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TALDA LEARNING CENTRE
Talda Learning Centre, Shop No. 70, 2nd Floor,
Gulshan Towers, Jaistambh, Amravati
Contact: 7030296420, 07212566909
CA IPC & CS EXECUTIVE
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“KOI PAGAL HI HOGA JO ISE IGNORE KAREGA”
CA AMIT TALDA
(For Private Circulation Only)
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TALDA LEARNING CENTRE
All Subjects with
-----ABOUT THE FACULTY-----
Amit Talda; B.com; CA
First attempt Chartered Accountant at the age of 21.
Worked in ICICI Bank, Corporate Office, Mumbai for around 15 months as a Risk Analyst.
Secured 100 marks in Accountancy & 92 marks in Economics in HSSC.
Highest marks in Amravati in CPT (May 2007).
48th Rank in PCC (June 2009) (Secured 93 marks in Advanced Accounts)
Attended 6 week residential training conducted by ICAI, Centre of Excellence, Hyderabad.
Currently in Practice having works related to Accounting, Income tax Planning, Project
Financing, Legal Advisory, etc.
Teaching Experience of more than 2 years.
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THEORY OF COST ACCOUNTING
Objectives Of Cost Accounting
The main objectives of Cost Accounting are as follows :
There are two methods of ascertaining costs, viz., Post Costing and
Post Costing means, analysis of actual information as recorded in
financial books. It is accurate and is useful in the case of ―Cost plus
Contracts‖ where price is to be determined finally on the basis of actual
Continuous Costing, aims at collecting information about cost as and
when the activity takes place so that as soon as a job is completed the
cost of completion would be known. This involves careful estimates
being prepared of overheads. In order to be of any use, costing must be a
Though the selling price of a product is influenced by market
conditions, which are beyond the control of any business, it is still
possible to determine the selling price within the market constraints.
For this purpose, it is necessary to rely upon cost data supplied by Cost
Cost Control And
To exercise cost control, broadly speaking the following steps should
(i) Determine clearly the objective, i.e., pre-determine the desired results;
(ii) Measure the actual performance;
(iii) Investigate into the causes of failure to perform according to plan;
(iv) Institute corrective action.
Cost Reduction The three-fold assumptions involved in the definition of cost reduction
may be summarized as under :
(a) There is a saving in unit cost.
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if
Profit Of Each
The profit of any activity can be ascertained by matching cost with the
revenue of that activity. The purpose under this step is to determine
costing profit or loss of any activity on an objective basis.
Decision making is defined as a process of selecting a course of action out
of two or more alternative courses. For making a choice between different
courses of action, it is necessary to make a comparison of the
outcomes, which may be arrived under different alternatives. Such a
comparison has only been made possible with the help of Cost Accounting
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ADVANTAGES OF A COST ACCOUNTING SYSTEM :
Important advantages of a Cost Accounting System may be listed as below:
1. Identify Unprofitable Activities or Products: A good Cost Accounting System helps in
identifying unprofitable activities, losses or inefficiencies in any form.
2. Reduces Cost: The application of cost reduction techniques, operations research techniques
and value analysis technique, helps in achieving the objective of economy in concern‘s
3. Identification of Root Causes: Cost Accounting is useful for identifying the exact causes for
decrease or increase in the profit/loss of the business. It also helps in identifying unprofitable
products or product lines so that these may be eliminated or alternative measures may be taken.
4. Helps in Decision Making: It provides information and data to the management to serve as
guides in making decisions involving financial considerations. Guidance may also be given by
the Cost Accountant on a host of problems such as, whether to purchase or manufacture a
given component, whether to accept orders below cost, which machine to purchase when a
number of choices are available.
5. Helps in Price Fixation: Cost Accounting is quite useful for price fixation. It serves as a guide
to test the adequacy of selling prices. The price determined may be useful for preparing estimates
or filling tenders.
6. Cost Control: The use of cost accounting technique viz., variance analysis, points out the
deviations from the pre-determined level and thus demands suitable action to eliminate such
deviations in future. Cost comparison helps in cost control. Such a comparison may be made
from period to period by using the figures in respect of the same unit of firms or of several units
in an industry by employing uniform costing and inter-firm comparison methods. Comparison
may be made in respect of costs of jobs, processes or cost centres.
7. Helps in Compliances: A system of costing provides figures for the use of Government, Wage
Tribunals and other bodies for dealing with a variety of problems. Some such problems include
price fixation, price control, tariff protection, wage level fixation, etc.
8. Identification of Idle Capacity Cost: The cost of idle capacity can be easily worked out, when a
concern is not working to full capacity.
Discuss the essential of a good costing accounting system?
The essential features, which a good Cost Accounting System should possess, are as follows:
(i) Cost Accounting System should be TAILOR-MADE, practical, simple and capable of meeting
the requirements of a business concern.
(ii) The data to be used by the Cost Accounting System should be ACCURATE; otherwise it may
distort the output of the system.
(iii) Necessary COOPERATION and participation of executives from various departments of the
concern is essential for developing a good system of Cost Accounting.
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(iv) The Cost of installing and operating the system should JUSTIFY THE RESULTS.
(v) The system of costing should not sacrifice the utility by introducing meticulous and
(vi) A CAREFULLY PHASED PROGRAMME should be prepared by using network analysis for
the introduction of the system.
(vii) Management should have a faith in the Costing System and should also provide a
helping hand for its development and success.
You have been asked to install a costing system in a manufacturing company. What
practical difficulties will you expect and how will you propose to overcome the same?
The practical difficulties with which a Cost Accountant is usually confronted with while installing
a costing system in a manufacturing company are as follows:
(i) Lack of top management support: Installation of a costing system does not receive the support
of top management. They consider it as interference in their work. They believe that such, a
system will involve additional paperwork. They also have a misconception in their minds that the
system is meant for keeping a check on their activities.
(ii) Resistance from cost accounting departmental staff: The staff resists because of fear of
loosing their jobs and importance after the implementation of the new system.
(iii) Non cooperation from user departments: The foremen, supervisor and other staff members
may not cooperate in providing requisite data, as this would not only add to their responsibilities
but will also increase paper work of the entire team as well.
(iv) Shortage of trained staff: Since cost accounting system‘s installation involves specialised
work, there may be a shortage of trained staff.
To overcome these practical difficulties, necessary steps required are:
To sell the idea to top management – To convince them of the utility of the system.
Resistance and non cooperation can be overcome by behavioral approach. To deal with the
staff concerned effectively. Proper training should be given to the staff at each level.
Regular meetings should be held with the cost accounting staff, user departments, staff
and top management to clarify their doubts / misgivings.
CLASSIFICATION OF COST AS PER NATURE:
Cost Object – Anything for which a separate measurement of cost is desired. Examples of
cost objects include a product, a service , a project , a customer , a brand category , an
activity , a department , a programme.
Cost Unit - It is a unit of product, service or time (or combination of these) in relation to which
costs may be ascertained or expressed. We may for instance determine the cost per tonne of
steel, per tonne kilometre of a transport service or cost per machine hour. Sometime, a single
order or a contract constitutes a cost unit. A batch which consists of a group of identical
items and maintains its identity through one or more stages of production may also be
considered as a cost unit.
Cost units are usually the units of physical measurement like number, weight, area, volume,
length, time and value. A few typical examples of cost units are given below :
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Industry or Product Cost Unit Basis
Cement Tonne/per bag
Chemicals Litre, gallon, kilogram
Power Kilo Watt Per Hour
Transport Passenger Km
Traceability of a object:
Direct Costs – Costs that are related to the cost object and can be traced in an
economically feasible way.
Indirect Costs – Costs that are related to the cost object but cannot be traced to it in an
economically feasible way.
Elements of cost:
(i) Direct Materials : Materials which are present in the finished product(cost object) or
can be economically identified in the product are called direct materials. For example,
cloth in dress making; materials purchased for a specific job etc.
(ii) Direct Labour : Labour which can be economically identified or attributed wholly to a
cost object is called direct labour. For example, labour engaged on the actual
production of the product or in carrying out the necessary operations for converting
the raw materials into finished product.
(iii) Direct Expenses : It includes all expenses other than direct material or direct labour
which are specially incurred for a particular cost object and can be identified in an
economically feasible way.
(iv) Indirect Materials : Materials which do not normally form part of the finished product
(cost object) are known as indirect materials. These are —
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Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks
Stores used by service departments like power house, boiler house, canteen etc.
(v) Indirect Labour : Labour costs which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour. Examples of indirect
labour includes - charge hands and supervisors; maintenance workers; etc.
(vi) Indirect expenses : Expenses other than direct expenses are known as indirect
expenses. Factory rent and rates, insurance of plant and machinery, power, light,
heating, repairing, telephone etc., are some examples of indirect expenses.
(vii) Overheads : It is the aggregate of indirect material costs, indirect labour costs and
indirect expenses. The main groups into which overheads may be subdivided are the
a. Production or Works overheads
b. Administration overheads
c. Selling overheads
d. Distribution overheads
Explicit Costs - These costs are also known as out of pocket costs and refer to costs involving
immediate payment of cash. Salaries, wages, postage and telegram, printing and stationery,
interest on loan etc. are some examples of explicit costs involving immediate cash payment.
Implicit Costs - These costs do not involve any immediate cash payment. They are not recorded
in the books of account. They are also know as economic costs.
Controllable: These are the costs which can be influenced by the action of a specified person in
an organisation. In every organisation, there are a number of departments which are called
responsibility centres, each under the charge of a specified level of management. Cost incurred
by these responsibility centres are influenced by the action of the incharge of the responsibility
centre. Thus, any cost that an organizational unit has the authority to incur may be identified
as controllable cost.
Non-Controllable Cost: These are the cost which cannot be influenced by the action of a
specified member of an undertaking. For example, expenditure incurred by ―Tool Room‖ is
controllable by the Tool Room Manager but the share of Tool Room Expenditure, which is
apportioned to the Machine Shop cannot be controlled by the manager of the Machine Shop.
However, the distinction between the controllable and non-controllable cost is not very sharp
and is sometimes left to individual judgment to specify a cost as controllable or non controllable
in relation to a particular individual manager.
Cost Allocation - It is defined as the assignment of the indirect costs to the chosen cost
Cost Absorption - It is defined as the process of absorbing all indirect costs allocated to or
apportioned over a particular cost centre or production department by the units produced.
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Hence, while allocating, the relevant cost objects would be the concerned cost centre or the
concerned department, while, the process of absorption would consider the units produced as
the relevant cost object. For example, the overhead costs of a lathe centre may be absorbed by
using a rate per lathe hour. Cost absorption can take place only after cost allocation. In other
words, the overhead costs are either allocated or apportioned over different cost centres and
afterwards they are absorbed on equitable basis by the output of the same cost centres.
Responsibility Centre - It is defined as an activity centre of a business organisation
entrusted with a special task. Under modern budgeting and control, financial executives tend to
develop responsibility centres for the purpose of control. Responsibility centres can broadly be
classified into three categories. They are :
(a) Cost Centres ;
(b) Profit Centres ; and
(c) Investment Centres ;
Cost Centre - It is defined as a location, person or an item of equipment (or group of these) for
which cost may be ascertained and used for the purpose of Cost Control. Cost Centres are of
two types, viz., Personal and Impersonal.
A Personal cost centre consists of a person or group of persons and an Impersonal cost
centre consists of a location or an item of equipment (or group of these).
In a manufacturing concern there are two main types of Cost Centres as indicated below :
(i) Production Cost Centre : It is a cost centre where raw material is handled for conversion into
finished product. Here both direct and indirect expenses are incurred. Machine shops, welding
shops and assembly shops are examples of production Cost Centres.
(ii) Service Cost Centre : It is a cost centre which serves as an ancillary unit to a production
cost centre. Power house, gas production shop, material service centres, plant maintenance
centres are examples of service cost centres.
Profit Centres - Centres which have the responsibility of generating and maximising profits
are called Profit Centres.
Investment Centres - Those centres which are concerned with earning an adequate return
on investment are called Investment Centres.
Association with the product: Product Cost vs Period Cost
Product Costs - These are the costs which are associated with the purchase and sale of
goods (in the case of merchandise inventory). In the production scenario, such costs are
associated with the acquisition and conversion of materials and all other manufacturing inputs
into finished product for sale. Hence, under marginal costing, variable manufacturing costs
and under absorption costing, total manufacturing costs (variable and fixed) constitute
inventoriable or product costs. Under the Indian GAAP, product costs will be those costs
which are allowed to be a part of the value of inventory as per Accounting Standard 2, issued by
the Council of the Institute of Chartered Accountants of India.
Period Costs - These are the costs, which are not assigned to the products but are
charged as expenses against the revenue of the period in which they are incurred. All non-
manufacturing costs such as general and administrative expenses, selling and distribution
expenses are recognised as period costs.
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Analytical and Decision Making Purpose:
Opportunity Cost - This cost refers to the value of sacrifice made or benefit of opportunity
foregone in accepting an alternative course of action. For example, a firm financing its
expansion plan by withdrawing money from its bank deposits. In such a case the loss of
interest on the bank deposit is the opportunity cost for carrying out the expansion plan.
Out-Of-Pocket Cost - It is that portion of total cost, which involves cash outflow. This cost
concept is a short-run concept and is used in decisions relating to fixation of selling price in
recession, make or buy, etc. Out–of–pocket costs can be avoided or saved if a particular
proposal under consideration is not accepted.
Shut Down Costs - Those costs, which continue to be, incurred even when a plant is
temporarily shutdown, e.g. rent, rates, depreciation, etc. These costs cannot be eliminated
with the closure of the plant. In other words, all fixed costs, which cannot be avoided during
the temporary closure of a plant, will be known as shut down costs.
Sunk Costs - Historical costs incurred in the past are known as sunk costs. They play no
role in decision making in the current period. For example, in the case of a decision relating to
the replacement of a machine, the written down value of the existing machine is a sunk cost
and therefore, not considered.
Discretionary Costs – Such costs are not tied to a clear cause and effect relationship
between inputs and outputs. They usually arise from periodic decisions regarding the
maximum outlay to be incurred. Examples include advertising, public relations, executive
Standard Cost - A pre-determined cost, which is calculated from managements ‗expected
standard of efficient operation‘ and the relevant necessary expenditure. It may be used as a
basis for price fixing and for cost control through variance analysis.
Marginal Cost - The amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit.
Note : In this context a unit may be a single article, an order, a stage of production, a process of
a department. It relates to change in output in the particular circumstances under
consideration within the capacity of the concerned organisation.
Pre-production Costs: These costs forms the part of development cost, incurred in
making a trial production run, preliminary to formal production. These costs are incurred when
a new factory is in the process of establishment or a new project is undertaken or a new product
line or product is taken up, but there is no established or formal production to which such costs
may be charged. These costs are normally treated as deferred revenue expenditure (except the
portion which has been capitalised) and charged to the costs of future production.
Research and Development Costs: Research costs are the costs incurred for the discovery of
new ideas or processes by experiment or otherwise and for using the results of such
experimentation on a commercial basis. Research costs are defined as the costs of searching for
new or improved products, new applications of materials, or improved methods, processes,
systems or services.
Development costs are the costs of the process which begins with the implementation of the
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decision to produce a new or improved product or to employ a new or improved
method and ends with the commencement of formal production of that product by that method.
Training Costs: These costs comprises of – wages and salaries of the trainees or learners, pay
and allowances of the training and teaching staff, payment of fees etc, for training or for
attending courses of studies sponsored by outside agencies and cost of materials, tools and
equipments used for training. Costs incurred for running the training department, the losses
arising due to the initial lower production, extra spoilage etc. occurring while providing training
facilities to the new recruits. All these costs are booked under separate standing order numbers
for the various functions. Usually there is a service cost centre, known as the Training Section,
to which all the training costs are allocated. The total cost of training section is thereafter
apportioned to production centers.
Cost classification based on variability
Fixed cost – These are costs, which do not change in total despite changes of a cost driver. A
fixed cost is fixed only in relation to a given relevant range of the cost driver and a given time
span. Rent, insurance, depreciation of factory building and equipment are examples of fixed
costs where the final product produced is the cost object.
Variable costs – These are costs which change in total in proportion to changes of cost driver.
Direct material, direct labour are examples of variable costs, in cases where the final product
produced is the cost object.
Semi-variable costs – These are partly fixed and partly variable in relation to output e.g.
telephone and electricity bill.
TYPES OF COSTING :
For ascertaining cost, following types of costing are usually used.
(i) Marginal Costing: It is defined as the ascertainment of marginal cost by differentiating
between fixed and variable costs. It is used to ascertain effect of changes in volume or type
of output on profit.
(ii) Standard Costing And Variance Analysis: It is the name given to the technique
whereby standard costs are pre-determined and subsequently compared with the
recorded actual costs. It is thus a technique of cost ascertainment and cost control. This
technique may be used in conjunction with any method of costing. However, it is
especially suitable where the manufacturing method involves production of standardised
goods of repetitive nature.
(iii) Absorption Costing: It is the practice of charging all costs, both variable and fixed to
operations, processes or products. This differs from marginal costing where fixed costs
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METHODS OF COSTING :
Different industries follow different methods of costing because of the differences in the nature of
their work. The various methods of costing are as follows:
Job Costing In this case the cost of each job is ascertained separately. It is
suitable in all cases where work is undertaken on receiving a
customer‘s order like a printing press, motor workshop, etc. In case
a factory produces a certain quantity of a part at a= time, say 5,000=
rims of bicycle, the cost can be ascertained like that of a job.=
Batch Costing It is the extension of job costing. A batch may represent a number of
small orders passed through the factory in batch. Each batch here is
treated as a unit of cost and thus separately costed. Here cost per
unit is determined by dividing the cost of the batch by the number of
units produced in the batch
Contract Costing Here the cost of each contract is ascertained separately. It is suitable
for firms engaged in the construction of bridges, roads, buildings etc.
Process Costing Here the cost of completing each stage of work is ascertained, like cost
of making pulp and cost of making paper from pulp. In mechanical
operations, the cost of each operation may be ascertained separately ;
the name given is operation costing.
Operating Costing It is used in the case of concerns rendering services like transport,
supply of water, retail trade etc.
Multiple Costing It is a combination of two or more methods of costing outlined above.
Suppose a firm manufactures bicycles including its components; the
parts will be costed by the system of job or batch costing but the
cost of assembling the bicycle will be computed by the Single or
output costing method. The whole system of costing is known as
DIRECT EXPENSES :
Meaning of Direct Expenses : Direct Expenses are also termed as ‗Chargeable expenses‘. These
are the expenses which can be allocated directly to a cost object. Direct expenses are defined
as ‗costs other than material and wages which are incurred for a specific product or saleable
Examples of direct expenses are :
(i) Hire charges of special machinery or plant for a particular production order or job.
(ii) Payment of royalties.
(iii) Cost of special moulds, designs and patterns.
(iv) Travelling and conveyance expenses incurred in connection with a particular job.
(v) Sub-contracting expenses or outside work costs if jobs are sent out for special
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Characteristics of Direct Expenses :
(i) Direct expenses are those expenses, which are other than the direct materials and direct
(ii) These expenses are either allocated or charged completely to cost centres or work orders.
(iii) These expenses are included in prime cost of a product.
RELATIONSHIP BETWEEN COST ACCOUNTING, FINANCIAL ACCOUNTING, MANAGEMENT
ACCOUNTING AND FINANCIAL MANAGEMENT :
Cost Accounting is a branch of accounting, which has been developed because of the
limitations of Financial Accounting from the point of view of management control and internal
reporting. Financial accounting performs admirably, the function of portraying a true and fair
overall picture of the results or activities carried on by an enterprise during a period and its
financial position at the end of the year. Also, on the basis of financial accounting, effective
control can be exercised on the property and assets of the enterprise to ensure that they are
not misused or misappropriated. To that extent financial accounting helps to assess the overall
progress of a concern, its strength and weaknesses by providing the figures relating to several
previous years. Data provided by Cost and Financial Accounting is further used for the
management of all processes associated with the efficient acquisition and deployment of
short, medium and long term financial resources. Such a process of management is known as
Financial Management. The objective of Financial Management is to maximise the wealth of
shareholders by taking effective Investment, Financing and Dividend decisions. Investment
decisions relate to the effective deployment of scarce resources in terms of funds while the
Financing decisions are concerned with acquiring optimum finance for attaining financial
objectives. The last and very important ‗Dividend decision‘ relates to the determination of the
amount and frequency of cash which can be paid out of profits to shareholders. On the other
hand, Management Accounting refers to managerial processes and technologies that are
focused on adding value to organisations by attaining the effective use of resources, in
dynamic and competitive contexts. Hence, Management Accounting is a distinctive form of
resource management which facilitates management‘s ‗decision making‘ by producing
information for managers within an organisation.
Cost Control Vs. Cost Reduction:
Basis Cost Control Cost Reduction
Meaning Cost control is the guidance
and regulation by executive
action of the cost of operating
Cost reduction is the achievement of
real and permanent reduction in the
unit cost of goods and services
without impairing their suitability.
Emphasis It emphasizes on past
performances and variance
It emphasizes on present and future
performance without considering the
Approach It is a conservative approach
which stresses on the
conformity to the set norms.
It is a dynamic approach were in
every function is analysed in a view of
Focus It is a short term review with
focus on reducing cost in a
It seek to reduce the unit cost on a
permanent basis on a systematic
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In is a corrective function It is a preventive function
State the types of cost in the following cases:
(i) Interest paid on own capital not involving any cash outflow.
(ii) Withdrawing money from bank deposit for the purpose of purchasing new machine for
(iii) Rent paid for the factory building which is temporarily closed
(iv) Cost associated with the acquisition and conversion of material into finished product.
Type of costs
(i) Imputed Cost
(ii) Opportunity Cost
(iii) Shut Down Cost
(iv) Product Cost
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Method of Costing and Cost Unit for various Industries/Activities
Industry (I) Service
(S) Activity (A)
Unit of Cost
1. Advertising S Job Per Job
2. Automobile I Multiple Per Number
3. Bicycles I Multiple Per Unit or Per Batch
4. Breweries I Process Per Barrel
5. Brick Works I Single/Unit Per 1,000 Bricks
6. Bridge Construction I Contract Per Contract
7. Cement I Unit Per Tonne or Per Bag
8. Chemicals I Process Per Litre, Gallon, Kilogram, Tonne, etc.
9. Coal Mining I Single/Unit Per Tonne
10. Credit Control (in
Bank, Sales Dept, etc.)
A NA Per Account maintained
11. Education Services S Operating Per Course, Per Student, etc.
12. Electronic Items I Multiple Per Unit or Per Batch
13. Engineering Works I Contract Per Job, Per Contract, etc.
14. Furniture I Multiple Per Unit
S Operating Per Patient-Day or Room-Day
16. Hotel/Catering S Operating Per Guest-Day or Room-Day, Per Meal
17. Interior Decoration S Job Per Job
18. Oil Refining I Process Per Barrel, Per Tonne, Per Litre, etc.
A NA Per Personnel Record, Per Employee
20. Pharmaceuticals I Batch/Unit Per Unit/Box
S Operating Per Chargeable Hour, Per Job, etc.
22. Power/Electricity I Operating Per Kilo-Watt Hour
23. Road Transport S Operating Per Tonne-Km/Passenger-Km
24. Selling A NA Per Customer Call, Per Order booked
25. Ship Building I Contract Per Ship
26. Soap I Process Per Unit
27. Steel I Process Per Tonne
28. Storage and
Handling of Materials
A NA Per Stores Requisition, Per Issue, etc.
29. Sugar Company
having own sugarcane
I Process Per Tonne or Per Quintal
30. Toy Making I Batch Per Batch
31. Transport S Operating Per Passenger Kilometer, Tonne-Km
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FORMAT OF COST SHEET
Opening Stock of Raw Materials
Add: Purchases (including Carriage Inwards, Transit Insurance etc.) ------
Less: Closing Stock of Raw Materials --------------------------.
Direct Materials Consumed/Raw Materials Consumed
Add: Direct Labour
Add: Direct Expenses
Add: Factory Overheads (also called Works OH/Manufacturing
Add: Opening Stock of Work-in-Progress
Less: Closing Stock of Work-in-Progress
FACTORY COST/WORKS COST
Add: Administration Overheads (also called Office OH) General
Research and Development OH (apportioned) (if any)
COST OF PRODUCTION
Add: Opening Stock of Finished Goods
COST OF GOODS AVAILABLE FOR SALE
Less: Closing Stock of Finished Goods
COST OF GOODS SOLD
Add: Selling and Distribution Overheads (also called Marketing OH)
COST OF SALES
Add: Profit/Loss (Balancing Figure)
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Techniques of Inventory Control:
1. Min-Max Plan: It is one of the oldest methods of inventory control. Under this plan the
analyst lays down a maximum and minimum for each stock item keeping in view its
usage, requirements and margin of safety required to minimum the risks of stock outs.
The minimum level establishes the reorder point and order is placed for that quantity of
material which will bring it to the maximum level.
The method is very simple and based upon the premise that minimum and maximum
quantity limits for different items can fairly be well defined and established.
Considerations like economic order quantity and identification of high value and critical
items of stock for special management attention are not cared for under this plan.
2. Two Bin Systems: The basic procedure used under this system is that for each item of
stock, two piles, bundles or bins are maintained. The first bin stocks that quantity of
inventory which is sufficient to meet its usage during the period that elapses between the
receipt of an order and the placing of next order. The second bin contains the safety stock
and also the normal amount used from order to delivery date. The moment stock
contained in the first bin is exhausted and the second bin is tapped, a requisition for new
supply is prepared and submitted to the purchasing department.
3. Order Cycling System: In order cycling system, quantities in hand of each item or class
of stock is reviewed periodically say 30, 60, 90 days, etc. if in the course of a scheduled
periodic review it is observed that the stock level of a given item will not be sufficient till
the next scheduled review keeping in view its probable rate of depletion, an order is placed
to replenish its supply. Review period will vary from firm to firm and also among different
materials in the same firm. Critical items of stock usually require a short review cycle.
Order for replenishing a given stock item, is placed to bring it to some desired level which
is often expressed in relation to number of days or week‘s supply,
4. ABC Analysis: with the numerous parts and materials that enter into each and every
industrial product, inventory control lends itself, first and foremost, to a problem of
analysis. Such analytical approach is popularly known as ABC Analysis (Always better
Control), which is believed to have originated in the General Electric Company of America.
The ABC plan is based upon segregation of material for selection of control. It measures
the money value i.e cost significance of each material item in relation to total cost and
inventory value. The logic behind this kind of analysis is that the management should
study each item of stock in terms of its usage, lead time, technical or other problems and
its relative money value in the total investment in inventories. Critical i.e high value items
deserve very close attention, and low value items need to be devoted minimum expense
and effort in the task of controlling inventories.
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Under ABC analysis, the different items of stock may be ranked in order of their average
inventory investment or on the basis of their annual rupee usage. The important steps
involved in segregating materials or inventory control are:
(i) Find out future use of each item of stock in terms of physical quantities for the
review forecast period.
(ii) Determine the price per unit of each item.
(iii) Determine the total project cost of each item by multiplying its expected units to be
used by the price per unit of such item.
(iv) Beginning with the item with the highest total cost, arrange different items in order
of their total cost as computed under step (iii) above
(v) Express the units of each item as a percentage of total cost of all items
(vi) Compute the total cost of each item as a percentage of total cost of all items.
If it is convenient different items may be classified into only three categories and labeled as
A, B and C respectively depending upon whether they are high value items, middle value
items and low value items. If need be, percentage of different items may be plotted on a
5. Fixation of various levels: Certain stock levels are fixed up for every items or stores so
that the stock and purchases can be efficiently controlled. These are:
a. Maximum Level: this represents the maximum quantity above which stock should not
be held at any time.
b. Minimum Level: This represents the minimum quantity of stock that should be held at
c. Danger Level: Normal issue of stock are usually stopped at this level and made only
under specific instructions.
d. Ordering level: it is the level at which indents should be placed for replenishing stock.
e. Ordering Quantity: it is the quantity that is ordered.
The basic problems of inventory control are two viz what quantity of an
item should be ordered at a time and when should an order be placed.
While deciding economic order quantity, the efforts are directed to
ascertain the ideal order size. While deciding the ideal order size, factors
such as Inventory carrying cost and the ordering cost associated with the
placement of purchase order are to be considered; the total of both has to
The inventory carrying charges include the interest on the capital invested
in the stores of materials, rent for the storage space, salaries and wages of
the storekeeper department, any loss due to pilferage and deterioration,
stores insurance charges, stationery, etc used by the stores, taxes on
Ordering cost may include rent for the space used by the purchasing
department, the salaries and wages of officers and staff in the purchasing
department, the depreciation on the equipment and furniture used by the
department, postage, telegraph charges and telephone bills, the stationery
and other consumables required by the purchase department, any
travelling expenditure incurred and the cost of inspection, etc on receipt of
18 | P a g e
The optimum order quantity i.e the quantity for which the cost of holding
plus the cost of purchasing is the minimum is called as Economic Order
Quantity and is calculated as under:
EOQ (Economic Order Quantity - Wilson‘s Formula) = √2AO/C
A = Annual usage units
O = Ordering cost per unit
C = Annual carrying cost of one unit i.e. Carrying cast % * Carrying cost of
While deciding the question as to what should be the economic ordering
quantity one has to ensure that the cost incurred should be minimum. An
ideal order size, therefore, is at the quantity where the cost is minimum ie.
Cost of holding the stock and ordering cost intersect each other.
The perpetual inventory system records changes in materials, WIP on a
daily basis. Hence, managerial control and preparation of interim financial
statement is easier. Perpetual inventory derived its name because it
indicates the amount of stock in hand at all times. It facilitates verification
of stock at any time and helps to authenticate the correctness of stock
The two main functions of perpetual inventory are:
(i) It records the quantity and value of stock in hand
(ii) There is continuous verification of physical stock
Chartered Institute of Management Accountants, London has defined it as
―The recording as they occur of receipts, issues and the resulting balances
of individual items of stock in either quantity or quantity and value.‖
A perpetual inventory system is usually checked by a programme of
continuous stock taking and the two terms are sometimes loosely
considered synonymous. Perpetual inventory means the system of records,
whereas continuous stock taking means the physical checking of those
records with actual stocks.
The perpetual inventory method has the following advantages:
(a) The inventory of various items can be easily ascertained. Hence, profit
and loss account and balance sheet can be easily prepared.
(b) Information regarding material on hand eliminates delays and stoppage
(c) The investment in stock can be reduced to the minimum keeping in
view the operational requirements.
(d) Because of internal check, the activities of various department are
checked. Hence, the stores records are reliable.
(e) Production need not be stopped when stock taking is carried out.
(f) These records give the cost of materials. Hence, management can
exercise control over costs.
(g) Discrepancies and errors are promptly discovered and remedial action
can be taken to prevent their re-occurrence in the future.
(h) This method has a moral effect on the staff, makes them disciplined and
careful and acts as a check against dishonest actions.
19 | P a g e
(i) Loss of interest on capital invested in stock, loss through deterioration,
obsolescence can be avoided.
(j) Stock figures are available for insurance purposes.
(k) It reveals the existence of surplus, dormant, obsolete and slow moving
material and hence, remedial action can be taken against them.
(i) The stores accounts reveal what the balances should be and a
physical verification reveals the actual stock position. Under this
system of verification, the total number of man-days available for
verification is calculated. The items to be verified per man-day is
selected by classifying the various items into groups depending upon
the time required. The stock verification staff plan the programme
and divide the work among themselves. The plan is such that all the
items are verified in the year.
(ii) There is an element of surprise and sometimes the stock verifier
knows of the items to be verified only on the actual date of
verification. Stock not recorded should not be mixed up with the
stock. After counting or weighting the results are recorded.
BIN CARD VS
Bin Card Stores Ledger
It is a quantity record It is a record of quantity and value
It is kept inside the stores. It is kept outside the stores
It is maintained by the storekeeper It is maintained by accounts
The postings are done before the
transaction takes place
The posting are done after the
transaction takes place
Each transaction is individually
Transactions may be posted
periodically and in total.
REVIEW OF SLOW
AND NON MOVING
The money locked up in inventory is money lost to the business. If more
money is locked up, lesser is the amount available for working capital and
the cost of carrying inventory also increases.
Stock turnover ratio should be as high as possible. Loss due to
obsolescence should be eliminated or these items used in some profitable
work. Slow moving stock should be identified and speedily disposed off.
The speed of movement should be increased. The turnover of difference
items of stock can be analysed to find out the slow moving stocks.
Materials become useless or obsolete due to changes in product, process,
design or method of production, slow moving items have a low turnover
ratio. Capital is locked up and cost of carrying have to be incurred. Hence,
management should take effective steps to minimize losses.
Under Cost Accounts normal spoilage costs i.e., (which is inherent in the
operation) are included in cost either by charging the loss due to spoilage
to the production order or charging it to production overhead so that it is
spread over all products. Any value realised from the sale of spoilage is
credited to production order or production overhead account, as the case
may be. The cost of abnormal spoilage (i.e. arising out of causes not
20 | P a g e
inherent in manufacturing process) is charged to the Costing Profit and
Loss Account. When spoiled work is the result of rigid specifications the
cost of spoiled work is absorbed by good production while the cost of
disposal is charged to production overheads.
The possible ways of treatment are as below:
(i) Defectives that are considered inherent in the process and are
identified as normal can be recovered by using the following methods:
(a) Charged to good products - The loss is absorbed by good units.
This method is used when ‗seconds‘ have a normal value and defectives
rectified into ‗seconds‘ or ‗first‘ are normal;
(b) Charged to general overheads - When the defectives caused in one
department are reflected only on further processing, the rework costs
are charged to general overheads;
(c) Charged to the department overheads - If the department responsible
for defectives can be identified then the rectification costs should be
charged to that department;
(d) Charged to Costing Profit and Loss Account - If defectives are
abnormal and are due to causes beyond the control of organisation, the
rework cost should be charged to Costing Profit and Loss Accounts.
(ii) Where defectives are easily identifiable with specific jobs, the work
costs are debited to the job.
WHAT IS JUST IN
JIT purchasing is the purchase of materials and supplies in such a manner
that delivery immediately precedes the demand of use. This will ensure that
stock are as low as possible or nearly cut to a minimum. Considerable
saving in material handling expenses is made by requiring suppliers to
inspect materials and guarantee their quality. This improved service is
obtained by giving more business to fewer suppliers, who can provide high
quality and reliable delivery. Encouragement is given to employees to
render goods service by placing with them long term purchasing order.
Companies which implements JIT purchasing substantially reduces their
investment in raw material and WIP.
Advantages of JIT:
It results in considerable savings in material handling expenses.
It results in savings in factory space.
Investment in raw material & WIP in substantially reduced.
Large quantity discounts can be obtained and paperwork is reduced
because of using of blanket long term order to few suppliers instead
of purchase orders.
It refers to the expenses involved in receiving, storing, issuing and handling
materials. To deal with this cost in cost accounts there are two prevalent
approaches as under:
First approach suggests the inclusion of these costs as part of the cost of
materials by establishing a separate material handling rate e.g., at the rate
of percentage of the cost of material issued or by using a separate material
handling rate which may be established on the basis of weight of materials
21 | P a g e
Under another approach these costs may be included along with those of
manufacturing overhead and be charged over the products on the basis of
direct labour or machine hours.
AT THE TIME OF
TAKING, IT WAS
THE CLERICAL OR
CAN BE POSSIBLE
REASONS FOR SUCH
WILL YOU DEAL
Possible reasons for differences arising at the time of physical stock taking
may be as follows when it was found that actual stock level was different
from that of the clerical or computer records:
(i) Wrong entry might have been made in stores ledger account or bin card,
(ii) The items of materials might have been placed in the wrong physical
location in the store,
(iii) Arithmetical errors might have been made while calculating the stores
balances on the bin cards or store-ledger when a manual system is
(iv) Theft of stock.
When a discrepancy is found at the time of stock taking, the individual
stores ledger account and the bin card must be adjusted so that they are in
agreement with the actual stock.
For example, if the actual stock is less than the clerical or computer record
the quantity and value of the appropriate store ledger account and bin card
(quantity only) must be reduced and the difference in cost be charged to a
factory overhead account for stores losses.
Reorder level = Maximum usage * Maximum lead time
(Or) Minimum level + (Average usage * Average Lead time)
Minimum level = Reorder level – (Average usage * Average lead time)
Maximum level = Reorder level + Reorder quantity – (Minimum usage *Minimum lead time)
Average level = Minimum level +Maximum level (or)
Minimum level + ½ Reorder quantity
EOQ (Economic Order Quantity - Wilson‘s Formula) = √2AO/C
Where A = Annual usage units
O = Ordering cost per unit
C = Annual carrying cost of one unit
i.e. Carrying cast % * Carrying cost of unit
Danger level (or) safety stock level
=Minimum usage * Minimum lead time (preferred)
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When workers are paid on time basis there is usually a difference between the
time for which the workers are paid and the time actually spent by them in
production. The loss of time for which the employer pays but obtains no
direct benefit is termed as idle time.
In other words, idle time cost represents the wages paid for the time lost i.e
time during which the worker was idle.
Treatment in Cost Accounting: Idle time may be normal or abnormal:
Normal idle time: It is inherent in any job situation and thus it cannot be
eliminated or reduced. For example:- time gap between the finishing of one
job and the starting of another; time lost due to fatigue etc.
The cost of normal idle time should be charged to the cost of production. This
may be done by inflating the labour rate. It may be transferred to factory
overheads for absorption, by adopting a factory overhead absorption rate.
Abnormal idle time: It is defined as the idle time which arises on account of
abnormal causes; e.g. strikes; lockouts; floods; major breakdown of
machinery; fire etc. Such an idle time is uncontrollable.
The cost of abnormal idle time due to any reason should be charged to
Costing Profit & Loss Account.
Control on Idle Time:
Idle time arising due to normal and controllable causes can be controlled by
proper planning but those arising due to abnormal causes cannot be
controlled. Idle time is bound to occur due to setting up of tools for various
jobs, time interval between two jobs, time to travel from factory gate to work
Idle time can be eliminated /minimized by taking the following steps:
i. Production should be properly planned in advance.
ii. Purchasing of material in time
iii. Proper maintenance of machines
iv. Utilizing man power effectively.
Responsibility for controlling idle time should be properly defined and fixed.
The different causes should be properly analysed by a detailed break up
under each head. Person/department responsible for the idle time should be
identified and remedial steps should be taken.
(a) If idle capacity is due to unavoidable reasons such as repairs &
maintenance, change over of job etc., a supplementary overhead rate may be
used to recover the idle capacity cost. In this case, the costs are charged to
production capacity utilized.
(b) If idle capacity cost is due to avoidable reasons such as faulty planning,
power failure etc, the cost should be charged to P/L A/c.
(c) If idle capacity is due to seasonal factors, then the cost should be charged
to cost of production by inflating overhead rates.
Overtime refers to the situation when a worker works beyond his normal
working hours. The overtime rate is always higher than the normal rate and
23 | P a g e
is usually double the normal rate.
Overtime consists of two elements viz the normal cost and the extra payment
or premium. The premium is known as overtime cost. The normal cost is
allocated to the production order or cost centre on which the worker is
working. The treatment of overtime cost varies according to the
Causes of Overtime:
Overtime arises due to the following circumstances:
i. For working due to seasonal rush;
ii. For making up time lost due to unavoidable reasons;
iii. For completing a job or order within a specified period as requested
by the customer;
iv. For working due to policy decisions i.e when there is general
pressure of work and labour shortage, etc
Treatment of Overtime Cost:
The premium or overtime cost can be charged as follows:
i. The job or order, if the overtime is worked at the customer‘s
ii. As a general overhead item if it has been paid because of general
pressure of work
iii. To the department responsible for the delay
iv. To costing profit and loss account if overtime was due to
v. To general overhead if caused due to seasonal rush.
Control on Overtime:
i. Overtime should be strictly controlled and discouraged. It should be
permitted only in emergencies.
ii. Overtime should be sanctioned by a competent authority.
iii. If overtime is being sanctioned for a long time, recruitment of more
man and extra shift working should be considered.
It is a common feature in any concern that some employee leave the concern
and others join it. Workers change the job either for personal betterment or
for better working conditions or due to compulsion. Labour turnover is the
ratio of the number of persons leaving in a period to average number
Causes of Labour Turnover: The main causes of labour turnover in an
organisation/ industry can be broadly classified under the following three
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.
Personal causes are those which induce or compel workers to leave their
jobs; such causes include the following:
(i) Change of jobs for betterment.
(ii) Premature retirement due to ill health or old age.
(iii) Domestic problems and family responsibilities.
24 | P a g e
(iv) Discontent over the jobs and working environment.
Unavoidable causes are those under which it becomes obligatory on the
part of management to ask one or more of their employees to leave the
organisation; such causes are summed up as listed below:
(i) Seasonal nature of the business;
(ii) Shortage of raw material, power, slack market for the product etc.;
(iii) Change in the plant location;
(iv) Disability, making a worker unfit for work;
(v) Disciplinary measures;
(vi) Marriage (generally in the case of women).
Avoidable causes are those which require the attention of management on
a continuous basis so as to keep the labour turnover ratio as low as possible.
The main causes under this case are indicated below
(i) Dissatisfaction with job, remuneration, hours of work, working conditions,
(ii) Strained relationship with management, supervisors or fellow workers;
(iii) Lack of training facilities and promotional avenues;
(iv) Lack of recreational and medical facilities;
(v) Low wages and allowances.
Separation rate method = Separation during the period
Average No. of worker‘s during the period
Replacement method = Number of replacements
Average No. of worker‘s during the period
Labour flux rate =
No. of separation + No. of New employees + No. of replacements
Average No. of worker‘s during the period
TO BE TAKEN TO
Exit interview with each outgoing employee to ascertain the reasons for
his leaving the organisation.
Job analysis and evaluation carried out even before recruitment to
ascertain the requirement of each job.
Scientific system of recruitment, placement and promotion, by fitting
the right person in the right job.
Use of committee, comprising of members from management and
workers to handle issue concerning the workers grievance,
Enlightened attitude of management – mental revolution on the part of
management by taking workers into confidence and acting a healthy
Job Evaluation: it can be defined as the process of analysis and assessment
of jobs to ascertain reliably their relative worth and to provide management
with a reasonably sound basis for determining the basic internal wage and
25 | P a g e
salary structure for the various job positions. In other words, job evaluation
provides a rationale for different wages and salaries for different group of
employees and ensures that these differentials are consistent and equitable.
Merit Rating: it is a systematic evaluation of the personality and
performance of each employee by his supervisor or some other qualified
Thus the main points of distinction between job evaluation and merit rating
are as follows:
1. Job evaluation is the assessment of the relative worth of jobs within a
company and merit rating is the assessment of the relative worth of the
man behind a job. In other words, job evaluation rates the job while merit
rating rates employees on the job.
2. Job evaluation and its accomplishment are means to set up a rational
wage and salary structure whereas merit rating provides scientific basis
for determining fair wages for each worker based on his ability and
3. Job evaluation simplifies wage administration by bringing uniformity in
wage rates. On the other hand merit rating is used to determine fair rate
of pay for different workers on the basis of their performance.
Recording of time has two purposes – time keeping and time booking. It is
necessary for both type of workers: direct and indirect. It is necessary even if
the workers are paid on piece basis.
Time keeping is necessary for the purpose of recording attendance and for
calculating wages. Time booking means a record for utilisation point of view;
the purpose is cost analysis and cost apportionment. Record keeping is
correct when time keeping and time booking tally.
The purpose of time keeping is to provide the basic data for:
i. Pay roll preparation
ii. Finding out the labour cost of a job/product/service.
iii. Attendance records to meet the statutory requirements.
iv. Determining the productivity and controlling labour cost
v. Calculating overhead cost of a job, product or service.
vi. To maintain discipline in attendance
vii. To distinguish between normal and overtime, late attendance and early
viii. To provide the internal check against dummy workers
The various methods of time booking:
i. Piece work card
ii. Daily time sheet
iii. Weekly time sheet
iv. Clock card
v. Time ticket
vi. Job ticket
vii. Combined time and job ticket
The objectives of time booking are:
i. To apportion overheads against jobs;
ii. To calculate the labour cost of jobs done;
26 | P a g e
iii. To ascertain idle time for the purpose of control;
iv. To find out that the time during which a worker is in the factory is
v. To evaluate labour performance, to compare actual and budgeted
vi. To determine overhead rates of absorbing overhead expenses under
the labour hour and machine hour methods;
vii. To calculate the wages and bonus provided the system of payment
depends on the time taken.
IN WHICH TIME
RATE SYSTEM OF
PREFERRED IN A
Circumstances in which time rate system of wage payment can be preferred:
In the following circumstances the time rate system of wage payment is
preferred in a factory.
1. Persons whose services cannot be directly or tangibly measured, e.g.,
general helpers, supervisory and clerical staff etc.
2. Workers engaged on highly skilled jobs or rendering skilled services, e.g.,
tool making, inspection and testing.
3. Where the pace of output is independent of the operator, e.g., automatic
HOW YOU WILL
Causal and outdoor workers: Casual workers (badli workers) are employed
temporarily, for a short duration to cope with sporadic increase in volume of
work. If the permanent labour force is not sufficient to cope effectively with a
rush of work, additional labour (casual workers) are employed to work for a
short duration. Out door workers are those workers who do not carry out
their work in the factory premises. Such workers either carry out the assigned
work in their homes (e.g., knitwear, lamp shades) or at a site outside the
Casual workers are engaged on a dally basis. Wages are paid to them either at
the end of the day‘s work or after a periodic interval. Wages paid are charged
as direct or indirect labour cost depending on their identifiability with specific
jobs, work orders, or department.
Rigid control should be exercised over the out-workers specially with regard
1. Reconciliation of materials drawn/issued from the store with the output.
2. Ensuring the completion of output during the stipulated time so as to meet
comfortably the orders and contracts.
IT SHOULD BE
Inventory turnover: It is a ratio of the value of materials consumed during a
period to the average value of inventory held during the period. A high
inventory turnover indicates fast movement of stock.
Labour turnover: It is defined as an index denoting change in the labour force
for an organization during a specified period. Labour turnover in excess of
normal rate is termed as high and below it as low turnover.
Effects of high inventory turnover and low labour turnover: High inventory
turnover reduces the investment of funds in inventory and thus accounts for
the effective use of the concern‘s financial resources. It also accounts for the
27 | P a g e
increase of profitability of a business concern. As against high labour
turnover the low labour turnover is preferred because high labour turnover
causes-decrease in production targets; increase in the chances of break-down
of machines at the shop floor level; increase in the number of accidents; loss
of customers and their brand loyalty due to either non-supply of the finished
goods or due to sub-standard production of finished goods; increase in the
cost of selection, recruitment and training; increase in the material wastage
and tools breakage.
All the above listed effects of high labour turnover accounts for the increase in
the cost of production/process/service. This increase in the cost finally
accounts for the reduction of concern‘s profitability. Thus, it is necessary to
keep the labour turnover at a low level.
As such, it is correct that management should endeavour to increase
inventory turnover and reduce labour turnover for optimum and best
utilization of available resources and reduce the cost of production and thus
increase the profitability of the organization.
WHAT DO YOU
MEAN BY TIME
STUDY? WHY IS IT
Time and motions study: It is the study of time taken and motions
(movements) performed by workers while performing their jobs at the place of
their work. Time and motion study has played a significant role in controlling
and reducing labour cost.
Time Study is concerned with the determination of standard time required by
a person of average ability to perform a job. Motion study, on the other hand,
is concerned with determining the proper method of performing a job so that
there are no wasteful movements, hiring the worker unnecessarily. However,
both the studies are conducted simultaneously. Since materials, tools,
equipment and general arrangement of work, all have vital bearing on the
method and time required for its completion. Therefore, their study would be
incomplete and would not yield its full benefit without a proper consideration
of these factors.
Time and motion study is important to management because of the following
1. Improved methods, layout, and design of work ensures effective use of
men, material and resources.
2. Unnecessary and wasteful methods are pin-pointed with a view to either
improving them or eliminating them altogether. This leads to reduction in the
work content of an operation, economy in human efforts and reduction of
3. Highest possible level of efficiency is achieved in all respect.
4. Provides information for setting labour standards - a step towards labour
cost control and cost reduction.
5. Useful for fixing wage rates and introducing effective incentive scheme.
TWO TYPES OF
Two types of costs which are associated with labour turnover are:
(i) Preventive costs: This includes costs incurred to keep the labour
turnover at a low level i.e., cost of medical schemes. If a company incurs high
preventive costs, the rate of labour turnover is usually low.
28 | P a g e
(ii) Replacement costs: These are the costs which arise due to high labour
turnover. If men leave soon after they acquire the necessary training and
experience of work, additional costs will have to be incurred on new workers,
i.e., cost of advertising, recruitment, selection, training and induction, extra
cost also incurred due to abnormal breakage of tools and machines,
defectives, low output, accidents etc., caused due to the inefficiency and
inexperienced new workers.
It is obvious that a company will incur very high replacement costs if the rate
of labour turnover is high. Similarly, only adequate preventive costs can keep
labour turnover at a low level. Each company must, therefore, workout the
optimum level of labour turnover keeping in view its personnel policies and
the behaviour of replacement costs and preventive costs at various levels of
labour turnover rates.
Taylor’s Piece Rate:
Less than 100% 83% of the Piece Rate
100% or more 125% of the Piece Rate
Merrick’s differential rate scheme:
Efficiency Level Piece Rate
Upto 83% Normal Rate
83% to 100% 110% of Normal Rate
Above 100% 120% of the Normal Rate
Gantt Task and Bonus Plan
Output below standard Guaranteed time wage
Output at standard Time rate plus Bonus @20% of time rate
Output above standard High piece rate on worker‘s whole output=
Emerson’s Efficiency System
Efficiency Piece Rate
66 2/3rd % Guaranteed Time Rate
90% Time Rate + 10% Bonus
100% Time Rate + 20% bonus
Above 100% Time Rate + 20% Bonus + 1% for every
increase of 1% beyond 100%.
Total wages = (time taken * Hourly rate) + 50% (time SAVED * hourly rate)
Total wages = (time taken * hourly rate) + [(time saved/standard time)*(time taken * hourly rate)]
Total wages = hourly rate * √Standard time * time taken
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Absorption of overhead refers to charging of overheads to individual
products or jobs. The overhead expenses pertaining to a cost centre are
ultimately to be charged to the products, jobs, etc. which pass through
that cost centre. For the purpose of the absorption of overheads to
individual jobs, processes or products, overheads absorption rates are
applied. The overhead rate of expenses for absorbing them to production
may be estimated on the following three basis:
(i) The figure of the previous year or period may be adopted as the
overhead rate to be charged on production in current year.
(ii) The overhead rate for the year may be determined on the basis
of the estimated expenses and the anticipated volume of
production or activity.
(iii) The overhead rate for the year may be determined on the basis
of normal volume of output or capacity of business.
After having collected the overheads under proper standing order numbers
the next step is to arrive at the amount for each department. This may be
through allocation or absorption. According to Chartered Institute of
Management Accountants, London, Cost Allocation is ―that part of cost
attribution which charges a specific cost to a cost centre or cost unit‖.
Thus, the wages paid to maintenance workers as obtained from wages
analysis book can be allocated directly to maintenance service cost centre.
Similarly, indirect material cost can also be allocated to different cost
centre according to use by pricing stores requisition.
The following are the differences between allocation and apportionment.
1. Allocation costs are directly allocated to cost centre. Overhead which
cannot be directly allocated are apportioned on some suitable basis.
2. Allocation allots whole amount of cost to cost centre or cost unit where
as apportionment allots part of cost to cost centre or cost unit.
3. No basis required for allocation. Apportionment is made on the basis of
area, assets value, number of workers etc.
Blanket overhead rate refers to the computation of one single overhead
rate for the entire factory. This is also known as plantwise or the single
overhead rate for the entire factory. It is determined as follows:
Blanket Overhead Rate = Overhead Cost for entire factory/base for the
Base for the year can be labour hours or machine hours.
Situation for using blanket rate:
The use of blanket rate may be considered appropriate for factories which
produce only one major product on a continuous basis. It may also be
used in those units in which all products utilise same amount of time in
each department. If such conditions do not exist, the use of blanket rate
will give misleading results in the determination of the production cost,
specially when such a cost ascertainment is carried out for giving
quotations and tenders.
DISCUSS IN BRIEF
The three main methods of allocating support departments costs to
operating departments are:
30 | P a g e
OF THESE THREE,
WHICH METHOD IS
(i) Direct re-distribution method: Under this method, support
department costs are directly apportioned to various production
departments only. This method does not consider the service provided by
one support department to another support department.
(ii) Step method: Under this method the cost of the support departments
that serves the maximum numbers of departments is first apportioned to
other support departments and production departments. After this the
cost of support department serving the next largest number of
departments is apportioned. In this manner we finally arrive on the cost of
production departments only.
(iii) Reciprocal service method: This method recognises the fact that
where there are two or more support departments they may render
services to each other and, therefore, these inter-departmental services are
to be given due weight while re-distributing the expenses of the support
departments. The methods available for dealing with reciprocal services
(a) Simultaneous equation method
(b) Repeated distribution method
(c) Trial and error method.
The reciprocal service method is conceptually preferable. This method is
widely used even if the number of service departments is more than two
because due to the availability of computer software it is not difficult to
solve sets of simultaneous equations.
TREATMENT IN COST
ACCOUNTS OF THE
COST OF SMALL
TOOLS OF SHORT
Small tools are mechanical appliances used for various operations on a
work place, specially in engineering industries. Such tools include drill
bits, chisels, screw cutter, files etc.
Treatment of cost of small tools of short effective life:
(i) Small tools purchased may be capitalized and depreciated over life if
their life is ascertainable. Revaluation method of depreciation may be used
in respect of very small tools of short effective life. Depreciation of small
tools may be charged to:
Overheads of the department using the small tool.
(ii) Cost of small tools should be charged fully to the departments to
which they have been
issued, if their life is not ascertainable.
EXPLAIN WHAT DO
YOU MEAN BY
TREATMENT IN COST
Chargeable expenses: All expenses, other than direct materials and direct
labour cost which are specifically and solely incurred on production,
process or job are treated as chargeable or direct expenses. These
expenses in cost accounting are treated as part of prime cost, Examples of
chargeable expenses include - Rental of a machine or plant hired for
specific job, royalty, cost of making a specific pattern, design, drawing or
making tools for a job.
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DEFINE SELLING AND
FOR SELLING AND
Selling expenses: Expenses incurred for the purpose of promoting,
marketing and sales of different products.
Distribution expenses: Expenses relating to delivery and despatch of
goods/products to customers.
Accounting treatment for selling and distribution expenses.
Selling and distribution expenses are usually collected under separate
cost account numbers.
These expenses may be recovered by using any one of following method of
1. Percentage on cost of production / cost of goods sold.
2. Percentage on selling price.
3. Rate per unit sold.
Basis Expense items
Area or cubic measurement of department
Direct labour hours or, where wage rates
are more or less uniform, total direct
wages of department.
Rent, rates, lighting and
Number of employees in departments Supervision
Cost of material used by departments Material handling charges
Value of assets Depreciation and
Horse power of machines Power
Service department cost Basis of apportionment
Maintenance Department Hours worked for each department
Employment department Rate of labour turnover or number of
employees in each department
Payroll Department Direct labour hours, machine hours
number of employees
No. of requisitions, quantity or value of
Welfare department No. of employees
Truck hours, truck mileage
Relative area of each department
Power house Floor area, Cubic contents
UNDER OR OVER
The treatment will depend on the cause that led to under or over
absorption. The amount relating to abnormal factors should be charged off
to costing profit and loss account, otherwise cost previously arrived at
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should be adjusted. The following are the main methods of disposal of
under or over absorption of overheads.
(i) Use of supplementary Rates: where the amount of under or over
absorption is considerable, the cost of jobs or products is adjusted
by means of a supplementary rate. This rate is determined by
dividing the amount of under or over absorption by the base that
was adopted for absorption. This rate may be positive or negative.
The amount of under absorption is set right by a positive rate while
a negative rate is determined for adjusting over absorption. The
amount of under or over absorption at the end of the accounting
period is adjusted in work in progress, finished goods and cost of
sales in proportion to direct labour hours or machine hours or
value of balances in each of these accounts by use of
(ii) Writing off to costing profit and loss account: where the
difference between the actual or absorbed overheads is not large,
the simple method is to write off to the costing profit and loss
account. When there is under absorption due to idle capacity, the
concerned amount is also written off in this manner, likewise, when
there was wasteful expenditure due to lack of control also.
(iii) Carry Forward to Subsequent Year: Difference should be carried
forward in the expectation that next year the position will be
automatically corrected. This would really mean that costing data
of two years would be wrong.
EXPLAIN THE COST
Cost of unsuccessful research is treated as factory overhead, provided the
expenditure is normal and is provided in the budget. If it is not budgeted,
it is written off to the profit and loss account. If the research is extended
for long time, some failure cost is spread over to successful research.
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INTEGRATED AND NON INTEGRATED ACCOUNTS
Integrated Accounting is the name given to a system of accounting
whereby cost and financial accounts are kept in the same set of books.
Such a system will have to afford full information required for costing as
well as for Financial Accounts. In other words, information and data
should be recorded in such a way so as to enable the firm to ascertain
the cost (together with the necessary analysis) of each product, job,
process, operation or any other identifiable activity. For instance,
purchases analysed by nature of material and its end use. Purchases
account is eliminated and direct postings are made to Stores Control
Account, Work-in-Progress accounts, or Overhead Account. Payroll is
straightway analysed into direct labour and overheads. It also ensures
the ascertainment of marginal cost, variances, abnormal losses and
gains, In fact, all information that management requires from a system
of costing for doing its work properly is made available. The integrated
accounts give full information in such a manner so that the profit and
loss account and the balance sheet can be prepared according to the
requirements of law and the management maintains full control over the
liabilities and assets of its business.
The main advantages of Integrated Accounting are as follows:
(i) Since there is one set of accounts, thus there is one figure of profit.
Hence the question of reconciliation of costing profit and financial profit
does not arise.
(ii) There is no duplication of recording of entries and efforts to maintain
separate set of books. (iii) Costing data are available from books of
original entry and hence no delay is caused in obtaining information.
(iv) The operation of the system is facilitated with the use of mechanized
(v) Centralization of accounting function results in economy.
The management‘s decision about the extent of integration of the
two sets of books. Some concerns find it useful to integrate up to the
stage of primary cost or factory cost while other prefer full
integration of the entire accounting records.
A suitable coding system must be made available so as to serve the
accounting purposes of financial and cost accounts.
An agreed routine, with regard to the treatment of provision for
accruals, prepaid expenses, other adjustment necessary for
preparation of interim accounts.
Perfect coordination should exist between the staff responsible for the
financial and cost aspects of the accounts and an efficient processing
of accounting documents should be ensured.
When the cost and financial accounts are kept separately, it is
imperative that those should be reconciled, otherwise the cost accounts
would not be reliable. In this connection, it is necessary to remember
that a reconciliation of the two sets of accounts only can be made if both
the sets contain sufficient details as would enable the causes of
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differences to be located. It is, therefore, important that in the financial
accounts, the expenses should be analysed in the same way as in the
In the text book, there appears a General Ledger Adjustment Account as
would appear in the Cost Ledger, students should study the entries
therein as well as a discussion that follows to explain the manner in
which the details of items included therein could be reconciled with the
corresponding items appearing in the financial accounts. They would
thus realise that the reconciliation of the balances generally, is possible
preparing a Memorandum Reconciliation Account. In this account, the
items charged in one set of accounts but not in the other or those
charged in excess as compared to that in the other are collected and by
adding or subtracting them from the balance of the amount of profit
shown by one of the accounts, shown by the other can be reached.
The procedure is similar to the one followed for reconciling the balance
with a bank that shown by the cash book or the ledger.
ITEMS INCLUDED IN
ACCOUNTS BUT NOT
IN COST ACCOUNTS :
(a) Matters of pure finance :
Interest received on bank deposits.
Interest, dividends, etc. received on investments.
Losses on the sales of investments, building etc.
Profits made on the sale of fixed assets.
Expenses of the company‘s share transfer office, if any.
Transfer fee received.
Remuneration paid to the proprietor in excess of a fair reward for
Damages payable at law.
Penalties payable at law.
Losses due to scrapping of machinery.
(b) Item included in the cost accounts only (notional expenses):
Charges in lieu of rent where premises are owned.
Interest on capital employed in production, but upon which no
interest is actually paid if the firm decided to treat interest as
part of cost.
Salary for the proprietor where he works but does not charge a
(c) Items whose treatment is different in the two sets of accounts. The
objective of cost accounting is to provide information to management
for decision making and control purposes while financial accounting
conforms to external reporting requirements. Hence there are chances
that certain items are treated differently in the two sets of accounts.
For example, LIFO method is not allowed for inventory valuation in
India as per the Accounting Standard 2 issued by the Council of the
ICAI. However, this method may be adopted for cost accounts as it is
more suitable for arriving at costs which shall be used as a base for
deciding selling prices. Similarly cost accounting may use a different
method of depreciation than what is allowed under financial accounting.
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(d) Varying basis of valuation: It is another factor which sometimes is
responsible for the difference. It is well known that in financial
accounts stock are valued either at cost or market price, whichever is
lower. But in Cost Accounts, stocks are only valued at cost.
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TYPES OF COSTING (JOB, CONTRACT, OPERATING, PROCESS, JOINT & BY PRODUCT)
Cost plus Contract Under Cost plus Contract, the contract price is ascertained by adding a
percentage of profit to the total cost of the work. Such type of contracts
are entered into when it is not possible to estimate the Contract Cost
with reasonable accuracy due to unstable condition of material, labour
(i) The Contractor is assured of a fixed percentage of profit. There is no
risk of incurring any loss on the contract.
(ii) It is useful specially when the work to be done is not definitely fixed
at the time of making the estimate.
(iii) Contractee can ensure himself about ‗the cost of the contract‘, as
he is empowered to examine the books and documents of the contractor
to ascertain the veracity of the cost of the contract.
Disadvantages - The contractor may not have any inducement to avoid
wastages and effect economy in production to reduce cost.
Escalation clause is a stipulation in the contract that the contract price
will be increased by an agreed amount or percentage if the price of the
raw material, wages, etc increases beyond a certain limit. The object of
this clause is to safeguard the interest of both side against unfavorable
change in price. While due to loss of the contractor‘s interest is
safeguarded as his profit percentage is not reduced. The customer‘s
interest is safeguarded as quality is ensured because due to the
escalation clause the contractor does not use material of low quality.
Notional Profit and
Retention Money in
Notional profit is the excess of income till date over expenditure till date
on a contract. Since actual profit can be computed only after the contract
is complete, notional profit is used to recognize profit during the course of
Notional profit = Value of work certified + cost of work uncertified – cost
incurred till date
Retention money: the contractor gets money on the basis of work
completed as certified by the certificate of work done. Sometimes the
customer does not pay the whole value of work done. As per the
agreement, a certain percentage of the value of work done is retained by
the customer. This is called as retention money.
The objective behind retention money is to place the customer in a
favorable position as against the contractor. It safeguards the interest of
the customer as against the failure of the contractor to fulfill any of the
clauses of the agreement or against the defective work found later on.
Recognition of Profit
Profit on uncompleted contract is computed on the basis of notional profit
and the percentage of the work done. It is transferred to costing profit
and loss account and computed as follows:
i. Stage of contract – Less than 25% : Profit to be recognized is NIL
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as it is impossible to foresee clearly the future position.
ii. Stage of contract – More than 25% but less than 50% : profit to
be recognized is
Profit = 1/3 * Notional Profit * Cash received/Work certified
iii. Stage of contract – More than 50% but less than 90% : profit to
be recognized is
Profit = 2/3 * Notional profit * Cash received/work certified
iv. Stage of contract – more than 90% : Profit to be recognized is a
proportion of estimated profit. The estimated profit is arrived at by
deducting the contract price the aggregate of estimated cost and
expenditure incurred. The proportion of estimated profit is
computed by adopting any of the following formula:
a. Estimated profit * work certified/contract price
b. Estimated profit * work certified/contract price * Cash
received/ work certified
c. Estimated profit * cost of work to date/ estimated total cost
Operating costing is one of the methods of costing used to ascertain the
cost of generating and rendering services such as transport, hospital,
canteens, electricity, etc. Job costing is undertaken in industries which
provides services such as canteens, hospitals, electricity, transport, etc.
Operating costing aims at ascertaining the operating costs.
The cost incurred to generate and render services such as hospital,
canteen, electricity, transport, etc is called operating cost.
Operating costs are classified into three broad categories;
i. Operating and running cost: these are the cost which are
incurred for operating and running the vehicle. For e.g. cost of
diesel, petrol, etc. these cost are variable in nature and vary with
the operations in more or less same proportions.
ii. Standing costs: standing cost are the cost which are incurred
irrespective of operation. For e.g. rent of garage, salary of drivers,
insurance premium, etc. it is fixed in nature and thus the cost
goes on accumulating as the time passes.
iii. Maintenance costs: Maintenance cost are the cost which are
incurred to keep the vehicle in good or running condition. For e.g.
cost of repair, painting, overhaulting, etc. it is semi variable in
nature and is influenced by both time and volume of operation.
Job Costing and
Accounting to job costing, costs are collected and accumulated according
to job. Each job or unit of production is treated as a separate entity for
the purpose of costing. Job costing may be employed when jobs are
executed for different customers according to their specification. Batch
costing is a form of job costing, a lot of similar units which comprises the
batch may be used as a cost unit for ascertaining cost. Such a method of
costing is used in case of pharmaceutical industry, readymade garments,
industries manufacturing parts of TV, radio sets etc.
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quantity in Batch
In batch costing the most important problem is the determination of
‗Economic Batch Quantity‘ The determination of economic batch quantity
involves two type of costs viz, (i) set up cost and (ii) carrying cost. With
the increase in the batch size, there is an increase in the carrying cost
but the set-up cost per unit of the product is reduced; this situation is
reversed when the batch size is reduced. Thus there is one particular
batch size for which both set up and carrying costs are minimum. This
size of a batch is known as economic or optimum batch quantity.
Economic batch quantity can be determined with the help of a table,
graph or mathematical formula. The mathematical formula usually used
for its determination is as follows:
Where, D = Annual demand for the product
S = Setting up cost per batch
C = Carrying cost per unit of production per annum
The presence of opening or closing WIP poses an accounting problem as
to the evaluation of inventory as well as ascertainment of cost per unit of
output. To solve this problem, the WIP or incomplete units are expressed
in terms of complete units, which are termed as equivalent unit of
Thus, equivalent production refers to a systematic procedure of
expressing the output of a process in terms of completed units. It is
therefore, the conversion of uncompleted production into its equivalent
Equivalent units of production means converting the uncompleted
production into its equivalent completed units. To compute the equivalent
units, in each process, an estimate is made of the percentage completion
of the closing WIP. The WIP is inspected and an estimate is made of the
degree of completion, usually on a percentage basis.
Abnormal Waste &
Abnormal Gain and
their treatment in
The loss, which is unavoidable and is expected during the course of
production, is called as normal process loss.
Normal process loss may arise due to evaporation, chemical reaction,
Accounting treatment of Normal Loss:
No separate account is maintained for normal process loss. This is
because the cost of normal loss is to be borne by the goods units
produced in the process. The cost of normal loss is ascertained and
charged to respective process account.
If normal loss is disposed off for some price, then the realizable value
from the sale of normal process loss is credited to the concerned process
account. Thus, in this type of situation, only the difference between the
cost of normal process loss and its realizable value is to be borne by the
Abnormal Process Loss:
There are certain losses, which are caused by unexpected or abnormal
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reasons such as fire, theft, breakage, negligence, etc. such losses are
known as abnormal process loss from accounting point of view.
Abnormal process loss = actual process loss – normal process loss
A separate account is maintained for abnormal loss account . this is so
because since the abnormal loss are avoidable and can be controlled, it is
not fair to charge the cost of abnormal loss to the goods units.
The abnormal process loss is closed by transferring the balance to costing
profit and loss account.
If the abnormal loss has some scrap value and is disposed off
accordingly, then only the balance abnormal loss is debited to costing
profit and loss account.
Abnormal Process Gain:
It is quite natural that certain amount of material will be lost or scraped
during the course of production. It is an expected loss, which cannot be
avoided. Such a loss is anticipated in advance and is termed as normal
process loss. If the actual loss is lower than anticipated normal loss, then
there arises abnormal gain.
A separate account of abnormal gain is maintained. The cost of abnormal
gain is ascertained and this cost is debited to the respective process
account and credited to abnormal gain account. The abnormal gain
account is debited with the figure of reduced normal loss both in units as
well as costs.
The abnormal gain is closed by transferring the balance to costing profit
and loss account.
Definition of product costs
Product costs are inventoriable costs. These are the costs, which are
assigned to the product. Under marginal costing variable manufacturing
costs and under absorption costing, total manufacturing costs constitute
Purposes for computing product costs:
The three different purposes for computing product costs are as follows:
(i) Preparation of financial statements: Here focus is on inventoriable
(ii) Product pricing: It is an important purpose for which product costs
are used. For this purpose, the cost of the areas along with the value
chain should be included to make the product available to the customer.
(iii) Contracting with government agencies: For this purpose government
agencies may not allow the contractors to recover research and
development and marketing costs under cost plus contracts.
Explain briefly the
procedure for the
valuation of Work-in-
Valuation of Work-in process: The valuation of work-in-process can be
made in the following three ways, depending upon the assumptions made
regarding the flow of costs.
– First-in-first-out (FIFO) method
– Last-in-first-out (LIFO) method
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– Average cost method
A brief account of the procedure followed for the valuation of work-in-
process under the above three methods is as follows;
FIFO method: According to this method the units first entering the
process are completed first. Thus the units completed during a period
would consist partly of the units which were incomplete at the beginning
of the period and partly of the units introduced during the period.
The cost of completed units is affected by the value of the opening
inventory, which is based on the cost of the previous period. The closing
inventory of work-in-process is valued at its current cost.
LIFO method: According to this method units last entering the process
are to be completed first. The completed units will be shown at their
current cost and the closing-work in process will continue to appear at
the cost of the opening inventory of work-in-progress along with current
cost of work in progress if any.
Average cost method: According to this method opening inventory of
work-in-process and its costs are merged with the production and cost of
the current period, respectively. An average cost per unit is determined by
dividing the total cost by the total equivalent units, to ascertain the value
of the units completed and units in process.
“Operation costing is
Operation costing is concerned with the determination of the cost of each
operation rather than the process:
In the industries where process consists of distinct operations, the
operation costing method is applied.
It offers better control and facilitates the computation of unit
operation cost at the end of each operation.
What is inter-process
profit? State its
Definition of Inter-Process Profit and Its advantages and disadvantages:
In some process industries the output of one process is transferred to the
next process not at cost but at market value or cost plus a percentage of
profit. The difference between cost and the transfer price is known as
The advantages and disadvantages of using inter-process profit, in the
case of process type industries are as follows:
1. Comparison between the cost of output and its market price at the
stage of completion is facilitated.
2. Each process is made to stand by itself as to the profitability.
1. The use of inter-process profits involves complication.
2. The system shows profits which are not realised because of stock not
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Joint products and
Joint Products are defined as the products which are produced
simultaneously from same basic raw materials by a common process or
processes but none of the products is relatively of more importance or
value as compared with the other.
For example spirit, kerosene oil, fuel oil, lubricating oil, wax, tar and
asphalt are the examples of joint products.
By products, on the other hand, are the products of minor importance
jointly produced with other products of relatively more importance or
value by the common process and using the same basic materials. These
products remain inseparable upto the point of split off. For example in
Dairy industries, batter or cheese is the main product, but butter milk is
Points of Distinction:
(1) Joint product are the products of equal economic importance, while
the by-products are of lesser importance.
(2) Joint products are produced in the same process, whereas by-
products are produced from the scrap or the discarded materials of the
(3) Joint products are not produced incidentally, but by-products emerge
Treatment of by-
product cost in Cost
(i) When they are of small total value, the amount realized from their sale
may be dealt as follows:
Sales value of the by-product may be credited to Profit and Loss
Account and no credit be given in Cost Accounting. The credit to
Profit and Loss Account here is treated either as a miscellaneous
income or as additional sales revenue.
The sale proceeds of the by product may be treated as deduction
from the total costs. The sales proceeds should be deducted either
from production cost or cost of sales.
(ii) When they require further processing: In this case, the net realizable
value of the by product at the split-off point may be arrived at by
subtracting the further processing cost from realizable value of by
products. If the value is small, it may be treated as discussed in (i)
of joint costs upto
the point of
the joint products
using market value
at the point of
separation and net
method is done?
Apportionment of Joint Cost amongst Joint Products using:
Market value at the point of separation
This method is used for apportionment of joint costs to joint products
upto the split off point. It
is difficult to apply if the market value of the product at the point of
separation is not available. It is useful method where further processing
costs are incurred disproportionately.
Net realizable value Method
From the sales value of joint products (at finished stage) are deducted:
− Estimated profit margins
− Selling distribution expenses, if any
− Post split off costs.
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The resultant figure so obtained is known as net realizable value of joint
products. Joint costs are apportioned in the ratio of net realizable value.
Describe briefly, how
joint costs upto the
point of separation
may be apportioned
joint products under
(i) Average unit cost
(iii) Market value at
the point of
(iv) Market value
(v) Net realizable
Methods of apportioning joint cost among the joint products:
(i) Average Unit Cost Method: under this method, total process cost
(upto the point of separation) is divided by total units of joint products
produced. On division average cost per unit of production is obtained.
The effect of application of this method is that all joint products will have
uniform cost per unit.
(ii) Contribution Margin Method: under this method joint costs are
segregated into two parts – variable and fixed. The variable costs are
apportioned over the joint products on the basis of units produced
(average method) or physical quantities. If the products are further
processed, then all variable cost incurred be added to the variable cost
determined earlier. Then contribution is calculated by deducting variable
cost from their respective sales values. The fixed costs are then
apportioned over the joint products on the basis of contribution ratios.
(iii) Market Value at the Time of Separation: This method is used
for apportioning joint costs to joint products upto the split off point. It is
difficult to apply if the market value of the products at the point of
separation are not available. The joint cost may be apportioned in the
ratio of sales values of different joint products.
(iv) Market Value after further Processing: Here the basis of
apportionment of joint costs is the total sales value of finished products
at the further processing. The use of this method is unfair where further
processing costs after the point of separation are disproportionate or
when all the joint products are not subjected to further processing.
(v) Net Realisable Value Method: Here joint costs is apportioned on
the basis of net realisable value of the joint products,
Net Realisable Value = Sale value of joint products (at finished stage)
(-) estimated profit margin
(-) selling & distribution expenses, if any
(-) post split off cost
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STANDARD COSTING, MARGINAL COSTING AND BUDGETARY CONTROL
Key factor or Limiting
Key Factor is a factor which at a particular time or over a period limits
the activities of an undertaking. It may be the level of demand for the
products or services or it may be the shortage of one or more of the
productive resources, e.g., labour hours, available plant capacity, raw
material‘s availability etc.
Examples of Key Factors or Limiting Factors are:
(a) Shortage of raw material.
(b) Shortage of labour.
(c) Plant capacity available.
(d) Sales capacity available.
(e) Cash availability.
The marginal cost remains constant per unit of output whereas the
fixed cost remains constant in total. Since marginal cost per unit
is constant from period to period within a short span of time, firm
decisions on pricing policy can be taken. If fixed cost is included,
the unit cost will change from day to day depending upon the
volume of output. This will make decision making task difficult.
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 of overheads if
production is less or if overheads are more. There will be over-
recovery of overheads if production is more than the budget or
actual expenses are less than the estimate. This creates the
problem of treatment of such under or over-recovery of overheads.
Marginal costing avoids such under or over recovery of overheads.
Advocates of marginal costing argues that under the marginal
costing technique, the stock of finished goods and work-in-
progress 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.
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.
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.
Marginal costing helps the management in taking a number of
business decisions like make or buy, discontinuance of a particular
product, replacement of machines, etc.
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.
Contribution of a product itself is not a guide for optimum
profitability unless it is linked with the key factor.
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
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should be cautioned while giving marginal cost.
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
Some of the assumptions regarding the behaviour of various costs
are not necessarily true in a realistic situation.
Marginal costing ignores time factor and investment. For example,
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
Assumptions of Cost
Changes in the levels of revenues and costs arise only because
of changes in the number of product (or service) units produced
and old – for example, the number of television sets produced
and sold by Sony Corporation or the number of packages
delivered by Overnight Express. The number of output units is
the only revenue driver and the only cost driver. Just as a cost
driver is any factor that affects costs, a revenue driver is a
variable, such as volume, that causally affects revenues.
Total costs can be separated into two components; a fixed
component that does not vary with output level and a variable
component that changes with respect to output level.
Furthermore, variable costs include both direct variable costs
and indirect variable costs of a product. Similarly, fixed costs
include both direct fixed costs and indirect fixed costs of a
When represented graphically, the behaviours of total revenues
and total costs are linear (meaning they can be represented as a
straight line) in relation to output level within a relevant range
(and time period).
Selling price, variable cost per unit, and total fixed costs (within a
relevant range and time period) are known and constant.
The analysis either covers a single product or assumes that 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, subtracted, and
compared without taking into account the time value of money.
Write short notes on
Angle of Incidence
This angle 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
Margin of Safety:
The margin of safety can be defined as the difference between the
expected level of sale and the breakeven sales. The larger the margin of
safety , the higher are the chances of making profits.
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The Margin of Safety can also be calculated by identifying the difference
projected sales and breakeven sales in units multiplied by the
contribution per unit. This is possible because, at the breakeven point
all the fixed costs are recovered and any further contribution goes into
the making of profits.
and Marginal Costing:
Basis Absorption Costing Marginal Costing
In this, absorption rates
includes both fixed and
Marginal costing rate
include only variable
In absorption costing,
valuation is on product
cost i.e prime cost plus
applied fixed and
Marginal costing will be at
prime cost plus applied
In absorption costing,
the overhead may be
classified as factory,
selling and distribution.
In marginal costing,
overheads are classified
as fixed and variable.
It distorts decision
It facilitates decision
Profitability Fixed cost are charged
to the cost of
reasonable share of fixed
costs and thus
profitability of a product
is influenced by an
apportionment of fixed
Fixed cost are regarded as
period costs. The
profitability of different
products are judged by
their PV ratio.
Need of Standard
Standard costing system is widely accepted as it serves the different
needs of an organisation. The standard costing is preferred for the
(a) Prediction of future cost for decision making: Standard costs are
set after taking into account all the future possibilities and can be
termed as future cost. Standard cost is used for calculating profitability
from a project/ order/ activity proposed to be undertaken. Hence,
standard cost is very useful for decision making purpose.
(b) Provide target to be achieved: Standard costs are the target cost
which should be no be crossed. It keeps challenging target before the
responsibility centres. Management of responsibility centres monitor the
performance continuously against the set standards and deviations are
(c) Used in budgeting and performance evaluation: Standard costs are
used to set budgets and based on these budgets managerial
46 | P a g e
performance is evaluated. This is of two benefits, one managers of a
responsibility centre will not compromise with the quality to fulfill the
budgeted quantity and second, variances can be traced with the
responsible department or person.
(d) Interim profit measurement and inventory valuation: Actual profit
is known only after the closure of the account. Few organisations used
to prepare profitability statement for some interim periods as per the
requirement of the management. To arrive at the profitability figure
standard costs are deducted from the revenue.
Process of Standard
The process of standard cost is as below:
(i) Setting of Standards: The first step is to set standards which are to
achieved, The process of standard setting is explained above.
(ii) Ascertainment of actual costs: Actual cost for each component of
cost is ascertained. Actual costs are ascertained from books of account,
material invoices, wage sheet, charge slip etc.
(iii) Comparison of actual cost and standard cost: Actual costs are
compared with the standards costs and variances are determined.
(iv) Investigation of variances: Variances arises are investigated for
further action. Based on this performance is evaluated and appropriate
actions are taken.
(v) Disposition of variances: variances arise are disposed off by
transferring it the relevant accounts (costing profit and loss account) as
per the accounting method (plan) adopted.
Types of Variances:
Controllable and un-controllable variances: The purpose of the
standard costing reports is to investigate the reasons for significant
variances so as to identify the problems and take corrective action.
Variances are broadly of two types, namely, controllable and
uncontrollable. Controllable variances are those which can be controlled
by the departmental heads whereas uncontrollable variances are those
which are beyond their control. Responsibility centres are answerable
for all adverse variances which are controllable and are appreciated for
Controllability is a subjective matter and varies from situation to
situation. If the uncontrollable variances are of significant nature and
are persistent, the standard may need revision.
Favourable and Adverse variance: Favourable variances are those
which are profitable for the company and Adverse variances are those
which causes loss to the company. While computing cost variances
favourable variance means actual cost is less than standard cost. On
the other hand adverse variance means actual cost is exceeding
standard cost. The situation will be reversed for sales variance.
Favourable variances are profitable for the company and on contrary
adverse variance causes loss to the company. Hence, these are credited
and debited in the costing profit and loss account respectively.
Favourable variance in short denoted by capital ‗F‘ and adverse
variances by capital ‗A‘.
Students may note that signs of favourable and adverse variance may or
may not match exactly with mathematical signs i.e. (+) or (-).
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There is no unanimity of opinion in regard to disposition of variances.
The following are the various methods:–
(a) Write off all variances to profit and loss account or cost of sales every
(b) Distribute the variance prorata to cost of sales, work-in-progress and
finished good stocks.
(c) Write off quantity variance to profit and loss account but the price
variances may be spread over cost of sales, work-in-progress and
finished goods stocks. The reason behind apportioning price variances
to inventories and cost of sales is that they represent cost although they
are described as variance.
The use of budgetary control system enables the management of
a business concern to conduct its business activities in the
It is a powerful instrument used by business houses for the
control of their expenditure. It infact provides a yardstick for
measuring and evaluating the performance of individuals and
It reveals the deviations to management, from the budgeted
figures after making a comparison with actual figures.
Effective utilisation of various resources like—men, material,
machinery and money is made possible, as the production is
planned after taking them into account.
It helps in the review of current trends and framing of future
It creates suitable conditions for the implementation of standard
costing system in a business organisation.
It inculcates the feeling of cost consciousness among workers.
The limitations of budgetary control system are as follows :
(i) Budgets may or may not be true, as they are based on estimates.
(ii) Budgets are considered as rigid document.
(iii) Budgets cannot be executed automatically.
(iv) Staff co-operation is usually not available during budgetary
(v) Its implementation is quite expensive.
Fixed budget -
According to Chartered Institute of Management Accountants of
England, ―a fixed budget, is a budget designed to remain unchanged
irrespective of the level of activity actually attained‖. A fixed budget
shows the expected results of a responsibility center for only one
activity level. Once the budget has been determined, it is not changed,
even if the activity changes. Fixed budgeting is used by many service
companies and for some administrative functions of manufacturing
companies, such as purchasing, engineering, and accounting. Fixed
Budget is used as an effective tool of cost control. In case, the level of
activity attained is different from the level of activity for budgeting
purposes, the fixed budget becomes ineffective. Such a budget is quite
suitable for fixed expenses. It is also known as a static budget.
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Master budget Master budget is a consolidated summary of the various functional
budgets. A master budget is the summary budget incorporating its
component functional budget and which is finally approved, adopted
and employed. It is the culmination of the preparation of all other
budgets like the sales budget, production budget, purchase budget, etc.
it consists in reality of the budgeted profit and loss account, the balance
sheet and budgeted cash flow statement.
Flexible budget Unlike static budgets, flexible budgets show the expected results of a
responsibility center for several activity levels. You can think of a
flexible budget as a series of static budgets for different levels of
activity. Such budgets are especially useful in estimating and
controlling factory costs and operating expenses. It is more realistic and
practicable because it gives due consideration to cost behaviour at
different levels of activity.
While preparing a flexible budget the expenses are classified into three
(ii) Variable, and
Semi-variable expenses are further segregated into fixed and variable
Flexible budgeting may be resorted to under following situations:
(i) In the case of new business venture due to its typical nature
it may be difficult to forecast the demand of a product
(ii) Where the business is dependent upon the mercy of nature
e.g., a person dealing in wool trade may have enough market
if temperature goes below the freezing point.
(iii) In the case of labour intensive industry where the production
of the concern is dependent upon the availability of labour.
Advantages of Zero
ZBB process identifies inefficient operation and considers every
time alternative ways of performing the same task.
ZBB is used in identification of wastage and obsolescent items of
ZBB is very much useful for the staff and support areas of an
organisation such as research and development, quality control,
pollution control, etc
The core resources will be allocated more efficiently according to
the priority of program.
Departmental budgets are closely linked with corporate
Limitation of ZBB:
i. ZBB requires skilled and trained managerial staff
ii. ZBB is time consuming as well as costly
iii. ZBB faces various operational problems during the
implementation of such technique.
iv. ZBB requires full support of top management.
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i. Sales budget
ii. Production budget
iii. Materials budget
iv. Labour budget
v. Manufacturing overhead budget
vi. Administration cost budget
vii. Plant utilization budget
viii. Cash budget
ix. Capital Expenditure budget
x. Research and Development budget
Zero base budgeting is a revolutionary concept of planning the future
activities and there is a sharp contradiction from conventional
budgeting. Zero base budgeting, may be better termed as ―De Nova
Budgeting‖ or budgeting from the beginning without any reference to
any base past budgets and actual happening. Zero base budgeting may
be defined as ―a planning and budgeting process which requires each
manager to justify his entire budget requested in detail from scratch
(hence zero base) and shifts the burden of proof to each manager to
justify why he should spend any money at all. The approach requires
that all activities be analyzed in decision packages which are evaluated
by systematic analysis and ranked in order of importance.‖
It is a technique which complements and links the existing planning,
budgeting and review processes. It identifies alternative and efficient
methods of utilizing limited resources in effective attainment of selected
benefits. It is a flexible management approach which provides a credible
rationale for reallocating resources by focusing on systematic review
and justification of the funding and performance levels of current
programs of activities.
The concept of ZBB was developed in USA. Under ZBB, each program
and each of its constituent part is challenged for its very inclusion in
each year‘s budget. Program objectives are also re-examined with a view
to start things afresh. It requires analysis and evaluation of each
program in order to justify its inclusion or exclusion from the final
Advantages of ZBB:
(i) ZBB is not based on incremental approach, so its promotes
operational efficiency because it requires managers to review and justify
their activities or the funds requested.
(ii) Since this system requires participation of all managers, preparation
of budgets, responsibilities of all levels at management in successful
execution of budgetary system can be ensured.
(iii) This technique is relatively elastic because budgets are prepared
every year on a zero base. This system make it obligatory to develop
financial planning and management information system.
(iv) This system weeds out inefficiency and reduces the cost of
production because every budget proposal is evaluated on the basis of
cost benefit analysis.
(v) It provides the organisation with a systematic way to evaluate
50 | P a g e
different operations and programs undertaken by the management. It
enables management to allocate resources according to priority of the
(vi) it is helpful to the management in making optimum allocation of
scarce resources because a unique aspect of zero base budgeting is the
evaluation of both current and proposed expenditure and placing it
some order of priority.
Criticism against ZBB:
(i) Defining the decision units and decision packages is rather difficult.
(ii) ZBB requires a lot of training for managers.
(iii) Cost of preparing the various packages may be very high in large
firms involving large number of decision packages.
(iv) it may lay more emphasis on short term benefits to the detriment of
long term objectives of the organisation.
(v) It will lead to enormous increase in paper work created by the
decision packages. The assumptions about cost and benefits in each
package must be continually up dated and new packages developed as
soon as new activities emerge.
(vi) Where objectives are very difficult to quantify as in research and
development, zero base budgeting does not offer any significant control
The concept of performance budgeting relates to greater management
efficiency specially in government work. With a view to introducing a
system‘s approach, the concept of performance budgeting was
developed and as such there was a shift from financial classification to
Cost or Objective Classification. Performance budgeting, is therefore,
looked upon as a budget based on functions, activities and projects and
is linked to the budgetary system based on objective classification of
The purpose of performance budgeting is to focus attention upon the
work to be done, services to be rendered rather than things to be spend
for or acquired. In performance budgeting, emphasis is shifted from
control inputs to efficient and economic management of functions and
objectives. Performance budgeting takes a system view of activities by
trying to associate the inputs of the expenditure with the output of
accomplishment in terms of services, benefits, etc. in performance
budgeting, the objective of the budget makers and setting the task and
sub task for accomplishment of the defined objectives are to be clearly
decided well in advance before budgetary allocations of inputs are
The main purpose of performance budgeting are:
(i) TO review at every stage, and at every level of organisation, so as to
measure progress towards the short term and long term objectives.
(ii) To inter relate physical and financial aspects of every programme,
project or activity.
(iii) TO facilitate more effective performance audit
(iv) TO assess the effects of the decision making of supervisor to the
middle and top managers.
(v) To bring annual plans and budgets in line with the short and long
51 | P a g e
term plan objectives.
(vi) To present a comprehensive operational document showing the
complete planning fabric of the programme and prospectus their
objectives interwoven with the financial and physical aspects.
However, Performance budgeting has certain limitations such as
difficulty in classifying Programmes and activities, problems of
evaluation of various schemes, relegation to the background of
important Programmes. Moreover, the technique enables only
quantitative evaluation scheme and sometimes the needed results
cannot be measured.
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TALDA LEARNING CENTRE
Shop No. 70, 2nd Floor, Gulshan Towers, Jaistambh Square, Amravati.
CA IPC & CS EXECUTIVE
CA AMIT TALDA
(For Private Circulation Only)
56 | P a g e
THEORY ON FINANCIAL MANAGEMENT (IPC)
TYPES OF FINANCING
BRIDGE FINANCE: Bridge finance refers to loans taken by a company normally from
commercial banks for a short period, pending disbursement of loans
sanctioned by financial institutions.
Normally, it takes time for financial institutions to disburse loans to
companies. However, once the loans are approved by the term lending
institutions, companies, in order not to lose further time in starting
their projects, arrange short term loans from commercial banks.
Bridge loans are also provided by financial institutions pending the
signing of regular term loan agreement, which may be delayed due to
non-compliance of conditions stipulated by the institutions while
sanctioning the loan.
The bridge loans are repaid/ adjusted out of the term loans as and
when disbursed by the concerned institutions.
Bridge loans are normally secured by hypothecating movable assets,
personal guarantees and demand promissory notes. Generally, the rate
of interest on bridge finance is higher as com- pared with that on term
The venture capital financing refers to financing of new high risky venture
promoted by qualified entrepreneurs who lack experience and funds to give
shape to their ideas. In broad sense, under venture capital financing
venture capitalist make investment to purchase equity or debt securities
from inexperienced entrepreneurs who undertake highly risky ventures
with a potential of success.
Methods of Venture Capital Financing: In India , Venture Capital financing
was first the responsibility of developmental financial institutions such as
the Industrial Development Bank of India (IDBI) , the Technical
Development and Information Corporation of India(now known as ICICI)
and the State Finance Corporations(SFCs). In the year 1988, the
Government of India took a policy initiative and announced guidelines for
Venture Capital Funds (VCFs). In the same year, a Technology
Development Fund (TDF) financed by the levy on all payments for
technology imports was established This fund was meant to facilitate the
financing of innovative and high risk technology programmes through the
The guidelines mentioned above restricted the setting up of Venture Capital
Funds by banks and financial institutions only. Subsequently guidelines
were issued in the month of September 1995, for overseas investment in
Venture Capital in India.
A major development in venture capital financing in India was in the year
1996 when the Securities and Exchange Board of India (SEBI) issued
guidelines for venture capital funds to follow. These guidelines described a
venture capital fund as a fund established in the form of a company or
trust, which raises money through loans, donations, issue of securities or
units and makes or proposes to make investments in accordance with the
regulations. This move was instrumental in the entry of various foreign
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venture capital funds to enter India.. The guidelines were further amended
in April 2000 with the objective of fuelling the growth of Venture Capital
activities in India. A few venture capital companies operate as both
investment and fund management companies; others set up funds and
function as asset management companies.
It is hoped that the changes in the guidelines for the implementation of
venture capital schemes in the country would encourage more funds to be
set up to give the required momentum for venture capital investment in
Some common methods of venture capital financing are as follows:
a) Equity financing : The venture capital undertakings generally requires
funds for a longer period but may not be able to provide returns to the
investors during the initial stages. Therefore, the venture capital finance
is generally provided by way of equity share capital. The equity
contribution of venture capital firm does not exceed 49% of the total
equity capital of venture capital undertakings so that the effective
control and ownership remains with the entrepreneur.
b) Conditional loan: A conditional loan is repayable in the form of a royalty
after the venture is able to generate sales. No interest is paid on such
loans. In India venture capital financiers charge royalty ranging between
2 and 15 per cent; actual rate depends on other factors of the venture
such as gestation period, cash flow patterns, risk and other factors of
the enterprise. Some Venture capital financiers give a choice to the
enterprise of paying a high rate of interest (which could be well above 20
per cent) instead of royalty on sales once it becomes commercially
c) Income note: It is a hybrid security which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay
both interest and royalty on sales but at substantially low rates. IDBI's
VCF provides funding equal to 80 – 87.50% of the projects cost for
commercial application of indigenous technology.
d) Participating debenture: Such security carries charges in three phases
— in the start up phase no interest is charged, next stage a low rate of
interest is charged up to a particular level of operation, after that, a
high rate of interest is required to be paid.
It is a method of recycling of funds. It is especially beneficial to financial
intermediaries to support the lending volumes. Assets generating steady
cash flows are packaged together and against this asset pool, market
securities can be issued, e.g. housing finance, auto loans, and credit card
Process of Debt Securitisation
(i) The origination function – A borrower seeks a loan from a finance
company, bank, HDFC. The credit worthiness of borrower is evaluated and
contract is entered into with repayment schedule structured over the life of
(ii) The pooling function – Similar loans on receivables are clubbed
58 | P a g e
together to create an underlying pool of assets. The pool is transferred in
favour of Special purpose Vehicle (SPV), which acts as a trustee for
(iii) The securitisation function – SPV will structure and issue securities
on the basis of asset pool. The securities carry a coupon and expected
maturity which can be asset-based/mortgage based. These are generally
sold to investors through merchant bankers. Investors are – pension funds,
mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors
bear the credit risk and issuer is under an obligation to pay to investors
only if the cash flows are received by him from the collateral. The benefits
to the originator are that assets are shifted off the balance sheet, thus
giving the originator recourse to off-balance sheet funding.
Benefits to the Originator
(i) The assets are shifted off the balance sheet, thus giving the originator
recourse to off balance sheet funding.
(ii) It converts illiquid assets to liquid portfolio.
(iii) It facilitates better balance sheet management as assets are transferred
off balance sheet facilitating satisfaction of capital adequacy norms.
(iv) The originator's credit rating enhances.
For the investor securitisation opens up new investment avenues. Though
the investor bears the credit risk, the securities are tied up to definite
As compared to factoring or bill discounting which largely solve the
problems of short term trade financing, securitisation helps to convert a
stream of cash receivables into a source of long term finance.
Leasing is a general contract between the owner and user of the asset over
a specified period of time. The asset is purchased initially by the lessor
(leasing company) and thereafter leased to the user (Lessee company)
which pays a specified rent at periodical intervals. Thus, leasing is an
alternative to the purchase of an asset out of own or borrowed funds.
Moreover, lease finance can be arranged much faster as compared to term
loans from financial institutions.
In recent years, leasing has become a popular source of financing in India.
From the lessee's point of view, leasing has the attraction of eliminating
immediate cash outflow, and the lease rentals can be deducted for
computing the total income under the Income tax Act. As against this,
buying has the advantages of depreciation allowance (including additional
depreciation) and interest on borrowed capital being tax-deductible. Thus,
an evaluation of the two alternatives is to be made in order to take a
decision. Practical problems for lease financing are covered at Final level in
paper of Strategic Financial Management.
a) The Seed capital assistance scheme is designed by IDBI for
professionally or technically qualified entrepreneurs and/or persons
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possessing relevant experience, skills and entrepreneurial traits.
b) All the projects eligible for financial assistance from IDBI, directly or
indirectly through refinance are eligible under the scheme. The project
cost should not exceed Rs. 2 crores and the maximum assistance under
the project will be restricted to 50% of the required promoter's
contribution or Rs. 15 lacs whichever is lower.
c) The Seed Capital Assistance is interest free but carries a service charge
of one per cent per annum for the first five years and at increasing rate
thereafter. However, IDBI will have the option to charge interest at such
rate as may be determined by IDBI on the loan if the financial position
and profitability of the company so permits during the currency of the
loan. The repayment schedule is fixed depending upon the repaying
capacity of the unit with an initial moratorium upto five years.
d) For projects with a project cost exceeding Rs. 200 lacs, seed capital may
be obtained from the Risk Capital and Technology Corporation Ltd.
(RCTC) For small projects costing upto Rs. 5 lacs, assistance under the
National Equity Fund of the SIDBI may be availed.
a) ECBs refer to commercial loans (in the form of bank loans , buyers
credit, suppliers credit, securitised instruments ( e.g. floating rate notes
and fixed rate bonds) availed from non resident lenders with minimum
average maturity of 3 years. Borrowers can raise ECBs through
internationally recognised sources like (i) international banks, (ii)
international capital markets, (iii) multilateral financial institutions
such as the IFC, ADB etc, (iv) export credit agencies, (v) suppliers of
equipment, (vi) foreign collaborators and (vii) foreign equity holders.
b) External Commercial Borrowings can be accessed under two routes viz
(i) Automatic route and (ii) Approval route. Under the Automatic route
there is no need to take the RBI/Government approval whereas such
approval is necessary under the Approval route. Company‘s registered
under the Companies Act and NGOs engaged in micro finance activities
are eligible for the Automatic Route where as Financial Institutions and
Banks dealing exclusively in infrastructure or export finance and the
ones which had participated in the textile and steel sector restructuring
packages as approved by the government are required to take the
EURO BONDS: Euro bonds are debt instruments which are not denominated in the
currency of the country in which they are issued. E.g. a Yen note floated in
Germany. Such bonds are generally issued in a bearer form rather than as
registered bonds and in such cases they do not contain the investor‘s
names or the country of their origin. These bonds are an attractive
proposition to investors seeking privacy.
Certain issuers need frequent financing through the Bond route including
that of the Euro bond. However it may be costly and ineffective to go in for
frequent issues. Instead, investors can follow the MTN programme. Under
this programme, several lots of bonds can be issued, all having different
features e.g. different coupon rates, different currencies etc. The timing of
each lot can be decided keeping in mind the future market opportunities.
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The entire documentation and various regulatory approvals can be taken at
one point of time
a) These are securities offered by non-US companies who want to list on
any of the US exchange. Each ADR represents a certain number of a
company's regular shares.
b) ADRs allow US investors to buy shares of these companies without the
costs of investing directly in a foreign stock exchange.
c) ADRs are issued by an approved New York bank or trust company
against the deposit of the original shares. These are deposited in a
custodial account in the US. Such receipts have to be issued in
accordance with the provisions stipulated by the SEC. USA which are
d) ADRs can be traded either by trading existing ADRs or purchasing the
shares in the issuer's home market and having new ADRs created,
based upon availability and market conditions.
e) When trading in existing ADRs, the trade is executed on the secondary
market on the New York Stock Exchange (NYSE) through Depository
Trust Company (DTC) without involvement from foreign brokers or
custodians. The process of buying new, issued ADRs goes through US
brokers, Helsinki Exchanges and DTC as well as Deutsche Bank. When
transactions are made, the ADRs change hands, not the certificates.
This eliminates the actual transfer of stock certificates between the US
and foreign countries.
f) In a bid to bypass the stringent disclosure norms mandated by the SEC
for equity shares, the Indian companies have however, chosen the
indirect route to tap the vast American financial market through private
debt placement of GDRs listed in London and Luxemberg Stock
g) The Indian companies have preferred the GDRs to ADRs because the US
market exposes them to a higher level or responsibility than a European
listing in the areas of disclosure, costs, liabilities and timing. The SECs
regulations set up to protect the retail investor base are some what
more stringent and onerous, even for companies already listed and held
by retail investors in their home country. The most onerous aspect of a
US listing for the companies is to provide full, half yearly and quarterly
accounts in accordance with, or at least reconciled with US GAAPs.
These are negotiable certificate held in the bank of one country
representing a specific number of shares of a stock traded on the exchange
of another country. These financial instruments are used by companies to
raise capital in either dollars or Euros. These are mainly traded in
European countries and particularly in London.
Meaning The depository receipts in
the world market is called
The depository receipts in the
US market in called ADR
GDRs do not have voting
ADRs may be with or without
Scope GDRs are more preferred
due to their easy
ADRs provide certain stringent
rules to be followed which
makes them less preferred.
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The cost involved in
operation of GDR is less
than that of ADR.
The cost involved in operation
of ADR is comparatively high
due to the formalities to be
fulfilled under US GAAP &
ADRs/GDRs and the Indian Scenario : Indian companies are shedding
their reluctance to tap the US markets. Infosys Technologies was the first
Indian company to be listed on Nasdaq in 1999. However, the first Indian
firm to issue sponsored GDR or ADR was Reliance industries Limited.
Beside, these two companies there are several other Indian firms are also
listed in the overseas bourses. These are Satyam Computer, Wipro, MTNL,
VSNL, State Bank of India, Tata Motors, Dr Reddy's Lab, Ranbaxy, Larsen
& Toubro, ITC, ICICI Bank, Hindalco, HDFC Bank and Bajaj Auto.
a) The concept of the depository receipt mechanism which is used to raise
funds in foreign currency has been applied in the Indian Capital Market
through the issue of Indian Depository Receipts (IDRs). IDRs are similar
to ADRs/GDRs in the sense that foreign companies can issue IDRs to
raise funds from the Indian Capital Market in the same lines as an
Indian company uses ADRs/GDRs to raise foreign capital.
b) The IDRs are listed and traded in India in the same way as other Indian
securities are traded. The actual shares underlying the IDRs would be
held by an overseas custodian, which shall authorize the Indian
depository to issue the IDRs.
c) The overseas custodian is required to be a foreign bank having a place
of business in India and needs approval from the Finance Ministry for
acting as a custodian while the Indian Depository needs to be registered
A Zero Coupon Bonds does not carry any interest but it is sold by the
issuing company at a discount. The difference between the discounted
value and maturing or face value represents the interest to be earned by
the investor on such bonds.
The companies can borrow funds for a short period say 6 months from
other companies which have surplus liquidity. The rate of interest on inter
corporate deposits varies depending upon the amount involved and time
The certificate of deposit is a document of title similar to a time deposit
receipt issued by a bank except that there is no prescribed interest rate on
The main advantage of CD is that banker is not required to encash the
deposit before maturity period and the investor is assured of liquidity
because he can sell the CD in secondary market.
a) Under this facility, customers are allowed to withdraw in excess of
credit balance standing in their Current Deposit Account.
b) A fixed limit is therefore granted to the borrower within which the
borrower is allowed to overdraw his account. Opening of an overdraft
account requires that a current account will have to be formally opened.
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c) Though overdrafts are repayable on demand, they generally continue for
long periods by annual renewals of the limits. This is a convenient
arrangement for the borrower as he is in a position to avail of the limit
sanctioned, according to his requirements. Interest is charged on daily
d) Since these accounts are operative like cash credit and current
accounts, cheque books are provided. As in the case of a loan account
the security in an overdraft account may be shares, debentures and
Government securities. In special cases, life insurance policies and fixed
deposit receipts are also accepted.
a) Cash Credit is an arrangement under which a customer is allowed an
advance up to certain limit against credit granted by bank. Under this
arrangement, a customer need not borrow the entire amount of advance
at one time; he can only draw to the extent of his requirements and
deposit his surplus funds in his account.
b) Interest is not charged on the full amount of the advance but on the
amount actually availed of by him. Generally cash credit limits are
sanctioned against the security of goods by way of pledge or
hypothecation. The borrower can also provide alternative security of
goods by way of pledge or hypothecation.
c) Though these accounts are repayable on demand, banks usually do not
recall such advances, unless they are compelled to do so by adverse
factors. Hypothecation is an equitable charge on movable goods for an
amount of debt where neither possession nor ownership is passed on to
the creditor. In case of pledge, the borrower delivers the goods to the
creditor as security for repayment of debt.
d) Since the banker, as creditor, is in possession of the goods, he is fully
secured and in case of emergency he can fall back on the goods for
realization of his advance under proper notice to the borrower.
PACKING CREDIT Packing credit is an advance made available by banks to an exporter. Any
exporter, having at hand a firm export order placed with him by his foreign
buyer on an irrevocable letter of credit opened in his favour, can approach
a bank for availing of packing credit. An advance so taken by an exporter is
required to be liquidated within 180 days from the date of its
commencement by negotiation of export bills or receipt of export proceeds
in an approved manner. Thus Packing Credit is essentially a short-term
Normally, banks insist upon their customers to lodge the irrevocable
letters of credit opened in favour of the customer by the overseas buyers.
The letter of credit and firms‘ sale contracts not only serve as evidence of a
definite arrangement for realisation of the export proceeds but also indicate
the amount of finance required by the exporter. Packing Credit, in the case
of customers of long standing may also be granted against firm contracts
entered into by them with overseas buyers. Packing credit may be of the
(i) Clean Packing credit: This is an advance made available to an exporter
only on production of a firm export order or a letter of credit without
exercising any charge or control over raw material or finished goods. It is a
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clean type of export advance. Each proposal is weighted according to
particular requirements of the trade and credit worthiness of the exporter.
suitable margin has to be maintained. Also, Export Credit Guarantee
Corporation (ECGC) cover should be obtained by the bank.
(ii) Packing credit against hypothecation of goods: Export finance is made
available on certain terms and conditions where the exporter has
pledgeable interest and the goods are hypothecated to the bank as security
with stipulated margin. At the time of utilising the advance, the exporter is
required to submit alongwith the firm export order or letter of credit,
relative stock statements and thereafter continue submitting them every
fortnight and whenever there is any movement in stocks.
(iii) Packing credit against pledge of goods: Export finance is made
available on certain terms and conditions where the exportable finished
goods are pledged to the banks with approved clearing agents who will ship
the same from time to time as required by the exporter. The possession of
the goods so pledged lies with the bank and is kept under its lock and key.
Some of the various financial instruments dealt with in the international
(a) Euro Bonds
(b) Foreign Bonds
(c) Fully Hedged Bonds
(d) Medium Term Notes
(e) Floating Rate Notes
(f) External Commercial Borrowings
(g) Foreign Currency Futures
(h) Foreign Currency Option
(i) Euro Commercial Papers.
Deep discount bonds are a form of zero-interest bonds. These bonds are
sold at discounted value and on maturity; face value is paid to the
investors. In such bonds, there is no interest payout during the lock- in
period. The investors can sell the bonds in stock market and realise the
difference between face value and market price as capital gain.
IDBI was the first to issue deep discount bonds in India in January 1993.
The bond of a face value of Rs. 1 lakh was sold for ` 2700 with a maturity
period of 25 years.
A commercial paper is an unsecured money market instrument issued in
the form of a promissory note. Since the CP represents an unsecured
borrowing in the money market, the regulation of CP comes under the
purview of the Reserve Bank of India which issued guidelines in 1990 on
the basis of the recommendations of the Vaghul Working Group.
These guidelines were aimed at:
(i) Enabling the highly rated corporate borrowers to diversify their sources
of short term borrowings, and
(ii) To provide an additional instrument to the short term investors.
It can be issued for maturities between 7 days and a maximum upto one
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year from the date of issue. These can be issued in denominations of ` 5
lakh or multiples therefore. All eligible issuers are required to get the credit
rating from credit rating agencies.
Long-term funds may also be provided by accumulating the profits of the
company and ploughing them back into business. Such funds belong to the
ordinary shareholders and increase the net worth of the company.
A public limited company must plough back a reasonable amount of its
profits each year keeping in view the legal requirements in this regard and
its own expansion plans. Such funds also entail almost no risk. Further,
control of present owners is also not diluted by retaining profits.
Secured premium notes are issued along with detachable warrants and are
redeemable after a notified period of say 4 to 7 years. This is a kind of NCD
attached with warrant.
It was first introduced by TISCO, which issued the SPNs to existing
shareholders on right basis. Subsequently the SPNs will be repaid in some
number of equal instalments.
The warrant attached to SPNs gives the holder the right to apply for and get
allotment of equity shares as per the conditions within the time period
notified by the company.
In the close-ended lease, the assets gets transferred to the lessor at the end
of lease, the riskof obsolescence, residual values etc. remain with the lessor
being the legal owner of theassets. In the open-ended lease, the lessee has
the option of purchasing the assets at the end of lease period.
Advantages of Issue of Preference Shares are:
(i) No dilution in EPS on enlarged capital base.
(ii) There is no risk of takeover as the preference shareholders do not have
(iii) There is leveraging advantage as it bears a fixed charge.
(iv) The preference dividends are fixed and pre-decided. Preference
shareholders do not participate in surplus profit as the ordinary
(v) Preference capital can be redeemed after a specified period.
raising funds by
issue of equity
Advantages of Raising Funds by Issue of Equity Shares
(i) It is a permanent source of finance. Since such shares are not
redeemable, the company has no liability for cash outflows associated with
(ii) Equity capital increases the company‘s financial base and thus helps
further the borrowing powers of the company.
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(iii) The company is not obliged legally to pay dividends. Hence in times of
uncertainties or when the company is not performing well, dividend
payments can be reduced or even suspended.
(iv) The company can make further issue of share capital by making a right
Some of the
forms of bank
(i) Short Term Loans: In a loan account, the entire advance is disbursed
at one time either in cash or by transfer to the current account of the
borrower. It is a single advance and given against securities like shares,
government securities, life insurance policies and fixed deposit receipts,
(ii) Overdraft: Under this facility, customers are allowed to withdraw in
excess of credit balance standing in their Current Account. A fixed limit is
therefore granted to the borrower within which the borrower is allowed to
overdraw his account.
(iii) Clean Overdrafts: Request for clean advances are entertained only
from parties which are financially sound and reputed for their integrity.
The bank has to rely upon the personal security of the borrowers.
(iv) Cash Credits: Cash Credit is an arrangement under which a
customer is allowed an advance up to certain limit against credit granted
by bank. Interest is not charged on the full amount of the advance but on
the amount actually availed of by him.
(v) Advances against goods: Goods are charged to the bank either by
way of pledge or by way of hypothecation. Goods include all forms of
movables which are offered to the bank as security.
(vi) Bills Purchased/Discounted: These advances are allowed against the
security of bills which may be clean or documentary.
Usance bills maturing at a future date or sight are discounted by the
banks for approved parties. The borrower is paid the present worth and the
bank collects the full amount on maturity.
(vii) Advance against documents of title to goods: A document
becomes a document of title to goods when its possession is recognised by
law or business custom as possession of the goods like bill of lading, dock
warehouse keeper's certificate, railway receipt, etc. An advance against the
pledge of such documents is an advance against the pledge of goods
(viii) Advance against supply of bills: Advances against bills for supply
of goods to government or semi-government departments against firm
orders after acceptance of tender fall under this category. It is this debt
that is assigned to the bank by endorsement of supply bills and executing
irrevocable power of attorney in favour of the banks for receiving the
amount of supply bills from the Government departments.
(Note: Students may answer any four of the above forms of bank credit.)
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SCOPE AND OBJECTIVE OF FINANCIAL MANGEMENT
The finance manager occupies an important position in the organizational
structure. Earlier his role was just confined to raising of funds from a
number of sources. Today his functions are multidimensional. The
functions by today‘s finance managers are as below:
1. Forecasting the financial requirement: a finance manager has to
make an estimate and forecast accordingly the financial requirements
of the firm.
2. Planning: a finance manager has to plan out how the funds will be
procured and how the acquired funds will be allocated.
3. Procurement of funds: a finance manager has to select the best
source of finance from a large number of options available. The
finance manager‘s decisions regarding the selection of source is
influenced by the need, purpose, object and the cost involved.
4. Allocation of Funds: a finance manager has also to invest or allocate
funds in best possible ways. In doing so a finance manager cannot
ignore the principles of safety, profitability and liquidity.
5. Maintaining proper Liquidity: A finance manager has also to manage
the cash in an efficient way. Cash is to be managed in such a way that
neither there is scarcity of it nor does it remain idle earning no return
6. Dividend decision: A Finance Manager has also to decide whether or
not to declare a dividend. If dividends are to be declared, that what
amount is to be paid to the shareholder and what amount is to be
retained in the business.
7. Evaluation of Financial performance: A finance manager has to
implement a system of financial control to evaluate the financial
performance of various units and then take corrective measures
8. Financial Negotiations: in order to procure and invest funds, a
finance manager has to negotiate with various financial institutions,
banks, public depositors in a meticulous way.
9. To ensure proper use of surplus: A finance manager has to see to the
proper use of surplus fund. This is necessary for expansion and
diversification plan and also for protecting the interest of share
Profit maximization is the main objective of business because:
(i) Profit acts as a measure of efficiency and
(ii) It serves as a protection against risk.
Arguments in favor of profit maximization:
(i) When profit earning is the main aim of business the ultimate
objective should be profit maximization.
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(ii) Future is uncertain. A firm should earn more and more profit to
meet the future contingencies.
(iii) Profit maximization is justified on the grounds of rationality as
profits act as a measure of efficiency and economic prosperity.
Arguments against profit maximization:
(i) It leads to exploitation of workers and consumers.
(ii) It ignores the risk factors associated with profits.
(iii) Profit in itself is a vague concept and means differently to
(iv) It is a narrow concept at the cost of social and moral
Wealth maximization is considered as the appropriate objective of an
enterprise. When the firms maximizes the stakeholder‘s wealth, the
individual stakeholder can use this wealth to maximize his individual
utility. Wealth maximization is the single substitute for a stake holder‘s
Arguments in favor of wealth maximization:
(i) Due to wealth maximization, the short term money lenders get
their payments in time.
(ii) The long time lenders too get a fixed rate of interest on their
(iii) The employee share in the wealth gets increased.
(iv) The various resources are put to economical and efficient use.
Arguments against wealth maximization:
(i) It is socially undesirable
(ii) It is not a descriptive idea
(iii) Only stock holders wealth maximization is endangered when
ownership and management are separate
Modern financial management has come a long way from traditional
corporate finance. As the economy is opening up and global resources are
being tapped, the opportunities available to a finance manager have no
limits. Financial management is passing through an era of
experimentation and excitement as a large part of finance activities are
carried out today.
A few instances of these are mentioned as below:
(i) Optimum debt equity mix is possible.
(ii) Treasury management
(iii) Risk management due to introduction of option and future
(iv) Raising resources globally through ADRs/GDRs.
(v) The rupee has become fully convertible.
(vi) Share buy backs and reverse book building\
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(vii) Free pricing and book building for IPOs, Seasoned equity
All the above three decisions are inter related because the ultimate aim of
all these is wealth maximization. Moreover, they influence each other in
one way or the other. For example, investment decision should be backed
by the finance for which financing decisions are to be taken. The
financing decision in turn influences and is influenced by dividend
Let us examine the three decisions in relation to their inter relationship:
1. Investment decision: the funds once procured have to be allocated to
the various projects. This requires proper investment decision. The
investment decisions are taken after careful analysis of various
projects through capital budgeting & risk analysis.
2. Financing Decisions: there are various sources of funds. A finance
manager has to select the best source of financing from a large
number of options available. The financing decisions regarding
selection of source and internal financing depends upon the need,
purpose, object and the cost involved.
The finance manager has also to maintain a proper balance between
long term & short term loan. He has also to ensure a proper mix of
loans funds and owner‘s fund which will yield maximum return to the
3. Dividend Decision: A finance manager has also to decide whether or
not to declare dividend. If dividend are to be declared then what
portion is to be paid to the shareholder and which portion is to be
retained in the business.
Procurement of Funds: funds can be obtained from different sources
having different characteristics in terms of risk, cost and control. The
funds raised from the issue of equity shares are the best from the risk
point of view since repayment is required only at the time of liquidation.
However, it is also the most costly source of finance due to dividend
expectations. on the other hand, debentures are cheaper than equity
shares due to their tax advantage. However, they are usually riskier than
equity shares. There are thus, risk, cost and control considerations which
a finance manager must consider while procuring funds. The cost of
funds should be at the minimum level for that a proper planning of risk
and control factors must be carried out.
Effective utilisation of funds: the finance manager has to ensure that
funds are not kept idle or there is no improper use of funds. The funds
are to be invested in a manner such that they generate returns higher
than the cost of capital to the firm. Besides this, decisions to invest in
fixed assets are to be taken only after sound analysis using capital
budgeting techniques. Similarly, adequate working capital should be
maintained so as to avoid risk of insolvency.
FINANCE FUNCTION The finance function is most important for all business enterprises. It
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remains a focus of all activities. It starts with the setting up of an
enterprise. It is concerned with raising of funds, deciding the cheapest
source of finance, utilization of funds raised, making provision for refund
when money is not required in the business, deciding the most profitable
investment, managing the funds raised and paying returns to the
providers of funds in proportion to the risks undertaken by them.
Therefore, it aims at acquiring sufficient funds, utilizing them properly,
increasing the profitability of the organization and maximizing the value
of the organization and ultimately the shareholder‘s wealth.
Though financial management and financial accounting are closely
related, still they differ in the treatment of funds and also with regards to
decision - making.
Treatment of Funds: In accounting, the measurement of funds is based
on the accrual principle. The accrual based accounting data do not reflect
fully the financial conditions of the organisation. An organisation which
has earned profit (sales less expenses) may said to be profitable in the
accounting sense but it may not be able to meet its current obligations
due to shortage of liquidity as a result of say, uncollectible receivables.
Whereas, the treatment of funds, in financial management is based on
cash flows. The revenues are recognised only when cash is actually
received (i.e. cash inflow) and expenses are recognised on actual payment
(i.e. cash outflow). Thus, cash flow based returns help financial managers
to avoid insolvency and achieve desired financial goals.
Decision-making: The chief focus of an accountant is to collect data and
present the data while the financial manager‘s primary responsibility
relates to financial planning, controlling and decision-making. Thus, in a
way it can be stated that financial management begins where financial
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FINANCIAL ANALYSIS: RATIO ANALYSIS
Ratio Analysis in
Evaluation of Liquidity: the ability of a firm to meet its short term
payment commitments is called as Liquidity. Current Ratio and Quick
Ratio helps to assess the short term solvency of the firm.
Evaluation of Operating Efficiency: Ratio thrown light on the degree
of efficiency in the management and utilisation of assets and
resources. These are indicated by Activity or Performance or Turnover
Ratios. These indicate the ability of the firm to generate revenue per
rupee of investment in its assets.
Evaluation of Profitability: Profitability ratios like GP ratio, NP ratio
are basic indicators of the profitability of the firm. In addition, various
profitability indicators like Return on capital employed, EPS, Return
on Assets are used to assess the financial performance.
Inter Firm & Intra Firm Comparison: Comparison of the firm‘s ratio
with the industry average will help evaluate the firm‘s position vis-à-
vis the industry. It will help in analyzing the firm‘s strength and
weaknesses and take corrective action. Trend analysis of ratio over a
period of years will indicate the direction of the firm‘s financial
Budgeting: Ratios are not mere post mortem of operations. This help
in depicting future financial positions. Ratios help predictor value and
are helpful in planning and forecasting the business activities of the
firm for future periods.
(i) Concept of Ideal Ratio: the concept of ideal ratio is vague and there
is no uniformity as to what an ideal ratio is.
(ii) Thin line of difference between good and bad ratio: the line of
difference between good and bad ratio is so thin that they are
(iii) Financial Ratio are not independent: the financial ratio cannot be
considered in isolation. They are inter related but not independent.
Thus, decision taken on the basis of one ratio may not be correct.
(iv) Misleading: various firms may follow different accounting policies.
In such cases ratios of companies may be misleading.
(v) Impact of Seasonal Factor: Seasonal factor brings boom or
recession. Ratios may indicate different results during different
(vi) Impact of Inflation: under the impact of inflation, the ratio might
not present true picture.
Types of Ratios
Liquidity Ratios Liquidity or short term solvency means ability of the business to pay its
short term liabilities. Inability to pay short term liabilities affects its
credibility as well as credit rating. Continuous default on the part of the
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business leads to commercial bankruptcy. Eventually such commercial
bankruptcy may lead to its sickness and dissolution. Short term lenders
and creditors of a business are very much interested to know its state of
liquidity because of their financial stake.
Current Ratio : Current Assets
Current Assets= Inventories + Sundry Debtors + Cash & Bank Balances
+ Loans & Advances + Disposable Investments
Current Liabilities= Sundry Creditors + Short term loans + Bank
Overdraft + Cash Credit + Outstanding Expenses + Proposed Dividends +
Provision for Taxation + Unclaimed Dividend
The main question the ratio addresses is ―does your business have
enough current assets to meet the payment schedule of its current debts
with a margin of safety for possible loss in current assets?‖
Standard Current Ratio is 1.33 but whether or not a specific ratio is
satisfactory depends upon the nature of business and characteristics of
its current assets and liabilities.
Quick Ratio = Quick Assets
Quick Assets= Current Assets – Inventories
Quick Liabilities= Current Liabilities – Bank Overdraft – Cash Credit
The Quick Ratio is a much more exacting measure than the Current
Ratio. By excluding inventories, it concentrates on the really liquid
assets, with value that is fairly certain. It helps answer the question: "If
all sales revenues should disappear, could my business meet its current
obligations with the readily convertible `quick' funds on hand?"
Quick Assets consist of only cash and near cash assets. Inventories are
deducted from current assets on the belief that these are not ‗near cash
assets‘. But in a seller‘s market inventories are also near cash assets.
Moreover, just like lag in collection of debtors, there is a lag in conversion
of inventories into finished goods and sundry debtors. Obviously slow
moving inventories are not near cash assets. However, while calculating
the quick ratio we have followed the conservatism convention. Quick
liabilities are that portion of current liabilities which fall due immediately.
Since bank overdraft and cash credit can be used as a source of finance
as and when required, it is not included in the calculation of quick
An acid-test of 1:1 is considered satisfactory unless the majority of "quick
assets" are in accounts receivable, and the pattern of accounts receivable
collection lags behind the schedule for paying current liabilities.
Debt Equity Ratio Debt Equity Ratio = Total Debt
A high ratio here means less protection for creditors. A low ratio, on the
other hand, indicates a wider safety cushion (i.e., creditors feel the
owner's funds can help absorb possible losses of income and capital).
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This ratio indicates the proportion of debt fund in relation to equity. This
ratio is very often referred in capital structure decision as well as in the
legislation dealing with the capital structure decisions (i.e. issue of shares
and debentures). Lenders are also very keen to know this ratio since it
shows relative weights of debt and equity.
Debt equity ratio is the indicator of leverage. According to the traditional
school, cost of capital firstly decreases due to the higher dose of leverage,
reaches minimum and thereafter increases. So infinite increase in
leverage (i.e. debt-equity ratio) is not possible. But according to
Modigliani-Miller theory, cost of capital and leverage are independent of
each other. But Modigliani-Miller theory is based on certain restrictive
assumptions, namely, perfect capital market, homogeneous expectations
by the present and prospective investors, presence of homogeneous risk
class firms, 100% dividend pay-out, no tax situation, etc. And most of
these assumptions are viewed as unrealistic. It is believed that leverage
and cost of capital are not unrelated.
Presently, there is no norm for maximum debt-equity ratio. Lending
institutions generally set their own norms considering the capital
intensity and other factors.
Debt Service Coverage Ratio = Earnings Available for Debt Service
Interest + Installment
Earnings Available for debt Service = Net profit + Non-cash operating
expenses like depreciation and other amortizations + Non-operating
adjustments like loss on sale of Fixed assets + Interest on Debt Fund.
This ratio is the vital indicator to the lender to assess the extent of ability
of the borrower to service the loan in regard to timely payment of interest
and repayment of principal amount.
It shows whether a business is earning sufficient profits to pay not only
the interest charges but also the installment due of the principal amount.
Interest Coverage Ratio = EBIT
This ratio also known as ―times interest earned ratio‖ indicates the firm‘s
ability to meet interest (and other fixed-charges) obligations. Earnings
before interest and taxes are used in the numerator of this ratio because
the ability to pay interest is not affected by tax burden as interest on debt
funds is deductible expense. This ratio indicates the extent to which
earnings may fall without causing any embarrassment to the firm
regarding the payment of interest charges. A high interest coverage ratio
means that an enterprise can easily meet its interest obligations even if
earnings before interest and taxes suffer a considerable decline. A lower
ratio indicates excessive use of debt or inefficient operations.
Preference Dividend Coverage Ratio = EAT
This ratio measures the ability of a firm to pay dividend on preference
shares which carry a stated rate of return. Earnings after tax is
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considered because unlike debt on which interest is charged on the profit
of the firm, the preference dividend is treated as appropriation of profit.
This ratio indicates margin of safety available to the preference
shareholders. A higher ratio is desirable from preference shareholders
point of view.
Capital Gearing Ratio
Formula = (Preference Share Capital + Debentures + Long term Loan)
(Equity Share Capital + Reserves & Surplus – Losses)
In addition to debt-equity ratio, sometimes capital gearing ratio is also
calculated to show the proportion of fixed interest (dividend) bearing
capital to funds belonging to equity shareholders.
For judging long term solvency position, in addition to debt-equity ratio
and capital gearing ratio, the following ratios are also used:
Long term fund
It is expected that fixed assets and core working capital are to be covered
by long term fund.
In various industries the proportion of fixed assets and current assets are
different. So there is no uniform standard of this ratio too. But it should
be less than one. If it is more than one, it means short term fund has
been used to finance fixed assets.
Inventory Turnover Ratio: This ratio also known as stock turnover ratio
establishes the relationship between the cost of goods sold during the
year and average inventory held during the year. It is calculated as
Formula = Cost of Goods Sold
*Average Inventory = (Opening Stock + Closing Stock)
This ratio indicates that how fast inventory is used/sold. A high ratio is
good from the view point of liquidity and vice versa. A low ratio would
indicate that inventory is not used/ sold/ lost and stays in a shelf or in
the warehouse for a long time.
Debtor’s Turnover Ratio: In case firm sells goods on credit, the
realization of sales revenue is delayed and the receivables are created.
The cash is realised from these receivables later on. The speed with which
these receivables are collected affects the liquidity position of the firm.
The debtors turnover ratio throws light on the collection and credit
policies of the firm.
Formula = Credit Sales
Average Account Receivables
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Creditor’s Turnover Ratio: This ratio is calculated on the same lines as
receivable turnover ratio is calculated. This ratio shows the velocity of
debt payment by the firm.
Formula = Credit Purchase
Average Account Payables
A low creditor‘s turnover ratio reflects liberal credit terms granted by
supplies. While a high ratio shows that accounts are settled rapidly.
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FINANCIAL ANALYSIS: CASH FLOW STATEMENTS
Limitations of Cash Flow Statement:
Cash flow statement cannot be equated with the Income Statement. An Income Statement
takes into account both cash as well as non-cash items and, therefore, net cash flow does
not necessarily mean net income of the business.
The cash balance as disclosed by the cash flow statement may not represent the real
liquid position of the business since it can be easily influenced by postponing purchases
and other payments.
Cash flow statement cannot replace the Income Statement or the Funds Flow Statement.
Each of them has a separate function to perform.
Cash Flow Statement Vs. Fund Flow Statement:
Basis Cash Flow Statement Fund Flow Statement
Object It indicates change in cash
It indicates change in
Scope Its coverage is narrow confined
only to cash
Its coverage is wide confined
to working capital
It is always prepared by opening
cash balance and closing cash
Opening and closing cash
balances are not required
Adjustment Due weightage is given to
outstanding and prepaid income
No adjustment is needed for
outstanding and prepaid
No need to prepare schedule of
change in working capital
It is necessary to prepare the
schedule of change in
Not shown Always shown
Calculation Cash generated from operation is
Funds generated from
operation is calculated
Analysis Essential for short term financial
Essential for long term
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MANAGEMENT OF WORKING CAPITAL
The importance of adequate working capital in commercial
undertakings can be judged from the fact that a concern needs funds
for its day-to-day running. Adequacy or inadequacy of these funds
would determine the efficiency with which the daily business may be
carried on. Management of working capital is an essential task of the
finance manager. He has to ensure that the amount of working capital
available with his concern is neither too large nor too small for its
requirements. A large amount of working capital would mean that the
company has idle funds. Since funds have a cost, the company has to
pay huge amount as interest on such funds.
The various studies conducted by the Bureau of Public Enterprises have
shown that one of the reason for the poor performance of public sector
undertakings in our country has been the large amount of funds locked
up in working capital This results in over capitalization. Over
capitalization implies that a company has too large funds for its
requirements, resulting in a low rate of return a situation which implies
a less than optimal use of resources. A firm has, therefore, to be very
careful in estimating its working capital requirements.
If the firm has inadequate working capital, it is said to be under-
capitalised. Such a firm runs the risk of insolvency. This is because,
paucity of working capital may lead to a situation where the firm may
not be able to meet its liabilities. It is interesting to note that many
firms which are otherwise prosperous (having good demand for their
products and enjoying profitable marketing conditions) may fail because
of lack of liquid resources.
If a firm has insufficient working capital and tries to increase sales, it
can easily over-stretch the financial resources of the business. This is
Factors to be taken into consideration while determining the
requirement of working capital:
(i) Production Policies (ii) Nature of the business (iii) Credit policy (iv)
Inventory policy (v) Abnormal factors (vi) Market conditions (vii)
Conditions of supply (viii) Business cycle (ix) Growth and expansion (x)
Level of taxes (xi) Dividend policy (xii) Price level changes (xiii)
A useful tool for managing working capital is the operating cycle. The
operating cycle analyzes the accounts receivable, inventory and
accounts payable cycles in terms of number of days. In other words,
accounts receivable are analyzed by the average number of days it takes
to collect an account. Inventory is analyzed by the average number of
days it takes to turn over the sale of a product (from the point it comes
in the store to the point it is converted to cash or an account
receivable). Accounts payable are analyzed by the average number of
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days it takes to pay a supplier invoice.
Working capital cycle indicates the length of time between a company‘s
paying for materials, entering into stock and receiving the cash from
sales of finished goods. It can be determined by adding the number of
days required for each stage in the cycle. For example, a company holds
raw materials on an average for 60 days, it gets credit from the supplier
for 15 days, production process needs 15 days, finished goods are held
for 30 days and 30 days credit is extended to debtors. The total of all
these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total working
The determination of working capital cycle helps in the forecast, control
and management of working capital. It indicates the total time lag and
the relative significance of its constituent parts. The duration of working
capital cycle may vary depending on the nature of the business.
In the form of an equation, the operating cycle process can be expressed
Operating Cycle = R + W + F + D – C
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Debtors collection period.
C = Credit period availed
Raw Material Storage Period = Average Stock of Raw Material
Average Cost of Raw Material
WIP Holding period = Average WIP Inventory
Average Cost of Production per day
Finished Goods storage period = Average Stock of Finished Goods
Average Cost of Goods Sold per day
Debtors Collection Period = Average Book Debts
Average Credit Sales per day
Credit period availed = Average Trade Creditors
Average Credit Purchases per day
1. Cash Management: The efficient collection and payment of cash
both inside the organisation and to third parties is the function of
the treasury department. The involvement of the department with
the details of receivables and payables will be a matter of policy.
There may be complete centralization within a group treasury or the
treasury may simply advise subsidiaries and divisions on policy
matter viz., collection/payment periods, discounts, etc. Any position
between these two extremes would be possible. Treasury will
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normally manage surplus funds in an investment portfolio.
Investment policy will consider future needs for liquid funds and
acceptable levels of risk as determined by company policy.
2. Currency management: The treasury department manages the
foreign currency risk exposure of the company. In a large
multinational company (MNC) the first step will usually be to set off
intra-group indebtedness. The use of matching receipts and
payments in the same currency will save transaction costs. Treasury
might advise on the currency to be used when invoicing overseas
3. Funding Management: Treasury department is responsible for
planning and sourcing the company‘s short, medium and long-term
cash needs. Treasury department will also participate in the decision
on capital structure and forecast future interest and foreign
4. Banking: It is important that a company maintains a good
relationship with its bankers. Treasury department carry out
negotiations with bankers and act as the initial point of contact with
them. Short-term finance can come in the form of bank loans or
through the sale of commercial paper in the money market.
5. Corporate Finance: Treasury department is involved with both
acquisition and divestment activities within the group. In addition it
will often have responsibility for investor relations. The latter activity
has assumed increased importance in markets where share-price
performance is regarded as crucial and may affect the company‘s
ability to undertake acquisition activity or, if the price falls
drastically, render it vulnerable to a hostile bid.
NEED OF CASH:
The following are three basic considerations in determining the amount
of cash or liquidity as have been outlined by lord Keynes:
(i) Transaction need: Cash facilitates the meeting of the day-to-day
expenses and other debt payments. Normally, inflows of cash
from operations should be sufficient for this purpose. But
sometimes this inflow may be temporarily blocked.
(ii) Speculative needs: Cash may be held in order to take advantage
of profitable opportunities that may present themselves and
which may be lost for want of ready cash/settlement.
(iii) Precautionary needs: Cash may be held to act as for providing
safety against unexpected events. Safety as is explained by the
saying that a man has only three friends an old wife, an old dog
and money at bank.
DIFFERENT KINDS OF
The term float is used to refer to the periods that affect cash as it moves
through the different stages of the collection process. Four kinds of float
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with reference to management of cash are:
(i) Billing float: An invoice is the formal document that a seller
prepares and sends to the purchaser as the payment request for
goods sold or services provided. The time between the sale and the
mailing of the invoice is the billing float.
(ii) Mail float: This is the time when a cheque is being processed by
post office, messenger service or other means of delivery.
(iii) Cheque processing float: This is the time required for the seller to
sort, record and deposit the cheque after it has been received by the
(iv) Banking processing float: This is the time from the deposit of the
cheque to the crediting of funds in the sellers account.
WILLIAM J. BAUMOL’S
This model tries to balance the income foregone on cash held by the
firm against the transaction cost of converting cash into marketable
securities or vice versa.
According to this model, optimum cash level is that level of cash where
the carrying costs and transactions costs are the minimum. The
carrying costs refers to the cost of holding cash, namely, the interest
foregone on marketable securities. The transaction costs refers to the
cost involved in getting the marketable securities converted into cash.
This happens when the firm falls short of cash and has to sell the
securities resulting in clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point
where these two costs are minimum. The formula for determining
optimum cash balance is:
C = 2U * P
Where, C = Optimum cash balance
U = Annual (or monthly) cash disbursement
P= Fixed cost per transaction.
S = Opportunity cost of one rupee p.a. (or p.m.)
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MILLER ORR CASH
According to this model the net cash flow is completely stochastic.
When changes in cash balance occur randomly the application of
control theory serves a useful purpose. The Miller-Orr model is one of
such control limit models. This model is designed to determine the time
and size of transfers between an investment account and cash account.
In this model control limits are set for cash balances. These limits may
consist of h as upper limit, z as the return point; and zero as the lower
limit. When the cash balance reaches the upper limit, the transfer of
cash equal to h – z is invested in marketable securities account. When it
touches the lower limit, a transfer from marketable securities account
to cash account is made. During the period when cash balance stays
between (h, z) and (z, 0) i.e. high and low limits no transactions between
cash and marketable securities account is made. The high and low
limits of cash balance are set up on the basis of fixed cost associated
with the securities transactions, the opportunity cost of holding cash
and the degree of likely fluctuations in cash balances. These limits
satisfy the demands for cash at the lowest possible total costs.
ELECTRONIC FUND With the developments which took place in the Information technology,
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TRANSFER the present banking system is switching over to the computerisation of
banks branches to offer efficient banking services and cash
management services to their customers. The network will be linked to
the different branches, banks. This will help the customers in the
♦ Instant updation of accounts.
♦ The quick transfer of funds.
♦ Instant information about foreign exchange rates.
For efficient cash management some firms employ an extensive policy of
substituting marketable securities for cash by the use of zero balance
accounts. Every day the firm totals the cheques presented for payment
against the account. The firm transfers the balance amount of cash in
the account if any, for buying marketable securities. In case of shortage
of cash the firm sells the marketable securities.
PETTY CASH IMPREST
For better control on cash, generally the companies use petty cash
imprest system wherein the day-to-day petty expenses are estimated
taking into account past experience and future needs and generally a
week‘s requirement of cash will be kept separate for making petty
expenses. Again, the next week will commence with the pre-determined
balance. This will reduce the strain of the management in managing
petty cash expenses and help in the managing cash efficiently.
AGEING SCHEDULE When receivables are analysed according to their age, the process is
known as preparing the ageing schedules of receivables. The
computation of average age of receivables is a quick and effective
method of comparing the liquidity of receivables with the liquidity of
receivables in the past and also comparing liquidity of one firm with the
liquidity of the other competitive firm. It also helps the firm to predict
collection pattern of receivables in future. This comparison can be made
The purpose of classifying receivables by age groups is to have a closer
control over the quality of individual accounts. It requires going back to
the receivables ledger where the dates of each customer‘s purchases
and payments are available. The ageing schedule, by indicating a
tendency for old accounts to accumulate, provides a useful supplement
to average collection period of receivables/sales analysis.
Because an analysis of receivables in terms of associated dates of sales
enables the firm to recognize the recent increases, and slumps in sales.
To ascertain the condition of receivables for control purposes, it may be
considered desirable to compare the current ageing schedule with an
earlier ageing schedule in the same firm and also to compare this
information with the experience of other firm.
Safety: Return and risk go hand in hand. As the objective in this
investment is ensuring liquidity, minimum risk is the criterion of
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Maturity: Matching of maturity and forecasted cash needs is
essential. Prices of long term securities fluctuate more with
changes in interest rates and are therefore riskier.
Marketability: it refers to the convenience, speed and cost at
which a security can be converted into cash. If the security can
be sold quickly without loss of time and price, it is highly liquid
Manual systems of recording the transactions and managing receivables
are cumbersome and costly. The automated receivable management
systems automatically update all the accounting records affected by a
transaction. This system allows the application and tracking of
receivables and collections to store important information for an
unlimited number of customers and transactions, and accommodate
efficient processing of customer payments and adjustments.
WRITE SHORT NOTE
It is a new financial service that is presently being developed in India.
Factoring involves provision of specialised services relating to credit
investigation, sales ledger management, purchase and collection of
debts, credit protection as well as provision of finance against
receivables and risk bearing. In factoring, accounts receivables are
generally sold to a financial institution (a subsidiary of commercial
bank-called ―Factor‖), who charges commission and bears the credit
risks associated with the accounts receivables purchased by it.
Its operation is very simple. Clients enter into an agreement with the
―factor‖ working out a factoring arrangement according to his
requirements. The factor then takes the responsibility of monitoring,
follow-up, collection and risk-taking and provision of advance. The
factor generally fixes up a limit customer-wise for the client (seller).
Factoring offers the following advantages which makes it quite attractive
to many firms.
(1) The firm can convert accounts receivables into cash without
bothering about repayment.
(2) Factoring ensures a definite pattern of cash inflows.
(3) Continuous factoring virtually eliminates the need for the credit
department. That is why receivables financing through factoring is
gaining popularly as useful source of financing short-term funds
requirements of business enterprises because of the inherent advantage
of flexibility it affords to the borrowing firm. The seller firm may
continue to finance its receivables on a more or less automatic basis. If
sales expand or contract it can vary the financing proportionally.
(4) Unlike an unsecured loan, compensating balances are not required
in this case. Another advantage consists of relieving the borrowing firm
of substantially credit and collection costs and to a degree from a
considerable part of cash management.
However, factoring as a means of financing is comparatively costly
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source of financing since its cost of financing is higher than the normal
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FINANCING DECISIONS: COST OF CAPITAL & CAPITAL STRUCTURE
Explicit & Implicit
The explicit cost of any source of capital may be defined as the
discount rate that equals the present value of the cash inflows that are
incremental to taking of financial opportunity with the present value of
its incremental cash outflows.
Implicit cost is the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be foregone if the
project presently under consideration by the firm was accepted.
The explicit cost arises when funds are raised and when funds are
used, implicit cost arises. For capital budgeting decisions, cost of
capital is nothing but the explicit cost of capital.
Capital Asset Pricing
This model describes the linear relationship between risk and return
for securities. The risk a security is exposed to are diversifiable and
non-diversifiable. The diversifiable risk can be eliminated through a
portfolio consisting of large number of well diversified securities. The
non-diversifiable risk is assessed in terms of beta coefficient (b or β)
through fitting regression equation between return of a security and
the return on a market portfolio.
Thus, the cost of equity capital can be calculated under this approach
Ke = Rf + b (Rm − Rf)
Ke = Cost of equity capital
Rf = Rate of return on security
b = Beta coefficient
Rm = Rate of return on market portfolio
Therefore, required rate of return = risk free rate + risk premium
The idea behind CAPM is that investors need to be compensated in two
ways- time value of money and risk. The time value of money is
represented by the risk-free rate in the formula and compensates the
investors for placing money in any investment over a period of time.
The other half of the formula represents risk and calculates the
amount of compensation the investor needs for taking on additional
risk. This is calculated by taking a risk measure (beta) which compares
the returns of the asset to the market over a period of time and
compares it to the market premium.
Cost of Capital
WACC, in other words, represents the investors' opportunity cost of
taking on the risk of putting money into a company. Since every
company has a capital structure i.e. what percentage of debt comes
from retained earnings, equity shares, preference shares, and bonds,
so by taking a weighted average, it can be seen how much interest the
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company has to pay for every rupee it borrows. This is the weighted
average cost of capital.
The weighted average cost of capital for a firm is of use in two major
areas: in consideration of the firm's position and in evaluation of
proposed changes necessitating a change in the firm's capital. Thus, a
weighted average technique may be used in a quasi-marginal way to
evaluate a proposed investment project, such as the construction of a
Thus, weighted average cost of capital is the weighted average after tax
costs of the individual components of firm‘s capital structure. That is,
the after tax cost of each debt and equity is calculated separately and
added together to a single overall cost of capital.
K0 = % D(mkt) (Ki) (1 – t) + (% Psmkt) Kp + (Cs mkt) Ke
K0 = Overall cost of capital
Ki = Before tax cost of debt
1 – t = 1 – Corporate tax rate
Kp = Cost of preference capital
Ke = Cost of equity
% Dmkt = % of debt in capital structure
%Psmkt = % of preference share in capital structure
% Cs = % of equity share in capital structure.
Securities analysts employ WACC all the time when valuing and
selecting investments. In discounted cash flow analysis, WACC is used
as the discount rate applied to future cash flows for deriving a
business's net present value. WACC can be used as a hurdle rate
against which to assess return on investment capital performance. It
also plays a key role in economic value added (EVA) calculations.
Investors use WACC as a tool to decide whether or not to invest. The
WACC represents the minimum rate of return at which a company
produces value for its investors.
Marginal Cost of
The marginal cost of capital may be defined as the cost of raising an
additional rupee of capital. Since the capital is raised in substantial
amount in practice marginal cost is referred to as the cost incurred in
raising new funds. Marginal cost of capital is derived, when the average
cost of capital is calculated using the marginal weights. The marginal
weights represent the proportion of funds the firm intends to employ.
Thus, the problem of choosing between the book value weights and the
market value weights does not arise in the case of marginal cost of
capital computation. To calculate the marginal cost of capital, the
intended financing proportion should be applied as weights to marginal
component costs. The marginal cost of capital should, therefore, be
calculated in the composite sense.
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When a firm raises funds in proportional manner and the component‘s
cost remains unchanged, there will be no difference between average
cost of capital (of the total funds) and the marginal cost of capital. The
component costs may remain constant upto certain level of funds
raised and then start increasing with amount of funds raised.
What is Capital
Capital structure refers to the mix of a firm‘s capitalisation and
includes long term sources of funds such as debentures, preference
share capital, equity share capital and retained earnings. According to
Gerstenberg capital structure is ―the make-up of a firm‘s
The theory of optimal capital structure deals with the issue of the right
mix of debt and equity in the long term capital structure of a firm. This
theory states that if a company takes on debt, the value of the firm
increases up to a point. Beyond that point if debt continues to increase
then the value of the firm will start to decrease. Similarly if the
company is unable to repay the debt within the specified period then it
will affect the goodwill of the company in the market and may create
problems for collecting further debt.
in Capital Structure
Type Risk Cost Control
Equity Capital Low Risk as
no question of
are not tax
control – since
the capital base
– principle is
after a certain
period of time.
than equity but
No dilution of
voting rights are
Loan Funds High Risk –
be repaid as
should be paid
interest rate are
to the extent of
after tax impact.
No dilution of
control – but
Trading on Equity:
When the return on capital employed is more than the rate of interest
on borrowed funds, financial leverage can be used favorably to
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maximise EPS. In such a case, the company is said to be Trading on
Concept of Debt
Equity or EBIT EPS
The determination of optimal level of debt in the capital structure of a
company is a formidable task and is a major policy decision. It ensures
that the firm is able to service its debt as well as contain its interest
cost. Determination of optimal level of debt involves equalizing between
return and risk.
EBIT EPS analysis is a widely used tool to determine the level of debt
in a firm. Through this analysis, comparison can be drawn for various
methods of financing by obtaining the indifference point. It is point to
the EBIT level at which EPS remain unchanged irrespective of debt
equity level. For example, indifference point for the capital mix can be
determined as below:
(EBIT – I1)(1-t) = (EBIT – I2)(1-t)
EBIT = indifference point
E1 = No. of equity shares in alternative 1
E2 = No. of equity shares in alternative 2
I1 = Interest charged in alternative 1
I2 = Interest charged in alternative 2
T = Tax Rate
Alternative 1 = All Equity Finance
Alternative 2 = Debt equity finance
in capital structure
There are only two sources of funds i.e Debt and Equity. (No
Firm has perpetual life (i.e Going Concern)
There are no Corporate or personal income tax.
The firm earns operating profits and it is expected to grow. (No
The payout ratio is 100%. (No Retained Earnings)
Cost of Debt is less than Cost of Equity.
Business risk is constant and is not affected by financing mix
According to this approach, capital structure decision is relevant to the
value of the firm. An increase in financial leverage will lead to decline
in the weighted average cost of capital, while the value of the firm as
well as market price of ordinary share will increase. Conversely a
decrease in the leverage will cause an increase in the overall cost of
capital and a consequent decline in the value as well as market price of
The value of the firm on the basis of Net Income Approach can be
ascertained as follows:
V = S + D
Where, V = Value of the firm
S = Market value of equity
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D = Market value of debt
Market value of equity (S) = NI
NI = Earnings available for equity shareholders
Ke = Equity Capitalisation rate
Under, NI approach, the value of the firm will be maximum at a point
where weighted average cost of capital is minimum. Thus, the theory
suggests total or maximum possible debt financing for minimising the
cost of capital. The overall cost of capital under this approach is:
Overall Cost of firm = EBIT
Value of firm
Thus according to this approach, the firm can increase its total value
by decreasing its overall cost of capital through increasing the degree of
leverage. The significant conclusion of this approach is that it pleads
for the firm to employ as much debt as possible to maximise its value.
Compute market value of Equity = EBIT – I
Cost of Equity
Compute Market value of Debt = Interest
Cost of Debt
Compute Market value of Firm = E + D
Compute Overall Cost of Capital = EBIT
Value of Firm
According to this approach, capital structure decisions of the firm are
irrelevant. Any change in the leverage will not lead to any change in the
total value of the firm and the market price of shares, as the overall
cost of capital is independent of the degree of leverage. As a result, the
division between debt and equity is irrelevant.
An increase in the use of debt which is apparently cheaper is offset by
an increase in the equity capitalisation rate. This happens because
equity investors seek higher compensation as they are opposed to
greater risk due to the existence of fixed return securities in the capital
Compute Market Value of Firm = EBIT
Compute Market value of Debt = Interest
Cost of Debt
Compute Market value of Equity = F – D
Compute cost of Equity = EBT
Value of Equity
The NOI approach is definitional or conceptual and lacks behavioural
significance. It does not provide operational justification for irrelevance
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of capital structure. However, Modigliani-Miller approach provides
behavioural justification for constant overall cost of capital and,
therefore, total value of the firm.
The approach is based on further additional assumptions like:
♦ Capital markets are perfect. All information is freely available and
there are no transaction costs.
♦ All investors are rational.
♦ Firms can be grouped into ‗Equivalent risk classes‘ on the basis of
their business risk.
♦ Non-existence of corporate taxes.
Based on the above assumptions, Modigliani-Miller derived the
following three propositions.
(i) Total market value of a firm is equal to its expected net operating
income dividend by the discount rate appropriate to its risk class
decided by the market.
(ii) The expected yield on equity is equal to the risk free rate plus a
premium determined as per the following equation: Kc = Ko + (Ko–
Average cost of capital is not affected by financial decision.
The operational justification of Modigliani-Miller hypothesis is
explained through the functioning of the arbitrage process and
substitution of corporate leverage by personal leverage. Arbitrage refers
to buying asset or security at lower price in one market and selling it at
higher price in another market. As a result equilibrium is attained in
different markets. This is illustrated by taking two identical firms of
which one has debt in the capital structure while the other does not.
Investors of the firm whose value is higher will sell their shares and
instead buy the shares of the firm whose value is lower. They will be
able to earn the same return at lower outlay with the same perceived
risk or lower risk. They would, therefore, be better off.
The value of the levered firm can either be neither greater nor lower
than that of an unlevered firm according this approach. The two must
be equal. There is neither advantage nor disadvantage in using debt in
the firm‘s capital structure.
Simply stated, the Modigliani Miller approach is based on the thought
that no matter how the capital structure of a firm is divided among
debt, equity and other claims, there is a conservation of investment
value. Since the total investment value of a corporation depends upon
its underlying profitability and risk, it is invariant with respect to
relative changes in the firm‘s financial capitalisation. The approach
considers capital structure of a firm as a whole pie divided into equity,
debt and other securities.
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The shortcoming of this approach is that the arbitrage process as
suggested by Modigliani-Miller will fail to work because of
imperfections in capital market, existence of transaction cost and
presence of corporate income taxes.
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INVESTMENT DECISIONS: CAPITAL BUDGETING
WHAT IS CAPITAL
The capital budgeting decision means a decision as to whether or not
money should be invested in long-term projects such as the setting up
of a factory or installing a machinery or creating additional capacities
to manufacture a part which at present may be purchased from
outside. It includes a financial analysis of the various proposals
regarding capital expenditure to evaluate their impact on the financial
condition of the company and to choose the best out of the various
PURPOSE OF CAPITAL
The capital budgeting decisions are important, crucial and critical
business decisions due to following reasons:
(i) Substantial expenditure: Capital budgeting decisions involves the
investment of substantial amount of funds. It is therefore necessary for
a firm to make such decisions after a thoughtful consideration so as to
result in the profitable use of its scarce resources.
The hasty and incorrect decisions would not only result into huge
losses but may also account for the failure of the firm.
(ii) Long time period: The capital budgeting decision has its effect over
a long period of time. These decisions not only affect the future benefits
and costs of the firm but also influence the rate and direction of growth
of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible.
Once they are taken, the firm may not be in a position to reverse them
back. This is because, as it is difficult to find a buyer for the second-
hand capital items.
(iv) Complex decision: The capital investment decision involves an
assessment of future events, which in fact is difficult to predict.
Further it is quite difficult to estimate in quantitative terms all the
benefits or the costs relating to a particular investment decision.
Planning Identify various possible investment
Determine the ability of the management to
exploit the opportunities
Reject opportunities which do not have
much merit, and prepare proposals in
respect of investment opportunities which
have reasonable value for the firm.
Evaluation Determine the inflows and outflows relating
to various proposals
Use appropriate technique to evaluate the
Selection Weigh the risk return trade off relating to
various investment proposals
Compare WACC or Cost of Capital with
Return from various proposals
Choose that project which will maximise the
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Execution After deciding on the project to be
implemented, obtain the necessary funds
for the project
Establish the infrastructure, acquire the
resources, and implement the project,
according to stipulated time frame
Control Obtain feedback reports to monitor the
implementation of the project
Review After the project is over, review the project
to explain its success or failure and to
generate ideas for new proposal to be
undertaken in future
PAYBACK PERIOD 1) The payback period of an investment is the length of time
required for the cumulative total net cash flows from the
investment to equal the total initial cash outlays. At that point
in time, the investor has recovered the money invested in the
The first step in calculating the payback period are determining the
total initial capital investment and the annual expected after-tax net
cash flows over the useful life of the investment. When the net cash
flows are uniform over the useful life of the project, the number of
years in the payback period can be calculated using the following
Payback Period = Total initial capital investment
Annual expected after tax net cash flow
A major advantage of the payback period technique is that it is
easy to compute and to understand as it provides a quick
estimate of the time needed for the organization to recoup the
The length of the payback period can also serve as an estimate
of a project‘s risk; the longer the payback period, the riskier the
project as long-term predictions are less reliable.
The payback period technique focuses on quick payoffs. In some
industries with high obsolescence risk or in situations where an
organization is short on cash, short payback periods often
become the determining factor for investments.
The major limitation of the payback period technique is that it
ignores the time value of money. As long as the payback periods
for two projects are the same, the payback period technique
considers them equal as investments, even if one project
generates most of its net cash inflows in the early years of the
project while the other project generates most of its net cash
inflows in the latter years of the payback period.
A second limitation of this technique is its failure to consider an
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investment‘s total profitability; it only considers cash flows from
the initiation of the project until its payback period and ignores
cash flows after the payback period.
Lastly, use of the payback period technique may cause
organizations to place too much emphasis on short payback
periods thereby ignoring the need to invest in long-term projects
that would enhance its competitive position.
ACCOUNTING RATE OF
2) The accounting rate of return of an investment measures the
average annual net income of the project (incremental income)
as a percentage of the investment.
Accounting Rate of Return = Average Annual net income
The numerator is the average annual net income generated by
the project over its useful life. The denominator can be either the
initial investment or the average investment over the useful life
of the project. Some organizations prefer the initial investment
because it is objectively determined and is not influenced by
either the choice of the depreciation method or the estimation of
the salvage value. Either of these amounts is used in practice
but it is important that the same method be used for all
investments under consideration.
The accounting rate of return technique uses readily available
data that is routinely generated for financial reports and does
not require any special procedures to generate data.
This method may also mirror the method used to evaluate
performance on the operating results of an investment and
management performance. Using the same procedure in both
decision-making and performance evaluation ensures
Lastly, the calculation of the accounting rate of return method
considers all net incomes over the entire life of the project and
provides a measure of the investment‘s profitability.
The accounting rate of return technique, like the payback period
technique, ignores the time value of money and considers the
value of all cash flows to be equal.
Additionally, the technique uses accounting numbers that are
dependent on the organization‘s choice of accounting
procedures, and different accounting procedures, e.g.,
depreciation methods, can lead to substantially different
amounts for an investment‘s net income and book values.
The method uses net income rather than cash flows; while net
income is a useful measure of profitability, the net cash flow is a
better measure of an investment‘s performance.
Furthermore, inclusion of only the book value of the invested
asset ignores the fact that a project can require commitments of
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working capital and other outlays that are not included in the
book value of the project.
NET PRESENT VALUE The net present value technique is a discounted cash flow method that
considers the time value of money in evaluating capital investments.
An investment has cash flows throughout its life, and it is assumed
that a rupee of cash flow in the early years of an investment is worth
more than a rupee of cash flow in a later year. The net present value
method uses a specified discount rate to bring all subsequent net
cash inflows after the initial investment to their present values.
Theoretically, the discount rate or desired rate of return on an
investment is the rate of return the firm would have earned by
investing the same funds in the best available alternative investment
that has the same risk. Determining the best alternative opportunity
available is difficult in practical terms so rather that using the true
opportunity cost, organizations often use an alternative measure for
the desired rate of return. An organization may establish a minimum
rate of return that all capital projects must meet; this minimum could
be based on an industry average or the cost of other investment
opportunities. Many organizations choose to use the cost of capital as
the desired rate of return; the cost of capital is the cost that an
organization has incurred in raising funds or expects to incur in
raising the funds needed for an investment.
Net present value = Present value of net cash flow - Total net initial
The steps to calculating net present value are
a) Determine the net cash inflow in each year of the investment,
b) Select the desired rate of return,
c) Find the discount factor for each year based on the desired rate
of return selected,
d) Determine the present values of the net cash flows by
multiplying the cash flows by the discount factors,
e) Total the amounts for all years in the life of the project, and
f) Subtract the total net initial investment.
With the help of discounted cash flow technique, the two alternative
proposals for capital expenditure can be compared. In certain cases we
have to compare a number of proposals each involving different
amounts of cash inflows. One of the methods of comparing such
proposals is to workout what is known as the ‗Desirability factor‘, or
‗Profitability index‘. In general terms a project is acceptable if its
profitability index value is greater than 1.
PI = Sum of Discounted Cash inflows
Total Discounted Cash outflow
The method also uses the concept of time value of money and is a
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better project evaluation technique than NPV.
Profitability index fails as a guide in resolving capital rationing
(discussed later in this chapter) where projects are indivisible. Once a
single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the
single project is excluded. Also situations may arise where a project
with a lower profitability index selected may generate cash flows in
such a way that another project can be taken up one or two years
later, the total NPV in such case being more than the one with a
project with highest Profitability Index.
The Profitability Index approach thus cannot be used indiscriminately
but all other type of alternatives of projects will have to be worked out.
INTERNAL RATE OF
Like the net present value method, the internal rate of return method
considers the time value of money, the initial cash investment, and all
cash flows from the investment. Unlike the net present value method,
the internal rate of return method does not use the desired rate of
return but estimates the discount rate that makes the present value of
subsequent net cash flows equal to the initial investment. Using this
estimated rate of return, the net present value of the investment will be
zero. This estimated rate of return is then compared to a criterion rate
of return that can be the organization‘s desired rate of return, the rate
of return from the best alternative investment, or another rate the
organization chooses to use for evaluating capital investments.
The procedures for computing the internal rate of return vary with the
pattern of net cash flows over the useful life of an investment. The first
step is to determine the investment‘s total net initial cash
disbursements and commitments and its net cash inflows in each year
of the investment. For an investment with uniform cash flows over its
life, the following equation is used:
Total initial investment = Annual net cash flow x Annuity discount
factor of the discount rate for the number of periods of the investment‘s
When the net cash flows are not uniform over the life of the
investment, the determination of the discount rate can involve trial and
error and interpolation between interest rates. It should be noted that
there are several spreadsheet programs available for computing both
net present value and internal rate of return that facilitate the capital
RATE OF RETURN
In cases where project cash flows change signs or reverse during the
life of a project e.g. an initial cash outflow is followed by cash inflows
and subsequently followed by a major cash outflow , there may be
more than one IRR.
In such situations if the cost of capital is less than the two IRRs , a
decision can be made easily , however otherwise the IRR decision rule
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may turn out to be misleading as the project should only be invested if
the cost of capital is between IRR1 and IRR2. To understand the concept
of multiple IRRs it is necessary to understand the implicit re
investment assumption in both NPV and IRR techniques.
This method makes use of the concept of time value of money.
All the cash flows in the project are considered.
IRR is easier to use as instantaneous understanding of desirability
can be determined by comparing it with the cost of capital.
IRR technique helps in achieving the objective of minimisation of
The calculation process is tedious if there are more than one cash
outflows interspersed between the cash inflows, there can be
multiple IRRs, the interpretation of which is difficult.
The IRR approach creates a peculiar situation if we compare two
projects with different inflow/outflow patterns.
It is assumed that under this method all the future cash inflows of
a proposal are reinvested at a rate equal to the IRR. It is ridiculous
to imagine that the same firm has a ability to reinvest the cash
flows at a rate equal to IRR.
If mutually exclusive projects are considered as investment options
which have considerably different cash outlays. A project with a
larger fund commitment but lower IRR contributes more in terms
of absolute NPV and increases the shareholders‘ wealth. In such
situation decisions based only on IRR criterion may not be correct.
CAPITAL RATIONING Generally, firms fix up maximum amount that can be invested in
capital projects, during a given period of time, say a year. The firm then
attempts to select a combination of investment proposals that will be
within the specific limits providing maximum profitability and rank
them in descending order according to their rate of return; such a
situation is of capital rationing.
A firm should accept all investment projects with positive NPV, with an
objective to maximise the wealth of shareholders. However, there may
be resource constraints due to which a firm may have to select from
among various projects. Thus there may arise a situation of capital
rationing where there may be internal or external constraints on
procurement of necessary funds to invest in all investment proposals
with positive NPVs.
Capital rationing can be experienced due to external factors, mainly
imperfections in capital markets which can be attributed to non-
availability of market information, investor attitude etc. Internal capital
rationing is due to the self-imposed restrictions imposed by
management like not to raise additional debt or laying down a specified
minimum rate of return on each project.
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Capital rationing may also be introduced by following the concept of
‗Responsibility Accounting‘, whereby management may introduce
capital rationing by authorising a particular department to make
investment only up to a specified limit, beyond which the investment
decisions are to be taken by higher-ups.
The selection of project under capital rationing involves two steps:
(i) To identify the projects which can be accepted by using the
technique of evaluation discussed above.
(ii) To select the combination of projects.
In capital rationing it may also be more desirable to accept several
small investment proposals than a few large investment proposals so
that there may be full utilisation of budgeted amount. This may result
in accepting relatively less profitable investment proposals if full
utilisation of budget is a primary consideration. Similarly, capital
rationing may also mean that the firm foregoes the next most profitable
investment following after the budget ceiling even though it is
estimated to yield a rate of return much higher than the required rate
of return. Thus capital rationing does not always lead to optimum
SOCIAL COST BENEFIT
- Social Cost Benefit Analysis (SCBA) is a part of process of
evaluating the proposal regarding undertaking a project.
- The concept of SCBA is that while evaluating the proposal
regarding investment in a project, the entrepreneur should
consider not only its financial soundness and technical
feasibility but also make cost benefit analysis of the project from
the point of society and economy as a whole.
- A project be financially and technically feasible but from the
viewpoint society in general and economically as a whole may
not be viable and vice-versa.
- For example, a project of providing rail links to some under
developed area may be financially unsound but from the social
and economic angles it is quite desirable (it will help in
development of that area).
- For every action, there is reaction. For (almost) every project,
there are some hidden social-economical disadvantages (these
are referred as negative externalities) and also there are such
advantages (these are referred as positive externalities).
- The examples of disadvantages (negative externalities) are:
dislocations of the persons whose land is acquired for the
project, environmental damage, ecological disturbances, damage
to heritage buildings in the long run, etc.
- The advantages (positive externalities) may be: employment
opportunities, availability of merit quality products at
reasonable prices, foreign exchange earnings, construction of
road, etc., for the project which may be used by other persons of
that area and which may help in development of some other
economic activities, etc. Hence, besides financial and technical
angles, a project should also be evaluated on the basis of its
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social costs and social benefits.
Risk Business Risk Financial Risk
Meaning It is associated with the
firm‘s operations and
refers to the uncertainty
about future net
operating income (EBIT).
It is the additional risk
placed on Equity
shareholders due to the
use of debt funds.
Measurement It can be measured by
the standard deviation of
Basic Earning Power i.e
It can be measured
using ratios like
Debt to Assets, etc
Linked to Economic Climate &
Nature of Business
Use of Debt Funds
Reduction Every firm would be
susceptible to business
risk due to changes in
the overall economic
climate and business
A firm which is entirely
financed by Equity will
have almost no
OPERATING LEVERAGE It is defined as the firm‘s ability to use fixed operating costs to magnify
effects of changes in sales on its EBIT.
When sales changes, variable costs will change in proportion to sales
while fixed costs will remain constant. So, a change in sales will lead to
a more than proportional change in EBIT. The effect of change in sales
on EBIT is measured by operating leverage.
When sales increases, Fixed costs will remain same irrespective of level
of output, and so the percentage increase in EBIT will be higher than
increase in Sales. This is favorable effect of operating leverage.
When sales decreases, the reverse process will be applicable and
hence, the percentage decrease in EBIT will be higher than decrease in
sales. This is the adverse effect of operating leverage.
OL = Contribution or % change in EBIT
EBIT % change in Sales
FINANCIAL LEVERAGE It is defined as the ability of a firm to use fixed financial charges to
magnify the effects of change in EBIT on firm‘s EPS.
Financial leverage occurs when a company has debt content in its
capital structure and fixed financial charges. These fixed financial
charges do not vary with EBIT. They are fixed and are to be paid
irrespective of the level of EBIT.
When EBIT increases, the interest payable on debt remains constant,
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and hence residual earnings available to shareholders will also
increase more than proportionately.
Hence an increase in EBIT will lead to a higher percentage increase in
EPS. This is measured by financial leverage.
FL = EBIT or % change in EPS
EBT % change in EBIT
COMBINED LEVERAGE Combined leverage is used to measure the total risk of a Firm i.e
Operating Risk and Financial Risk.
CL = Contribution or % change in EPS or OL * FL
EBT % change in Sales
RELEVANCE OF TIME
VALUE OF MONEY IN
Time value of money means that worth of a rupee received today is
different from the worth of a rupee to be received in future. The
preference of money now as compared to future money is known as
time preference for money.
A rupee today is more valuable than rupee after a year due to several
Risk − there is uncertainty about the receipt of money in future.
Preference for present consumption − Most of the persons and
companies in general, prefer current consumption over future
Inflation − In an inflationary period a rupee today represents a
greater real purchasing power than a rupee a year hence.
Investment opportunities − Most of the persons and companies
have a preference for present money because of availabilities of
opportunities of investment for earning additional cash flow.
Many financial problems involve cash flow accruing at different points
of time for evaluating such cash flow an explicit consideration of time
value of money is required.
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