022.
(ii) Calculate Estimated Total Profit on this Contract. (10 Marks)
(b) N Ltd. produces a product which passes through two processes – Process-I. and Process-II, The company has provided following information related to the Financial Year 2021-22:

	Process I	Process II:
Raw Material @ ₹	65 per units
Direct Wages	₹ 1,40,000	₹1,30,000
Direct Expenses	30% of Direct Wages	35% of Direct Wages
Manufacturing Overheads	₹ 21,500	₹ 24,500
Realisable value of scrap per unit	₹ 4.00	₹ 16.00
Normal Loss	250 units	500 units
Units transferred to Process II/finished stock	6,000 units	5,500 units
Sales	–	5,000 units

There was no opening or closing stock of work-in-progress.
You are required to prepare:
(i) Process-I Account
(ii) Process-II Account
(iii) Finished Stock Account (10 Marks)
Answer:
(a)
(i) Contract A/c for year ended on 31st March, 2022

(ii) Calculation of estimated total profit on the contract.

(b)

Working Notes:
1. Calculation of cost per unit of completed units and abnormal loss :
= \(\frac{6,26,000-1,000}{6,500-250}\) = ₹ 100 Process – I

Question 4.
(a) An agriculture based company having 210 hectares of land is engaged in growing three different cereals namely, wheat, rice and maize annually. The yield of the different crops and their selling prices are given below:

	Wheat	Rice	Maize
Yield (in kgs per hectare)	2,000	500	100
Selling price (₹ per kg)	20	40	250

The variable cost data of different crops are given below:
(All figures in ₹per kg)

Crop	Labour Charges	Packing Materials	Other variable expenses
Wheat	8	2	4
Rice	10	2	1
Maize	120	10	20

The company has a policy to produce and sell all the three kinds of crops. The maximum and minimum area to be cultivated for each crop is as follows:

Crop	Maximum area (in hectares)	Minimum Area (in hectares)
Wheat	160	100
Rice	50	40
Maize	60	10

You are required to:
(i) Rank the crops on the basis of contribution per hectare.
(ii) Determine the optimum product mix considering that all the three cereals are to be produced.
(iii) Calculate the maximum profit which can he achieved if the total fixed cost per annum is ₹ 21,45,000.
(Assume that there are no other constraints applicable to this company) (10 Marks)
(b) PNME Ltd. manufactures two types of masks- ‘Disposable Masks’ and ‘Cloth Masks’. The cost data for the year ended on 31 st March, 2022 is as follows:

	₹
Direct Materials	12,50,000
Direct Wages	7.00,000
Production Overhead	4.00,000
Total	23,50,000

It is further ascertained that:

• Direct material cost per unit of Cloth Mask was twice as m uch of Direct material cost per unit of Disposable Mask.
• Direct wages per unit for Disposable Mask were 60% of those for Cloth Mask.
• Production overhead per unit was at same rate for both the types of the masks.
• Administration overhead was 50% of Production overhead for each type of mask.
• Selling cost was ₹ 2 per Cloth Mask.
• Selling Price was ₹ 35 per unit of Cloth Mask.
• No. of units of Cloth Masks sold- 45,000
• No. of units of Production of:
  Cloth Masks: 50,000
  Disposable Masks: 1,50,000

You are required to prepare a cost sheet for Cloth Masks showing :
(i) Cost per unit and Total Cost,
(ii) rofit per unit and Total Profit. (10 Marks)
Answer:
(a)
(i) Calculation of contribution per hectare.

(ii) Determination of optimum product mix
First of all, minimum area required for each crop will be utilised i.e.
100 for Wheat
40 for Rice
10 for maize
150 Hectares
Now, we are left with 60 Hectare of land (210-150), which will be utilised on the basis of ranking.
Firstly , it will be utilised for cultivation of rice, as it gives highest contribution.
Therefore 10 acres of land will be cultivated for rice.
Afterwards, remaining 50 Acres of land will be allocated for cultivation of wheat, as it gives 2nd highest contribution.
Therefore mix will be as follows:
Wheat 100 + 50 = 150
Rice 40 + 10 = 50
Maize 10 + 0 = 10
= 210 Hectares

(iii) Project will be maximum if optimum mix is followed.

(b)

Working Notes:
Direct material cost per unit of Disposable mask is x
Direct material cost per unit of cloth mask is 2x
To, Direct material cost
= (2x × 50,000) + (x ×, 1,50,000) = ₹ 12,50,000
= 1,00,000 x + 1,50,000 x = ₹ 12,50,000
x = ₹5
Therefore, Direct material cost per unit of cloth mask = 2x = ₹ 10

2. Direct wages per unit of cloth mask = y
Direct wages per unit of disposable mask = 0.6y
= (y × 50,000) + (0.6y × 1,50,000) = ₹ 7,00,000
= 1,40,000y = ₹ 7,00,000
y = ₹5

3. Production overhead per unit = ₹ 4,00,000
50,000 + 1,50,000
= ₹ 2

Question 5
(a) Y Ltd. manufactures “Product M” which requires three types of raw materials “A”, “B” & “C”. Following information related to 1st quarter of the F.Y. 2022-23 has been collected from its books of account. The standard material input required for 1,000 kg of finished product ‘M’ are as under:

During the period, the company produced 20,000 kg of product ‘M’ for which the actual quantity of materials consumed and purchase prices are as under:

Material	Quantity (Kg.)	Purchase price per Kg. (₹)
A	11,000	23
B	7,500	48
C	4,500	60

You are required to calculate:
(i) Material Cost Variance
(ii) Material Price Variance for each raw material and Product ‘M’
(iii) Material Usage Variance for each raw material and Product ‘M’
(iv) Material Yield Variance
Note: Indicate the nature of variance i.e. Favourable or Adverse. (10 Marks)
(b) ‘X’ Ltd. follows Non-Integrated Accounting System. Financial Accounts of the company show a Net Profit of ₹ 5,50,000 for the year ended 31st March, 2022. The chief accountant of the company has provided following information from the Financial Accounts and Cost Accounts:

Particulars	(₹)
(i) Legal Charges provided in financial accounts	15,250
(ii) Interim Dividend received credited in financial accounts	4,50,000
(iii) Preliminary Expenses written off in financial accounts	25,750
(iv) Over recovery of selling overheads in cost accounts	11,380
(v) Profit on sale of capital asset credited in financial accounts	30,000
(vi) Under valuation of closing stock in cost accounts	25,000
(vii) Over recovery of production overheads in cost accounts	10,200
(viii) Interest paid on Debentures shown in financial accounts	50,000

Required:
Find out the Profit (Loss) as per Cost Accounts by preparing a Reconciliation Statement. (5 Marks)
(c) ASR Ltd. mainly produces Product ‘L’ and gets a by-Product *M’ out of a joint process. The net realizable value of the by-product is used to reduce the joint production costs before the joint costs are allocated to the main product. During the month of October 2022, company incurred joint production costs of ₹ 4,00,000. The main Product ‘L’ is not marketable at the split off point. Thus, it has to be processed further. Details of company’s operation are as under:

Particulars	Product L	By Product M
Production (units)	10,000	200
Selling pricing per kg	₹ 45	₹ 5
Further processing cost	₹ 1,01,000	–

You are required to find out:
(i) Profit earned from Product ‘L’.
(ii) Selling price per kg of product ‘L’ if the company wishes to earn a profit of ₹ 1,00,000 from the above production. (5 Marks)
Answer:
(a)

(i) Material cost variance = SQ × SR – AQ × AR.
= 8,40,000 – 8,83,000
= 43,000(A)

(ii) Material Price variance
Material A = AQ(SP – AP)
= 11,000 (25 – 23)
= 22,000 (F)
Material B = 7,500 (45 – 48)
= 22,500 (A)
Material C = 4500 (55 – 60)
= 22,500 (A)
Product M = 22,000 (F) + 22,500 (A) + 22,500 (A)
= 23,000 (A)

(iii) Material Usage variance
Material A = SP (SQ – AQ)
= 25(10,000 – 11,000)
= 25,000 (A)
Material B = 45(7,000 – 7,500)
= 22,500 (A)
Material C = 55(5,000 – 4,500)
= 27,500 (F)
Product M = 25,00(A) + 22,500 (A) + 27,500 (F)
= 20,000 (A)

(iv) Material yield variance
Std. Mix for Actual Qty. (RSQ)
A = 23,000 × \(\frac{10,000}{22,000}\) = 10,455
B = 23,000 × \(\frac{17000}{22,000}\) = 7,318
C = 23,000 × \(\frac{5000}{22,000}\) = 5,227
Material Yield Variance = (SQ – RSQ) × SP
Material A = (10,000 – 10,455) × 25 = 11,375 (A)
Material B = (7,000 – 7318) × 45 = 14.310(A)
Material C = (5,000 – 5227) × 55 = 12.485(A)
Total = 37.170(A)

OR

(b)

(c) (i) Net realisable value of by product M
= 200 units × ₹ 5/ unit
= ₹ 1,000
Joint cost allocable to product L
= ₹ 4,00,000 – ₹ 1,000
= ₹ 3,99,000.
Profit earned from product L
Sales (10,000 × ₹ 45) = 4,50,000
Less: Allocable joint cost = (3,99,000)
Further processing cost = (1,01,000)
(50,000)

Therefore there is loss of ₹ 50,000

(ii) If company wishes to earn a profit of ₹ 1,00,000, then selling price should be:
\(\frac{3,99,000+1,01,000+1,00,000}{10,000 \text { units }}\) = ₹ 60/ unit

Question 6.
Answer any four of the following :
(a) Which system of inventory management is known as ‘Demand pull’ or ‘Pull through’ system of production ? Explain. Also, specify the two principles on which this system is based.

(b) Indicate, for following items, whether to be show n in the Cost Accounts or Financial Accounts:
(i) Preliminary expenses written off during the year
(ii) Interest received on bank deposits
(iii) Dividend, interest received on investments
(iv) Salary for the proprietor at notional figure though not incurred
(v) Charges in lieu of rent where premises are owned
(vi) Rent receivables
(vii) Loss on sale of Fixed Assets
(viii) Interest on capital at notional figure though not incurred
(ix) Goodwill written off
(x) Notional Depreciation on the assets fully depreciated for which book value is Nil.

(c) PP Limited is in the process of implementation of Activity Based Costing System in the organisation. For this purpose, it has identified the following Business Functions in its organisation :
(i) Research and Development
(ii) Design of Products, Services and Procedures
(iii) Customer Service
(iv) Marketing
(v) Distribution
You are required to specify two cost drivers for each Business Function Identified above.
(d) Define Budget Manual. What are the salient features of Budget Manual?

(e) Mention the cost units (physical measurements) for the following industry/product:
(i) Automobile
(iii) Brickworks
(iv) Power
(v) Steel
(vi) Transport (by road)
(vii) Chemical
(viii) oil
(ix) Brewing
(x) Cement (Marks 4 × 5 = 20)
Answer:
(a) ‘Just in Time’ is a system of inventory management with an approach to have a zero inventories in stores. According to this approach material should only be purchased when it is actually required for production.

• This system is also known as “Demand pull” or “Pull Through” system of production.
  Note: JIT is based on two principles,
  (i) Produce goods only when it is required.
  (ii) The product should be delivered to customers at the time only when they want.

(b) Items to be shown in cost accounts.

• Salary for the proprietor at notional figure though not incurred.
• Charges in lieu of rent where premises are owned.
• Interest on capital at notional figure though not incurred.
• Notional depreciation on the assets fully depreciated for which book value is NIL.

Note: Items to be shown in financial accounts.

• Primary expenses written off during the year.
• Interest received on bank deposits.
• Dividend, interest received on investments.
• Rent receivables.
• Loss on sale of fixed assets.
• Goodwill written off.

(c)

Business Functions	Cost Driver
Research and Development	Number of research projects Personnel hours on a project
Design of products, services and procedures	Number of products in design Number of parts per products Number of engineering hours
Customer service	Number of service calls Number of products serviced Hours spent on servicing products
Marketing	Number of advertisements Number of Sales personnel Sales revenue
Distribution	Number of units distributed Number of customers

(d) Budget Manual:
The Budget manual is a document or booklet which contain guidelines for the preparation of budget in an organization.

CIMA, London, defines budget manual as, “A document which sets out the responsibilities of the persons engaged in, the routine of, and the forms and records required for, budgetary control.”
Note: Salient features of budget manual:

(e)

Industry	Cost unit (Physical Measurements)
Automobile	Number of vehicles
Gas	Cubic Meter
Bricks works	Thousand
Power	Kilo-watt hour
Steel	Tonne
Transport	Tonne – kilometer, passenger kilometer
Chemical	Litre, Kilogram, Tonne
Oil	Barrels
Brewing Cement	Tonnes, kilogram

 

Money Market Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

Money Market Notes – CA Inter ECO Notes

1. Functions of Money:

• Money is a convenient medium of exchange,
• Money is an explicitly defined unit of value or ‘common measure of value’ or ‘common denominator of value’,
• Money serves as a unit or standard of deferred payment.

2. General Characteristics of Money:

• Generally acceptable,
• Durable or long-lasting,
• Effortlessly recognizable,
• Difficult to counterfeit i.e. not easily reproducible by people,
• Relatively scarce, but has elasticity of supply,
• Portable or easily transported,
• Possessing uniformity; and
• Divisible into smaller parts.

3. The Demand for Money:
If people desire to hold money, we say there is demand for money. Demand for money is actually demand for liquidity and demand to store value.

4. Classical Approach: The Quantity Theory of Money (QTM):

The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’published in 1911 and later by the neoclassical economists. Fisher’s version, also termed as ‘equation of exchange ‘or ‘transaction approach ’ is formally stated as follows:

MV = PT
Where,
M = the total amount of money in circulation
V = transactions velocity of circulation
P = average price level (P = MV/T)
T = the total number of transactions.
Fisher’s extended the equation:
MV + M’V’ = PT
Where,
M’ = the total quantity of credit money
V’ = velocity of circulation of credit money

5. The Neo-classical Approach Or The Cambridge Approach:
In the early 1900’s Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes put forward a fundamentally different approach to quantity theory, known as neoclassical theory or cash balance approach. The Cambridge version holds that money increases utility in the following two ways:

• Enabling the possibility of split-up of sale and purchase to two different points, and
• Being a hedge against uncertainty.

The Cambridge equation:
M^d = k PY
Where,
M^d = demand for money
Y = real national income
P = average price level
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances

6. The Keynesian Theory of Demand for Money:
Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory ’. According to Keynes, people hold money (M) in cash for three motives:

• Transactions motive,
• Precautionary motive, and
• Speculative motive.

7. Inventory Approach to Transaction Balances:
Baumol(l 952) and Tobin {1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money or Veal cash balance’ was essentially viewed as an inventory held for transaction purposes. Inventory models assume that there are two media for storing value:

• Money and
• An interest-bearing alternative financial asset.

There is a fixed cost of making transfers between money and the alternative assets and Liquid financial assets other than money offer a positive return.
Therefore, people hold an optimum combination of bonds and cash balance, i. e., an amount that minimizes the opportunity cost.

8. Friedman’s Restatement of The Quantity Theory:
Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price theory.

• The demand for money as nothing more than theory of demand for capital assets
• Demand for money is affected by the same factors as demand for any other asset, namely:
• Permanent income
• Relative returns on assets (which incorporate risk).

Friedman identifies the following four determinants of the demand for money:

• is a function of total wealth,
• is positively related to the price level, P,
• rises if the opportunity costs of money holdings decline,
• is influenced by inflation.

9. The demand for money as behaviour toward risk (Tobin’s Risk-Aversion Approach):
In his classic article, ‘Liquidity Preference as Behaviour towards Risk’(1958), Tobin established that the theory of risk-avoiding behaviour of individuals provided the foundation for:

• The liquidity preference and
• For a negative relationship between the demand for money and the interest rate.

According to Tobin, the optimal portfolio structure is determined by:

• The risk/reward characteristics of different assets,
• The taste of the individual in maximizing his utility consistent with the existing opportunities.
  Demand for money as a store of wealth will decline with an increase in the interest rate.

10. Measurement of Money Supply:
From April 1977, the RBI has been publishing data on four alternative measures of money supply denoted by Ml, M2, M3 and M4 besides the reserve money:
M1 = Currency notes and coins with the people + demand deposits
of banks (Current and Saving deposit accounts) + other deposits with the RBI
M2 = M1 + savings deposits with post office savings banks
M3 = M1 + net time deposits with the banking system
M4 = M3 + total deposits with the Post Office Savings Organization
(excluding National Savings Certificates)

Following the recommendations of the Working Group on Money (1998), the RBI has started publishing a set of four new monetary aggregates:

Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
= Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks+RBI’s net

Foreign assets + Government’s Currency liabilities to the public-RBI’s net non monetary Liabilities
NM1 = Currency with the public+Demand deposits with the banking
system + ‘Other’deposits with the RBI
NM2 = NM1 + Short-term time deposits of residents (including and up to contractual maturity of one year)
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial institutions

‘Liquidity’ aggregates in addition to the monetary aggregates:
L1 = NM3 + All deposits with the post office savings banks(excluding National Savings Certificates)
L2 = L1 +Term deposits with term lending institutions and
refinancing institutions (FIs) + Term borrowing by FIs + Certificates of deposit issued by FIs
L3 = L2 + Public deposits of non-banking financial companies

11. Money Multiplier:
Money Multiplier (m) = Money supply ÷ Monetary base

12. The Money Multiplier Approach to Supply of Money:
The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three factors as immediate determinants of money supply, namely:

• The stock of high-powered money (H)
• The ratio of reserves to deposites, e = (ER/D) and
• The ratio of currency to depoists, c = (C/D)

To summarise the money multiplier approach, the size of the money multiplier is determined by the required reserve ratio (r) at the central bank, the excess reserve ratio (c) of commercial banks and the currency ratio (c) of the public. The lower these ratios are, the larger the money multiplier is.

13. The Credit Multiplier: Credit Multiplier = 1 ÷ Required Reserve Ratio

14. Monetary Policy Defined:
Monetary policy is essentially a programme of action undertaken by the monetary authorities, normally the central bank, to control and regulate the demand for and supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals.

15. The Monetary Policy Framework:

• The objectives of monetary policy,
• The analytics of monetary policy, and
• The operating procedure.

16. The Objectives of Monetary Policy:
The objectives of monetary policy generally coincide with the overall objectives of economic policy. In developing countries:

• Maintenance the economic growth,
• Ensuring an adequate flow of credit,
• Sustaining – a moderate structure of interest, and
• Creation of an efficient market for government securities.

17. Analytics of Monetary Policy:
The process or channels through which the change of monetary aggregates affects the level of production and prices etc. There are mainly four different mechanisms:

• The interest rate channel,
• The exchange rate channel,
• The quantum channel (relating to money supply and credit), and
• The asset price channel ie. via equity and real estate prices.

18. Operating Procedures and Instruments:
The operating framework relates to all aspects of implementation of monetary policy. It primarily involves three major aspects, namely,

• Choosing the operating target,
• Choosing the intermediate target, and
• Choosing the policy instruments.

The operating target refers to the variable (e.g. inflation) that monetary policy can influence with its actions.
The intermediate target (e.g. economic stability) is a variable which the central bank can hope to influence to a reasonable degree through the operating target and which displays a predictable and stable relationship with the goal variables.

The monetary policy instruments are the various tools that a central bank can use to influence money market and credit conditions and pursue its monetary policy objectives.

19. Cash Reserve Ratio (CRR):
Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time liabilities (NDTL) of a scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank.

20. Statutory Liquidity Ratio (SLR):
As per the Banking Regulations Act, 1949, all scheduled commercial banks in India are required to maintain a stipulated percentage of their total Demand and Time Liabilities (DTL)/Net DTL (NDTL) in one of the following forms:

• Cash
• Gold, or
• Investments in unencumbered Instruments

21. Liquidity Adjustment Facility (LAF):
LAF is a facility extended by the Reserve Bank of India to the scheduled com-mercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement on an overnight basis against the collateral of government securities including State Government securities.

22. Marginal Standing Facility (MSF):
The Marginal Standing Facility (MSF) announced by the Reserve Bank of India “
(RBI) in its Monetary Policy, 2011-12 refers to the facility under which scheduled commercial banks can borrow additional amount of overnight money from the central bank over and above what is available to them through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.

23. Market Stabilisation Scheme (MSS):
This instrument for monetary management was introduced in 2004 following – a MoU between the Reserve Bank of India (RBI) and the Government of India (GOI) with the primary aim of aiding the sterilization operations of the RBI. Under this scheme, the Government of India borrows from the RBI and issues treasury-bills/dated securities for absorbing excess liquidity from the market arising from large capital inflows.

24. The Monetary Policy Framework Agreement:
Agreement reached between the Government of India and the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability. The amended RBI Act (2016) provides for a statutory basis.

• The inflation target is to be set, once in every five years
• 4 percent CPI inflation as the target for August 5, 2016 to March 31, 2021
• Upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent
• Publish a Monetary Policy Report every six months,
• The following factors are notified by the CG:
• The average inflation is more than the upper tolerance level for any three consecutive quarters; or
• The average inflation is less than the lower tolerance level for any three consecutive quarters.

25. The Monetary Policy Committee (MPC):
An important landmark in India’s monetary history is the constitution of an empowered six-member Monetary Policy Committee (MPC) in September, 2016 consisting of the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three Central Government nominees representing the Government of India who are persons of ability, integrity and standing, having knowledge and experience in the held of Economics or banking or finance or monetary policy.

26. Repurchase Options or in short ‘Repo’: is defined as ‘an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed’.

27. Reverse Repo: is defined as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.

28. Bank Rate: Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as ‘the standard rate at which the Reserve Bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the Act’. The bank rate once used to be the policy rate in India i.e. the key interest rate based on which all other short term interest rates moved.

29. Open Market Operations: Open Market Operations (OMO) is a general term used for market operations conducted by the Reserve Bank of India by way of sale/purchase of Government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

Public Finance – CA Inter Economics Study Material is designed strictly as per the latest syllabus and exam pattern.

Public Finance – CA Inter Economics Study Material

Theory Questions

Question 1.
Explain the role of Government in a market economy as stated by Richard Musgrave. (3 Marks May 2018)
Answer:
Role of government in a market as stated by Richard Musgrave: Richard Musgrave introduced in his classic treatise ‘The Theory of Public Finance’ (1959), the three branch taxonomy of the role of government in a market economy. The objective of the economic system and the role of government is to improve the well-being of individuals or households.

According to ‘Musgrave Three Function Framework’, the functions of government are to be separated into three, namely, resource allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic function. The allocation function aims to correct the sources of inefficiency in the economic system while the distribution role ensures that the distribution of wealth and income is fair. The stabilization branch is to ensure achievement of macroeconomic stability, maintenance of high levels of employment and price stability.

Question 2.
Describe the meaning and mechanism of Crowding out’ effect of public expenditure. (3 Marks May 2018, 2 Marks Jan. 2021)
Answer:
Crowding Out: Crowding out effect refers to the negative effect of fiscal policy may generate when spending by government in an economy substitutes private spending. For example, if government provides free computers to students, the demand from students for computers may not be forthcoming.

Crowding Out Mechanism: Private investments are sensitive to interest rates and therefore some private investment spending is discouraged. Similarly, when government increases the budget deficit by selling bonds or treasury bills, the amount of money with the private sector decreases and consequently interest rates will be pushed up.

As a result, private investments, especially the ones which are interest – sensitive, will be reduced. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion in demand resulting from an increase in government expenditure.

Question 3.
Describe features of public goods. (2 Marks May, 2018 Nov. 2020)
Answer:
Features of public goods :

1. Public goods yield utility and their consumption is essentially collective in nature.
2. Public goods are non-rival in consumption i.e. consumption of a public good by one individual does not reduce the quality or quantity available for all other individuals:
3. Public goods are non-excludable i.e. consumers cannot (at least at less than prohibitive cost) be excluded from consumption benefits.
4. Public goods are characterized bv indivisibility, each individual may consume all of the good i.e. the total amount consumed is the same for each individual.
5. Once a public good is provided, the additional resource cost of another person consuming the good is zero. No direct payment by the consumer is involved in the case of pure public goods and these goods are generally more vulnerable to issues such as externalities, inadequate property rights, and free rider problems.
6. Competitive private markets will fail to generate economically efficient outputs of public goods. E.g. national defence.

Question 4.
Which types of Government interventions are applied for correcting information failure? (2 Marks May 2018)
Answer:
Types of Government Interventions for correcting information failure :

1. Government makes it mandatory to have accurate labelling and content disclosures by producers.
2. Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.
3. Regulation of advertising and setting of advertising standards to make advertising more responsible, informative and less persuasive.

A few examples are : SEBI mandates on accurate information disclosure to prospective buyers of new stocks, mandatory statutory information, licensing of doctors practicing medicine, awareness campaigns and funding of organisations to influence public, media and government attitudes.

Question 5.
Explain the objectives of Fiscal Policy. (3 Marks May 2018)
Answer:
Objectives of Fiscal Policy are :

1. Achievement and maintenance of full employment,
2. Maintenance of price stability,
3. Acceleration of the rate of economic development,
4. Equitable distribution of income and wealth,
5. Eradication of poverty, and
6. Removal of regional imbalances in different parts of the country.

The importance and order of priority of these objectives may vary from country to country and from time to time. For instance, while stability and equality may be the priorities of developed nations, economic growth, employment and equity may get higher priority in developing countries. Also, these objectives are not always compatible; for instance the objective of achieving equitable distribution of income may conflict with the objective of economic growth and efficiency.

Question 6.
How the Government intervenes to ensure stability in price level? (2 Marks Nov. 2018)
Answer:
Government intervenes to ensure price stability and thus regulate aggregate demand with two policy instruments namely, monetary (credit) policy and fiscal (budgetary) policy. Monetary policy attempts to stabilise aggregate demand in the economy by influencing the availability and rate of interest. Fiscal policy, on the other hand, aims at influencing aggregate demand by altering tax, public expenditure and public debt of the government.

When total spending is too low, the government may increase its spending and lower taxes to reduce unemployment and the central bank may lower interest rates. When total spending is excessive, the government may cut its spending and raise taxes to foster price stability and the central bank may raise interest rates. In addition, the government may initiate regulatory measures such as price ceiling and price floors.

Question 7.
Define the Contractionary Fiscal Policy. What measures under this policy are to be adopted to eliminate the inflationary gap? (3 Marks Nov. 2018)
Answer:
Contractionary Fiscal Policy: It refers to the deliberate policy of government applied to curtail aggregate demand and consequently the level of economic activity. In other words, it is fiscal policy aimed at eliminating an inflationary gap.
Measures under this policy are :
1. Decrease in government spending: With decrease in government spending, the total amount of money available in the economy is reduced whic h is turns trim down the aggregate demand.

2. Increase in personal income taxes and/or business taxes : An increase in personal income taxes reduces disposable income leading to fall in consumption spending and aggregate demand. An increase in taxes on business profits reduces the surpluses available to businesses, and as a result, firms’ investments shrink causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants who will respond by holding back fresh investments.

3. A combination of decrease in government spending and increase in personal income taxes and/or business taxes.

Question 8.
What is allocation function of Fiscal Policy? Or Describe the allocation instruments available to the Government to influence resource allocation in an economy, (2 Marks Nov. 2018, 3 Marks Jan. 2021)
Answer:
Allocation function .-Allocation function of fiscal policy is concerned with the process by which the total resources of the economy are divided among various uses as well as for provision of an optimum mix of various social goods (both public goods and merit goods). The allocation function also involves the reallocation of society’s resources from private use to public use.

The Resource allocation role of the government’s fiscal policy focuses on the potential of the government to improve economic performance through its expenditure and tax policies. The allocative function in budgeting determines who and what will be taxed as well as how and on what the government revenue will be spent. The allocative function also involves the reallocation of society’s resources from private to public use.

A variety of allocation instruments are available by which governments can influence resource allocation in the economy. For example :

1. Government may directly produce an economic good.
2. Government may influence private allocation through incentives and disincentives.
3. Government may influence allocation through its competitive policies, merger policies etc. which affect the structure of industry and commerce.
4. Government’s regulatory activities such as licensing control minimum wages and directives on location of industry influence resource allocation.
5. Government sets legal and administrative framework and
6. Any mixture of intermediate methods may be adopted by the government.

Question 9.
Define the market failure. Why do markets fail? (3 Marks Nov, 2018)
Answer:
Market failure : It is a situation in which the free market with an unrestricted price system determined by forces of supply and demand leads to misallocation of society’s scarce resources in the sense that there is either overproduction or underproduction of particular goods and services leading to a less than optimal outcome.

Reasons for market failure are :

1. Though perfectly competitive markets work efficiently, most often the prerequisites of competition are unlikely to be present in an economy.
2. Market power of firms enables them to act as price makers and keep the level of prices and output that give them positive economic profits.
3. Externalities hinder the ability of market prices to convey accurate information about how much to produce and how much to buy.
4. Public goods are not produced at all or produced less than optimal quantities due to its special characteristics such as indivisibility, non – excludability and non-rivalry.
5. Free rider problem causing overuse, degradation and depletion of common resources.
6. Information failure manifest in asymmetric information, adverse selection and moral hazard.

Question 10.
How do Governments correct market failure resulting from demerit Goods? (3 Marks Nov. 2018)
Answer:
Government acts to correct market failure resulting from demerit goods are:

1. At the extreme, the government may enforce complete ban on a demerit good; e.g. intoxicating drugs. In such cases, the possession, trading or consumption of the good is made illegal.
2. Impose unusually high taxes on producing or purchasing the demerit goods making them very costly and unaffordable to many.
3. Through persuasion which is mainly intended to be achieved by negative advertising campaigns which emphasize the dangers associated with consumption of demerit goods and granting of subsidies for such advertisements.
4. Through legislations that prohibit the advertising or promotion of demerit goods in whatsoever manner.
5. Strict regulations of the market for the good may be put in place so as to limit access to the good, especially by vulnerable groups such as children and adolescents. Restrictions in terms of a minimum age may be stipulated at which young people are permitted to buy cigarettes and alcohol.
6. Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of tobacco to be away from schools, and time restrictions under which sale at particular times during the day is banned.

Question 11.
Explain the concept of Social Costs. (2 Marks Nov. 2018)
Answer:
Social costs : Social costs is the total costs to the society on account of a production or consumption activity. Social costs are private costs borne by individuals directly involved in a transaction together with the external costs borne by third parties not directly involved in the transaction. Social costs represent the true burdens carried by society in monetary and non-monetary terms.

Question 12.
Define ‘Market power’. What is its disadvantage? (2 Marks May 2019)
Answer:
Market power: Market power refers to the ability of a price making firm to profitably raise the market price of a good or service over its marginal cost and thus earn supernormal profits or positive economic profits. Market power is an important cause of market failure. Market failure occurs when the free market outcomes do not maximize net benefits of an economic activity and therefore there is deadweight losses and inefficient allocation of resources.

Excess market power causes a single producer or a small number of producers to strategically reduce their supply and charge higher prices compared to competitive market. Market power can cause markets to be inefficient because it keeps price and output away from the equilibrium of supply and demand. Market power thus results in suboptimal outcomes such as deadweight loss, underproduction of goods and services, higher prices and loss of consumer surplus.

Question 13.
Why is there a need for the government to resort to resource allocation? (3 Marks May 2019)
Answer:
Government need to resort to resource allocation during market failure. Market failures are situations in which a particular market, left to itself, is inefficient and leads to misallocation of society’s scarce resources. In the absence of appropriate government intervention in resource allocation, the resources are likely to be misallocated with too much production of certain goods or too little production of certain other goods.

The allocation responsibility of the governments involves suitable corrective action when private markets fail to provide the right and desirable combination of goods and services to ensure optimal outcomes in terms of social welfare.

Question 14.
Describe the limitations of fiscal policy. (3 Marks May 2019)
Answer:
Limitations of fiscal policy are :
1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is the different types of lags involved in fiscal policy action. There are significant lags such as recognition lag, decision lag, implementation lag and impact lag

2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an expansionary policy is initiated when the economy is already on a path of recovery and vice versa.

3. There are difficulties in instantaneously changing governments’ spending and taxation policies.

4. It is practically difficult to reduce government spending on various items such as defence and social security as well as on huge capital projects which are already midway.

5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.

6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and also promptly determining the accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal policy such that a policy designed to achieve one goal may adversely affect another. For example, an expansionary fiscal policy may worsen inflation in an economy.

8. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example, increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security benefits may adversely affect incentives to work and save.

9. Deficit financing increases the purchasing power people. The production of goods and services, especially in under developed countries may not catch up simultaneously to meet the increased demand. This will result in prices spiraling beyond control.

10. Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid. If the economy lags behind in productive utilization of borrowed money, sufficient surpluses will not be generated for servicing debts. External debt burden has been a constant problem for India and many developing countries.

11. An increase in the size of government spending during recessions will ‘crowd out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic growth.

12. If governments compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may not be realized.
(Student may write any six)

Question 15.
What is meant by expansionary fiscal policy? Under what circumstances do government pursue expansionary policy? (3 Marks May 2019)
Answer:
Expansionary fiscal policy :
An expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes.

The objectives of expansionary fiscal policy are reduction in cyclical unemployment, increase in consumer demand and prevention of recession and possible depression. In other words, it aims to close a ‘recessionary gap’ or a contractionary gap wherein the aggregate demand is not sufficient to create conditions of full employment. This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes.

Government uses subsidies, transfer payments, welfare programmes, corporate and personal income tax cuts and increased spending on public works such as on infrastructure development to put more money into consumers’ hands to give them more purchasing power.

Question 16.
What is meant by quasi public goods? (2 Marks May 2019)
Answer:
Quasi public goods are :
(1) Not completely non rival. For example, public roads wi-fi networks and public parks do not get congested so as to reduce the space available for others when extra consumers use them only up to an optimal point. When more people use it beyond that, the amount others can benefit from these is reduced to some extent, because there will be increased congestion.

(2) It is easy to keep people away from quasi public goods by charging a price or fee. For example, it is possible to exclude some users by building toll booths to charge for road usage on congested routes. Other examples are education, and health services. It is easy to keep people away from them by charging a price or fee. However, it is undesirable to keep people away from such goods because the society would be better off if more people consume them. This particular characteristic namely, the combination of virtually infinite benefits and the ability to charge a price results in some quasi-public goods being sold through markets and others being provided by government.

Question 17.
What do you mean by ‘Global Public Goods’? Explain in brief. (2 Marks Nov. 2019)
Answer:
Global Public Goods: These are those public goods with benefits or costs that potentially extend to everyone in the world. These goods have widespread impact on different countries and regions, population groups and generations throughout the entire globe. Global Public Goods may be :

1. Final public goods which are ‘outcomes’ such as ozone layer preservation or climate change prevention, or
2. Intermediate public goods, which contribute to the provision of final public goods e.g. International health regulations

The distinctive characteristic of global public goods is that there is no mechanism (either market or government) to ensure an efficient outcome. The World Bank identifies five areas of global public goods which it seeks to address : namely, the environmental commons (including the prevention of climate change and biodiversity), communicable diseases (including HIV/ AIDS, tuberculosis, malaria, and avian influenza), international trade, international financial architecture, and global knowledge for development.

Question 18.
Describe the problems in administering an efficient pollution tax. (3 Marks Nov. 2019)
Answer:
Following are the problems in administering an efficient pollution tax :
(1) Pollution taxes are complex to determine and administer because it is difficult to discover the right level of taxation that would ensure that the private cost plus taxes will exactly equate with the social cost.

(2) If the demand for the good on which pollution tax is imposed is inelastic, the tax may only have an insignificant effect in reducing demand. The producers will be able to easily shift the tax burden in the form of higher product prices. This will have an inflationary effect and may reduce consumer welfare.

(3) Imposition of pollution tax involves the use of complex and costly administrative procedures for monitoring the polluters.

(4) Pollution tax does not provide any genuine solutions to the problem. It only establishes an incentive system for use of methods which are less polluting.

(5) Pollution taxes also have potential negative consequences on employment and investments because high pollution taxes in one country may encourage producers to shift their production facilities to those countries with lower pollution taxes.

Question 19.
Distinguish between ‘pump priming’ and ‘compensatory spending’. (2 Marks Nov. 2019)
Answer:
Pump priming: Pump priming refers to the one shot injection of government expenditure into a depressed economy with the aim of boosting business confidence and encouraging larger private investment. It is a temporary fiscal stimulus in order to set off the multiplier process. The argument is that with a temporary injection of purchasing power into the economy through a rise in government spending financed by borrowing rather than taxes, it is possible for government to bring about permanent recovery from a slump.

Compensatory spending: Compensatory spending is said to be resorted to when the government spending is deliberately carried out with the obvious intention to compensate for the deficiency in private investment.

Question 20.
Distinguish between positive and negative externalities. (2 Marks Nov. 2019)
Answer:
An externality refers to the uncompensated impact of one person’s production and/or consumption actions on the well-being of another who is not involved in the activity and such effects are not reflected directly in market prices. If the impact on the third parties’ is adverse, it is called a negative externality. If it is beneficial, it is called a positive externality.

When negative externalities are present, the social cost of production or consumption is greater than the private cost. The benefit of a negative externality goes to the agent producing it, while the costs are invariably borne by the society at large.

When a positive externality exists, the benefit to the individual or firm is less than the benefit to the society i.e. the social value of the good exceeds the private value. In both cases, the outcome is market failure and inefficient allocation of resources.

Question 21.
How does a discretionary fiscal policy help in correcting instabilities in the economy? (3 Marks Nov. 2019)
Answer:
Discretionary fiscal policy helps in correcting instabilities in the economy during inflation by:

1. Decrease in government spending,
2. Increase in personal and business taxes, and introduction of new taxes,
3. A combination of decrease in government spending and increase in personal income taxes and/or business taxes,
4. A smaller government budget deficit or a larger budget surplus,
5. A reduction in transfer payments,
6. Increase in government debt from the domestic economy.

Discretionary fiscal policy helps in correcting instabilities in the economy during deflation by:

1. Increased government spending,
2. decrease in personal and business taxes,
3. A combination of increase in government spending and decrease in personal income taxes and/or business taxes,
4. A larger government budget deficit or a lower budget surplus,
5. An increase in transfer payments,
6. Repayment of public debt to people.

Question 22.
What is ‘Recessionary Gap’? (2 Marks Nov. 2019)
Answer:
Recessionary Gap or Contractionary Gap: It is said to exist if the existing levels of aggregate production is less than what would be produced with full employment of resources. It is a measure of output that is lost when actual national income falls short of potential income, and represents the difference between the actual aggregate demand and the aggregate demand which is required to establish the equilibrium at full employment level of income.

This gap occurs during the contractionary phase of business cycle and results in higher rates of unemployment. In other words, a recessionary gap occurs when the aggregate demand is not sufficient to create conditions of full employment.

Question 23.
Discuss the “Fiscal Policy Measures” which are useful for reduction in inequalities of income and wealth. (3 Marks Nov. 2020)
Answer:
‘Fiscal Policy Measure’ which are useful for reduction in inequalities of income and wealth are :
(1) Progressive direct tax system : A progressive system of direct taxes ensures that those who have greater ability to pay contribute more towards defraying the expenses of government and that the tax burden is distributed fairly among the population.

(2) Differential indirect taxes system : The indirect taxes may be designed in such a way that the commodities which are primarily consumed by the richer income groups, such as luxuries, are taxed heavily and the commodities the expenditure on which form a larger proportion of the income of the lower income group, such as necessities, are taxed light.

(3) A carefully planned policy of public expenditure :It helps in redistributing income from the rich to the poorer sections of the society. This is done through spending programmes targeted on welfare measures for the disadvantaged, such as poverty alleviation programmes, free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of living of the poor, infrastructure provision on a selective basis, various social security schemes under which people are entitled to old-age pensions, unemployment relief, sickness allowance etc., subsidized production of products of mass consumption, public production and/or grant of subsidies to ensure sufficient supply of essential goods, and strengthening of human capital for enhancing employability etc.

Question 24.
‘Lemons Problem’ is an important source of market failure. How? (2 Marks Nov. 2020)
Answer:
Asymmetric information between the buyers and sellers is the reason of ‘Lemon Problem’. The problem exists in many markets, but it was popularized by the used car market in which cars are classified as good from those defined as “lemons” (poor quality vehicles).

The owner of a car knows much more about its quality than anyone else. While placing it for sale, he may not disclose all that he knows about the mechanical defects of the vehicle. Based on the probability that the car on sale is a ‘lemon’, the buyers’ willingness to pay for any particular car will be based on the ‘average quality’ of used cars.

Not knowing the honesty of the seller means, the price offered for the vehicle is likely to be less to account for this risk. If buyers were aware as to which car is good, they would pay the price they feel reasonable for a good car. Since the price offered in the used car market is lower than the acceptable one, sellers of good cars will not be inclined to sell. The market becomes flooded with ‘lemons’ and eventually the market may offer nothing but lemons’. The good -quality cars disappear because they are kept by their owners or sold only to friends.

The result is : the proportion of good products that is actually offered falls further and there will be market distortion with lower prices and lower average quality of cars. Low quality cars can drive high quality cars out of the market. Eventually, this process may lead to a complete breakdown of the market.

Question 25.
Explain the various types of externalities. (3 Marks Nov. 2020)
Answer:
There are four types of externalities which are :
(1) Negative Production Externalities : A negative production externality initiated in production which imposes an external cost on others may be received by another in consumption or production. As an example, a negative production externality occurs when a factory discharges untreated waste water into a nearby river and pollutes the water.

(2) Positive production externalities : A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption. For example, positive production externality occurs when a firm offers training to its employees for increasing their skills. Training generates positive benefits on the productive efficiency of other firms when they hire such workers as they change their jobs.

(3) Negative consumption externalities .’Negative consumption externalities initiated in consumption confer external costs on others that may be received in production or in consumption. For example, smoking cigarettes by one person in public place causes passive smoking by others. These external costs affect consumption of others by causing consumption of poor quality air or by creating litter and diminishing the aesthetic value of the place.

(4) Positive consumption externalities: A positive consumption externality occurs when an individual’s consumption increases the well-being of others but the individual is not compensated by those others. For example, if people get immunized against contagious diseases, they would confer a social benefit on others as well by preventing others from getting infected.

Question 26.
Explain the market outcome of price ceiling through diagram. (2 Marks Nov. 2020)
Answer:
The market outcome of price ceiling or maximum price through diagram:

In case of prices of certain essential commodities rise excessively, government may resort to controls in the form of price ceilings for making a resource or commodity available to all at reasonable prices. For example : maximum prices of food grains and essential items are set by government during times of scarcity. The market outcome of price ceiling can be explained with the help of the following diagram.

Market Outcome of Price Ceiling

The intersection of demand and supply curves set the market price of the commodity in question at ₹ 150. Since the market determined equilibrium price is considered high considering the welfare of people, the government intervenes in the market and a price ceiling is set at ₹ 75 which is below the prevailing market clearing price.

At price ₹ 75, the quantity demanded is Q2 and the quantity supplied is only Ql. In other words, there is excess demand equal to Q1-Q2. Thus the market outcome a price ceiling which is below the market determined price leads to generation of excess demand over supply.

Question 27.
Calculate the Fiscal Deficit and Primary Deficit from the data given below: (3 Marks Jan. 2021)

	(₹ in Crores)
Total Expenditure on Revenue Account and Capital Account	547.62
Revenue Receipts	226.82
Non-debt Capital Receipts	103.00
Interest Payments	84.00

Answer:
Fiscal Deficit = Total Expenditure on Revenue Account and Capital Account – Revenue Receipts – Non-debt Capital Receipts
= 547.2 – 226.82 – 103.00
= 217.8 Crores
Primary Deficit = Fiscal Deficit – Interest Payments
= 217.8 – 84.00
= 133.8 Crores

Question 28.
Explain the significance of public debt as an instrument of fiscal policy. (2 Marks Jan 2021)
Answer:
Public Debt and its significance / When a government has borrowed money over the years to finance its deficits and has not paid it back through accumulated surpluses then it is said to be in debt. Public debt may be internal or external, when the government borrows from its own people in the country, it is called internal debt. On the other hand, when the government borrows from outside sources, the debt is called external debt.

Public debt takes two forms namely, market loans and small savings. A national policy of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy. Repayment of debt by government increases the availability of money in the economy and increase aggregate demand.

Question 29.
Explain the concept of ‘private cost’. (2 Marks Jan 2021)
Answer:
Private cost: Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the case of a producer his private cost includes direct cost of labour, materials, energy, and other indirect overheads.
Private Cost = Social cost – External Cost

Important Questions

Question 1.
If country X has a marginal propensity to consume of 0, what is the value of fiscal multiplier?
Answer:
Given MPC = 0;
MPS = (1 – 0) = 1
The spending multiplier = 1
There is no multiplier effect.

Question 2.
Average per capita income of country Y rose from 42,300 to 50,000 and the corresponding figures for per capita consumption rose from 35,400 to 42,500.
Find the spending multiplier for this economy.
Answer:
Spending multiplier = 1/(1 – MPC)
MPC = Increase in Consumption/Increase in Income (42,500—35,400)/(50,000 – 42,300) = 0.922
Multiplier = 1/(1 -0.922) = 12.82
= 1/(0.078)

Question 3.
Assume that the MPC is equal to 0.6.
(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on equilibrium GDP?
(c) What about a 50 billion decrease in government spending?
Answer:
(a) \(\frac{1}{1-\mathrm{MPC}}\) = \(\frac{1}{1-0.6}\) = 2.5

(b) Change in GDP = Initial Change in Spending × \(\frac{1}{1-\mathrm{MPC}}\)
Change in GDP = 50 × 2.5 = 125 billion

(c) Change in GDP = Initial Change in Spending × \(\frac{1}{1-\mathrm{MPC}}\)
Change in GDP = -50 × 2.5 = -125 billion

Question 4.
What would be the impact on GDP if both government spending and taxes are increased by 5 billion when the MPC is 0.9?
Answer:
I I
Spending Multiplier = \(\frac{1}{1-\mathrm{MPC}}\) = \(\frac{1}{1-0.9}\) = 10

Change in GDP = Initial Change in Spending × 10
= 5 × 10 = 50 billion

Tax multiplier = \(\frac{-b}{1-b}\) = \(\frac{-0.9}{1-0.9}\) = -9
Change in GDP = Initial Change in Tax × -9 = -45 billion
The net result is that output increases by 5 billion.

Determination of National Income – CA Inter Economics Study Material is designed strictly as per the latest syllabus and exam pattern.

Determination of National Income – CA Inter Economics Study Material

Theory Questions

Question 1.
Explain the leakages and injections in the circular flow of Income. (2 Marks May 2018)
Answer:
Leakages: Outflow or withdrawal of income from the circular flow is known as leakages like: savings, taxes and import etc. Leakages are money leaving the circular flow and therefore, not available for spending on currently produced goods and services. Leakages reduce the flow of income.

Injections: Addition of money in the circular flow is known as injections like: investment, government spending and export etc. It is a non-consumption expenditure. It is an expenditure on goods and services produced within the domestic territory but not used by the domestic household for consumption purposes. Injections are exogenous additions to the circular flow and add to the total volume of the basic circular flow.

In the two-sector model with households and firms, household saving is the only leakage and investment is the only injection. In the three-sector model which includes the government, saving and taxes are the two leakages and investment and government purchases are the two injections. In the four-sector model which includes foreign sector also, saving, taxes, and imports are the three leakages; investment, government purchases, and exports are the three injections.

The state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports

Question 2.
Explain the Concept of Gross National Product at market price (GNPMp). (2 Marks Nov. 2018)
Answer:
Gross National Product (GNP): Gross National product is a measure of the market value of all final economic goods and services, gross of depreciation, produced within the domestic territory of a country by normal residents during an accounting year plus net factor incomes from abroad. Thus, GNP includes earnings of Indian corporations overseas and Indian residents working overseas.
GNP_MP = GDP_MP + Net Factor Income from Abroad

Net factor income from abroad is the difference between the income received from abroad for rendering factor services by the normal residents of the country to the rest of the world and income paid for the factor services rendered by non-residents in the domestic territory of a country.

Question 3.
Distinguish between Personal Income and Disposable Personal Income. (3 Marks Nov. 2018)
Answer:
Personal Income:
Personal Income refers to the income received by the household sector including Non-Profit organisations serving households. Thus, while national income is a measure of income earned and personal income is a measure of actual current income receipts of persons from all sources which may or may not be earned from productive activities during a given period of time.

In other words, it is the income ‘actually paid out’ to the household sector, but not necessarily earned. Examples of this include transfer payments such as social security benefits, unemployment compensation, welfare payments etc. Individuals also contribute income which they do not actually receive; for example, undistributed corporate profits and the contribution of employers to social security. Personal income forms the basis for consumption expenditures and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received
PI = NI – Undistributed profits – Net interest payments made by households – Corporate Tax + Transfer Payments to the households from firms and Government

Disposable Personal Income (DI):
It is a measure of amount of the money in the hands of the individuals that is available for their consumption or savings. Disposable personal income is derived from personal income by subtracting the direct taxes paid by individuals and other compulsory payments made to the government.
DI = PI – Personal Income Taxes – Non tax payments

Question 4.
What are the conceptual difficulties in the measurement of national income? (2 Marks May 2019)
Answer:
Conceptual difficulties in the measurement of national income are:
(a) Lack of an agreed definition of national income,
(b) Accurate distinction between final goods and intermediate goods,
(c) Issue of transfer payments,
(d) Services of durable goods,
(e) Difficulty of incorporating distribution of income,
(f) Valuation of a new good at constant prices, and
(g) Valuation of government services rendered without remuneration.

Question 5.
Explain the consumption function using a suitable table and diagram. (3 Marks Nov. 2019)
Answer:
Consumption function shows the functional relationship between aggregate consumption expenditure and aggregate disposable income, expressed as:
C = f(Y)
In case of low income, consumption expenditures of households will exceed their disposable income and households dis-save i.e. they either borrow money or draw from their past savings to purchase consumption goods. If the disposable income increases, consumers will increase their planned expenditures and current consumption expenditures rise, but only by less than the increase in income. This can be illustrated with the following table and diagram: The positive relationship between consumption spending and disposable income is described by the consumption function.

Disposable Income (Yd)	Consumption (C)
0	400
1,000	1,200
2,000	2,000
3,000	2,800

The specific form of consumption income relationship termed the consumption function, proposed by Keynes is as follows:
C = a+bY
Where C = aggregate consumption expenditure; Y = total disposable income; a is a constant term which denotes the (positive) value of consumption at zero level of disposable income; and the parameter b, the slope of the function, (∆ C/ ∆ Y) is the marginal propensity to consume (MPC) i.e the increase in consumption per unit increase in disposable income.

Question 6.
Explain the circular flow of income in an economy. (3 Marks Nov. 2019)
Answer:
Circular flow of income refers to the continuous circulation of production, income generation and expenditure involving different sectors of the economy. There are three different interlinked phases in a circular flow of income, viz: production, distribution and disposition as can be seen from the following figure.

Circular Flow of Income

1. In the production phase, firms produce goods and services with the help of factor services.
2. In the income or distribution phase, the flow of factor incomes in the form of rent, wages, interest and profits from firms to the households occurs.
3. In the expenditure or disposition phase, the income received by different factors of production is spent on consumption goods and services and investment goods. This expenditure leads to further production of goods and services and sustains the circular flow.

It is clear from the above figure that income is first generated in production unit, then it is distributed to households in the form of wages, rent, interest and profit. This increases the demand for goods and services and as a result there is increase in consumption expenditure. This leads to further production of goods and services and thus make the circular flow complete. These processes of production, distribution and disposition keep going on simultaneously.

Question 7.
Clarify the concept of ‘Average Propensity to Save’ with the help of formula and example. (2 Marks Nov. 2020)
Answer:
Average propensity to save: Average Propensity to Save (APS) is the ratio of total saving to total income or we can say, it is that part of total income which is saved.
APS = Total Saving/Total Income = S/Y
For example, if saving is ₹ 200 at national income of ₹ 1,000, then:
APS = S/Y = 20/100 = 0.20, i.e. 20%
The estimation of APS is illustrated with the help of the following table:

Income	Saving	APS = S/Y	APS
0	-400	–	–
1,000	-200	(-200/1,000)	-0.20
2,000	0	(0/2,000)	0
3,000	200	(200/3,000)	0.067
4,000	400	(400/4,000)	0.10

Question 8.
Which method is used in India for measurement of National Income? Also, state the method which is considered the most suitable for measurement of National Income of the developed economies. (2 Marks Nov. 2020)
Answer:
The method is used in India for measurement of National Income: In India, the Central Statistics Office under the Ministry of Statistics and Programme Implementation is responsible for macro-economic data gathering and statistical record keeping. Since reliable statistical data are not available, it is not possible to estimate India’s national income wholly by one method.

Therefore, a combination of output method and income method is used. The value added method is used largely in the commodity producing sectors like agriculture and manufacturing. Thus, in agricultural sector, net value added is estimated by the production method, in small scale sector net value added is estimated by the income method and in the construction sector net value added is estimated by the expenditure method also.

The method which is considered suitable for measurement of National Income of developed economies: Income method may be most suitable for developed economies where data in respect of factor income are readily available. With the growing facility in the use of the commodity flow method of estimating expenditures, an increasing proportion of the national income is being estimated by expenditure method.

Practical Problems

Question 1.
Calculate Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MP$) from the following data: (2 Marks May 2018)
Income – Consumption – Level
8,000 – 6,000 – Initial Level
12,000 – 9,000 – Changed Level
Answer:
(a) MPC(b) = ∆C/∆Y
= (9,000 – 6,000) ÷ (12,000 – 8,000) = 0.75

(b) MPS = 1 – b = 1 – 0.75 = 0.25

Question 2.
Suppose in an economy: (5 Marks May 2018)
Consumption Function = 150 + 0.75 Y_d
Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) Exports (X) = 40
Imports (M) = 15 + 0.1Y
Where, Y and Y_d are National Income and Personal Disposable Income respectively. All figures are in rupees.
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level
Answer:
(a) The equilibrium level of National Income:
Y = C + I + G + (X – M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 ÷ 0.5
= 800

(b) Consumption at equilibrium level:
C = 150 + 0.75Y_d
Y_d = Y – Tax + Transfer Payments,
= Y – (20 + 0.2Y) + 40
= = 0.8Y + 20,
C = 150 + 0.75Y_d
= 150 + 0.75 (0.8Y + 20) (where Y_d = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800
= 645

(c) Net Exports at equilibrium level:
X – M = 35 – (15 + 0.1Y)
= 35 – (15 + 0.1 × 800)
= – 60
There is adverse balance of trade

Question 3.
From, the following data, compute the Gross National Product at Market Price using Value Added method: (3 Marks May 2018)
(₹ in Crores)
Value of output in secondary sector – 1,000
Intermediate consumption in primary sector – 300
Value of output in tertiary sector – 3,000
Intermediate consumption in secondary sector – 400
Net factor income from abroad – 100
Value of output in primary sector – 800
Intermediate consumption in tertiary sector – 900
Answer:
Value Added Method:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 800 – 300 + 1,000 – 400 + 3,000 – 900
= 3,200 Crores
GNP_MP = GDP_MP + NFIA = 3,200 – 100 = 3,100 Crores

Question 4.
In a two sector economy, the business sector produces 7,500 units at an average price of ₹ 7. (5 Marks Nov. 2018)
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 75 per cent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
Answer:
(a) The money value of output == 7,500 × 7 = ₹ 52,500

(b) In a two sector economy, households receive an amount equal to the money
value of output. Therefore, the money income of households is the same as the money value of output i.e 152,500.

(c) Total spending by households = ₹ 52,500 × 0.75 = ₹ 39,375

(d) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 39,3 75.

(e) The business sector makes payments of ₹ 52,500 to produce output, whereas the households purchase only output worth ₹ 3 9,3 75 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 13,125. They should be expected to decrease output.

Question 5.
Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the following data: (2 Marks Nov. 2018)
Income – 4,000
Consumption – ₹ 3,000
Answer:
APC = C/Y = 3,000/4,000 = 0.75
APS = S/Y = 1,000/4,000 = 0.25

Question 6.
Given:
Consumption function C = 300 + 0.75Y
Investment = ₹ 800
Net Imports = ₹ 100
Calculate equilibrium level of output. (3 Marks May 2019)
Answer:
Y = C + I + G + (X – M)
Y = (300 + 0.75Y) + 800 + 0 + (-100)
Y = 300 + 0.75Y + 800 – 100
0.25Y = 1,000
Y = ₹ 4,000

Question 7.
Compute GNP at factor cost and NDP at market price using expenditure method from the following data: (5 Marks May 2019)

Answer:
GDP_MP = Personal consumption expenditure + Government purchase of goods and services + gross public investment + inventory investment + gross residential construction investment + Gross business fixed investment + [export – import]
= 2,900 + 1,100 + 500 + 170 + 450 + 410 + (200 – 300) = ₹ 5,430 Crores
GNP_FC = GDP_MP + Net Factor Income from Abroad – Net Indirect Taxes
= 5,430 + (-30) + 80 = ₹ 5,480 Crores
NDP_MP = GDP_MP – Consumption of fixed capital
= 5430 – 60 = 5,370 Crores

Question 8.
When investment in an economy increases from ₹ 10,000 crores to ₹ 14,000 crores and as a result of this national income rises from ₹ 80,000 crores to ₹ 92,000 crores, compute investment multiplier. (2 Marks May 2019)
Answer:
Investment Multiplier K = ∆Y/∆I = 12,000/4,000 = 3

Question 9.
Compute the amount of subsidies from the following data: (3 Marks Nov. 2019)
GDP at market price (₹ in crores) – 7,79,567
Indirect taxes (₹ in crores) – 4,54,367
GDP at factor cost (₹ in crores) – 3,60,815
Answer:
GDP_MP = GDP_FC + Indirect taxes – Subsidies
₹ 7,79,567 crores = ₹ 3,60,815 crores + ₹ 4,54,367 crores – Subsidies
Subsidies = ₹ 35,615 crores

Question 10.
Compute NNP at factor cost or national income from the following data using income method: (3 Marks Nov. 2019)

	(₹ In Crores)
Compensation of employees	3,000
Mixed income of self-employed	1,050
Indirect taxes	480
Subsidies	630
Depreciation	428
Rent	1,020
Interest	2,010
Profit	980
Net factor income from abroad	370

Answer:
GDP_MP = Employee compensation (wages) + rent + interest + profits + mixed income + depreciation+net indirect taxes (Indirect taxes – subsidies)
= 3,000 + 1,020 + 2,010 + 980 + 1,050 + 428 + (480 – 630) = ₹ 8,338 crores
NNP_FC = GDP_MP – Net indirect taxes – Depreciation + NFIA
= 8,338 + 150 – 428 + 370 = ₹ 8,430 crores

Question 11.
Compute the amount of depreciation from the following data: (3 Marks Nov. 2020)

	(₹ in Crores)
GDP at Market Price (GDPMP) Net factor income from abroad Aggregate amount of Indirect Taxes Subsidies National Income (NNPFC)	8,76,532 (-) 232 564 30 8,46,576

Answer:
GDP_MP = NNP_FC – NFIA + NIT + Depreciation
8,76,532 = 8,46,576 – (-232) + (564 – 30) + Depreciation
8,76,532 = 8,46,576 + 232 + 534 + Depreciation
Depreciation = 29,190 Crores

Question 12.
You are given the following information of an economy:
Consumption Function: C = 200 + 060 Yd
Government Spending’ G = 150
Investment Spending I = 240
Tar Tx = 10 + 0.20Y
TransferPayrnent: Tr = 50
Exports: X = 30 + 0.2Y
Imports M = 400
Where Y and Yd are National Income and Personal Disposable Income respectIvely.

Find:
(i) The equilibrium level of National Income.
(ii) Net Exports at equilibrium level.
(iii) Consumption at equilibrium level. (5 Marks Nov. 2020)
Answer:
(i) The equilibrium level of national income:
Y = C + I + G +(X – M)
= 200 + 0.60 (40 + 0.8Y) + 240 + 150 + (30 + 0.2 Y – 400)
= 200 + 24 +.48 Y + 240 + 150 + 30 + 0.2 Y – 400
= 244 + 0.68Y
Y = 244 ÷ 0.32 . = 762.5
Yd = Y + Tr – Tax
= Y + 50 – 10 – 0.2Y
Yd = 40+0.8 Y

(ii) Net exports ai equilibrium leveL
Net X – M = 30 + 0.2Y – 400
Exports
= 30 + 0.2 (762.5) – 400 = -217.5
There is adverse balance of trade

(iii) Consumption at equilibrium level:
C = 200 + 0.60 (40 + 0.8Y)
= 200 + 24 + 0.60 (40 + 0.8 × 762.5)
= 200 + 24 + 366 = 590

Question 13.
Given the following equations:
C = 200 + 0.8Y
I = 1,200
Calculate equilibrium level of National Income and the Consumption Expenditure at equilibrium level of National Income. (3 Marks Jan. 2021)
Answer:
Y = C + I = 200 + 0.8Y + 1,200 = 1,400 + 0.8Y
Y = 1,400 ÷ 0.2 = 7,000
C = 200+ 0.8Y = 200 + 0.8 × 7,000 = 5,800

Question 14.
Calculate GNP at market price from the following data using Value Added Method. (5 Marks Jan. 2021)

	(₹ in Crores)
Government Transfer Payments	1.800
Value of output in Primary Sector	1,500
Value of output in Secondary Sector	2.700
Value of output in Tertiary Sector	2,100
Net factor income from Abroad	(-) 60
Intermediate Consumption in Primary Sector	750
Intermediate Consumption in Secondary Sector	1,200
Intermediate Consumption in Tertiary Sector	900

Answer:
GVA_MP = Value of Output – Intermediate Consumption
= 1,500 + 2,700 + 2,100 – 750 – 1,200 – 900 = 3,450 Crores
GNP_MP = GVA_MP + Net factor Income from Abroad
= 3,450 + (-) 60 = 3,390 Crores

Question 15.
Compute GDP at market price and Mixed Income of Self-Employed from the data given below: (3 Marks Jan. 2021)

	(₹ in Crores)
Compensation of Employees	810
Depreciation	26
Rent, Interest and Profit	453
NDP at factor cost	1,450
Subsidies	18
Net factor Income from Abroad	(-) 17
Indirect taxes	57

Answer:
GDP_MP = NDP_FC + Depreciation + Net Indirect Taxes
= 1,450+ 26+ (57- 18) = 1,515Crores
NDP_FC = Compensation of employees + Operating Surplus + Mixed Income of Self Employed
1,450 = 810 + 453 + Mixed Income of Self Employed
187 Crores = Mixed Income of Self Employed

Question 16.
Due to Recession in an economy, Government expenditure increases by ₹ 6 billion. If Marginal Propensity to Consume (MPC or b) in the economy is 0.8, compute the increase in GDP. (2 Murks Jan. 2021)
Answer:
Government Spending Multiplier = 1 ÷ (1 – b) = 1 ÷ (1 – 0.8) = 5
Increase in GDP = Increase in Government Expenditure × Multiplier
= 6 billion × 5 = 30 billion

Important Questions

Question 1.
The nominal and real GOP respectively of a country In a particular year are ₹ 3,000 Crores and ₹ 4,700 Crores respectively. Calculate GOP deflator and comment on the level of prices of the year In comparison with the base year.
Answer:
Nominal GDP = ₹ 3000 Crores
Real GDP = ₹ 4,700 Crores
GDP Deflator = \(\frac{\text { Nominal GDP }}{\text { Real GDP }}\) × 100
= \(\frac{3,000}{4,700}\) × 100
= 63.83
The price level has fallen since GDP deflator is less than loo at 63.83.

Question 2.
In a two sector economy, the business sector produces 7,000 units at an average price of ₹ 5.
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 80 percent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
Answer:
(a) The money value of output equals total output times the average price per unit. The money value of output is: = 7,000 × 5 = ₹ 35,000

(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore, the money income of households is the same as the money value of output i.e. 135,000.

(c) Total spending by households: =₹ 35,000 × 0.8 = ₹ 28,000

(d) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 28,000.

(e) The business sector makes payments of ₹ 35,000 to produce output, whereas the households purchase only output worth₹ 28,000 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 7,000. They should be expected to decrease output.

Question 3.
Assume that an economy’s consumption function is specified by the equation C = 500 + 0.80Y.
(a) What will be the consumption when disposable income (Y) is ₹ 4,000, ₹ 5,000, and ₹ 6,000?
(b) Find saving when disposable income is ₹ 4,000, ₹ 5,000, and ₹ 6,000.
(c) What amount of consumption for consumption function C is autonomous?
(d) What amount is induced when disposable income is ₹ 4,000, ₹ 5,000, ₹ 6,000?
Answer:
(a) Consumption for each level of disposable income is found by substituting the specified disposable income level into the consumption equation.
When Y = ₹ 4,000
C = ₹ 500 + 0.80 (₹ 4,000) = ₹ 500 + ₹ 3,200 = ₹ 3,700
When Y = ₹ 5,000
C = ₹ 500 + 0.80 (₹5,000) = ₹ 500 + ₹ 4,000 = ₹ 4,500
When Y = ₹ 6,000
C = ₹ 500 + 0.80 (₹ 6,000) = ₹ 500 + ₹ 4,800 = ₹ 5,300

(b) Saving is the difference between disposable income and consumption:
S = Y – C
= 4,000 – 3,700 = ₹ 300 (when Y is ₹ 4,000)
= 5,000 – 4,500 = ₹ 500 (when Y is ₹ 5,000)
= 6,000 – 5,300 = ₹ 700 (when Y is ₹ 6,000)

(c) Autonomous consumption is the amount consumed when disposable income is zero; autonomous consumption is ₹ 500, i.e. the consumption expenditure when the disposable income is 0. Since autonomous consumption is unrelated to income, autonomous consumption is ₹ 500 for all levels of income.

(d) Induced consumption is the amount of consumption that depends upon the level of income. Consumption is ₹ 3,700 when disposable income is ₹ 4,000. Since ₹ 500 is autonomous (i.e. consumed regardless of the income level), ₹ 3,200 out of the ₹ 3,700 level of consumption is induced by disposable income. Similarly, Induced consumption is ₹ 4,000 when disposable income is ₹ 5,000, and ₹ 4,800 when disposable income is ₹ 6,000.

Question 4.
Compute the amount of subsidies from the following data:
GDP at market price (₹ in crores) – 7,79,567
Indirect taxes (₹ in crores) – 4,54,367
GDP at factor cost (₹ in crores) – 3,60,815
Answer:
GDP_MP = GDP_FC + Indirect taxes – Subsidies
₹ 7,79,567 crores = ₹ 3,60,815 crores + ₹ 4,54,367 crores – Subsidies
Subsidies = ₹ 35,615 crores

Question 5.
Calculate the aggregate value of depreciation when the GDP at market price of a country in a particular year was ₹ 1,100 Crores. Net Factor Income from Abroad was ₹ 100 Crores, The value of Indirect taxes – Subsidies was ₹ 150 Crores and National Income was ₹ 850 Crores,
Answer:
NNP_FC = GDP_MP – NIT + NFIA – Depreciation
850 = 1,100 – 150 + 100 – Depreciation
Depreciation = 1,050 – 850 = 200 Crores

Question 6.
Calculate ‘Sales’ from the following data:

Answer:
NVA_FC = Sales + Change in stocks – Intermediate consumption – depreciation – NIT
2,000 = Sales + (600 – 100) – 3,000 – 700 – (-200)
Sales = 2,000 – 500 + 3,000 + 700 – 200 = 5,000 Lakhs

Question 7.
Compute GNP at factor cost and NDP at market price using expenditure method from the following data:

Answer:
GDP_MP = Personal consumption expenditure + Government purchase of goods and services + gross public investment + inventory investment + gross residential construction investment + Gross business fixed investment + [export-import]
= 2,900 + 1,100 + 500 + 170 + 450 + 410 + (200 – 300)
= ₹ 5,430 Crores
GNP_FC = GDP_MP + Net Factor Income from Abroad – Net Indirect Taxes
= 5,430 + (-30) + 80
= ₹ 5,480Crores
NDP_MP = GDP_MP – Consumption of fixed capital
= 5430 – 60
= ₹ 5,370 Crores

Question 8.
From the following data, calculate NNP_FC, NNP_MP, GNP_MP and GDP_MP.

Answer:
GDP_MP = Compensation of employees + mixed income of self-employed + operating surplus + depreciation + net indirect taxes
GDP_MP = 1,000 + 1,100 + 2,000 + 400+ 450 = 4,950 Crores
GNP_MP = GDP_MP + NFIA
= 4,950 + (50) = 4,900 Crores
NNP_MP = GNP_MP – Depreciation
= 4,900 – 400 = 4,500 Crores
NNP_FC = NNP_MP – Net indirect tax
= 4,500 – 450 = 4,050 Crores

Question 9.
From the following data, estimate National Income and Personal Income

Answer:
National = Net national product at market price – Indirect taxes + Subsidies Income
= 1,891 – 175 + 30 = 1,746 Crores
Personal Income = National income – Income from property and entrepreneurship accruing to government administrative departments – Saving of non-departmental enterprises + National debt interest + Current transfers from government + Current transfers from rest of the world – Saving of private corporate sector – Corporate profit tax
= 1,746 – 45 – 10 + 15 + 35 + 20 – 25 – 25
= 1,711 Crores

Question 10.
On basis of following information, calculate NNP at market price and Disposable personal income

Answer:
NNP_MP = NDP_FC + NFIA + NIT
= 14,900 + 80 + 335 – 262 = 15,053 Crores
Disposable personal income (DI):
DI = PI – Personal income tax
= NI + Income received but not earned – Income earned but not received – Personal Income Tax
= (14,900 + 80) + (170 + 60 + 30) – (150 + 222 + 105) – 100
= 14,663 Crores

Question 11.
Calculate National Income by Value Added Method with the help of following data:

Answer:
GVA_MP = Value of output- Intermediate consumption
= Sales + Change in stock – Intermediate consumption
= 700 + (400 – 500) – 350 = 250 Crores
NVA_FC = GVA_MP – Depreciation + NFIA – Net Indirect Tax
NI = 250 – 150 + 30 – (110 – 50) = 70 Crores

Question 12.
Calculate the Operating Surplus with the help of following data:

Answer:
GVA_MP = Value Output – Intermediate consumption
= (Sales + Change in stock) – Intermediate consumption
= 4,000 – 600 = 3,400 Crores
NDP_MP = GDP_MP – Consumption of Fixed capital
= 3,400 – 200 = 3,200 Crores
NDP_FC = NDP_MP – NIT
= 3,200 – 500 = 2,700 Crores
NDP_FC Compensation of employees + Operating surplus + Mixed income
2,700 = 800 + Operating Surplus + 400
Operating surplus = 1,500 Crores

Question 13.
Calculate national Income by value added method

Answer:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 2,000 – 200 + 2,800 – 800 + 1,600- 600 = 4,800 Crores
NNP_FC = GDP_MP + NFIA – NIT – Depreciation
= 4,800 + (-30) – 300 – 470 = 4,000 Crores

Question 14.
Calculate NNPFC by expenditure method with the help of following information:

Answer:
GDP_MP = Government final consumption expenditure (Public final consumption expenditure) + Private final consumption expenditure + Gross domestic capital formation (Gross domestic fixed capital formation + Change stock + Net acquisition of valuables) + Net export
= 5 + 10 + [350 + 30 + 10] + (- 20) = 385 Crores
NNP_FC = GDP_MP – Depreciation + Net factor income from abroad (Income from abroad – Income paid to abroad) – Net Indirect tax (Indirect tax – subsidies)
= 385 – 30 + [0 – 20] – [0 – 100] = 435 Crores

Question 15.
Given the following data, determine the National Income of a country using expenditure method and income method;
₹ in Crores
Private Final Consumption Expenditure – 1,000
Government Final Consumption Expenditure – 550
Compensation of Employees – 600
Net Exports – 15
Net Indirect Taxes – 60
Net Domestic Fixed Investment – 385
Consumption of Fixed Capital Formation – 65
Net Factor Income from Abroad – 10
Interest – 310
Rent – 200
Mixed Income of Self-Employed – 350
Profit – 400
Answer:
Expenditure Method:
NNP_FC = Private Final Consumption Expenditure + Net Domestic Fixed Investment + Government final consumption expenditure+Net Exports + Net factor income from abroad – Indirect Taxes
= 1,000 + 385 + 550 -15 – 10 – 60 = 1,850 Crores

Income Method:
NNP_FC = Employee compensation + Profits + Rent + Interest + Mixed income + NFIA
= 600 + 400 + 200 + 310 + 350-10 = 1,850 Crores

Question 16.
Suppose in an economy: C = 100 + b (Y – 50 – tY); I = 50; G = 50; X = 10; M = 5 + 0.1Y; MPC (b) = 0.8; Proportional income tax rate (t) = 0.25
(a) Find the equilibrium national income, foreign trade multiplier, equilibrium value of imports.
(b) If equilibrium national income falls short of full employment income by ₹ 50, how much government should increase its expenditure to attain full – employment?
Answer:
(a) Y = C + I + G + (X – M)
= 100 + b (Y – 50 – tY) + 50 + 50 + (10 – 5 – 0.1Y)
= 100 + 0.8 (Y – 50 – 0.25Y) + 105 – 0.1Y
= 100 + 0.8Y – 40 – 0.2Y + 105 – 0.1Y
= 165 + 0.5Y
Y = 165 ÷ 0.5 = 330
Foreign trade multiplier = \(\frac{1}{1-b(1-t)+m}\) = \(\frac{1}{1-0.8(1-0.25)+0.1}\) = 2
Equilibrium value of imports can be obtained by substituting the equilibrium income in the import function. Thus,
M = 5 + 0.1Y = 5 + 0.1 × 330 = 38

(b) Required increase in government expenditure to attain ₹ 50 increase in income can be obtained as under:
∆Y = Foreign trade multiplier × ∆G
= \(\frac{1}{1-b(1-t)+m}\) × ∆G
50 = 2 × ∆G
∆G = 50 ÷ 2 =25

Question 17.
Suppose the consumption function is C = 50 + 0.8Yd, I = 180 crores, G = 190 crores, T = 0.20Y
(a) Find the equilibrium level of income.
(b) Find the revenue from taxes at equilibrium. Is the government budget balanced?
(c) Find the equilibrium level of income when investment increases by 120 crores.
Answer:
(a) Y = C + I + G + (X – M)
= 50 + 0.8(Y – 0.2Y) + 180 + 190
= 420 + 0.8Y – 0.16Y
Y = 420 ÷ 0.36 = 1,166.66 Crores

(b) T = 0.2Y
= 0.2 × 1,166.66 = 233.332 Crores
G i.e. 190 < T i.e. 233.332, thus, budget is not in balance. There exists a budget Surplus.

(c) Change in Y = Change in I/(1 – b + bt)
= 120/(1 – 0.8 + 0.16)
= 120/.36 = 333.33 Crores
So new Y equilibrium
Y new = 1,166.66 + 333.33 = 1,499.99 Crores

CA Inter Costing Question Paper May 2022 – CA Inter Costing Study Material is designed strictly as per the latest syllabus and exam pattern.

CA Inter May 2022 Costing Question Paper Solution

Question 1.
Answer the following :
(a) A Limited a toy company purchases its requirement of raw material from S Limited at ₹ 120 per kg. The company incurs a handling cost of ₹ 400 plus freight of ₹ 350 per order. The incremental carrying cost of inventory of raw material is ₹ 0.25 per kg. per month. In addition the cost of working capital finance on the investment in inventory of raw material is ₹ 15 per kg. per annum. The annual production of the toys is 60,000 units and 5 units of toys are obtained from one kg. of raw material.
Required:
(i) Calculate the Economic Order Quantity (EOQ) of raw materials.
(ii) Advise, how frequently company should order to minimize its procurement cost. Assume 360 days in a year.
(iii) Calculate the total ordering cost and total inventory carrying cost per annum as per EOQ.
(b) PQR Limited has replaced 72 workers during the quarter ended 31st March 2022. The labour rates for the quarter are as follows :

Flux method	16%
Replacement method	8%
Separation method	5%

You are required to ascertain:
(i) Average number of workers on roll (for the quarter),
(ii) Number of workers left and discharged during the quarter,
(iii) Number of workers recruited and joined during the quarter,
(iv) Equivalent employee turnover rates for the year.

(c) Top-tech a manufacturing company is presently evaluating two possible machines for the manufacture of superior Pen-drives. The following information is available :

Particulars	Machine A	Machine B
Selling price per unit	₹ 400.00	₹ 400.00
Variable cost per unit	₹ 240.00	₹ 260.00
Total fixed costs per year	₹ 350 lakhs	₹ 200 lakhs
Capacity (in units)	8,00,000	10,00,000

(i) Recommend which machine should be chosen?
(ii) Would you change your answer, if you were informed that in near future demand will be unlimited and the capacities of the two machines are as follows?
Machine A – 12,00,000 units
Machine B – 12,00,000 units Why?
(d) Coal is transported from two mines X & Y and unloaded at plots in a railway station. X is at distance of 15 kms and Y is at a distance of 20 kms from the rail head plots. A fleet of lorries having carrying capacity of 4 tonnes is used to transport coal from the mines. Records reveal that average speed of the lorries is 40 kms per hour when running and regularly take 15 minutes to unload at the rail head.
At Mine X average loading time is 30 minutes per load, while at mine Y average loading time is 25 minutes per load.
Additional Information:
Drivers’ wages, depreciation, insurance and taxes, etc. 12 per hour Operated Fuel, oil tyres, repairs and maintenance, etc. ₹ 1.60 per km.
You are required to prepare a statement showing the cost per tonne kilometre of carrying coal from each mine ‘X’ and ‘Y’. (Marks 4 × 5 = 20)
Answer:
Answer the following:
(a) Ordering Cost (O) = 400 + 350 = ₹ 750
Price per kg. = ₹ 120
Carrying cost (C) = 0.25 × 12 + 15 = ₹ 18
Annual requirement (A) = \(\frac{60,000}{5}\) = 12,000
(i) EOQ = \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\)
= \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\)
= 1000 units

(ii) Frequency = 360 × \(\frac{\mathrm{EOQ}}{\mathrm{A}}\)
= 360 × \(\frac{1000}{12000}\)
= 30 days
∴ Company should order every 30 days to minimize its procure¬ment cost.

(iii) Total Ordering Cost = \(\frac{\mathrm{A}}{\mathrm{EOQ}}\) × O
= \(\frac{12000}{1000}\) × 750 = ₹ 9000

Total Inventory Carrying Cost = \(\frac{\mathrm{EOQ}}{\mathrm{A}}\) × C
= \(\frac{1000}{2}\) × 18 = ₹ 9000

(b) (i) Employee Turnover rate using Replacement Method
= \(\frac{\text { No. of Replacements }}{\text { Average No. of workers on roll }}\) × 100
\(\frac{8}{100}=\frac{72}{\text { Average No. of workers on roll }}\)
Average No. of workers on roll = 900

(ii) Employee turnover Rate (Separation Method)
= \(\frac{\text { No. of Separations(S) }}{\text { Average No. of workers on roll }}\) × 100
\(\frac{5}{100}=\frac{S}{900}\)
or S = 45
Hence, No. of workers left and discharged comes to 45.

(iii) Employee Turnover Rate (Flux Method)
= \(\frac{\text { No. of Separations }(\mathrm{S})+\text { No. of Accession(A) }}{\text { Average No. of workers on roll }}\)
\(\frac{16}{100}=\frac{45+A}{900}\)
A = 99
No. of workers joined and recruited is 99

(iv) Calculation of equivalent employee turnover ratio:

(c) (i) Statement of profit from Machine A and Machine B

	Machine A	Machine B
Capacity	8,00,000	10,00,000
Selling price p.u. (₹)	400	400
Less: Variable Lost p.u. (₹)	240	260
Contribution p.u. (₹)	160	140
Total Contribution (₹)	12,80,00,000	14,00,00,000
Less: Fixed cost (₹)	(3,50,00,000)	(2,00,00,000)
Profit (₹)	9,30,00,000	12,00,00,000

As the profit in Machine B is higher, Machine B should be selected.

(ii) Now, if the capacity for both the machine are similar, the profit under both the machine will be as under:

	Machine A	Machine B
Total Contribution (₹)	19,20,00,000 (12,00,000 × ₹ 160p.u.)	16,80,00,000 (12,00,000 × ₹ 140p.u.)
Less: Fixed cost (₹)	(3,50,00,000)	(2,00,00,000)
Profit (₹)	15,70,00,000	14,80,00,000

Therefore, as the profit under Machine A is higher, machine A will be recommended.
The profit under machine A is higher because the contribution per unit under machine A is greater as compared to machine B and the higher fixed cost in Machine A is offset by the higher contribution per unit in machine A.

(d) Calculate of cost per tonne km

	MineX	Mine Y
Driver’s wages, dep, evs, & taxes [WN-1]	₹ 18	₹ 20
Fuel, Oil, R&M [WN-2]	₹ 48	₹ 64
Total cost	₹ 66	₹ 84
Total Tonne – km	60 tonne – km	80 tonne – km
Cost per tonne km	₹ 1.1	₹ 1.05

Working Notes:
1.

	Mine X	Mine Y
Loading at mines	30 min	25 min
From mine to Rail Station	22.50 min	30 min
Unloading at Rail Station	15 min	15 min
Rail Station to mine	22.50 min	30 min
	90 min or	100 min or
	₹ 1.5 Hr	₹ 1.67 Hr.
Cost per Hour	₹ 12/Hr	₹ 12/Hr.
Total	₹ 18	₹20

2.

	Mine X	Mine Y
Total distance travelled	30 km (15 km × 2)	40 km (20 km × 2)
Cost per km	₹ 1.60	₹ 1.60
Total cost	₹ 48	₹ 64

Question 2.
(a) In a manufacturing company, the overhead is recovered as follows:
Factory Overheads: a fixed percentage basis on direct wages and Administrative overheads: a fixed percentage basis on factory cost.
The company has furnished the following data relating to two jobs undertaken by it in a period.

	Job 1 (₹)	Job 2 (₹)
Direct materials	1,08,000	75,000
Direct wages	84,000	60,000
Selling price	3,33,312	2,52,000
Profit percentage on total cost	12%	20%

You are required to :
(i) Compute the percentage recovery rates of factory overheads and administrative overheads.
(ii) Calculate the amount of factory overheads, administrative overheads and profit for each of the two jobs.
(iii) Using the above recovery rates, determine the selling price to be quoted for Job 3. Additional data pertaining to Job 3 is as follows : (10 Marks)

Direct materials	₹ 68,750
Direct wages	₹ 22,500
Profit percentage on selling price	15%

(b) Paramount Constructions Limited is engaged in construction and erection of bridges under long term contracts. It has entered into a big contract at an agreed price of ₹ 250 Lakhs subject to an escalation clause for material and labour as spelt out in the contract and corresponding actual are as follows :

Required:
(i) Prepare a statement showing admissible additional claim of material and labour due to escalation clause.
(ii) Determine the final price payable after admissible escalation claim. (5 Marks)
(c) Distinguish between Job costing and Process Costing. (Any five points of differences) (5 Marks)
Answer:
(a)
(i) Let the factory overhead recovery rate as percentage of direct wages be ‘F’ and Administrative overhead recovery rate as percentage of factory cost be ‘A’
Factory cost of jobs:
Direct materials + Direct wages + Factory overhead
For Job 101 = ₹ 1,08,000 + ₹ 84,000 + ₹ 84,000 F
For Job 102 = ₹ 75,000 + ₹ 60,000 + ₹ 60,000F
Total Cost of Jobs: Factory cost + Administrative overhead
For Job 1 = (₹ 1,92,000 + ₹ 84,000F) + (₹ 1,92,000 + ₹ 84,000F) A
= ₹ 2,97,600 [WN-1]
For Job-2 = (₹ 1,35,000 + ₹ 60,000F) + (₹ 1,35,000 + ₹ 60,000F) A
= ₹ 2,10,000 [WN-2]

The value of F & A can be found using following equations
1.92.0 + 84,000F + 1,92,000A + 84,000AF = 2,97,600 …eqn (i)
1.35.0 + 60,000F + l,35,OOOA + 60,000AF = 2,10,000 …eqn (ii)

Multiplying Equation (i) by 5 and Equation (ii) by 7

15.000A = 3,000
A = 0.2
Now put the value of ‘A’ in equation (z) to find the value of ‘F’
1,92,0 + 84000F + 1,92,000(0.2)+ 16,800F = 2,97,600
F = 0.6667
On solving the above relations: F = 0.6667 and A = 0.20
Hence, percentage recovery rates of:
Factory overheads = 66.67% of wages and Administrative overheads = 20% of factory cost.

Working note:

(ii) Statement of jobs, showing amount of factory overheads, administrative overheads and profit:

(iii) Selling price of Job 3

(b) Statement Showing Final Claim

Final Claim = (A) + (B) = 5,25,000 + 8,80,000 = ₹ 14,05,000

Statement Showing Final Price Payable

	₹ (in lakhs)
Agreed Price	250.00
Agreed Escalation
Material Cost	5.25
Labour Cost	8.80
	264.05

(c)

Job Costing	Process Costing
A Job is carried out or a product is produced by specific orders.	The process of producing the product has a continuous flow and the product produced is homogeneous.
Costs are determined for each job.	Costs are compiled on time basis ie., for production of a given accounting period for each process or department.
Each job is separate and independent of other jobs.	Products lose their individual identity as they are manufactured in a continuous flow.
Each job or order has a number and costs are collected against the same job number.	The unit cost of process is an average cost for the period.
Costs are computed when a job is completed. The cost of a job may be determined by adding all costs against the job.	Costs are calculated at the end of the cost period. The unit cost of a process may be computed by dividing the total cost for the period by the output of the process during that period.
As production is not continuous and each job may be different, so more managerial attention is required for effective control.	Process of production is usually standardized and is therefore, quite stable. Hence control here is comparatively easier.

Question 3.
(a) SR Ltd. is a manufacturer of Garments. For the first three months of financial year 2022-23 commencing on 1st April 2022, production will he constrained by direct labour. It is estimated that only 12,000 hours of direct labour hours w ill be available in each month.
For market reasons, production of either of the two garments must be at least 25% of the production of the other. Estimated cost and revenue per garment are as follows :

	Shirt (₹)	Short(₹)
Sales price	60	44
Raw Materials
Fabric @12 per metre	24	12
Dyes and cotton	6	4
Direct labour @ 8 per hour	8	4
Fixed Overhead @4 per hour	4	2
Profit	18	22

From the month of July, 2022 direct labour will no longer be a constraint. The company expects to be able to sell 15,000 shirts and 20,000 shorts in July 2022. There wrill be no opening stock at the beginning of July 2022.
Sales volumes are expected to grow at 10% per month cumulatively thereafter throughout the year. Following additional information is available:

• The company intends to carry stock of finished garments sufficient to meet 40% of the next month’s sale from July 2022 onwards.
• The estimated selling price will be same as above.

Required:
I. Calculate the number of shirts and shorts to be produced per month in the first quarter of financial year 2022-23 to maximize company’s profit.
II. Prepare the following budgets on a monthly basis for July, August and September 2022:
(i) Sales budget showing sales units and sales revenue for each product.
(ii) Production budget (in units) for each product. (10 Marks)
(b) The following data are available from the books and records of A Ltd. for the month of April 2022 :

Particulars	Amount (₹)
Stock of raw materials on 1st April 2022	10,000
Raw materials purchased	2,80,000
Manufacturing wages	70,000
Depreciation on plant	15,000
Expenses paid for quality control check activities	1000
Lease Rent of Production Assets	10,000
Administrative Overheads (Production)	15,000
Expenses paid for pollution control and engineering & maintenance	1000
Stock of raw materials on 30th April 2022	40,000
Primary packing cost	8,000
Research & development cost (Process related)	5.000
Packing cost for redistribution of finished goods	1,500
Advertisement expenses	1,300

Stock of finished goods as on 1st April 2022 was 200 units having a total cost of ₹ 28,000. The entire opening stock of finished goods has been sold during the month. Production during the month of April, 2022 was 3,000 units. Closing stock of finished goods as on 30th April, 2022 was 400 units.
You are required to :
I. Prepare a Cost Sheet for the above period showing the:
(i) Cost of Raw Material consumed
(ii) Prime Cost
(iii) Factory Cost
(iv) Cost of Production
(v) Cost of goods sold
(vi) Cost of Sales
II. Calculate selling price per unit, if sale is made at a profit of 20% on sales. (10 Marks)
Answer:
(a)

Particulars	Shirt (₹)	Short (₹)
Profit p.u (Given)	18	22
Direct Labour @18 per hour	8	4
Actual Labour hours required [i.e. Actual Cost/Cost per hour]	1 hour	0.5 hour
Profit per Labour Hour [re. Profit p.u/Actual Labour Hours]	₹ 18/hour	₹ 44/hour
Ranking	II	I

Given That Production of one garment must be 25% of the production of other
So, let the No. of units production of shorts be x
the production of shirts will be 0.25x.
→ The labour hours of shorts + labour hours of shirts must be 12,000
Now, 0.5 hours (x) + 1 hour (0.25x) = 12,000 hours
0.5x + 0.25x = 12,000
0.75x = 12,000
x = 16,000
∴ Production of Shorts will be 16,000 units and Production of Shirts will be 4,000 units.
The Profit for the first quarter will be:
16,000 units × ₹ 22 + 4,000 units × ₹ 18
= ₹ 4,24,000

(II)
(i) Sales Budget

(ii) Production Budget (Shirts)

Production Budget (Shorts)

(I) Cost Sheet: (Amount in ₹)

(II) Total no. of Units sold
= Opening + Production – Closing
= 200 + 3000 – 400
= 2800 Units

Total Selling Price

Question 4.
(a) STG Limited is a manufacturer of Chemical ‘GK’ which is required for industrial use. The complete production operation requires two processes.
The raw material first passes through Process I, where Chemical ‘G’ is produced. Following data is furnished for the month April 2022 ;

Particulars	(in kgs.)
Opening work-in-progress quantity (Material 100% and conversion 50% complete)	9.500
Material input quantity	1,05,000
Work Completed quantity	83,000
Closing work-in-progress quantity (Material 100% and conversion 60% complete)	16,500

You are further provided that:

Particulars	(in ₹)
Opening work-in-progress cost
Material cost	29,500
Processing cost	14,750
Material input cost	3,34,500
Processing cost	2,53,100

Normal process loss may be estimated to be 10% of material input. It has no realizable value. Any loss over and above normal loss is considered to be 100% complete in material and processing.
The Company transfers 60,000 kgs. of output (Chemical G) from Process I to Process II for producing Chemical ‘GK’ Further materials are added in Process II which yield 1.20 kg. of Chemical ‘GK’ for every kg. of Chemical ‘G’ introduced. The chemicals transferred to Process II for further processing are then sold as Chemical ‘GK’ for ₹ 10 per kg. Any quantity of output completed in Process I, are sold as Chemical ‘G’ @ ₹ 9 per kg.
The monthly costs incurred in Process II (other than the cost of Chemical ‘G’ are :
Input 60,000 kg. of Chemical ‘G’
Materials Cost ₹ 5,000
Processing Costs ₹ 50,000
You are required:
(i) Prepare Statement of Equivalent production and determine the cost per kg. of Chemical ‘G’ in Process I using the weighted average cost method.
(ii) Prepare a statement showing cost of Chemical ‘G’ transferred to Pro-cess II, cost of abnormal loss and cost of closing work-in-progress.
(iii) STG is considering the option to sell 60,000 kg. of Chemical ‘G’ of Process I without processing it further in Process-II. Will it be beneficial for the company over the current pattern of processing 60,000 kg. in process II ?
(Note : You are not required to prepare Process Accounts) (10 Marks)

(b) UV Limited started a manufacturing unit from 1st October, 2021. It produces designer lamps and sells its lamps at ₹ 450 per unit.
During the quarter ending on 31st December, 2021, it produced and sold
12,0 units and suffered a loss of ₹ 35 per unit.
During the quarter ending on 31st March, 2022, it produced and sold 30,000 units and earned a profit of ₹ 40 per unit.
You are required to calculate :
(i) Total fixed cost incurred by UV Ltd. per quarter.
(ii) Break Even sales value (in rupees)
(iii) Calculate Profit, if the sale volume reaches 50,000 units in the next quarter (i.e., quarter ending on 30th June, 2022). (5Marks)

(c) Journalize the following transactions assuming the cost and financial accounts are integrated: (5 Marks)

Particulars	Amount (₹)
Direct Materials issued to production	₹ 5,88,000
Allocation of Wages(Indirect)	₹ 7,50,000
Factory Overheads (Over absorbed)	₹ 2,25,000
Administrative Overheads (Under absorbed)	₹ 1,55,000
Deficiency found in stock of Raw material (Normal)	₹ 2,00,000

Answer:
(a)
(i) Statement of equivalent production

(ii) Calculation of cost per unit
Material Cost = 1 04 000 “ = ₹ 3.5/kg.
2,53,100 + 14,750 ‘
Conversion Cost = Q7 = ₹ 2.75/kg.
Cost of chemical & transferred to process II
Material cost = ₹ 3.5/kg × 60,000 kg = 2,10,000
Conversion cost = ₹ 2.75/kg × 60,000 kg = 1,65,000
= 3,75,000

Cost of abnormal loss
Material cost = ₹ 3.5/kg × 4,500 kg
Conversion cost = ₹ 2.75/kg × 4,500 kg
Cost of Closing W-I-P
Material cost = ₹ 3.5/kg × 16,500 kg
Conversion cost = ₹ 2.75/kg × 9,900 kg

(iii) If chemical G is further processed in process II Total Sales value 7,20,000
(60,000 kg × 1.2 × ₹ 10/kg)

Less: Chemical G	3,75,000
Material cost	85,000
Processing cost	50,000
	2,10,000

If chemical G is not further processed

Sales value (60,000 kg × ₹ 9)	5,40,000
Less: Material cost	(2,10,000)
Conversion cost	(1,65,000)
	1,65,000

Therefore, further processing of Chemical G will give incremental revenue of ₹ 45,000 ie. (2,10,000 – 1,65,000).

(b) Contribution p.u. = \(\frac{\text { Change in Contribution }}{\text { Change in No. of Units }}\)
Change in Contribution = (12,000 × ₹ 35) + (30,000 × ₹ 40)
= ₹ 16,20,000
Change in No. of Units = 30,000 – 12,000
= 18,000 Units
Contribution p.u. = \(\frac{₹ 16,20,000}{18,000 \text { units }}\)
= ₹ 90 p.u.
∴ P/V Ratio = \(=\frac{₹ 90}{₹ 450}\) × 100 = 20%

(i) Fixed Cost = Total Contribution + Loss
= (12,000 × ₹ 90) + (12,000 × ₹ 35)
= ₹ 10,80,000 + ₹ 4,20,000
= ₹ 15,00,000

(ii) Break Even Sales Value (in ?)
= \(\frac{\text { Fixed Cost }}{P / V \text { Ratio }}\)
= \(\frac{15,00,000}{20 \%}\)
= ₹ 75,00,000

(iii) Total Profit = Total Contribution – Fixed Cost
= (50,000 × ₹ 90) – ₹ 15,00,000
= ₹ 45,00,000 – ₹ 15,00,000
= ₹ 30,00,000

(c)
Journal Entries

Question 5.
(a) StaT Limited manufacture three products using the same production methods. A conventional product costing system is being used currently. Details of the three products for a typical period are :

Direct Labour costs ₹ 20 per hour and production overheads are absorbed on a machine hour basis. The overhead absorption rate for the period is ₹ 30 per machine hour.
Management is considering using Activity Based Costing system to ascertain the cost of the products. Further analysis shows that the total production overheads can be divided as follows :

Particulars	%
Cost relating to set ups	40
Cost relating to machinery	10
Cost relating to material handling	30
Costs relating to inspection	20
Total production overhead	100

The following activity volumes are associated with the product line for the period as a whole. Total activities for the period :

Required:
(i) Calculate the cost per unit for each product using the conventional method.
(ii) Calculate the cost per unit for each product using activity based costing method. (10 Marks)
(b) A manufacturing department of a company has employed 120 workers. The standard output of product “NPX” is 20 units per hour and the standard wage rate is ₹ 25 per labour hour.
In a 48 hours week, the department produced 1,000 units of ‘NPX’ despite 5% of the time paid being lost due to an abnormal reason. The hourly wages actually paid were ₹ 25.70 per hour.
Calculate:
(i) Labour Cost Variance
(ii) Labour Rate Variance
(iii) Labour Efficiency Variance
(iv) Labour Idle time Variance (5 Marks)
(c) RST Limited produces three joint products X, Y and Z. The products are processed further. Pre-separation costs are apportioned on the basis of weight of output of each joint product. The following data are provided for the month of April, 2022.
Cost incurred up to separation point: ₹ 10,000

You are required to :
(i) Prepare a statement showing profit or loss made by each product after further processing using the presently adopted method of apportionment of pre-separation cost.
(ii) Advise the management whether, on purely financial consideration, the three products are to be processed further or not.
Answer:
(a)
(i) Statement Showing Cost (Conventional Method)

Total Overhead = Σ Overhead Cost per unit × No. of Units
= (7,500 × ₹ 60) + (12,500 × ₹ 45) + (25,000 × ₹ 75)
= 28,87,500

Cost driver Rates

(ii) Calculate the cost per unit for each product using activity based costing method.

(b) Standard output per hour = 20 units
Standard rate (SR) = ₹ 25/Hr
Actual output = ₹ 1,000 units
Actual Hrs. (AH) = 48 Hrs – idle time (48 × 5%)
= 45.60 Hr

Standard has required for actual output (SH) = \(\frac{1,000 \text { units }}{20 \text { units } / \mathrm{hr}}\) = 50 hrs
Actual Rate (AR) = ₹ 25.70 Hr.
Idle time = ₹ 48 Hrs × 5% = 2.4 Hrs.
(i) Labour Cost Variance = SH × SR – AH × AR
= 50 × ₹ 25/Hr – 48 Hr × ₹ 25.70/Hr
= ₹ 16.40 (F).

(ii) Labour Rate Variance = AH (SR – AR)
= 48 Hrs (25 – 25.70) 1 Hr .
= ₹ 33.60 (A).

(iii) Labour Efficiency Variance = SR (SH – AH)
= 25 (50 – 45.60)
= 110(F)

(iv) Labour IDLE TIME variance = Idle time × Std. Rate (SR)
= 2.4 Hrs × 25 = 60 (A).

(c)
(i) Statement showing profit and loss of each product if products are processed further:

(ii) Statement showing profit/loss if products are not processed further

Therefore,

As clearly visible that further processing of Products X & Z to be incremental benefit, so it should be processed further.
However, Product Y should not be processed further as it leads to loss, so it should be sold at separation point.

Question 6.
Answer any four of the following :
(a) Briefly explain the essential features of a good Cost Accounting System.

(b) Write down the treatment of following items associated with purchase of materials.
(i) Cash discount
(ii) IGST
(iii) Demurrage
(iv) Shortage
(v) Basic Custom Duty

(c) Explain the treatment of Overtime Premium in following situations:
(i) SV & Co. wants to grab some special orders, and overtime is required to meet the same.
(ii) Dept. X has to work overtime to make up a shortfall in produc¬tion due to some fault of management in dept. Y.
(iii) S Ltd. has to work overtime regularly throughout the year as a policy due to the workers’ shortage.
(iv) Due to flood in Odisha, RS Ltd. has to work overtime to com¬plete the job.
(v) A customer requested the company MN Ltd. to expedite the job because of his urgency of work.

(d) Discuss briefly some of the criticism which may be levelled against the Standard Costing System.

(e) Identify the methods of costing from the following statements:
(i) Costs are directly charged to a group of products.
(ii) Nature of the product is complex and method cannot be ascertained.
(iii) Cost is ascertained for a single product.
(iv) All costs are directly charged to a specific job.
(v) Costs are charged to operations and averaged over units pro-
Answer:
(a) The essential features, which a good cost accounting system should possess, are as follows:

• Informative and simple: Cost accounting system should be tailor-made, practical, simple and capable of meeting the requirements of a business concern. The system of costing should not sacrifice the utility by introducing inaccurate and unnecessary details.
• Accurate and authentic: The data to be used by the cost accounting system should be accurate and authenticated; otherwise it may distort the output of the system and a wrong decision may be taken.
• Uniformity and consistency: There should be uniformity and consistency in classification, treatment and reporting of cost data and related information. This is required for benchmarking and comparability of the results of the system for both horizontal and vertical analysis.
• Integrated and inclusive: The cost accounting system should be integrated with other systems like financial accounting, taxation, statistics and operational r esearch etc. to have a complete overview and clarity in results.
• Flexible and adaptive: The cost accounting system should be flexible enough to make necessary amendment and modifications in the system to incorporate changes in technological, reporting, regulatory and cither requirements.
• Trust on the system: Management should have trust on the system and its output. For this, an active role of management is required for the development of such a system that reflects a strong conviction in using information for decision making.

(b) (i) Cash discount will be treated as an income and will be credited to P/I. A/c
(ii) Amount of IGST will have no effect on the value of purchase. It shall be excluded from the value of Materials, if already included.
(iii) Demurrage
(iv) The value of shortage will be excluded from the value of materials and be charged to P/L A/c
(v) Basic Custom Duty will be added to the purchase amount.

(c)
(i) Overtime premium will be including in the cost of order
(it) Since the overtime was required due to the fault of management in Department Y, such overtime premium will be charged to overheads of Department Y.
(iii) Overtime premium will be added to the cost of contract
(iv) Overtime premium will be charged to costing P/L A/c
(v) Overtime premium will be including in the cost of order

(d) The following are some of the criticism which may be levelled against the standard costing system. The arguments have been suitably answered as stated against each by advocates of the standard costing and hence they do not invalidate the usefulness of the system to business enterprises.

• Variation in price: One of the chief problems faced in the operation of the standard costing system is the precise estimation of likely prices or rate to be paid. The variability of prices is so great that even actual prices are not necessarily adequately representative of cost. But the use of sophisticated forecasting techniques should be able to cover the price fluctuation to some extent. Besides this, the system provides for isolating uncontrollable variances arising from variations to be dealt with separately.
• Varying levels of output: If the standard level of output set for pre-determination of standard costs is not achieved, the standard costs are said to be not realised. However, the statement that the capacity utilisation cannot be precisely estimated for absorption of overheads may be true only in some industries of jobbing type. In vast majority of industries, use of forecasting techniques, market research, etc., help to estimate the output with reasonable accuracy and thus the variation is unlikely to be very large. Prime cost will not be affected by such variation and, moreover, variance analysis helps to measure the effects of idle time.
• Changing standard of technology: In case of industries that have frequent technological changes affecting the conditions of pro¬duction, standard costing may not be suitable. This criticism does not affect the system of standard costing. Cost reduction and cost control is a cardinal feature of standard costing because standards once set do not always remain stable. They have to be revised.
• Attitude of technical people: Technical people are accustomed to think of standards as physical standards and, therefore, they will be misled by standard costs. Since technical people can be educated to adopt themselves to the system through orientation courses, it is not an insurmountable difficulty.
• Mix of products: Standard costing presupposes a pre-determined combination of products both in variety and quantity. The mix¬ture of materials used to manufacture the products may vary in the long run but since standard costs are set normally for a short period, such changes can be taken care of by revision of standards.
• Level of Performance: Standards may be either too strict or too liberal because they may be based on (a) theoretical maximum efficiency, (b) attainable good performance or (c) average past performance. To overcome this difficulty, the management should give thought to the selection of a suitable type of standard. The type of standard most effective in the control of costs is one which represents an attainable level of good performance.
• Standard costs cannot possibly reflect the true value in exchange:
  If previous historical costs are amended roughly to arrive at estimates for ad /zocpurposes, they are not standard costs in the strict sense of the term and hence they cannot also reflect true value in exchange. In arriving at standard costs, however, the economic and technical factors, internal and external, are brought together and analysed to arrive at quantities and prices which reflect opti¬mum operations. The resulting costs, therefore, become realistic measures of the sacrifices involved.
• Fixation of standards may be costly: It may require high order of skill and competency. Small concerns, therefore, feel difficulty in the operation of such system.

(e) (i) Batch Costing
(ii) Standard Costing
(iii) Unit Costing
(iv) Job Costing
(v) Process Costing

Public Finance Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

Public Finance Notes – CA Inter ECO Notes

1. Richard Musgrave’s Three Branch Taxonomy on Public Finance:
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch taxonomy of the role of government in a market economy:

• Resource Allocation (efficiency),
• Income Redistribution (fairness), and
• Macroeconomic Stabilization.

2. The Allocation Function:
Resource allocation refers to the way in which the available factors of production are allocated among the various uses to which they might be put. One of the most important functions of an economic system is the optimal or efficient allocation of scarce resources so that the available resources are put to their best use and no wastages are there.

3. Main Reasons of Need of Efficient Allocation:

• Imperfect competition and presence of monopoly power,
• Markets typically fail to provide collective goods,
• Externalities,
• Factor immobility which causes unemployment and inefficiency,
• Imperfect information, and
• Inequalities in the distribution of income and wealth.

4. State/Government and Allocation:
The allocative function in budgeting determines who and what will be taxed as well as how and on what the government revenue will be spent. It is con-cerned with the provision of public goods and the process by which the total resources of the economy are divided among various uses and an optimum mix of various social goods (both public goods and merit goods).

5. Allocation Instruments:

• Government may directly produce the economic good,
• Government may influence private allocation through incentives and disincentives,
• Government may influence allocation through its competition policies, merger policies etc.,
• Governments’ regulatory activities such as licensing, controls, minimum wages etc.,
• Government sets legal and administrative frameworks, and
• Any of a mixture of intermediate techniques may be adopted by gov-ernments.

6. Redistribution Function:
It is concerned with the adjustment of the distribution of income and wealth so as to ensure distributive justice namely, equity and fairness. The distribution function also relates to the manner in which the effective demand over the economic goods is divided among the various individual and family spending units of the society.

7. Aim of Redistribution Function:

• To achieve an equitable distribution of societal output among households,
• Advancing the well-being of all,
• Providing equality in income, wealth and opportunities,
• Providing security for people who have hardships, and
• Ensuring that everyone enjoys a minimal standard of living.

8. Redistribution Function Performed By Government:

• Progressive taxation of the rich and subsidy to the poor households,
• Financing public services, especially those-that benefit low-income households,
• Employment reservations and preferences,
• Regulation of the manufacture and sale of certain products to ensure the health and well-being of consumers, and
• Special schemes for backward regions and for the vulnerable sections.

9. Stabilization Function:
The stabilization function is one of the key functions of fiscal policy and aims at eliminating macroeconomic fluctuations arising from suboptimal allocation.

10. Concern of Stabilization Function:

• Labour employment and capital utilization,
• Overall output and income,
• General price levels,
• Balance of international payments, and
• The rate of economic growth.

11. The Concept of Market Failure:
Market failure is a situation in which the free market leads to misallocation of society’s scarce resources in the sense that there is either overproduction or underproduction of particular goods and services leading to a less than optimal outcome. There are four major reasons for market failure. They are:

• Market power,
• Externalities,
• Public goods, and
• Incomplete information.

12. Market Power or Monopoly Power:
Market power or monopoly power is the ability of a firm to profitably raise the market price of a good or service over its marginal cost.

13. Externalities:
Sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part of the market price. Such costs or benefits which are not accounted for by the market price are called externalities because they are “external” to the market. The four possible types of externalities are:

• Negative production externalities,
• Positive production externalities,
• Negative consumption externalities, and
• Positive consumption externalities.

1. Negative production externalities: A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production.
2. Positive production externalities: A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption.
3. Negative consumption externalities: A negative consumption external-ities initiated in consumption which imposes an external cost on others may be received by another in consumption or in production.
4. Positive consumption externalities: A positive consumption externality initiated in consumption that confers external benefits on others may be received in consumption or in production.

14. Private Cost and Social Cost:
Private cost includes direct cost of labour, materials, energy and other indirect overheads.
Social Cost = Private Cost + External Cost

15. Public Goods/Collective Consumption Goods/Social Goods:
Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’is usually recognized as the first economist to develop the theory of public goods.

A public good (also referred to as collective consumption good or social good) is defined as one which all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtraction from any other individuals’ consumption of that good.

16. Classification of Public Goods:

	Excludable	Non-excludable
Rivalrous	A Private goods: Food, clothing, cars etc.	B Common resources: Fish stocks, forest resources, coal etc.
Non-rivalrous	C Club goods: Cinemas, private parks, satellite television etc.	D Pure public goods: National defence

17. Pure Public Goods: Which perfectly satisfy non-rivalness and non-ex-cludability.

18. Impure Public Goods:
Hybrid goods that possess some features of both,public and private goods. These goods are partially rivalrous or congestible.

• Club goods; first studied by Buchanan, Examples: Swimming pools, fitness centres etc.
• Variable use public goods; first analyzed by Oakland and Sandmo, Examples: Roads, bridges etc. They can be excludable or non excludable.

19. Quasi Public Goods (Mixed Goods) or Near Public Goods:
Possess nearly all of the qualities of the private goods and some of the benefits of public good.
Examples: Education, health services etc.

20. Common Access Resources or Common Pool Resources:
Non-excludable and rival in nature. Some important natural resources fall into this category.

21. Global Public Goods:
There are several public goods benefits of which accrue to everyone in the world. The WHO delineates two categories of global public goods:

• Final public goods which are ‘outcomes’, and
• Intermediate public goods, which contribute to the provision of final public goods.

World Bank identifies five areas of global public goods:

• The environmental commons,
• Communicable diseases (including HIV/AIDS, COVID-19),
• International trade,
• International financial architecture, and
• Global knowledge for development.

22. Free Rider Problem:
Free riding is benefiting from the actions of others without paying. Due to free-rider problem, the following two outcomes are possible:

• No public good,
• Under production public goods.

23. Incomplete Information:
Complete information is an important element of competitive market. Perfect information implies that both buyers and sellers have complete information about anything that may influence their decision making.

24. Asymmetric Information and Lemons (poor items in market) Problem:
Asymmetric information occurs when there is an imbalance in information between buyer and seller.

25. Adverse selection:
A situation in which asymmetric information about quality eliminates high- quality goods from a market.

26. Moral Hazard:
An informed person’s taking advantage of a less-informed person through an unobserved action. It arises from lack of information about someone’s future behaviour.

27. Government Intervention to Minimize Market Power:

• By establishing rules and regulations,

For example, in India, we have the Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007)

• Price regulation in the form of setting maximum prices that firms can charge,
• Determines an acceptable price, called as rate-of-return regulation,
• Setting price-caps based on the firm’s variable costs, past prices, and possible inflation and productivity growth.

28. Government Intervention to Correct Externalities:

Direct Controls:

• Prohibit specific activities or limited to a certain level,
• Stringent rules are in place in respect of tobacco advertising, packaging and labelling etc.,
• Governments may pass laws to alleviate the effects of negative exter-nalities,
• Government stipulated environmental standards are rules. For example, India has enacted the Environment (Protection) Act, 1986.

The Market Based Approaches:

• Setting the price directly through a pollution tax (Pigouvian taxes),
• Setting the price indirectly through the establishment of a cap-and-trade system (tradable emissions permits).

29. In Case of Positive Externalities:
Subsidies involve government paying part of the cost to the firms in order to promote the production of goods having positive externalities.

30. Government Intervention in the Case of Merit Goods:

• Merit goods are goods which are deemed to be socially desirable.
  Examples:Education, health care, welfare services, fire protection, waste management, public libraries, museum and public parks etc.
• Free of cost direct provision of merit goods by government.

31. Government Intervention in the Case of Demerit Goods:

• At the extreme, government may enforce complete ban,
• Negative advertising campaigns,
• Prohibit the advertising or promotion of demerit goods,
• Strict regulations to limit access to the good,
• Regulatory controls in the form of spatial restrictions e.g. smoking in public places,
• Imposing unusually high taxes,
• Fix a minimum price.

32. Government Intervention in the Case of Public Goods:

• Direct provision of a public good (free of cost),
• Excludable public goods can be provided by government and the same can be financed through entry fees.
• Grant licenses to private firms to build a public good facility.

33. Price Intervention:

Price controls may take the form of either:

• A price floor (a minimum price buyers are required to pay), or
• A price ceiling (a maximum price sellers are allowed to charge for a good or service).

34. Government Intervention for Correcting Information Failure:

• Accurate labelling and content disclosures by producers,
• Public dissemination of information,
• Regulation of advertising and setting of advertising standards.

35. Government Intervention for Equitable Distribution:

• Progressive income tax,
• Targeted budgetary allocations,
• Unemployment compensation,
• Transfer payments,
• Subsidies,
• Social security schemes,
• Job reservations,
• Land reforms,
• Gender sensitive budgeting etc.

36. Government Failure in Intervention:

• Cost of intervention is higher than benefit from intervention,
• Intervention produces fresh and more serious problems.

37. Objectives of Fiscal Policy:

• Achievement and maintenance of full employment,
• Maintenance of price stability,
• Acceleration of the rate of economic development, and
• Equitable distribution of income and wealth.

38. Automatic Stabilizers Versus Discretionary Fiscal Policy:

• In automatic or non-discretionary fiscal policy, the tax policy and ex-penditure pattern are so framed that taxes and government expenditure automatically change with the change in national income.
• Discretionary fiscal policy refers to deliberate policy actions on the part of government to change the levels of expenditure, taxes to influence the level of national output, employment and prices.

39. Instruments of Fiscal Policy:

• Taxes,
• Government expenditure,
• Public debt, and
• Budget.

40. Government Expenditure as an Instrument of Fiscal Policy:

Government expenditures include:

• Current expenditures to meet the day to day running of the government,
• Capital expenditures (capital equipments and infrastructure), and
• Transfer payments.

41. Taxes as an Instrument of Fiscal Policy:

• During recession and depression, the tax policy is framed to encourage private consumption and investment,
• During inflation, new taxes can be levied and the rates of existing taxes are raised to reduce disposable incomes and to wipe off the surplus purchasing power.

42. Public Debt as an Instrument of Fiscal Policy:

• Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy,
• Repayments of debt by governments increase the availability of money in the economy and increase aggregate demand.

43. Budget as an Instrument of Fiscal Policy:

• A balanced budget will have no net effect on aggregate demand,
• A budget surplus has a negative net effect on aggregate demand since leakages exceed injections,
• A budget deficit has a positive net effect on aggregate demand since total injections exceed leakages from the government sector.

44. Types of Fiscal Policy:

• Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction,
• Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely to induce inflation.

45. Fiscal Policy for Reduction in Inequalities of Income and Wealth:

• A progressive direct tax system,
• Indirect taxes can be differential,
• A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer sections of the society.

46. Crowding Out:
An increase in the size of government spending during recessions will ‘crowd- out- private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic growth.

Determination of National Income Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

Determination of National Income Notes – CA Inter ECO Notes

1. Meaning of National Income:

• National Income Accounting, pioneered by the Nobel prize-winning economists Simon Kuznets and Richard Stone, is one such measure.
• National Income is defined as the net value of all economic goods and services produced within the domestic territory of a country in an ac-counting year plus the net factor income from abroad.

2. Usefulness and Significance of National Income Estimates:

• Framework for analyzing and evaluating the short-run performance of an economy
• Pattern of demand for goods and services
• Economic welfare
• Quantitative basis for assessing and choosing economic policies
• Throw light on income distribution
• Assist in determining eligibility for loans etc.
• A guide to make policies for growth and inflation
• Forecasting about the future development trends of the economy

3. Different Concepts of National Income:
Market Price = Factor Cost + Net Indirect Taxes = Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price – Net Indirect Taxes = Market Price – Indirect Taxes + Subsidies
Net Indirect Taxes = Indirect Taxes – Subsidies
Gross = Net + Depreciation
Net = Gross – Depreciation
GDP_MP = Value of Output in the Domestic Territory – Value of Intermediate Consumption
Or
GDP_MP = Σ Value Added

• The basis of distinction between ‘gross’and ‘net’is depreciation or con-sumption of fixed capital.
• If NFIA is positive, then National Income will be greater than domestic factor incomes.

4. Few Important Points While Learning About National Income:

• The value of only final goods and services or only the value added is considered.
• ‘Value Added’ means the difference between value of output and pur-chase of intermediate goods.
• Consumption of fixed assets is ignored.
• Production of agriculture, forestry and fishing which are used for own consumption of producers is also included.
• Economic activities, include all human activities which create goods and services that are exchanged in a market and valued at market price.
• Non-economic activities are not considered e.g. hobbies, housekeeping and child-rearing services of home makers and services of family members that are done out of love and affection.
• National income is a ‘flow’ measure of output per time period (like 1 year).
• The net change in inventories may be positive or negative.

5. Nominal GDP VS Real GDP (GDP at Current and Constant Prices):

• GDP in terms of current market prices, termed ‘nominal GDP’ or ‘GDP at current prices’,
• ‘Real GDP’ or ‘GDP at constant prices’ which is the value of domestic product in terms of constant prices

6. Per Capita Income:
GDP_FC per capita = GDP_FC ÷ Population

7. Personal Income (PI):

PI = NI + Income received but not earned – Income earned but not received

PI = NI – Undistributed profits – Net interest payments made by households – Corporate Tax + Transfer Payments to the households from firms and Government

PI = Factor income from net domestic product accruing to the private sector + Net factor income from abroad + National debt interest + Current transfers from government + Other net transfers from the rest of the world – Undistributed profits – Corporate Tax

8. Disposable Personal Income (DI):
DI = PI – Personal Income Taxes – Non-tax payments
Two more concepts need to be understood, namely:

(a) Net National Disposable Income (NNDI)

NNDI = Net National Income + Other net current transfers from the rest of the world (Receipts less payments)
= NNI + Net taxes on income and wealth receivable from abroad + Net social contributions and benefits receivable from abroad.

(b) Gross National Disposable Income (GNDI)

GNDI = NNDI + CFC (Consumption of fixed capital)
= GNI + Other net current transfers from the rest of the world (Receipts less payments) (Other Current Transfers refer to current transfers other than the primary incomes)

9. Categories of Domestic Income:

• Income from domestic product accruing to the public sector which includes income from property and entrepreneurship accruing to gov-ernment administrative departments and savings of non-departmental enterprises.
• Income from domestic product accruing to private sector = NDPFC – Income from property and entrepreneurship accruing to government administrative departments – Savings of non-departmental enterprises.

10. Private Income:
Private Income = Factor income from net domestic product accruing to the private sector + Net factor income from abroad + National debt interest + Current transfers from government + Other net transfers from the rest of the world.

Private Income = Personal Income + Undistributed Profit + Corporate tax

11. There are many reasons to dispute the validity of GDP as a perfect measure of well being:

• Income distributions and, therefore, GDP per capita is a completely inadequate measure of welfare.
• Quality improvements in systems and processes are ignored.
• Productions hidden from government authorities.
• Non-market production and Non-economic contributors to well-being.
• The disutility of loss of leisure time.
• Economic ‘bads’.
• The volunteer work and services rendered without remuneration.
• Many things such as, leisure time, fairness, gender equality, security of community feeling etc.
• Both positive and negative externalities.
• The distinction between production that makes us better off and pro-duction that only prevents us from becoming worse off.

12. The Circular Flow of Income:

13. Value Added Method or Product Method or Industrial Origin Method or Net Output Method:

Step 1: All the producing enterprises are broadly classified into three main sectors namely:

(a) Primary sector,
(b) Secondary sector, and
(c) Tertiary sector or service sector

Step 2: Estimating the gross value added (GVA_MP) by each producing enterprise:
GDP/GVA_MP = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption

Step 3: Estimation of National income for each individual unit and then Na-tional Income:
NDP/NVA_MP = (GVA_MP) – Depreciation
NDP/NVA_FC = NVA_MP – Net Indirect taxes
NI/NNP_FC = NVA_FC + NFIA

14. Income Method or Factor Payment Method or Distributed Share Method:
National income is calculated by summation of factor incomes paid out by all production units within the domestic territory of a country as wages and salaries, rent, interest, and profit. By definition, it includes factor payments to both residents and non- residents.

NDP_FC = Sum of factor incomes paid out by all production units within the domestic territory of a country
NNP_FC/NI = Compensation of employees + Operating Surplus (rent + interest + profit) + Mixed Income of Self- employed + NFIA

15. Expenditure Method:
Under this method, National income is calculated by summation of following items:

1. Final Consumption Expenditure:
(a) Private Final Consumption Expenditure (PFCE)
(b) Government Final Consumption Expenditure
2. Gross Domestic Capital formation
3. Net Exports

GDP_MP = Final consumption expenditure + Gross domestic capital formation + Net Expon
GNP_MP = GDP_MP + NFIA
GNP_FC = GNPMP – Net indirect taxes
NNP_FC or NI = GNP_FC – Depreciation

16. National Income as per Keynes:
A comprehensive theory of National Income was first put forward by the British economist John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936.

The Keynesian theory of income determination is presented in three models:

• The two-sector model consisting of the household and the business sectors,
• The three-sector model consisting of household, business and government sectors, and
• The four-sector model consisting of household, business, government and foreign sectors.

17. The Simple Two Sector Economy Model Assumes:

• Only two sectors in the economy viz., households and firms,
• Only consumption and investment outlays,
• Households own all factors of production,
• They sell their factor services to earn factor incomes,
• They do not save,
• No corporations, corporate savings or retained earnings,
• Y = Y_d
• No government, no taxes, no government expenditure or transfer payments,
• The economy is a closed economy, i.e., foreign trade does not exist.
  Factor Payments = Household Income = Household Expenditure = Total Receipts of Firms = Value of Output

18. The Aggregate Demand Function (AD): Two-Sector Model:

Aggregate demand (AD) or aggregate expenditure consists of only two components:

(i) Aggregate demand for consumer goods (C), and
(ii) Aggregate demand for investment goods (I)
AD = C + I (constant investment)

19. The Consumption Function (C):
C = f(Y)
According to Keynes:
C = a + bY
C = Aggregate consumption expenditure;
Y = Total disposable income;
a = Consumption at zero level of disposable income;
b = The slope of the function, (ΔC/ΔY)

20. Marginal Propensity to Consume (MPC) ‘b’: MPC(b) = ΔC /ΔY

21. Average Propensity to Consume (APC): APC = C/Y
22. The Saving Function (S): S = f(Y)
S = Y – C

23. The Marginal Propensity to Save (MPS): MPS(1 – b) = ΔS/ΔY

• MPC is always less than unity, but greater than zero, i.e., 0 < b < 1
• MPC + MPS = 1

24. Average Propensity to Save (APS): APS = S/Y

25. Relationship Between Income and Consumption:

26. The Consumption and Saving Function:
Since C+ S = Y, the national income equilibrium can be written as:
Y = C + I
CPS = C + I, or S = I

27. Determination of Equilibrium Income: Three Sector Model:
Y = C + I + G

28. Determination of Equilibrium Income: Four Sector Model:
Y = C + I + G + (X – M)

29. Effects on Income when Imports are Greater than Exports: National income will decrease.

30. The Investment Multiplier (k)

In two sector model:
k = ΔY/ΔI or ΔY = k × Δl
ΔY/ΔI = 1/1-MPC = 1/MPS

In three sector model;
k = \(\frac{1}{1-b(1-t)}\)

In four sector model:
k = \(\frac{1}{1-b(1-t)+m}\)