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Q.'Purchase of goods ₹ 35,000 for cash will increase the operating ratio.' Is the statement correct ? Give reasons.

CBSECBSE Class XII Board 2020Subjective· 1mImportance★★★★★
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The statement is incorrect. A cash purchase of goods is an asset conversion (cash to inventory) and does not immediately affect the Cost of Revenue from Operations, Operating Expenses, or Revenue from Operations, thus leaving the Operating Ratio unchanged.

The question asks whether a cash purchase of goods will increase the operating ratio. To answer this, we first need to understand what the Operating Ratio is and how its components are calculated.

The Operating Ratio is a profitability ratio that measures the operational efficiency of a business. It indicates the proportion of revenue from operations that is consumed by operating costs. A lower operating ratio generally indicates better operational efficiency.

Operating Ratio = Cost of Revenue from Operations+Operating ExpensesRevenue from Operations×100\frac{\text{Cost of Revenue from Operations} + \text{Operating Expenses}}{\text{Revenue from Operations}} \times 100

Let's break down each component:

  1. Cost of Revenue from Operations (or Cost of Goods Sold - COGS): This represents the direct costs attributable to the production of the goods sold by a company. It includes opening stock, purchases, direct expenses, less closing stock. Crucially, this cost is recognized only when the goods are sold.
  2. Operating Expenses: These are expenses incurred in the normal course of business operations, other than the cost of goods sold. Examples include administrative expenses, selling and distribution expenses, and employee benefits expenses.
  3. Revenue from Operations (or Net Sales): This is the revenue earned from the primary activities of the business, typically from the sale of goods or services.

Now, let's analyze the impact of "Purchase of goods ₹ 35,000 for cash" on each component of the Operating Ratio.

Impact of "Purchase of goods ₹ 35,000 for cash"

  1. Impact on Cost of Revenue from Operations:

    When goods are purchased for cash, the accounting entry is:

    • Purchases A/c Dr.
    • To Cash A/c Cr. This transaction increases the 'Purchases' figure. However, the Cost of Revenue from Operations (COGS) is calculated as: COGS = Opening Stock + Net Purchases + Direct Expenses - Closing Stock. If goods worth ₹35,000 are purchased but not yet sold, they become part of the Closing Stock. Therefore, the increase in 'Purchases' is offset by an equivalent increase in 'Closing Stock'. For example, if Purchases increase by ₹35,000 and Closing Stock also increases by ₹35,000, the net effect on COGS is zero. COGS is only affected when the goods are sold. A mere purchase does not change the COGS for the period unless those goods are immediately sold.

  2. Impact on Operating Expenses:

    A purchase of goods is a direct cost related to the inventory, not an operating expense like salaries, rent, or advertising. Therefore, operating expenses remain unchanged.

  3. Impact on Revenue from Operations:

    A purchase of goods does not generate revenue. Revenue from Operations (sales) is generated when goods are sold. Therefore, Revenue from Operations remains unchanged.

Conclusion

Since the "Purchase of goods ₹ 35,000 for cash" does not immediately affect the Cost of Revenue from Operations, Operating Expenses, or Revenue from Operations, both the numerator (Cost of Revenue from Operations + Operating Expenses) and the denominator (Revenue from Operations) of the Operating Ratio remain unchanged.

Therefore, the Operating Ratio will remain the same. The statement that it will increase is incorrect.

Watch out

It is a common mistake to assume that an increase in purchases directly increases the Cost of Revenue from Operations. Remember, COGS is linked to sales, not just purchases. If purchased goods are not sold, they remain as inventory and do not impact COGS in the current period.

Working Notes

Let's illustrate with a hypothetical example:

Scenario 1: Before the purchase of goods

| Particulars | Amount (₹) |

| :-------------------------- | :--------- | …

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