19107552 13823737 Cost Accounting and Financial Management[1]

PROFESSIONAL COMPETENCE COURSESTUDY MATERIAL

COST ACCOUNTING AND FINANCIAL MANAGEMENT

PAPER

4

Cost Accounting and Financial Management

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject. Students should also supplement their study by reference to the recommended text books. In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein, they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.

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The Institute of Chartered Accountants of India

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Published by Dr. T.P. Ghosh, Director of Studies, ICAI, C-1, Sector-1, NOIDA-201301 Typeset and designed at Board of Studies, The Institute of Chartered Accountants of India. Printed at VPS Engineering Impex Pvt. Ltd. Phase II Noida.� August, 2006, 25,000 copies

PREFACEThe recent surge in globalisation and the massive cross border flow of capital has increased the significance of Cost Accounting and Financial Management for management and control purposes. The study of these two important subjects opens new opportunities for Chartered Accountancy students. It provides them with an opportunity to draw upon previous experiences and education to apply various business concepts and analytical tools to complex problems and issues in organizational settings. This study material provides the basic concepts, theories and techniques relating to Cost Accounting and Financial Management and aims to develop the students ability in understanding the different concepts and their� application in the real life situations. The study material is divided into two parts. Part I relates to Cost Accounting and Part II deals with Financial Management. The Cost Accounting portion has ten chapters having an in depth analysis of concepts relating to Material, Labour, Overheads and other important costing techniques. Standard Costing, Marginal Costing and Budgeting have been included in the syllabus at an introductory level. The syllabus has been designed in such a way that it helps students understand the traditional concepts, their applications, advantages and disadvantages. Contemporary changes in the subject shall be dealt with in the Final stage . The portion on Financial Management is divided into seven chapters. Chapter 1 describes the scope, objectives and importance of financial management and its relationship with other disciplines. Time value of money is discussed in Chapter 2. Chapter 3 explains various tools and techniques of financial management namely Ratio Analysis and Cash Flow Analysis and their application in practical situations. Chapters 4, 6 and 7 deal with the theories, concepts and assumptions underlying financial decisions, namely, Financing, Investment and Working Capital Management. Chapter 5 describes the various Sources of Finance available to business enterprises to cater their different types of requirements. The entire study material has been written in a simple language. A number of self-examination questions are given at the end of each chapter for practice by students. There are also a number of illustrations in each chapter to help students to have a better grasp of the subjects.

SYLLABUSPAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT�(One paper - Three hours 100 Marks) Level of Knowledge: Working knowledge�

Part I Cost Accounting (50 Marks)�Objectives: (a) To understand the basic concepts and processes used to determine product costs, (b) To be able to interpret cost accounting statements, (c) To be able to analyse and evaluate information for cost ascertainment, planning, control and decision making, and (d) To be able to solve simple cases. Contents 1. Introduction to Cost Accounting (a) Objectives and scope of Cost Accounting (b) Cost centres and Cost units (c) Cost classification for stock valuation, Profit measurement, Decision making and control (d) Coding systems (e) Elements of Cost (f) Cost behaviour pattern, Separating the components of semi-variable costs (g) Installation of a Costing system (h) Relationship of Cost Accounting, Financial Accounting, Management Accounting and Financial Management

2.

Cost Ascertainment (a) Material Cost (i) (ii) Procurement procedures - Store procedures and documentation in respect of receipts and issue of stock, Stock verification Inventory control - Techniques of fixing of minimum, maximum and reorder levels, Economic Order Quantity, ABC classification; Stocktaking and perpetual inventory

(iii) Inventory accounting (iv) Consumption - Identification with products of cost centres, Basis for consumption entries in financial accounts, Monitoring consumption. (b) Employee Cost (i) (ii) Attendance and payroll procedures, Overview of statutory requirements, Overtime, Idle time and Incentives Labour turnover

(iii) Utilisation of labour, Direct and indirect labour, Charging of labour cost, Identifying labour hours with work orders or batches or capital jobs (iv) Efficiency rating procedures (v) Remuneration systems and incentive schemes. (c) Direct Expenses Sub-contracting - Control on material movements, Identification with the main product or service. (d) Overheads (i) Functional analysis - Factory, Administration, Selling, Distribution, Research and Development Behavioural analysis - Fixed, Variable, Semi variable and Step cost (ii) Factory Overheads - Primary distribution and secondary distribution, Criteria for choosing suitable basis for allotment, Capacity cost adjustments, Fixed absorption rates for absorbing overheads to products or services

(iii) Administration overheads - Method of allocation to cost centres or products (iv) Selling and distribution overheads - Analysis and absorption of the expenses in products/customers, impact of marketing strategies, Cost effectiveness of various methods of sales promotion.

3.

Cost Book- keeping Cost Ledgers - Non-integrated accounts, Integrated accounts, Reconciliation of cost and financial accounts.

4.

Costing Systems (a) Job Costing Job cost cards and databases, Collecting direct costs of each job, Attributing overhead costs to jobs, Applications of job costing. (b) Batch Costing (c) Contract Costing Progress payments, Retention money, Escalation clause, Contract accounts, Accounting for material, Accounting for plant used in a contract, Contract profit and Balance sheet entries. (d) Process Costing Double entry book keeping, Process loss, Abnormal gains and losses, Equivalent units, Inter-process profit, Joint products and by products. (e) Operating Costing System

5.

Introduction to Marginal Costing Marginal costing compared with absorption costing, Contribution, Breakeven analysis and profit volume graph.

6.

Introduction to Standard Costing Various types of standards, Setting of standards, Basic concepts of material and Labour standards and variance analysis.

Part II Financial Management (50 Marks)�Objectives: (a) To develop ability to analyse and interpret various tools of financial analysis and planning, (b) To gain knowledge of management and financing of working capital, (c) To understand concepts relating to financing and investment decisions, and (d) To be able to solve simple cases.

Contents 1. Scope and Objectives of Financial Management (a) Meaning, Importance and Objectives (b) Conflicts in profit versus value maximisation principle (c) Role of Chief Financial Officer. 2. Time Value of Money Compounding and Discounting techniques- Concepts of Annuity and Perpetuity. 3. Financial Analysis and Planning (a) Ratio Analysis for performance evaluation and financial health (b) Application of Ratio Analysis in decision making (c) Analysis of Cash Flow Statement. 4. Financing Decisions (a) Cost of Capital - Weighted average cost of capital and Marginal cost of capital (b) Capital Structure decisions - Capital structure patterns, Designing optimum capital structure, Constraints, Various capital structure theories (c) Business Risk and Financial Risk - Operating and financial leverage, Trading on Equity. 5. Types of Financing (a) Different sources of finance (b) Project financing - Intermediate and long term financing (c) Negotiating term loans with banks and financial institutions and appraisal thereof (d) Introduction to lease financing (e) Venture capital finance. 6. Investment Decisions (a) Purpose, Objective, Process (b) Understanding different types of projects

(c) Techniques of Decision making: Non-discounted and Discounted Cash flow Approaches - Payback Period method, Accounting Rate of Return, Net Present Value, Internal Rate of Return, Modified Internal Rate of Return, Discounted Payback Period and Profitability Index (d) Ranking of competing projects, Ranking of projects with unequal lives. 7. Management of Working Capital (a) Working capital policies (b) Funds flow analysis (c) Inventory management (d) Receivables management (e) Payables management (f) Management of cash and marketable securities (g) Financing of working capital.

CONTENTSPART I COST ACCOUNTING�CHAPTER 1 BASIC CONCEPTS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 12. 13. 14. 15. 16.� Evolution of Cost Accounting ......................................................................... 1.1 Cost Accounting and Inventory Valuation ....................................................... 1.2 Objectives of Cost Accounting ....................................................................... 1.3 Importance of Cost Accounting ...................................................................... 1.5 Advantages of a Cost Accounting system .... 1.7 Essential factors�� for. establishing a Cost Accounting system ..1.8 Relationship between Cost�� Accounting, Financial Accounting Management Accounting and Financial Management ..

. 1.10 Cost concepts and terms ...................�� .1.12 Elements of��

cost..................................................................... ..1.17 Classification of costs��

.................................................................................. 1.18 Coding systems ........................................................................................... 1.26 Types of Costing ......................................................................................... 1.27 Methods of Costing...................................................................................... 1.28 Direct expenses .......................................................................................... 1.29 Self examination questions .......................................................................... 1.31

CHAPTER 2 MATERIAL 1. 2. 3. 4. Introduction� .................................................................................................. 2.1 Material control ............................................................................................ 2.2 Material procurement procedure ..................................................................... 2.4 Material storage .......................................................................................... 2.14

5. 6. 7. 8. 9. 10. 11. 12.

Inventory control.......................................................................................... 2.19 Valuation of material receipts ....................................................................... 2.44 Valuation of material issues ......................................................................... 2.47 Valuation of returns and shortages ............................................................... 2.64 Treatment of Normal and Abnormal loss of material ...................................... 2.65 Accounting and control: waste,scrap,spoilage & defective ............................. 2.65 Consumption of material .............................................................................. 2.71 Self examination questions .......................................................................... 2.73

CHAPTER 3 LABOUR 1 2 3 4 5 6 7. 8. 9. 10. 11. 12 Introduction� .................................................................................................. 3.1 Labour cost control ........................................................................................ 3.1 Attendance & payroll procedures ................................................................... 3.3 Idle time...................................................................................................... 3.11 Overtime ..................................................................................................... 3.13 Labour turnover ........................................................................................... 3.18 Incentive system ......................................................................................... 3.25 Labour utilisation ......................................................................................... 3.28 System of wage payment and incentive ...................................................... 3.31 Absorption of wages .................................................................................... 3.66 Efficiency rating procedures ........................................................................ 3.74 Self examination questions .......................................................................... 3.76

CHAPTER 4 OVERHEADS 1 2 3 Introduction� .................................................................................................. 4.1 Classification of Overheads............................................................................ 4.2 Accounting and control of Manufacturing Overheads. ...................................... 4.8

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4 5 6 7. 8 9. 10 11

Distribution of overheads ............................................................................. 4.10 Methods of absorbing Overheads ................................................................. 4.35 Treatment of Overheads in Cost Accounting ................................................. 4.46 Accounting and control of Administrative Overhead ....................................... 4.59 Accounting and control of Selling &Distribution Overhead.............................. 4.64 Concepts related to Capacity ....................................................................... 4.68 Treatment of certain items in Cost Accounting .............................................. 4.69 Self examination questions .......................................................................... 4.73

CHAPTER 5 NON INTEGRATED ACCOUNTS 1. 2. 3. 4. 5. Introduction� ................................................................................................... 5.1 Non Integrated Accounting System ................................................................ 5.1 Integrated Accounting System ...................................................................... 5.34 Reconciliation of Cost and Financial Accounts .............................................. 5.49 Self examination questions .......................................................................... 5.61

CHAPTER 6 METHOD OF COSTING(I) 1. 2. 3. 4. 5. 6. Introduction� ................................................................................................... 6.1 Job Costing ................................................................................................... 6.2 Contract Costing ........................................................................................... 6.9 Batch Costing.............................................................................................. 6.31 Operating Costing ....................................................................................... 6.33 Self examination questions ......................................................................... 6. 41

CHAPTER 7 METHOD OF COSTING (II) 1 2 Meaning of Process� Costing........................................................................... 7.1 Operation Costing ......................................................................................... 7.2

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3 7 8 9 10

Treatment of Process losses .......................................................................... 7.4 Costing of Equivalent production units ............................................................ 7.6 Inter Process Profits. ................................................................................... 7.13 Joint products and by products..................................................................... 7.15 Self examination questions .......................................................................... 7.31

CHAPTER 8 STANDARD COSTING 1. 2 3 4 5 6 7 8 9. 10. Introduction� ................................................................................................... 8.1 Definition of standard cost ............................................................................. 8.3 Setting up of standard cost ............................................................................ 8.3 Types of standards ........................................................................................ 8.8 Need for standard cost................................................................................... 8.9 Process of standard costing ......................................................................... 8.10 Types of variances ...................................................................................... 8.11 Accounting procedure for standard cost ........................................................ 8.23 Advantages and criticisms ........................................................................... 8.26 Self examination questions .......................................................................... 8.29

CHAPTER 9 MARGINAL COSTING 1 2 3 4 5 6 7 Introduction� ................................................................................................... 9.1 Theory of Marginal Costing ............................................................................ 9.2 Ascertainment of Marginal costing .................................................................. 9.5 Distinction between Marginal and Absorption Costing...................................... 9.7 Advantages and Limitation of Marginal Costing ............................................. 9.11 Cost Volume Profit Analysis ......................................................................... 9.13 Self Examination Questions ................................................................................

iv

CHAPTER 10 BUDGETS AND BUDGETARY CONTROL 1 2 3 4 5 6 Introduction� ................................................................................................. 10.1 Objectives of budgeting ............................................................................... 10.2 Budgetary control ........................................................................................ 10.3 Different types of budgets ............................................................................ 10.7 Preparation of budgets ................................................................................ 10.8 Self examination questions .................................................................................

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CONTENTSPART II FINANCIAL MANAGEMENT�CHAPTER 1 SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1. 2. 3. 4. 5. 6. 7. 8.� 9. Introduction .................................................................................................. 1.1 Meaning of Financial Management ................................................................ 1.2 Evolution of Financial Management ............................................................... 1.4 Importance of Financial Management ............................................................ 1.5 Scope of Financial Management .1.5 Objectives of�� Financial Management ..1.6 Conflicts in Profit versus Value�� Maximisation Principle . 1.10 Role of Chief Financial Officer (CFO)��

.1.12 Relationship of Financial Management with Related�� Disciplines ..1.13��

CHAPTER 2 TIME VALUE OF MONEY 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Concept of Time� Value of Money ................................................................... 2.1 Simple Interest ............................................................................................. 2.2 Compound Interest ....................................................................................... 2.3 Effective Rate of Interest .............................................................................. 2.8 Present Value ............................................................................................... 2.8 Annuity ....................................................................................................... 2.10 Perpetuity .................................................................................................. 2.12 Sinking Fund ............................................................................................... 2.14 Techniques of Discounting ........................................................................... 2.14 Techniques of Compounding ........................................................................ 2.18

CHAPTER 3 FINANCIAL ANALYSIS AND PLANNING UNIT I : APPLICATION OF RATIO ANALYSIS� FOR PERFORMANCE EVALUATION, FINANCIAL HEALTH AND DECISION MAKING 1.1 1.2 1.3 1.4 1.5 1.6 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 Introduction .................................................................................................. 3.1 Ratio Analysis .............................................................................................. 3.1 Types of Ratios ............................................................................................ 3.2 Application of Ratio Analysis in Financial Decision Making ............................ 3.17 Limitations of Financial Ratios ...................................................................... 3.18 Summary of Ratios .................................................................................... 3.19 Introduction ................................................................................................ 3.42 Utility of Cash Flow Analysis ...................................................................... 3.42 Limitations of Cash Flow Analysis .............................................................. 3.43 Benefits of Cash Flow Information ............................................................... 3.44 Definitions .................................................................................................. 3.44 Cash and Cash Equivalents ........................................................................ 3.44 Presentation of Cash Flow Statement .3.45 Procedure in�� Preparation of Cash Flow Statement ........................................... 3.49 Funds Flow Statement vs. Cash Flow Statement ..3.54��

UNIT II : CASH FLOW ANALYSIS

CHAPTER 4 FINANCING DECISIONS UNIT I : COST OF CAPITAL 1.1 1.2 1.3 1.4 1.5� Introduction .................................................................................................. 4.1 Definition of Cost of Capital .......................................................................... 4.3 Measurement of Cost of Capital . ................................................................... 4.4 Weighted Average Cost of Capital (WACC) ................................................... 4.17 Marginal Cost of Capital .............................................................................. 4.21

vii

UNIT II : CAPITAL STRUCTURE DECISIONS 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 Meaning of Capital Structure ....................................................................... 4.26 Choice of Capital Structure ......................................................................... 4.26 Significance of Capital Structure ................................................................. 4.28 Optimal Capital Structure ............................................................................ 4.30 EBIT-EPS Analysis ..................................................................................... 4.30 Cost of Capital, Capital Structure and Market Price of Share ........................ 4.33 Capital Structure Theories .......................................................................... 4.34 Capital Structure and Taxation .................................................................... 4.46

UNIT III : BUSINESS RISK AND FINANCIAL RISK 3.1 3.2 3.3 Introduction ................................................................................................. 4.47 Debt versus Equity Financing ...................................................................... 4.48 Types of Leverage ...................................................................................... 4.50

CHAPTER 5 TYPES OF FINANCING 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Introduction� ................................................................................................... 5.1 Financial Needs and Sources of Finance of a Business .................................. 5.1 Long Term Sources of Finance ........................................................................ 5.4 Venture Capital Financing ........................................................................... 5.12 Debt Securitisation ..................................................................................... 5.14 Lease Financing ........................................................................................ 5.16 Short Term Sources of Finance ................................................................... 5.16 Other Sources of Financing ......................................................................... 5.25 New Instruments ....................................................................................... 5.27 International Financing ................................................................................ 5.29

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CHAPTER 6 INVESTMENT DECISIONS 1. 2. 3. 4. 5. 6. 7. 8. Introduction� ................................................................................................... 6.1 Purpose of Capital Budgeting 6.2�� Capital Budgeting Process ............................................................................ 6.2 Types of capital Investment Decisions ............................................................ 6.3 Project Cash flows......................................................................................... 6.4 Basic Principles for Measuring Project Cash Flows ....................................... 6. 5 Capital Budgeting Techniques ...................................................................... 6. 9 Capital Rationing ......................................................................................... 6.18

CHAPTER 7 MANAGEMENT OF WORKING CAPITAL UNIT I : MEANING, CONCEPT AND POLICIES� OF WORKING CAPITAL 1.1 1.2 1.3 1.7 1.8 1.9 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 Introduction .................................................................................................. 7.1 Meaning and Concept of Working Capital ...................................................... 7.1 Management of Working Capital ................................................................... 7.5 Issues in the Working Capital Management ................................................... 7.6 Estimating Working Capital Needs ................................................................. 7.9 Operating or Working Capital Cycle ............................................................... 7.9 Treasury Management: Meaning ................................................................. 7.30 Functions of Treasury Department ............................................................... 7.30 Management of Cash .................................................................................. 7.31 Methods of Cash Flow Budgeting ................................................................ 7.34 Cash Management Models .7.48 Recent Developments in Cash�� Management .7.50 Cash Management Services The ICICI Bank Way��

7.54 Management of Marketable Securities .7.55��

UNIT II : TREASURY AND CASH MANAGEMENT

ix

UNIT III : MANAGEMENT OF INVENTORY 3.1 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 5.1 5.2 5.3 5.4 Inventory Management ................................................................................ 7.56 Introduction ................................................................................................ 7.57 Role to be Played by the Finance Manager 7.57�� Aspects of Management of Debtors ............................................................ 7.57 Factors Determining Credit Policy ............................................................... 7.58 Factors under the Control of the Finance Manager ....................................... 7.59 Financing Receivables ................................................................................ 7.67 Innovations in Receivable Management ...................................................... 7.69 Monitoring of Receivables .......................................................................... 7.74 Introduction ................................................................................................ 7.76 Sources of Finance 7.77 Working�� Capital Finance from Banks ........................................................... 7.81 Factors Determining Credit Policy ............................................................... 7.82 UNIT IV : MANAGEMENT OF RECEIVABLES

UNIT V : FINANCING OF WORKING CAPITAL

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PART ICOST ACCOUNTING

CHAPTER

1

BASIC CONCEPTSLearning Objectives When you have finished studying this chapter, you should be able to ? Understand the objective and importance of Cost Accounting. ? Understand the cost accounting terminology. ? Differentiate between cost accounting and financial accounting ? Understand the relationship between Cost Accounting, Management Accounting and Financial Management. ? Understand the concept of codes and the process of codification. ? Understand the various types and methods of cost accounting. 1.1 EVOLUTION OF COST ACCOUNTING Financial Accounting,

Prior to the industrial revolution, businesses were small and characterised by simple market exchanges between individuals and organisations. In those times there was a need of accurate book keeping though not that much of cost accounting. However, by the seventeenth century in France, the Royal Wallpaper Manufactory had a Cost Accounting System. Some iron masters and potters in eighteenth century in England too began to produce Cost Accounting information before the Industrial Revolution. Subsequently, with the advent of the industrial revolution, large sized process industries performing single activities (e.g. textiles , railways etc)came into being. During this period, there was a lack of market for intermediary products because of which cost information gained importance as a tool for measuring efficiency of different processes. The period, 1880 AD 1925� AD saw the development of complex product designs and the emergence of multi activity diversified corporations like Du Pont, General Motors etc. It was during this period that scientific management was developed which led accountants to convert physical standards into cost standards, the latter being used for variance analysis and control. During World War I and II the social importance of cost accounting grew with the growth of each country s defence expenditure. In the� absence of competitive markets for most of the material required to fight war, the Governments in several countries placed cost-plus contracts

Cost Accounting

under which the price to be paid was the cost of production plus an agreed rate of profit. The reliance on cost information by the parties to defence contracts continued after World War II as well. Even today, most of the government contracts are decided on a cost plus basis. 1.2 COST ACCOUNTING AND INVENTORY VALUATION

The spurt in the industrial growth, as mentioned above, also resulted in the increased importance of financial accounting and audit (1900 AD onwards).One of the fundamental issues to be resolved by the accountants during this period was the measurement of the value of inventory while preparing financial statements. The valuation had a deep impact over the projected profitability of a company, which in turn affected the willingness of various stakeholders to inject large amount of capital in the business. The valuation also directly affected the taxes which the company was obliged to pay to the government since higher profits meant higher taxes and vice versa. It was in this context that the need of establishing rules for inventory valuation was felt. It was then decided that inventory should be valued at cost or market value which ever is lower. The term cost , being� � � � � � restricted to the money expended in manufacturing the product till the time the product was sold. Hence, expenditure incurred in research and development, distribution, marketing or customer support functions was to be excluded while computing costs for inventory valuation. The computation of the cost incidence� � on different types of inventory with different degrees of completion necessitated the need of accounting for costs in order to arrive at the correct values. As� � you would have understood by now, cost accounting was initiated for� � manufacturing organizations and as a field of practice was limited within the factory premises. However, with the increase in its scope , cost accounting today is equally important to both manufacturing and service organizations and also does not restrict itself to inventory valuation alone. It is used in (1)various decision making scenarios e.g. whether to produce for captive consumption or buy from outside suppliers,(2) supply of information to the government (cost audit), (3)planning and control of expenses(variance analysis) , (4)tracking expenses through a products life cycle (life cycle costing),(5) fixation of selling prices (cost plus and other approaches) etc. The use of information technology has helped companies keep /maintain different cost systems for different purposes. Today, Cost Accounting is popularly known as Cost and Management Accounting . Before you� � begin your study of Cost Accounting, you must be clear in your mind that you are going to study a subject, which is immensely useful in all economic activities. It is a natural instinct with all of us to measure the pros and cons of everything. A prudent housewife who goes for shopping considers the quality and price of each product before she buys it. In short, each economic activity, if rationally viewed, has two aspects - firstly, the costs involved in it1.2

Basic Concept

and secondly, the benefits obtained out of it. This analysis is technically known as cost-benefit analysis. It is very important in industrial and commercial activities. Cost Accounting involves a study of those concepts, tools, and techniques, which help us in ascertaining and analysing costs. 1.2.1 Definition of Costing, Cost Accounting and Cost Accountancy: Costing is defined as the� technique and process of ascertaining costs . Cost Accounting is defined as "the� process of accounting for cost which begins with the recording of income and expenditure or the bases on which they are calculated and ends with the preparation of periodical statements and reports for ascertaining and controlling costs." Cost Accountancy has been defined as the application of costing and cost� accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived there from for the purpose of managerial decision making.� 1.3 (i) (ii) OBJECTIVES OF COST ACCOUNTING Ascertainment of cost. Determination of selling price.

The main objectives of Cost Accounting are as follows :

(iii) Cost control and cost reduction. (iv) Ascertaining the profit of each activity. (v) Assisting management in decision-making. 1.3.1 Ascertainment of Cost: There are two methods of ascertaining costs, viz., Post Costing and Continuous Costing. 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 cost.� 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 continuous process. Cost ascertained by the above two methods may be compared with the standard costs which are the target figures already compiled on the basis of experience and experiments.

1.3

Cost Accounting

1.3.2 Determination of selling price: 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 Accountants. 1.3.3 Cost control and cost reduction: as The guidance and� regulation, by executive action of the cost of operating an undertaking . The word� guidance indicates a goal or target to be guided; regulation indicates taking� � � � action where there is a deviation from what is laid down; executive action denotes action to regulate must be initiated by executives i.e. persons responsible for� � carrying out the job or the operation; and all this is to be exercised through modern methods of costing in respect of expenses incurred in operating an undertaking. To exercise cost control, broadly speaking the following steps should be observed: (i) (ii) Determine clearly the objective, i.e., pre-determine the desired results; Measure the actual performance;

(iii) Investigate into the causes of failure to perform according to plan; and (iv) Institute corrective action. The target cost and/or targets of performance should be laid down in respect of each department or operation and these targets should be related to individuals who, by their action, control the actual and bring them into line with the targets. Actual cost of performance should be measured in the same manner in which the targets are set up, i.e. if the targets are set up operation-wise, then the actual costs should also be collected operation-wise and not cost centre or department-wise as this would make comparison difficult. Cost Reduction, may be defined "as the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for the use intended or diminution in the quality of the product." Cost reduction should not be confused with Cost control. Cost saving could be a temporary affair and may be at the cost of quality. Cost reduction implies the retention of the essential characteristics and quality of the product and thus it must be confined to permanent and genuine savings in the cost of manufacture, administration, distribution and selling, brought about by elimination of wasteful and inessential elements from the design of the product and from the techniques carried out in connection therewith. In other words, the essential characteristics and quality of the products are retained through improved methods and techniques and thereby a permanent reduction in unit cost is achieved. The definition of cost reduction does not, however, include reduction in expenditure arising from reduction in taxation or similar Government action or the effect of price agreements.

1.4

Basic Concept

The three-fold assumptions involved in the definition of cost reduction may be summarised 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 not improved. 1.3.4 Ascertaining the profit of each activity : 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. 1.3.5 Assisting management in decision making : 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 information. 1.4 IMPORTANCE OF COST ACCOUNTING TO BUSINESS CONCERNS

Management of business concerns expects from Cost Accounting a detailed cost information in respect of its operations to equip their executives with relevant information required for planning, scheduling, controlling and decision making. To be more specific, management expects from cost accounting - information and reports to help them in the discharge of the following functions : (a) Control of material cost : Cost of material usually constitute a substantial portion of the total cost of a product. Therefore, it is necessary to control it as far as possible. Such a control may be exercised by (i) Ensuring un-interrupted supply of material and spares for production. (ii) By avoiding excessive locking up of funds/capital in stocks of materials and stores. (iii) Also by the use of techniques like value analysis, standardisation etc. to control material cost. (b) Control of labour cost : It can be controlled if workers complete their work within the standard time limit. Reduction of labour turnover and idle time too help us, to control labour cost. (c) Control of overheads : Overheads consists of indirect expenses which are incurred in the factory, office and sales department ; they are part of production and sales cost. Such expenses may be controlled by keeping a strict check over them. (d) Measuring efficiency : For measuring efficiency, Cost Accounting department should provide information about standards and actual performance of the concerned activity. (e) Budgeting : Now a days� � detailed estimates in terms of quantities and amounts are drawn up before the start of each activity. This is done to ensure that a practicable course of

1.5

Cost Accounting

action can be chalked out and the actual performance corresponds with the estimated or budgeted performance. The preparation of the budget is the function of Costing Department. (f) Price determination: Cost accounts should provide information, which enables the management to fix remunerative selling prices for various items of products and services in different circumstances. (g) Curtailment of loss during the off-season: Cost Accounting can also provide information, which may enable reduction of overhead, by utilising idle capacity during the offseason or by lengthening the season. (h) Expansion: Cost Accounts may provide estimates of production of various levels on the basis of which the management may be able to formulate its approach to expansion. (i) Arriving at decisions: Most of the decisions in a business undertaking involve correct statements of the likely effect on profits. Cost Accounts are of vital help in this respect. In fact, without proper cost accounting, decision would be like taking a jump in the dark, such as when production of a product is stopped. 1.5 VARIOUS REPORTS PROVIDED BY COST ACCOUNTING DEPARTMENT

Following reports may be provided by a Cost Accounting Department for the use of its executives: (a) Cost sheets setting out the total cost, analysed into various elements, giving comparative figures for the previous period and for other plants under the same management. (b) Consumption of material statements, showing total quantity of materials issued for production, materials actually embodied in production and wastage. (c) Labour utilisation statements providing details about the total number of hours paid for, standard hours for the output, idle time (and amount involved) and causes thereof. (d) Overheads incurred compared with budgets; overheads actually charged to production and the difference between the amount actually incurred and the amount so charged. (e) Sales effected compared with budgets, showing the difference between the two because of quality being different from those taken into account while budgeting. (f) Reconciliation of actual profit earned with estimated or budgeted profit. (g) The total cost of abnormally spoiled work in the factory and abnormal losses in the store. (h) The total cost of inventory carried, analysed into raw materials in chief stores and other stores. The number of months for which stocks would be sufficient (on the basis of average consumption being worked out).1.6

Basic Concept

(i)

Labour turnover, and the cost of recruitment and training of new employees.

(j) Expenses incurred on Research and Development as compared with the budgeted amount. Reports about particular departments and operations (like transport or power generation) may also be compiled and submitted to the departmental manager concerned. 1.6 1. 2. ADVANTAGES OF A COST ACCOUNTING SYSTEM A good Cost Accounting System helps in identifying unprofitable activities, losses or inefficiencies in any form. The application of cost reduction techniques, operations research techniques and value analysis technique, helps in achieving the objective of economy in concern s operations. Continuous efforts are being made by the business� organisation for finding new and improved methods for reducing costs. 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. 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. 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. 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. 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.

Important advantages of a Cost Accounting System may be listed as below :

3.

4.

5.

6.

7.

8.

1.7

Cost Accounting

9.

The cost of idle capacity can be easily worked out, when a concern is not working to full capacity.

10. The use of Marginal Costing technique, may help the executives in taking short term decisions. This technique of costing is highly useful during the period of trade depression, as the orders may have to be accepted during this period at a price less than the total cost. 11. The marginal cost has linear relationship with production volume and hence in formulating and solving Linear Programming� Problems , marginal cost is useful. 1.7 ESSENTIAL FACTORS FOR INSTALLING A COST� ACCOUNTING SYSTEM

As in the case of every other form of activity, it should be considered whether it would be profitable to have a cost accounting system. The benefits from such a system must exceed the amount to be spent on it. This would depend upon many factors including the nature of the business and the quality of the management. Management, which is prone to making decisions on the basis of pre-conceived notions without taking into account the information and data placed before it, cannot derive much benefit from a costing system. On the other hand management, which is in the habit of studying information thoroughly before making decisions, would require cost accounting system. Before setting up a system of cost accounting the under mentioned factors should be studied: (i) (ii) The objective of costing system, for example whether it is being introduced for fixing prices or for insisting a system of cost control. The areas of operation of business wherein the managements action will be most beneficial. For instance, in a concern, which� is anxious to expand its operations, increase in production would require maximum attention. On the other hand for a concern, which is not able, to sell the whole of its production the selling effort would require greater attention. The system of costing in each case should be designed to highlight, in significant areas, factors considered important for improving the efficiency of operations in that area.

(iii) The general organisation of the business, with a view of finding out the manner in which the system of cost control could be introduced without altering or extending the organisation appreciably. (iv) The technical aspects of the concern and the attitude and behaviour that will be successful in winning sympathetic assistance or support of the supervisory staff and workmen. (v) The manner in which different variable expenses would be affected with expansion or cessation of different operations.1.8

Basic Concept

(vi) The manner in which Cost and Financial accounts could be inter-locked into a single integral accounting system and in which results of separate sets of accounts, cost and financial, could be reconciled by means of control accounts. (vii) The maximum amount of information that would be sufficient and how the same should be secured without too much clerical labour, especially the possibility of collection of data on a separate printed form designed for each process; also the possibility of instruction as regards filling up of the forms in writing to ensure that these would be faithfully carried out. (viii) How the accuracy of the data collected can be verified? Who should be made responsible for making such verification in regard to each operation and the form of certificate that he should give to indicate the verification that he has carried out ? (ix) The manner in which the benefits of introducing Cost Accounting could be explained to various persons in the concern, specially those in charge of production department and awareness created for the necessity of promptitude, frequency and regularity in collection of costing data. 1.7.1 Essentials of a good Cost Accounting System: The essential features, which a good Cost Accounting System should possess, are as follows: (i) (ii) Cost Accounting System should be tailor-made, practical, simple and capable of meeting the requirements of a business concern. 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. (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 unnecessary details. (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.

1.9

Cost Accounting

1.8 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. 1.8.1 Limitations of Financial Accounting: There are, however, serious limitations of financial accounting from the point of view of management. These stem from the fact that management must have information properly analysed and continuously flowing to it. Management cannot be satisfied with a broad picture, and that too available at the end of a period. The limitations of financial accounts together with procedures that overcome the limitations are given below :

1.10

Basic Concept

Limitations A. Forecasting and Planning Management requires information so that it can make effective plans for the coming year and the period after that. In other words, information about the future is required. Financial Accounts, provide this information.

Procedures that overcome limitations The technique of budgeting has been evolved. Starting with the assessment of the limiting factors that may be operating, careful estimates can be prepared of all the activities that will be undertaken and these then can cannot be translated in terms of money. (An analysis of cost into fixed and variable is most useful in this respect). These estimates ,� � properly coordinated, become budgets and plans of action. It is the complete analysis of cost incurred that can help management in making the type of decisions mentioned. The analysis has to be two-fold :

B. Decision making Management requires information daily for making decision of any type. Financial Accounts normally are not able to provide information for this purpose. Information is required to answer the under mentioned questions amongst others : (i) What should be the product under normal circumstances and under special circumstances ? Should a part be produced in the factory itself or bought from the market ?

(i)

The total cost of each job, product, process etc. as to be ascertained; and The cost must be further analysed as fixed and variable.

(ii)

(ii)

(iii) Should the production of a product be given up ?

(iii) In other words, management should have information to see what the effect on the revenues and cost (both) will be if a proposed course of action is taken. This is the marginal costing technique and most problems can be handled with the aid of this technique.

(iv) What should be the priority accorded to a product ?

1.11

Cost Accounting

(v) Should investment be made in a new project ? (vi) How much should be produced to earn a certain profit, given the selling price? C. Control and assessment Management requires information to assess the performance of various persons and departments and to see that costs do not exceed a reasonable limit for a given quantum of work of the requisite quality. Financial accounts cannot provide information for this purpose. Apart from the generality of the above, management requires to know : (i) (ii) the profitability of each product ; and the extent of unnecessary material, labour, facilities etc. The techniques of budgeting and standard costing enable management to perform this function which is one of most important one. In this case also the main activity is analysis and comparison. If standard costing is not adopted, simple comparison of figures over the periods for each element of cost in terms of quantity if possible is of great help. Profitability of each waste product can be easily established by comparing its selling price with the contribution it makes i.e., the difference between the selling price and its variable cost.

It will be seen from the above that the chief limitation of financial accounting is lack of analysis of information and absence of measuring rods. Cost accounting with the aid of budgeting, standard costing and marginal costing has filled the need in this respect. 1.9 COST CONCEPTS AND TERMS

1.9.1 Cost (a) The amount of expenditure (actual or notional) incurred on or attributable to a specified article, product or activity. (here the word cost is used as a noun) (b) To ascertain the cost of a given thing. (here the word cost is used as a verb) NOTE : The word Cost can rarely stand on its own and should be� � qualified as to its limitation (e.g., historical, variable etc.) and related to a particular thing or object of thought e.g., a given quantity or unit of goods� � made or services performed. 1.9.2 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. 1.9.3 Direct costs Costs that are related to the cost object and� can be traced in an economically feasible way.1.12

Basic Concept

1.9.4 Indirect costs Costs that are related to the cost object but cannot be� traced to it in an economically feasible way. 1.9.5 Pre-determined - A cost which is computed in advance before production or operations start, on the basis of specification of all the factors affecting cost, is known as a predetermined cost. 1.9.6 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. 1.9.7 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. 1.9.8 Cost of Sales - The cost which is attributable to the sales made. Note: It is not uncommon to use this in a restricted sense as the production cost of goods sold. 1.9.9 Total Cost - The sum of all costs attributable to the cost object under consideration. 1.9.10 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. 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.

(ii)

1.9.11 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

1.13

Cost Accounting

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 : Industry or Product Automobile Cement Chemicals Power Steel Cost Unit Basis -Number -Tonne/per bag etc. -Litre, gallon, kilogram, tonne etc. -Kilo-watt hour -Tonne

Transport -Passenger kilometre 1.9.12 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 ; 1.9.13 Profit Centres - Centres which have the responsibility of generating and maximising profits are called Profit Centres. 1.9.14 Investment Centres - Those centres which are concerned with earning an adequate return on investment are called Investment Centres. 1.9.15 Cost allocation - It is defined as the assignment of the indirect costs to the chosen cost object. 1.9.16 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. 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.1.14

Basic Concept

1.9.17 Estimated cost - Kohler defines estimated cost as the expected cost of� manufacture, or acquisition, often in terms of a unit of product computed on the basis of information available in advance of actual production or purchase .� Estimated cost are prospective costs since they refer to prediction of costs. 1.9.18 Differential cost - (Incremental and decremental costs). It represents the change (increase or decrease) in total cost (variable as well as fixed) due to change in activity level, technology, process or method of production, etc. For example if any change is proposed in the existing level or in the existing method of production, the increase or decrease in total cost or in specific elements of cost as a result of this decision will be known as incremental cost or decremental cost. 1.9.19 Imputed costs - These costs are notional costs which do not involve any cash outlay. Interest on capital, the payment for which is not actually made, is an example of imputed cost. These costs are similar to opportunity costs. 1.9.20 Capitalised costs These are costs which are initially recorded as assets� and subsequently treated as expenses. 1.9.21 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. 1.9.22 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. 1.9.23 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. 1.9.24 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.

1.15

Cost Accounting

1.9.25 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. 1.9.26 Absolute cost - These costs refer to the cost of any product, process or unit in its totality. When costs are presented in a statement form, various cost components may be shown in absolute amount or as a percentage of total cost or as per unit cost or all together. Here the costs depicted in absolute amount may be called absolute costs and are base costs on which further analysis and decisions are based. 1.9.27 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 training etc. 1.9.28 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 nonmanufacturing costs such as general and administrative expenses, selling and distribution expenses are recognised as period costs. 1.9.29 Engineered costs - These are costs that result specifically from a clear cause and effect relationship between inputs and outputs. The relationship is usually personally observable. Examples of inputs are direct material costs, direct labour costs etc. Examples of output are cars, computers etc. 1.9.30 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. 1.9.31 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.

1.16

Basic Concept

1.10 ELEMENTS OF COST A diagram as given below shows the elements of cost described as under : ELEMENTS OF COSTMATERIALS COST LABOUR COST OTHER EXPENSES

DIRECT MATERIALS COST

INDIRECT MATERIALS COST

DIRECT LABOUR COST

INDIRECT LABOUR COST

DIRECT EXPENSES

INDIRECT EXPENSES

OVERHEADS

PRODUCTION OR WORKS OVERHEADS

ADMINISTRATION OVERHEADS

SELLING OVERHEADS

DISTRIBUTION OVERHEADS

1.10.1 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. Note: However in some cases a material may be direct but it is treated as indirect, because it is used in small quantities and it is not economically feasible to identify that quantity. 1.10.2 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. 1.10.3 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. 1.10.4 Indirect materials : Materials which do not normally form part of the finished product (cost object) are known as indirect materials. These are Stores used for� maintaining machines and buildings (lubricants, cotton waste, bricks

1.17

Cost Accounting

etc.) Stores used by service departments like power house, boiler house, canteen etc. 1.10.5 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. 1.10.6 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. 1.10.7 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 following : (i) Production or Works overheads (ii) Administration overheads (iii) Selling overheads 1.11 CLASSIFICATION OF COSTS It means the grouping of costs according to their common characteristics. The important ways of classification of costs are : (1) By nature or element (3) As direct and indirect (5) By controllability (2) By functions (4) By variability (6) By normality (iv) Distribution overheads

1.11.1 By Nature of Element - Under this classification the costs are divided into three categories i.e., materials cost, labour cost and expenses. This type of classification is useful to determine the total cost. 1.11.2 By Functions - Under this classification, costs are divided according to the function for which they have been incurred. Some of the examples are : Production cost - The cost of sequence of operations which begins with supplying materials, labour and services and ends with primary packing of the product. Selling cost - The cost seeking to create and stimulate demand (sometimes termed marketing ) and of securing orders.� � Distribution cost - The cost of the sequence of operations which begins with making the packed product available for despatch and ends with making the reconditioned returned empty package, if any available for re-use.1.18

Basic Concept

Note - It also includes expenditure incurred in transporting articles to central or local storage. Distribution costs include expenditure incurred in moving articles to and from prospective customers as in case of goods on sale or return basis. In the gas, electricity and water industry distribution means pipes, mains and services which may be regarded as the equivalent of packing and transportation. Administrative cost - The cost of formulating the policy, directing the organisation and controlling the operations of an undertaking which is not related directly to a production, selling and distribution, research or development activity or function. Research cost - The cost of researching for new or improved products, new applications of materials, or improved methods. Development cost - The cost of the process which begins with the implementation of the decision to produce a new or improved product or to employ a new or improved method and ends with commencement of formal production of that product or by that method. Pre-production cost - The part of development cost incurred in making a trial production run preliminary to formal product. Note - This term is sometimes used to cover all activities prior to production including research and development, but in such cases the usage should be made clear in the context. Conversion cost - The sum of direct wages, direct expenses and overhead cost of converting raw materials to the finished stage or converting a material from one stage of production to the next. Note - In some circumstances this phrase is used to include any excess material cost or loss of material incurred at the particular stage of production. Product costs Please refer to 1.9.21 Purposes for computing� product costs : The three different purposes for computing product costs are as follows : (i) (ii) Preparation of financial statements: Here focus is on inventoriable costs for complying with Accounting Standard 2 , issued by the� Council of ICAI. Product pricing: It is an important purpose for which product costs are used. For this purpose, the cost of the other areas of the value chain should be included to make the product available to the customer.

(iii) Contracting with government agencies: Normally such contracts are on a cost plus basis. For this purpose government agencies may not allow the contractors to recover research and development and marketing costs under cost plus contracts. 1.11.3 As Direct and Indirect Please refer to 1.9.3 and 1.9.4�

1.19

Cost Accounting

1.11.4 By Variability - According to this classification costs are classified into three groups viz., fixed, variable and semi-variable. (a) Fixed costs - These are the costs which are incurred for a period, and which, within certain output and turnover limits, tend to be unaffected by fluctuations in the levels of activity (output or turnover). They do not tend to increase or decrease with the changes in output. For example, rent, insurance of factory building etc., remain the same for different levels of production. A fixed cost can be depicted graphically as follows, Total Fixed Cost Rs. 1,000 Activity Level The graph shows that the cost is constant (Rs.1,000) for all activity levels. However, it should be noted that this is only true for a relevant range of activity. Fixed costs tend to change beyond the relevant range. Such cost behaviour pattern is described as a stepped fixed cost:

Total Fixed Cost (Rs.)

Relevant Relevant Range 1 Range 2

Relevant Range 3

Activity Level (b) Variable costs - These costs tend to vary with the volume of activity. Any increase in the activity results in an increase in the variable cost and vice-versa. For example, cost of direct labour, etc. Variable costs are depicted graphically as follows, Total variable Cost (Rs.)

Activity Level1.20

Basic Concept

(c) Semi-variable costs - These costs contain both fixed and variable components and are thus partly affected by fluctuations in the level of activity. Examples of semi variable costs are telephone bills, gas and electricity etc. Such costs are depicted graphically as follows: Total Cost (Rs.) Variable Cost

Fixed Cost Activity Level Methods of segregating Semi-variable costs into fixed and variable costs - The segregation of semi-variable costs into fixed and variable costs can be carried out by using the following methods: (a) Graphical method (b) High points and low points method (c) Analytical method (d) Comparison by period or level of activity method (e) Least squares method (a) Graphical method: Under this method, a large number of observations regarding the total costs at different levels of output are plotted on a graph with the output on the X-axis and the total cost on the Y-axis. Then, by judgment, a line of best-fit ,� � which passes through all or most of the points is drawn. The point at which this line cuts the Y-axis indicates the total fixed cost component in the total cost. If a line is drawn at this point parallel to the X-axis, this indicates the fixed cost. The variable cost, at any level of output, is derived by deducting this fixed cost element from the total cost. The following graph illustrates this:

1.21

Cost Accounting

(b) High points and low points method: - Under this method in the following illustration the difference between the total cost at highest and lowest volume is divided by the difference between the sales value at the highest and lowest volume. The quotient thus obtained gives us the rate of variable cost in relation to sales value. The fixed cost is the remainder. See the following illustration. Illustration : Sales value Rs. 1,40,000 80,000 60,000 Total cost Rs. 72,000 60,000 12,000

At the Highest volume At the Lowest volume

Thus, Variable Cost (Rs. 12,000/Rs. 60,000) = 1/5 or 20% of sales value = Rs. 28,000 (at highest volume) Fixed Cost : Alternatively : Rs. 72,000 Rs. 28,000� i.e., (20% of Rs. 1,40,000) = Rs. 44,000. Rs. 60,000 Rs. 16,000 (20% of Rs.� 80,000) = Rs. 44,000.

(c) Analytical method: Under this method an experienced cost accountant tries to judge empirically what proportion of the semi-variable cost would be variable and what would be fixed. The degree of variability is ascertained for each item of semi-variable expenses. For example, some semi-variable expenses may vary to the extent of 20% while others may vary to the extent of 80%. Although it is very difficult to estimate the extent of variability of an expense, the method is easy to apply. (Go through the following illustration for clarity).

1.22

Basic Concept

Illustration Suppose, last month the total semi-variable expenses amounted to Rs. 3,000. If the degree of variability is assumed to be 70%, then variable cost = 70% of Rs. 3,000 = Rs. 2,100. Fixed cost = Rs. 3,000 Rs. 2,100 = Rs. 900. Now in the� future months, the fixed cost will remain constant, but the variable cost will vary according to the change in production volume. Thus, if in the next month production increases by 50%, the total semi-variable expenses will be: Fixed cost of Rs. 900, plus variable cost viz., Rs. 3,150 i.e., (Rs. 2,100(V.C.) plus 50% increase of V.C. i.e., Rs. 1,050) i.e., Rs. 4,050. (d) Comparison by period or level of activity method - Under this method, the variable overhead may be determined by comparing two levels of output with the amount of expenses at those levels. Since the fixed element does not change, the variable element may be ascertained with the help of the following formula.

Change in the amount of expense Change in the quantity of outputSuppose the following information is available: Production Units January February Difference The variable cost : 100 140 40 Semi-variable expenses Rs. 260 300 40

Rs. 40 Change in Semi - variable expenses = = Re. 1/unit 40 units Change in production volumeThus, in January, the variable cost will be 100 Re. 1 = Rs. 100 and the fixed� cost element will be (Rs. 260 Rs. 100) or Rs. 160. In February, the variable� cost will be 140 Re. 1 = Rs. 140 whereas the fixed cost element will remain the� same, i.e., Rs. 160. (e) Least squared method : This is the best method to segregate semi-variable costs into its fixed and variable components. This is a statistical method and is based on finding out a line of best fit for a number of observations. The method uses the linear equation y = mx + c, where m represents the variable element of cost per unit, c represents the total fixed cost, y� � � � represents the total cost, x represents the volume of output. The total cost is� � thus split into its

1.23

Cost Accounting

fixed and variable elements by solving this equation. By using this method, the expenditure against an item is determined at various levels of output and values of x and y are fitted in the above formula to find out the values of m and c. The following illustration may be helpful to understand this method. Level of activity Capacity % Volume (Labour hours) x Semi-variable expenses (maintenance of plant) y 60% 150 Rs. 1,200 80% 200 Rs. 1,275

Substituting the values of x and y in the equation, y = mx + c, at both the levels of activity, we get 1,200 = 150 m + c 1,275 = 200 m + c On solving the above equation, we get (c) (Fixed cost) = Rs. 975 and m (Variable cost) = Rs. 1.50 per labour hour. Advantages of Classification of Costs into Fixed and Variable: The primary objective of segregating semi-variable expenses into fixed and variable is to ascertain marginal costs. Besides this, it has the following advantages also. (a) Controlling expenses: The classification of expenses into fixed and variable components helps in controlling expenses. Fixed costs are generally policy costs, which cannot be easily reduced. They are incurred irrespective of the output and hence are more or less non controllable. Variable expenses vary with the volume of activity and the responsibility for incurring such an expenditure is determined in relation to the output. The management can control these costs by giving proper allowances in accordance with the output achieved. (b) Preparation of budget estimates: The segregation of overheads into fixed and variable part helps in the preparation of flexible budget. It enables a firm to estimate costs at different levels of activity and make comparison with the actual expenses incurred. Suppose in October, 2006 the output of a factory was 1,000 units and the expenses were: Fixed Variable Semi-variable (40% fixed) Rs. 5,000 4,000 6,000 15,000

1.24

Basic Concept

In November, 2006 the output was likely to increase to 1,200 units. In that case the budget or estimate of expenses will be : Rs. Fixed Variable 5,000 4,800

? Rs.4,000 1,200 units ? ? ? 1,000 units ? ?�Semi-variable

Fixed, 40% of Rs. 6,000

2,400 6,720 16,520

? Rs.3,600 1,200 units ? Variable: ? ? 4,320 1,000 units ? ?�

It would be a mistake to think that with the output going up from 1,000 units to 1,200 units the expenses would increase proportionately to Rs. 18,000. (c) Decision making: The segregation of semi variable cost between fixed and variable overhead also helps the management to take many important decisions. For example, decisions regarding the price to be charged during depression or recession or for export market. Likewise, decisions on make or buy, shut down or continue, etc., are also taken after separating fixed costs from variable costs. In fact, when any change is contemplated, say, increase or decrease in production, change in the process of manufacture or distribution, it is necessary to know the total effect on cost (or revenue) and that would be impossible without a correct segregation of fixed and variable costs. The technique of marginal costing, cost volume profit relationship and break-even analysis are all based on such segregation.1.11.5 By Controllability - Costs here may be classified into controllable and uncontrollable costs.

(a) Controllable costs - These are the costs which can be influenced by the action of a specified member of an undertaking. A business organisation is usually divided into a number of responsibility centres and an executive heads each such centre. Controllable costs incurred in a particular responsibility centre can be influenced by the action of the executive heading that responsibility centre. Direct costs comprising direct labour, direct material, direct expenses and some of the overheads are generally controllable by the shop level management.

1.25

Cost Accounting

(b) Uncontrollable costs - Costs which cannot be influenced by the action of a specified member of an undertaking are known as uncontrollable costs. For example, expenditure incurred by, say, the Tool Room is controllable by the foreman incharge of that section but the share of the tool-room expenditure which is apportioned to a machine shop is not to be controlled by the machine shop foreman. The distinction between controllable and uncontrollable costs is not very sharp and is sometimes left to individual judgement. In fact no cost is uncontrollable; it is only in relation to a particular individual that we may specify a particular cost to be either controllable or uncontrollable.1.11.6 By Normality - According to this basis cost may be categorised as follows:

(a) Normal cost - It is the cost which is normally incurred at a given level of output under the conditions in which that level of output is normally attained. (b) Abnormal cost - It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is charged to Costing Profit and loss Account.1.12 CODING SYSTEMS Codes

The Chartered Institute of Management Accountants has defined a code as a system� of symbols designed to be applied to a classified set of items to give a brief account reference , facilitating entry collation and analysis Hence cost� classification forms the basis of any cost coding. It helps us understand the characteristic of any cost through a short symbolised form.Composite Codes

Let us consider the following example A company has devised a system of codification in which the first three digits indicate the nature of the expenditure and the last three digits the cost centre or cost unit to be charged e.g. if the first digit is 1, the system implies that it refers to raw material and if the number is 2 it represents a labour cost. The second and third numbers relating to 1 i.e., raw material, provide details of the type e.g., whether the raw material is an electronic component (number 4), mechanical component (number 1) consumables(number 2) or packing (number 3) and the name respectively. Hence the description of a cost with a code 146.729 shall be understood as follows: ? Since the first number is 1 the cost refers to raw material cost1.26

Basic Concept

? The second number being 4 indicates that the raw material is an electronic component. ? The third number 6 refers to the description which according to the company s codification refers to Diodes. The last three numbers provide details of� the cost centre e.g. the first number provides details of the location of the plant, the second number gives detail of the department (machining or assembly or something else) and the third number indicates whether the cost is direct or indirect.Advantages of a coding system

The following are some of the advantages of a well-designed coding system : (a) Since the code is, most of the times, briefer than a description, it saves time when systems are worked upon manually and in case the system is computerised it reduces the data storage capacity. The illustration above demonstrates this advantage very clearly. (b) A code helps in reducing ambiguity. In case two professionals understand the same item differently a code will help them objectively. (c) Unlike detailed descriptions, a code facilitates data processing in computerised systems.The requirements for an efficient coding system

(a) Every number used in the code should be unique and certain, i.e. it should be easily identified from the structure of the code. (b) Elasticity and comprehensiveness is an absolute must for a well designed coding system. It should be possible to identify a code for every item and the coding system should be capable of expanding to accommodate new items. (c) The code should be brief and meaningful. (d) The maintenance of the coding system should be centrally controlled. It should not be possible for individuals to independently add new codes to the existing coding system. (e) Codification systems should be of the same length. This makes errors easier to spot and it assists computerised data processing.1.13 TYPES OF COSTING

For ascertaining cost, following types of costing are usually used.1.13.1 Uniform Costing: When a number of firms in an industry agree among themselves to follow the same system of costing in detail, adopting common terminology for various items and processes they are said to follow a system of uniform costing. In such a case, a

1.27

Cost Accounting

comparison of the performance of each of the firms can be made with that of another, or with the average performance in the industry. Under such a system it is also possible to determine the cost of production of goods which is true for the industry as a whole. It is found useful when tax-relief or protection is sought from the Government.1.13.2 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. 1.13.3 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. 1.13.4 Historical Costing: It is the ascertainment of costs after they have been incurred. This type of costing has limited utility. 1.13.5 Direct Costing: It is the practice of charging all direct costs to operations, processes or products leaving all indirect costs to be written off against profits in which they arise. 1.13.6 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 are excluded. 1.14 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:1.14.1 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. The name then given is Batch Costing. 1.14.2 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. 1.14.3 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.

1.28

Basic Concept

1.14.4 Single or Output Costing : Here the cost of a product is ascertained, the product being the only one produced like bricks, coals, etc. 1.14.5 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. 1.14.6 Operating Costing : It is used in the case of concerns rendering services like transport, supply of water, retail trade etc. 1.14.7 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 multiple costing. 1.15. DIRECT EXPENSES 1.15.1. 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 services .�

Examples of direct expenses are : (i) (ii) Hire charges of special machinery or plant for a particular production order or job. Payment of royalties.

(iii) Cost of special moulds, designs and patterns. (iv) Experimental costs before undertaking the job concerned. (v) Travelling and conveyance expenses incurred in connection with a particular job. (vi) Sub-contracting expenses or outside work costs if jobs are sent out for special processing.1.15.2 Characteristics of Direct Expenses :

(i) (ii)

Direct expenses are those expenses, which are other than the direct materials and direct labour. 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.

1.29

Cost Accounting

The nature of direct expenses demands a strict control over such expenses. This feature of controlling direct expenses in business houses compels their management to treat some of the direct expenses as indirect expense. Sometime a direct expense is assumed as indirect due to the convenience. Sometimes a concern may treat an expense as direct whereas another may treat the same expense as indirect. Further the amount of these expenses in proportion to the total cost also influences the decision to treat them as direct expense or as an indirect expense.1.15.3 Sub-contracting : It is a common business practice followed by business concerns, under which operations requiring special processing are sub-contracted. Examples of such operations are painting, cutting, stitching etc. This is done due to following reasons :

(i)

The operations, which are given to outside sub-contractors, are those operations, which require the use of special skill, or special equipment, which is not available with the concern. If the management of a concern intends to engage available labour hours and machine hours for operations, which require special skill or special facility available with the concern, the operations, which require a lower level of skill or general-purpose machine, are given to outsider.

(ii)

(iii) If there is temporary increase in demand of product of a concern, some of the operations are given to outsiders to bridge the imbalance between the production capacities available with various work-centres. The payments made to sub-contractors or outsiders are charged as direct expenses of the specific jobs/work orders.1.15.4. Documentation: The basic document which is used for the charging of direct expenses to products or batches or work order is the invoice received from suppliers of such service. The payment to supplier of service is made on the basis of invoice & expenses are booked in financial accounts.

For example, hiring charges of a machine is charged to the product for which it is hired on the basis of invoice received from supplier of machinery.1.15.5. Identification of direct expenses with main product or service: For the identification of direct expense with main product or service it is required that the code number of product or service should be inscribed on invoice received from supplier of services.

For example, if a machine is hired to complete a particular product, then the hiring charging of a machine is direct expense of the particular product. For charging hiring charges of machine to a particular product it is required that the invoice received from supplier of machine should be coded with the product code for ensuring that the hiring charges of machine is charged to the particular product. Alternatively, if cash is paid, then the cash book analysis will show the product code which is to be charged with the cost of hiring machinery.1.30

Basic Concept

1.16 Self Examination Questions Multiple Choice Questions

(a) The main purpose of cost accounting is to : (i) (ii) maximise profits; help in inventory valuation;

(iii) provide information to management for decision making; (iv) aid in the fixation of selling price. (b) One of the most important tools in cost planning is : (i) (ii) direct cost; budget;

(iii) cost sheet; (iv) marginal costing. (c) Increase in total variable cost is due to : (i) (ii) increase in fixed cost; increase in sales;

(iii) increase in production. (d) An example of fixed cost is : (i) direct material cost; (ii) works manager s salary; (iii) depreciation of machinery; (iv)� chargeable expenses. (e) Cost of goods produced includes : (i) (ii) (f) production cost and finished goods inventory; production cost and work-in-progress;

(iii) production cost, work-in-progress and finished goods inventory. Conversion cost is equal to the total of : (i) (ii) material cost and direct wages; material cost and indirect wages;

1.31

Cost Accounting

(iii) direct wages and factory overhead; (iv) material cost and factory overhead. (g) Costs which are ascertained after they have been incurred are known as (i) (ii) imputed costs; sunk costs;

(iii) historical costs; (iv) opportunity costs. (h) Prime costs plus variable overhead is known as : (i) (ii) production cost; marginal costs;

(iii) total cost; (iv) cost of sales. (i) Indirect costs are known as: (i) (ii) Variable costs; Fixed costs;

(iii) Overheads; (iv) None of the above. (j) Accounting standard 2 recommends the valuation of inventory on: (i) (ii) Absorption costing; Marginal costing;

(iii) Activity based costing; (iv) None of the above. (k) If Rs 10 is spend on producing 10 units and Rs 15 for producing 15, then the fixed cost per unit is: (i) (ii) Rs 0; Rs 1;

(iii) Rs 2; (iv) None of the above. (l)1.32

The variable cost per unit is:

Basic Concept

(i) (ii)

Variable in nature; Fixed in nature;

(iii) Semivariable in nature; (iv) None of the above. (m) The total cost for producing 10 items is Rs 15 and that for producing 15 items is Rs 20. What is the fixed cost? (i) (ii) Rs 10; Rs 15;

(iii) Rs 5; (iv) None of the above. (n) A company presently does not utilise its available capacity. In case of full capacity utilisation, the cost per unit shall (i) (ii) Increase; Decrease;

(iii) Remain constant; (iv) None of the above. (o) The following extract is taken from the distribution cost budget of DC Ltd. Volume delivered (units) Distribution cost (i) (ii) (iii) (iv) Rs. 6,600 Rs. 9,000 Rs. 9,400 Rs. 10,800 8,000 Rs. 7,200 14,000 Rs. 10,500

The budgeted cost allowance for distribution cost for a delivery volume of 12,000 units is

Answers to Multiple Choice Questions (a) iii; (b) ii; (c) iii; (d) ii; (e) ii; (f) iii; (g) iii; (h) ii; (i) iii; (j) i; (k) i; (l) ii; (m) i; (n) ii; (o) iii Short Answer Type Questions

1.

What is Cost Accounting? Explain its important objectives.

1.33

Cost Accounting

2.

Write short note on: (i) (ii) Conversion cost. Sunk cost.

(iii) Differential cost. (iv) Opportunity cost. (v) Out of pocket cost. 3. Distinguish between: (i) (ii) Cost centre and cost unit. Cost control and cost reduction.

(iii) Period cost and product cost. (iv) Controllable and non-controllable costs. (v) Estimated cost and standard cost. (vi) Variable cost and direct cost. 4. Write brief answers to the following : (a) While introducing a cost accounting system, to what should most attention be paidproduction or sales ? (b) Are direct expenses more important than indirect expenses ? (c) Is prompt reporting better than accurate reporting ? (d) If the selling price for a product is not within the control of the firm, why should it have a system of cost accounting ? 5. Below is given a list of industries and also the methods of costing and cost unit. Give the correct number of methods of costing and unit of cost against each industry.Industry Methods of Costing Unit of Cost

(i) (ii)

Nursing Home Road Transport iron ore mines)

(a) Process (b) Job (c) Multiple (d) Single (e) Operating (f) Contract

1. Each job 2. Bed per week or per day 3. Per tonne 4. Each contract 5. Each unit 6. Per tonne-kilo-metre

(iii) Steel (owning (iv) Coal (v)1.34

Bicycle

Basic Concept

(vi) Bridge construction (vii) Interior decoration (viii) Advertising (ix) Furniture (x) 7. Sugar company having own sugarcane fields A company manufacturing garments. The following costs are incurred by the company. You are required to group the costs which are listed below into following classifications: (a) direct materials (b) direct labour (c) direct expenses (d) indirect production overhead (e) research and development cost (f) selling & distribution cost (g) administration costs (h) finance costs. (i) (ii) Lubricant for sewing machines Floppy disk for general office computer

(iii) Maintenance contact for office photocopying machine (iv) Road licence for delivery vehicle (v) Market research prior to new product launch (vi) Cost of painting advertising slogans in delivery vans (vii) Trade magazine (viii) Upkeep of delivery vehicles (ix) Wages of operative in cutting department (x) Interest on bank overdraftLong Answer Type Questions

1.

State and explain the differences between Financial Accounting, Cost Accounting and Management Accounting.

1.35

Cost Accounting

2. 3. 4. 5.

What do you understand by direct expenses? What are their characteristics? Discuss the factors which a Cost Accountant should consider before installing a costing system in a manufacturing concern. Discuss the various methods known to you which may be utilised for segregating a semi variable cost into its fixed and variable component. How is Cost Accounting important to business concerns? Discuss.

1.36

CHAPTERMATERIALLearning Objectives

2

When you have finished studying this chapter, you should be able to ? Understand the need and importance of material control. ? Describe the procedures involved in procuring, storing and issuing material. ? Differentiate amongst the various methods of valuing material. ? Understand the meaning and the accounting treatment for normal and abnormal loss of material. ? Understand the meaning and the accounting treatment of waste, scrap, spoilage and defectives. 2.1 INTRODUCTION

We have acquired a basic knowledge about the concepts, objectives, advantages, methods and elements of cost. We shall now study each element of cost separately. The first element of cost is Direct Material Cost . Materials constitute a very� � significant proportion of total cost of finished product in most of the manufacturing industries. A proper recording and control over the material costs is essential because of the following : (a) The exact quality of specification of materials required should be determined according to the required quality of the finished product. If too superior quality of material is purchased, it would mean higher cost due to high prices; if the quality of materials purchased is too low, the product will be of inferior quality. (b) The price paid should be the minimum possible otherwise the higher cost of the finished products would make the product uncompetitive in the market. (c) There should be no interruption in the production process for want of materials and stores, including small inexpensive items like lubricating oil for a machine. Sometime their out of stock situation may lead to stoppage of machines.

Cost Accounting

(d) There should be no over stocking of materials because that would result in loss of interest charges, higher godown charges, deterioration in quality and losses due to obsolescence (either due to manufacture of certain articles being given up or the material previously required for the production not being required any longer due to a change in methods of production). (e) Wastage and losses while the materials are in store should be avoided as far as possible; and (f) Wastage during the process of manufacture should be the minimum possible. It may also be added that information about availability of materials and stores should be continuously available so that production may be planned properly and the required materials purchased in time. 2.2 MATERIAL CONTROL

The publication of the Institute of Cost and Management Accountants on Budgetary Control defines it as the function of ensuring that sufficient goods are retained� in stock to meet all requirements without carrying unnecessarily large stocks .� When the functions of indexing buying, receiving, inspection, storing and paying of the goods are separated it is essential that these should be properly co-ordinated so as to achieve the advantages of specialisation. 2.2.1 Objectives of system of material control : The objectives of a system of material control are the following : (i) Ensuring that no activity, particularly production, suffers from interruption for want of materials and stores-it should be noted that this requires constant availability of every item that may be needed howsoever small its cost may be. Lubricating oil may cost much less than the main raw material but, from the point of view of uninterrupted production, both have equal importance. Seeing to it that all the materials and stores are acquired at the lowest possible price considering the quality that is required and considering other relevant factors like reliability in respect of delivery, etc.

(ii)

(iii) Minimisation of the total cost involved, both for acquiring stocks (apart from the price paid to the supplier) and for holding them. (iv) Avoidance of unnecessary losses and wastages that may arise from deterioration in quality due to defective or long storage or from obsolescence. It may be noted that losses and wastages in the process of manufacture, concern the production department.

2.2

Material

(v) Maintenance of proper records to ensure that reliable information is available for all items of materials and stores that not only helps in detecting losses and pilferages but also facilitates proper production planning. The fulfilment of the objectives mentioned above will require that standard lists of all the materials and stores required for the firm s work be drawn up with the weekly consumption� figures. Also the lead time for each item has to be determined which will then enable the firm to ascertain the minimum quantity for each items. It is also necessary to fix maximum quantity so that capital is not locked up unnecessarily and the risk of obsolescence is minimised. Costs are minimised through the use of ABC analysis (which means classification of the various items on the basis of investment involved into three categories, viz., A, B and C.) 2.2.2 Requirements of material control - Material control requirements are as follows: 1. 2. 3. 4.� 5. 6. 7. Proper co-ordination of all departments involved viz., finance, purchasing, receiving, inspection, storage, accounting and payment. Determining purchase procedure to see that purchases are made, after making suitable enquiries, at the most favourable terms to the firm. Use of standard forms for placing the order, noting receipt of goods, authorising issue of the materials etc. Preparation of budgets concerning materials, supplies and equipment to ensure economy in purchasing and use of materials. Operation of a system of internal check so that all transactions involving materials, supplies and equipment purchases are properly approved and automatically checked. Storage of all materials and supplies in a well designated location with proper safeguards. Operation of a system of perpetual inventory together with continuous stock checking so that it is possible to determine at any time the amount and value of each kind of material in stock. Operation of a system of stores control and issue so that there will be delivery of materials upon requisition to departments in the right amount at the time they are needed. Development of system of controlling accounts and subsidiary records which exhibit summary and detailed material costs at the stage of material receipt and consumption.

8.

9.

2.3

Cost Accounting

10. Regular reports of materials purchased, issue from stock, inventory balances, obsolete stock, goods returned to vendors, and spoiled or defective units. 2.3 MATERIALS PROCUREMENT PROCEDURE

If a concern can afford it, there should be a separate purchase department for all purchases to be made on behalf of all other departments. Purchasing should be centralised i.e. all purchases should be done by the purchasing department except for small purchases which may be done by the user s department. What is needed is� that there should be staff wholly devoted to purchasing. Such a staff is bound to become expert in the various matters to be attended to, for examples units of� materials to be purchased and licences to be obtained, transport, sources of supply, probable price etc. The concerned officers in this department keep themselves in constant touch with the markets either by reading various trade magazines or by direct association, to have the latest information. If a concern has a number of factories requiring the same material and stores, there will be advantage in centralising purchases since important economies in prices and even transport may be obtained by placing large orders at a time. In such a case inspection at a source may also be possible. Of course, there will be a little delay in supply because of clerical processes and sometimes, there may be a misunderstanding resulting in supply of wrong articles. However, there is no advantage in centralised purchasing if different materials, and stores are required by different plants. Materials purchase department in a business house is confronted with the following issues: (i) (ii) What to purchase ? When to purchase ?

(iii) How much to purchase ? (iv) From where to purchase. (v) At what price to purchase. To overcome the above listed issues, the purchase department follows the procedure involving following steps : 1. 2.2.4

Receiving purchase requisitions. Exploring the sources of materials supply and selecting suitable material suppliers.

Material

3. 4. 5.

Preparation and execution of purchase orders. Receipt and inspection of materials. Checking and passing of bills for payment.

2.3.1 Receiving purchase requisitions - Since the materials and stores purchased will be used by the production departments, there should be constant co-ordination between the purchase and production departments. A purchase requisition is a form used for making a formal request to the purchasing department to purchase materials. This form is usually filled up by the store keeper for regular materials and by the departmental head for special materials (not stocked as regular items). The requisition form is duly signed by either works manager or plant superintendent, in addition to the one originating it. At the beginning a complete list of materials and stores required should be drawn up, the list should have weekly consumption figures. It should be gone through periodically so that necessary deletion and addition may be made. If there is any change in the rate of consumption per week (say, due to extra shift being worked), the purchase department should be informed about the new figures. Once an item has been included in the standard list, it becomes the duty of the purchase department to arrange for fresh supplies before existing stocks are exhausted. But if the production department requires some new material, it should make out an indent well in time and send it to the purchase department for necessary action. Control over buying - For control over buying of regular stores materials it is necessary to determine their maximum, minimum, reorder level and economic order quantities. The use of economic order quantities and various levels constitutes an adequate safeguard against improper indenting of regular materials. In respect of special materials, required for a special order or purpose, it is desirable that the technical department concerned should prepare materials specifications list specifying the quantity, size and order specifications of materials to be drawn from the store and those to be specially procured. In all cases, the starting point in the process for purchasing is the issue of a proper purchase requisition (form is given below). (Students may note that the forms suggested in this booklet as well as in the text books are illustrative in nature. The actual form may differ under different circumstances). It may originate either in the stores department in connection with regular stock of materials or in the production planning or in other technical departments concerned in respect of special materials. Its purpose is to request and authorise the purchase department to order to procure the materials specified in

2.5

Cost Accounting

stated quantities. It should be made out in triplicate. The original copy is sent to the purchasing department, the duplicate is kept by the storekeeper or the department which initates the requisition and the triplicate is sent to the authorising executive. Purchase Requisition (Regular/Special) (Use a separate form for each item) No.................. Date............. Purchase................... Description of Materials required Department................................. Date by which material required............................... Quantity required Exact specification

........................ Indentor For use in purchase department Firm Quotations

..................................................................................

..... Price (including charges)

..................................................................................

..... Price............................... Date of Delivery

..................................................................................

..... Remarks Purchase Manager Date of dly................... With...................................... 1. 2. 3. Order No. & Date...........................

2.6

Material

A specimen form of purchase requisition for reordering regular stock items. Purchase Requistion No. S.No. Name of article Present stock Minimum stock Maximum stock Date Remarks

Remarks

.............................. ..............................

.............................. Purchase manager

.............................. Stores Ledger Clerk

2.3.2 Exploring the sources of materials supply and selecting suitable material suppliers: A source for the supply of each material may be selected after the receipt of the purchase requisition. Purchase department in each business house usually maintains a list of suppliers for each group of materials, required by their concern. Atleast three quotations are invited from such suppliers. On the receipt of these quotations a comparative statement is prepared. For selecting material suppliers the factors which the purchase department keeps in its mind are price; quantity; quality offered; time of delivery; mode of transportation;� terms of payment; reputation of supplier; etc. In addition to the above listed factors purchase manager obtains the necessary information from the statement of quotations; past records, buyer guides etc. for finally selecting material suppliers. 2.3.3 Preparation and execution of purchase orders : Having decided on the best quotation that should be accepted, the purchase manager or concerned officer proceeds to issue the formal purchase order. It is a written request to the supplier to supply certain specified materials at specified rates and within a specified period. Copies of purchase order are sent to : (i) (ii) The supplier; Store or the order indenting department;

(iii) Receiving department; and (iv) Accounting department. A copy of the purchase order, alongwith relevant purchase requisitions, is held in the file

2.7

Cost Accounting

of the department to facilitate the follow-up, of the delivery and also for approving the invoice for payment. 2.3.4 Receipt and inspection of materials: Under every system of stores organisation, a distinction is made between the function of receiving and storing, so that each acts as a check on the other. The receiving department or section is responsible for taking charge of the incoming materials, checking and verifying their quantities, inspecting them as regards their grade, quality or other technical specifications and if found acceptable, passing them on to the stores (or other departments for which these might have been purchased). In large organisation, a special inspection wing is often attached to the receiving department and, where it is not so, technical appraisal of the incoming supplies is carried out by the general inspecting staff. In case the quality is not the same as ordered, the goods are not accepted. If everything is in order and the supply is considered suitable for acceptance, the Receiving department prepares a Receiving Report or Material Inward Note or Goods Received Note. It is prepared in quadruplicate, the copies being distributed as under : (i) (ii) First copy is sent to the Purchase Department for verifying supplier s bill� for payment. Second copy is sent to the store or the department that indents the material.

(iii) Third copy is sent to the stores ledger clerk in the Cost Department. (iv) Fourth and the last copy is retained for use by the receiving department. A good plan would be that the receiving clerk sends all the three copies (meant for others) along with the materials to the store or the department that placed the order. The materials are then physically inspected and the particulars thereof as recorded in the Receiving Report are verified. If the quantity and quality are in order, the delivery of the same is accepted and copies of the report are signed; two copies of the report are forwarded to the Purchase Department and the third is kept on the file as documentary evidence of the quantities of stores received for storage or use, as the case may be. The Purchase Department in turn, enters the purchase price and forwards one copy to the Accounts Department and the second to the Cost Department. A specimen form of the receiving report is given below:

2.8

Material

Goods Received Note Received from.............................. Order No. .................. Amount Quantity Code Description Amount due to supplier Rs. Charges Rs. Total Rs. Remarks No. .............. Date............................

Inspector....................... Receiver........................

Store Keeper.................................. Store Ledger Clerk......................

Material outward return note - Sometimes materials have to be returned to suppliers after these have been received in the factory. Such returns may occur before or after the preparation of the receiving report. If the return takes place before the preparation of the receiving report, such material obviously would not be included in the report and hence not debited in the stores books and ledgers. In that case, no adjustment in the account books would be necessary. But if the material is returned after its entry in the receiving report, a suitable document must be drawn up in support of the credit entry so as to exclude from the Stores of Material Account the value of the materials returned back. This document usually takes the form of a Material outward return note. The Material outward return note is drawn up by the Stores or the Despatch Department. Five copies of it are usually prepared; two for the supplier (one of which is to be sent back by the supplier after he has signed the same), one for Store, one for Cost (stores) Ledger and one copy to be retained in the Material outward return book. (Please draw up the form yourself and then see the text book). 2.3.5 Checking and passing of bills for payment : The invoice received from the supplier is sent to the stores accounting section to check authenticity and mathematical accuracy. The quantity and price are also checked with reference to goods received note and the purchase order respectively. The stores accounting section after checking its accuracy finally certifies and passes the invoice for payment. In this way the payment is

2.9

Cost Accounting

made to supplier. 2.4 MATERIAL ISSUE PROCEDURE

Issue of material must not be made except under properly authorised requisition slip; usually it is the foreman of a department who has the authority to draw materials from the store. Issue of material must be made on the basis of first in first out, that is, out of the earliest lot on hand. If care is not exercised in this regard, quality of earliest lot of material may deteriorate for having been kept for a long period. Material requisition note : It is the voucher of the authority as regards issue of materials for use in the factory or in any of its departments. Where a Materials List has been prepared, either the whole of the� � materials would be withdrawn on its basis or separate materials requisitions would be prepared by the person or department and the material drawn upto the limit specified in the list. The Requisition Notes are made out in triplicate. The copies are distributed in the following manner : One copy for the Store-keeper. One copy for Cost department. One copy for the Department requiring it. If no material list has been prepared, it is desirable that the task of the preparation of Material Requisition Notes be left to the Planning Department. If there is no Planning Department, (or although in existence, is unable to undertake this task), the Requisition Notes should be prepared by the person or department that requires the materials. Usually, a foreman s authority is enough but, in the case of costly� materials, it would be desirable to have such requisitions duly approved by some higher authority, like the Superintendent or Works Manager before these are presented to Stores. A specimen form of the Material Requisition is shown below: Material Requisition Note Work Order No. ............................ Department ..................................... Item No. Particulars No. .......................................... Date ....................................... Qnty. Rate Amount Rs. Rs.

Store-keeper

Workman receiving the material

Foreman

S.L. Clerk

2.10

Material

Bill of material : It is also known as Material Specification List or simply Material List. It is a schedule of standard quantities of materials required for any job or other unit of production. A comprehensive Materials List should rigidly lay down the exact description and specifications of all materials required for a job or other unit of production and also required quantities so that if there is any deviation from the standard list, it can easily be detected. The materials List is prepared by the Engineering or Planning Department in a standard form. The number of copies prepared vary according to the requirement of each business, but four is the minimum number. A copy of it is usually sent to each of the following department : (i) (ii) Stores department. Cost Accounts Department.

(iii) Production Control department. (iv) Engineering or Planning department. The advantages of using bill of material , by the above departments may be summed up� � as follows: Stores Department : 1. 2. 3. A bill of material serves as an� important basis of preparing material purchase requisitions by stores department. It acts as an authorisation for issuing total material requirement. The clerical activity is reduced as the stores clerk issues the entire/part of the material requirement to the users if the details of material asked are present in the bill of materials.

Cost Accounts Department : 1. 2. Bill of material, is used by Cost Accounts department for preparing an estimate/budget of material cost for the job/process/operation, it is meant. It may be used as a device for controlling the excess cost of material used. This is done after determining material variances and ascertaining the reasons for their occurrence.

Production Control Department : 1. 2. Bill of material, may be used by this department for controlling usage of materials. Its usage saves time which otherwise would have been wasted for preparing separate requisitions of material.

2.11

Cost Accounting

Engineering or Planning department : As stated earlier this department prepares the materials list in a standard form. A copy of list is sent to stores, cost accounts and production control department. Proforma of Bill of Materials Job No. ............................................. Department authorised ............... Sl. No. Code No. or Description Qty. Date of issue & Qty. issued Date Qty. No. ...................................... Date ................................... Rate Rs. Amount Rs.

Authorised by .................................................. Store Keeper s� signature .............................

Received by ......................... Checked by .......................... Cost clerk .............................

Transfer of material: The surplus material arising on a job or other units of production may sometime be unsuitable for transfer to Stores because of its bulk, heavy weight, brittleness or some such reason. It may, however, be possible to find some alternative use for such materials by transferring it to some other job instead of returning it to the Store Room. It must be stressed that generally transfer of material from one job to another is irregular, if not improper, in so far it is not conducive to correct allocation and control of material cost of jobs or other units of production. It is only in the circumstances envisaged above that such direct transfer should be made, at the time of material transfer a material transfer note should be made in duplicate, the disposition of the copies of this note being are as follows : One copy for the Cost Department, and One copy for the department making the transfer. No copy is required for the Store as no entry in the stores records would be called for. The Cost Department would use its copy for the purpose of making the necessary entries

2.12

Material

in the cost ledger accounts for the jobs affected. The form of the Material Transfer Note is shown below: Material Transfer Note From Job No. .................................. To Job No. ........................................ Item No. Particulars No. .................................... Date ................................. Rate Rs. Amount Rs.

Transferred by

Received by .................................... Job Ledger Clerk

Return of material: Sometimes, it is not possible before hand to make any precise estimate of the material requirements or units of production. Besides, at times due to some technical or other difficulty, it is not practicable to measure exactly the quantity of material required by a department. In either case, material may have to be issued from stores in bulk, often in excess of the actual quantity required. Where such a condition exists, it is of the utmost importance from the point of view of materials control that any surplus material left over on the completion of a job should be promptly hand over to the storekeeper for safe and proper custody. Unless this is done, the surplus material may be misappropriated or misapplied to some purpose, other than that for which it was intended. The material cost of the job against which the excess material was originally drawn in that case, would be overstated unless the job is given credit for the surplus arising thereon. The surplus material, when it is returned to the storeroom, should be accompanied by a document known either as a Shop Credit Note or alternatively as a Stores Debit Note. This document should be made out, by the department returning the surplus material and it should be in triplicate to be used as follows: One copy for the Store Room; One copy for the Cost Department; and One copy (book copy) for the department returning the surplus material.

2.13

Cost Accounting

The form of Shop Credit Note is given below: Shop Credit Note Job No. ...................................... Department ............................ Item No. Particulars Qnty. No. ........................ Date ...................... Rate Amount

Store-keeper

S.L. Clerk

Foreman of the Returning Department

2.5

MATERIAL STORAGE

Proper storing of materials is of primary importance. It is not enough only to purchase material of the required quality. If the purchased material subsequently deteriorates in quality because of bad storage, the loss is even more than what might arise from purchase of bad quality materials. Apart from preservation of quality, the store-keeper also must ensure safe custody of the material. It should be the function of store-keeper that the right quantity of materials always should be available in stock. 2.5.1 1. 2. 3. 4. Duties of store keeper : These can be briefly set out as follows : To exercise general control over all activities in Stores Department To ensure safe keeping both as to quality and quantity of materials. To maintain proper records. To initiate purchase requisitions for the replacement of stock of all regular stores items whenever the stock level of any item of store approaches the minimum limit fixed in respect thereof. To initiate action for stoppage of further purchasing when the stock level approaches the maximum limit. To check and receive purchased materials forwarded by the receiving department and to arrange for the storage in appropriate places. To reserve a particular material for a specific job when so required. To issue materials only in required quantities against authorised requisition notes/material lists.

5. 6. 7. 8.

2.14

Material

9.

To check the book balances, with the actual physical stock at frequent intervals by way of internal control over wrong issues, pilferage, etc.

2.5.2 Minimising the cost of purchasing and store-keeping: There are two types of costs which are involved in making a purchase and keeping the goods in the store. For placing each order, a certain amount of labour is required and, therefore, it will involve a certain sum of money as cost. It should be noted that the cost of making a purchase not only includes the cost incurred by the purchasing department but it also includes the cost of receiving and inspecting the goods. These costs will naturally increase if the number of order is large; there can be saving if the number of orders is reduced. The other type of cost is concerned with keeping the goods is stock, it comprises the money invested, the loss which is likely to take place if the goods are kept, the expenses incurred on looking after the items etc. Larger the stock, higher will be this type of cost. In order to reduce this cost, it is necessary to bring down level of the stock. It may be noted that the number of orders can be cut down only, if the quantity of each order is increased, but if that is done, the average quantity on hand will increase and, therefore, interest and the cost of store keeping will be higher. It is necessary, therefore to have balance between those two costs and to keep total of the two at the minimum level. With this objective in view, the economic order quantity is worked out. But different items for stock have to be treated differently. The name given to such classification is the ABC Analysis, or the Selective Inventory Control.� � 2.5.3 Different classes of stores: Broadly speaking, there are three classes of stores viz., central or main stores, sub-stores and departmental stores. The central stores are the most common of all and in practice, factories generally have only a central store under the control of one store keeper. Such a store is centrally situated and is easily accessible to all departments. If receipts and issues of different items of stores are not large, and the various departments are close to each other, one central store for all purposes is sufficient. In big organisations, particularly in the case of collieries, tea gardens, etc., where the work spots are distributed over a large area, sub-stores are created. A sub-store is in fact a branch of the central store. It is generally created to facilitate easy accessibility to the various work spots or consumption centres. Only the essential items, as well as those required urgently, are kept in them. The issues to sub-stores are not treated as consumption but only as a transfer, from one store (central) to another sub-store. The control in the matter of ordering or receiving rests with the central stores and the sub-stores do not generally receive any item directly.

2.15

Cost Accounting

Departmental stores are created normally to minimise the time spent on drawing from stores. For example, a week s supply may be drawn at one time and kept in a� departmental store at a place marked for the purpose. Such stores, however, are essential where one or more production departments work in multiple shifts and the central store works for only one shift; also for the storage of work in progress and semifinished components where these are large in number or in bulk. Unlike a sub store in the departmental store, the control rests with the department in charge. The materials are generally issued in bulk to the departmental store and it is the responsibility of the department-in-charge to keep proper accounts as regards issues and stock. If the bulk of materials is required for only one department, it is usually stored near the department under the charge of the super intendent concerned. 2.5.4 Stores location : The location of store should be carefully planned. It should be near to the material receiving department so that transportation charges are minimum. At the same time, it should be easily accessible to all other departments of the factory, railway siding, roads etc. Planned location of the stores department avoids delay in the movement of materials to the departments in which they are needed. 2.5.5 Stores layout : The store should be adequately provided with the necessary racks, drawers and other suitable receptacles for storing materials. Each place (for example, a drawer or a corner) where materials are kept is called a bin. Each bin should be serially numbered and for every item a bin should be allowed. All receipts of the item of the same type should be kept in the bin allotted, for convenience of access. The number of the bin should be entered in the Store Ledger concerned accounts. 2.6 STORE RECORD

The record of stores may be maintained in three forms: (a) Bin Cards (b) Stock Control Cards, (c) Stores Ledger. The first two forms of accounts are records of quantities received, issued and those in balance, but the third one is an account of their cost also. Usually, the account is kept in both the forms, the quantitative in the store and quantitative-cum-financial in the Cost Department. Bin Cards and Stock Control Cards : These are essentially similar, being only quantitative records of stores. The latter contains further information as regards stock on order. Bin2.16

Material

cards are kept attached to the bins or receptacles or quite near thereto so that these also assist in the identification of stock. The Stock Control Cards, on the other hand, are kept in cabinets or trays or loose binders. Advantages of Bin Cards : (i) (ii) There would be less chances of mistakes being made as entries will be made at the same time as goods are received or issued by the person actually handling the materials. Control over stock can be more effective, in as much as comparison of the actual quantity in hand at any time with the book balance is possible.

(iii) Identification of the different items of materials is facilitated by reference to the Bin Card the bin or storage receptacle. Disadvantages of Bin Cards : (i) (ii) Store records are dispersed over a wide area. The cards are liable to be smeared with dirt and grease because of proximity to material and also because of handling materials.

(iii) People handling materials are not ordinarily suitable for the clerical work involved in writing Bin Cards. Advantages of Stock Control Cards : (i) (ii) Records are kept in a more compact manner so that reference to them is facilitated. Records can be kept in a neat and clean way by men solely engaged in clerical work so that a division of labour between record keeping and actual material handling is possible.

(iii) As the records are at one place, it is possible to get an overall idea of the stock position without the necessity of going round the stores. Disadvantages of Stock Control Cards : (i) (ii) On the spot comparison of the physical stock of an item with its book balance is not facilitated. Physical identification of materials in stock may not be as easy as in the case of bin cards, as the Stock Control Cards are housed in cabinets or trays.

The specimen forms of these cards may be studied from any text book. Stores Ledger: A Modern Stores Ledger is a collection of cards or loose leaves specially ruled for maintaining a record of both quantity and cost of stores received, issued and those in stock. It being a subsidiary ledger to the main cost ledger, it is maintained by the Cost Accounts Department. It is posted from Goods Received Notes and Materials

2.17

Cost Accounting

requisition. The advantages of writing up Stores Ledger mechanically are: (1) It enables distribution of work among a number of clerks due to which receipts and issues are posted quickly and regularly. (2) It enables stock records to be centralised in case of an organisation having a number of depots. (3) The accuracy of posting can be mechanically tested more conveniently. (4) The records are clearer and neater. Also the recurring cost of maintaining them is much less than those kept manually. (5) If up-to-date records are available, the management will be able to exercise greater control over quantities held in stock from time to time which may result in a great deal of saving in both the amount of investment in stock and their cost. Now-a-days, mostly a duplicate record of issues and receipt of materials is kept one on Bin Cards in the Store and the second in the Stores Ledger in the stores. The form of ruling the Store Ledger and Bin Cards should be studied from the text book. 2.6.1 Treatment of shortages in stock taking : At the time of stock taking generally discrepancies are found between physical stock shown in the bin card and stores ledger. These discrepancies are in the form of shortages or losses. The causes for these discrepancies may be classified as unavoidable or avoidable. Losses arising from unavoidable causes should be taken care of by setting up a standard percentage of loss based on the study of the past data. The issue prices may be inflated to cover the standard loss percentage. Alternatively, issues may be made at the purchase price but the cost of the loss or shortage may be treated as overheads. Actual losses should be compared with the standard and excess losses should be analysed to see whether they are due to normal or abnormal reasons. If they are attributable to normal causes, an additional charge to overheads should be made on the basis of the value of materials consumed. If they arise from abnormal causes, they should be charged to the Costing Profit and Loss account. Avoidable losses are generally treated as abnormal losses. These losses should be debited to the Costing Profit and Loss Account. Losses or surpluses arising from errors in documentation, posting etc., should be corrected through adjustment entries.

2.18

Material

2.7

INVENTORY CONTROL

The main objective of inventory control is to achieve maximum efficiency in production and sales with the minimum investment in inventory. Inventory comprises of stocks of materials, components, work-in-progress, and finished products and stores and spares. The techniques commonly applied for inventory control are as follows: Techniques of Inventory control : (i) (ii) Setting of various stock levels. ABC analysis.

(iii) Two bin system. (iv) Establishment of system of budgets. (v) Use of perpetual inventory records and continuous stock verification. (vi) Determination of economic order quantity. (vii) Review of slow and non-moving items. (viii) Use of control ratios. 2.7.1 Setting of various stock levels: Minimum level - It indicates the lowest figure of inventory balance, which must be maintained in hand at all times, so that there is no stoppage of production due to nonavailability of inventory. The main consideration for the fixation of minimum level of inventory are as follows: 1. 2. 3. Information about maximum consumption and maximum delivery period in respect of each item to determine its re-order level. Average rate of consumption for each inventory item. Average delivery period for each item. This period can be calculated by averaging the maximum and minimum period.

The formula used for its calculation is as follows: Minimum level of inventory = Re-order level (Average rate of consumption average time of inventory� � delivery)

2.19

Cost Accounting

Maximum level : It indicates the maximum figure of inventory quantity held in stock at any time. The important considerations which should govern the fixation of maximum level for various inventory items are as follows : 1. The fixation of maximum level of an inventory item requires information about its-re-order level. The re-order level itself depends upon its maximum rate of consumption and maximum delivery period. It in fact is the product of maximum consumption of inventory item and its maximum delivery period. Knowledge about minimum consumption and minimum delivery period for each inventory item should also be known. The determination of maximum level also requires the figure of economic order quantity. Availability of funds, storage space, nature of items and their price per unit are also important for the fixation of maximum level. In the case of imported materials due to their irregular supply, the maximum level should be high.

2. 3. 4. 5.

The formula used for its calculation is as follows : Maximum level of inventory = Re-order-level + Re-order quantity - (Minimum consumption Minimum re-order� period) Re-order level - This level lies between minimum and the maximum levels in such a way that before the material ordered is received into the stores, there is sufficient quantity on hand to cover both normal and abnormal consumption situations. In other words, it is the level at which fresh order should be placed for replenishment of stock. The formula used for its calculation is as follows : Re-order level = Maximum re-order period Maximum Usage (or) = Minimum level +� (Average rate of consumption Average time to obtain fresh supplies). Average� Inventory Level - This level of stock may be determined by using the following equal formula : Average inventory level = Minimum level + 1/2 Re-order quantity (or) =Maximum level + Minimum level 2

2.20

Material

Danger level - It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made. Danger level = Average consumption Lead time for emergency purchases Illustration - Two components, A� and B are used as follows : Normal usage Maximum usage Minimum usage Re-order quantity Re-order period 50 per week each 75 per week each 25 per week each A: 300; B : 500 A : 4 to 6 weeks B : 2 to 4 weeks Calculate for each component (a) Re-ordering level, (b) Minimum level, (c) Maximum level, (d) Average stock level. Solution : (a) Re-ordering level : Minimum usage per week Maximum delivery� period. Re-ordering level for component A = Re-ordering level for component B = (b) Minimum level : Re-order level (Normal usage Average period) Minimum level� � for component A = 450 units 50 units 5 weeks = 200 units Minimum level for� � component B = 300 units 50 units 3 weeks = 150 units (c) Maximum level : ROL +� � ROQ (Min. usage Minimum period) Maximum level for component A = (450 units +� � 300 units) (25 units 4 weeks) = 650 units Maximum level for component B = (300� � units + 500 units) (25 units 2 weeks) = 750 units (d) Average stock level : � � � (Minimum + Maximum) stock level 75 units 6 75 units 4 weeks = 450 units weeks =� � 300 units

2.21

Cost Accounting

Average stock level for component A = (200 units + 650 units) = 425 units.� Average stock level for component B = (150 units + 750 units) = 450 units.� Illustration A Company uses three raw materials A, B and C for a particular product for which the following data apply:Raw Material Usage per unit of Product (Kgs.) Minimum

Re-order quantity (Kgs.)

Price per Kg.

Delivery period (in weeks)

Reorder level (Kgs)

Minimu m level (Kgs.)

Average

Maximum

Rs.

A B C

10 4 6

10,000 5,000 10,000

0.10 0.30 0.15

1 3 2

2 4 3

3 5 4

8,000 4,750 2,000

Weekly production varies from 175 to 225 units, averaging 200 units of the said product. What would be the following quantities : (i) (ii) Minimum stock of A ? Maximum stock of B ?

(iii) Re-order level of C ? (iv) Average stock level of A ? Solution (i) Minimum stock of A Re-order level (Average rate of consumption Average time required� � to obtain fresh delivery) = 8,000 (200 10 2) = 4,000 kgs. (ii) Maximum stock� � � of B Re-order level (Minimum consumption Minimum re-order period) + Re-order� � quantity

2.22

Material

= 4,750 (175 4 3) + 5,000 = 9,750 2,100 = 7,650 kgs. (iii) Re-order level� � � � of C Maximum re-order period Maximum usage = 4 225 6 = 5,400 kgs. OR Re-� � �order level of C = Minimum stock of C + [Average rate of consumption Average� time required to obtain fresh delivery] = 2,000 + [(200 6) 3] kgs. = 5,600� � kgs. (iv) Average stock level of A = Minimum stock level of A + Re-order� quantity of A = 4,000 + 10,000 = 4,000 + 5,000 = 9,000 kgs. OR Average Stock� � level of A

Minimum stock level of A + Maximum stock level of A (Refer to working note) 24,000 + 16,250 = 10,125 kgs. 2Working note Maximum stock of A = ROL+ ROQ (Minimum consumption Minimum re-� �order period) = 8,000 + 10,000 [(175 10) 1] = 16,250 kgs. 2.7.2 ABC� � � Analysis: It is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved. Usually the items are divided into three categories according to their importance, namely,

2.23

Cost Accounting

their value and frequency of replenishment during a period. (i) A Category of� � items consists of only a small percentage i.e., about 10% of the total items handled by the stores but require heavy investment about 70% of inventory value, because of their high prices or heavy requirement or both. (ii) B Category of� � items are relatively less important; they may be 20% of the total items of material handled by stores. The percentage of investment required is about 20% of the total investment in inventories. (iii) C Category of items do not require� � much investment; it may be about 10% of total inventory value but they are nearly 70% of the total items handled by store. A category of items can be controlled� � effectively by using a regular system which ensures neither over-stocking nor shortage of materials for production. Such a system plans its total material requirements by making budgets. The stocks of materials are controlled by fixing certain levels like maximum level, minimum level and re-order level. A reduction in inventory management costs is achieved by determining economic order quantities after taking into account ordering cost and carrying cost. To avoid shortage and to minimize heavy investment in inventories, the techniques of value analysis, variety reduction, standardisation etc., may be used. In the case of B category� � of items, as the sum involved is moderate, the same degree of control as applied in A category of items is not warranted. The orders for the items, belonging to� � this category may be placed after reviewing their situation periodically. For C� � category of items, there is no need of exercising constant control. Orders for items in this group may be placed either after six months or once in a year, after ascertaining consumption requirements. In this case the objective is to economise on ordering and handling costs. Illustration A factory uses 4,000 varieties of inventory. In terms of inventory holding and inventory usage, the following information is compiled: No. of varieties % % value of inventory of inventory holding (average) 3,875 96.875 20 110 2.750 30 15 0.375 50 4,000 100.000 100 Classify the items of inventory as per ABC analysis with reasons.2.24

% of inventory usage (in end-product) 5 10 85 100

Material

Solution Classification of the items of inventory as per ABC analysis 1. 15 number of varieties of inventory items should be classified as A category items because� � of the following reasons : (i) (ii) Constitute 0.375% of total number of varieties of inventory handled by stores of factory, which is minimum as per given classification in the table. 50% of total use value of inventory holding (average) which is maximum according to the given table.

(iii) Highest in consumption about 85% of inventory usage (in end-product). 2. 110 number of varieties of inventory items should be classified as B category items� � because of the following reasons : (i) (ii) Constitute 2.750% of total number of varieties of inventory items handled by stores of factory. Requires moderate investment of about 30% of total use value of inventory holding (average).

(iii) Moderate in consumption about 10% of inventory usage (in end product). 3.� 3,875 number of varieties of inventory items should be classified as C category� � items because of the following reasons: (i) (ii) Constitute 96.875% of total varieties of inventory items handled by stores of factory. Requires about 20% of total use value of inventory holding (average).

(iii) Minimum inventory consumption i.e. about 5% of inventory usage (in end-product). Advantages of ABC analysis : The advantages of ABC analysis are the following : (i) It ensures that, without there being any danger of interruption of production for want of materials or stores, minimum investment will be made in inventories of stocks of materials or stocks to be carried. The cost of placing orders, receiving goods and maintaining stocks is minimised specially if the system is coupled with the determination of proper economic order quantities.

(ii)

(iii) Management time is saved since attention need be paid only to some of the items rather than all the items as would be the case if the ABC system was not in operation.

2.25

Cost Accounting

(iv) With the introduction of the ABC system, much of the work connected with purchases can be systematized on a routine basis to be handled by subordinate staff. 2.7.3 Two bin system: Under this system each bin is divided into two parts - one, smaller part, should stock the quantity equal to the minimum stock or even the re-ordering level, and the other to keep the remaining quantity. Issues are made out of the larger part; but as soon as it becomes necessary to use quantity out of the smaller part of the bin, fresh order is placed. Two Bin System is� � supplemental to the record of respective quantities on the bin card and the stores ledger card. 2.7.4 Establishment of system of budgets: To control investment in the inventories, it is necessary to know in advance about the inventories requirement during a specific period usually a year. The exact quantity of various type of inventories and the time when they would be required can be known by studying carefully production plans and production schedules. Based on this, inventories requirement budget can be prepared. Such a budget will discourage the unnecessary investment in inventories. 2.7.5 Use of perpetual inventory records and continuous stock verification - Perpetual inventory represents a system of records maintained by the stores department. It in fact comprises: (i) Bin Cards, and (ii) Stores Ledger. Bin Card maintains a quantitative record of receipts, issues and closing balances of each item of stores. Separate bin cards are maintained for each item. Each card is filled up with the physical movement of goods i.e. on its receipt and issue. Like bin cards, the Store Ledger is maintained to record all receipt and issue transactions in respect of materials. It is filled up with the help of goods received note and material issue requisitions. A perpetual inventory is usually checked by a programme of continuous stock taking. Continuous stock taking means the physical checking of those records (which are maintained under perpetual inventory) with actual stock. Perpetual inventory is essential for material control. It incidentally helps continuous stock taking. The success of perpetual inventory depends upon the following: (a) The Stores Ledger-(showing quantities and amount of each item). (b) Stock Control cards (or Bin Cards). (c) Reconciling the quantity balances shown by (a) & (b) above. (d) Checking the physical balances of a number of items every day systematically and by rotation.2.26

Material

(e) Explaining promptly the causes of discrepancies, if any, between physical balances and book figures. (f) Making corrective entries where called for after step (e) and (g) Removing the causes of the discrepancies referred to in step (e) Advantages - The main advantages of perpetual inventory are as follows : (1) Physical stocks can be counted and book balances adjusted as and when desired without waiting for the entire stock-taking to be done. (2) Quick compilation of Profit and Loss Account (for interim period) due to prompt availability of stock figures. (3) Discrepancies are easily located and thus corrective action can be promptly taken to avoid their recurrence. (4) A systematic review of the perpetual inventory reveals the existence of surplus, dormant, obsolete and show-moving materials, so that remedial measures may be taken in time. (5) Fixation of the various stock levels and checking of actual balances in hand with these levels assist the Store keeper in maintaining stocks within limits and in initiating purchase requisitions for correct quantity at the proper time. Continuous stock verification - The checking of physical inventory is an essential feature of every sound system of material control. Such a checking may be periodical or continuous. Annual stock-taking, however, has certain inherent shortcomings which tend to detract from the usefulness of such physical verification. For instance, since all the items have to be covered in a given number of days, either the production department has to be shut down during those days to enable thorough checking of stock or else the verification must be of limited character. Moreover, in the case of periodical checking there is the problem of finding an adequately trained contingent. It is likely to be drawn from different departments where stock-taking is not the normal work and they are apt to discharge such temporary duties somewhat perfunctorily. The element of surprise, that is essential for effective control is wholly absent in the system. Then if there are stock discrepancies, they remain undetected until the end of the period. It means that the figures of stock during the period continue to be supplied incorrectly. Often, the discrepancies are not corrected. The system of continuous stock-taking consists of counting and verifying the number of items daily throughout the year so that during the year all items of stores are covered three or four times. The stock verifiers are independent of the stores, and the stores staff have no foreknowledge as to the particular items that would be checked on any particular

2.27

Cost Accounting

day. But it must be seen that each item is checked a number of times in a year. Advantages - The advantages of continuous stock-taking are : 1. 2. Closure of normal functioning is not necessary. Whole time specialised staff can be engaged for the purpose since the work is spread throughout the year. In smaller concerns, duties may be assigned to various officers of middle rank by rotation to the checking, say, of 20 items. This would be easy because the store ledger card and the bin card will bear the bin number. The officers concerned need only walk up to the particular bin number, count, weigh or measure the article lying there and enter the quantity on the form provided for the purpose. The rest of the work (comparison with book figures) can be done by the stores ledger clerk. Stock discrepancies are likely to be brought to the notice and corrected much earlier than under the annual stock-taking system. The system generally has a sobering influence on the stores staff because of the element of surprise present therein. The movement of stores items can be watched more closely by the stores auditor so that chances of obsolescence buying are reduced. Final Accounts can be ready quickly. Interim accounts are possible quite conveniently.

3. 4. 5. 6.

2.7.6 Economic Order Quantity (EOQ): Purchase department in manufacturing concerns is usually faced with the problem of deciding the quantity of various items� � which they should purchase. If purchases of material are made in bulk then inventory carrying cost will be high. On the other hand if order size is small each time, then the ordering cost will be high. In order to minimise ordering and carrying costs it is necessary to determine the order quantity which minimises these two costs. The size of the order for which both ordering and carrying cost are minimum is known as economic order quantity. Assumptions underlying E.O.Q.: The calculation of economic order of material to be purchased is subject to the following assumptions: (i) (ii) Ordering cost per order and carrying cost per unit per annum are known and they are fixed. Anticipated usage of material in units is known.

(iii) Cost per unit of the material is constant and is known as well. (iv) The quantity of material ordered is received immediately i.e. the lead time is zero. The famous mathematician Wilson derived the formula which is used for determining the size of order for each of purchases at minimum ordering and carrying costs.2.28

Material

The formula given by Wilson for calculating economic order quantity is as follows : EOQ = where, A S C Illustration Calculate the Economic Order Quantity from the following information. Also state the number of orders to be placed in a year. Consumption of materials per annum Order placing cost per order Cost per kg. of raw materials Storage costs: Solution EOQ = A S C = = = : : : 10,000 kg. Rs. 50 Rs. 2 = = =

2AS CAnnual usage units Ordering cost per order Annual carrying cost of one unit, i.e., carrying cost percentage cost of one unit.�

8% on average inventory

2A S C�Units consumed during year Ordering cost per order Inventory carrying cost per unit per annum.

EOQ =

2 10,000 50 = 2 8 100� � �2,500 kg.

2 10,000 50 25 4� � �

=

No. of orders to be placed in a year =

Total consumption of materials per annum EOQ

2.29

Cost Accounting

= Illustration

10,000 kg. = 4 Orders per year 2,500 kg.

X Ltd. is committed to supply 24,000 bearings per annum to Y Ltd. on steady basis. It is estimated that it costs 10 paise as inventory holding cost per bearing per month and that the set-up cost per run of bearing manufacture is Rs. 324. (a) What would be the optimum run size for bearing manufacture ? (b) Assuming that the company has a policy of manufacturing 6,000 bearings per run, how much extra costs the company would be incurring as compared to the optimum run suggested in (a) above ? (c) What is the minimum inventory holding cost ? Solution (a) Optimum production run size (Q) = where, U P I = = = No. of units to be produced within one year. Set-up cost per production run Carrying cost per unit per annum. =

2UP I

2UP 2 24,000 Rs.324 = I 0.10 12� � �

= 3,600 bearings. (b) Total Cost (of maintaining the inventories) when production run size (Q) are 3,600 and 6,000 bearings respectively Total cost = Total set-up cost + Total carrying cost. (Total set-up cost) Q = 3,600 = (No. of production runs ordered) (Set-up cost per production run) =�24,000 Rs. 324 3,600�

= Rs. 2,1602.30

...(1)

Material

(Total set up cost) Q = 6,000 = = 1,296�

24,000 Rs. 324 6,000�

...(2)

(Total carrying cost) Q = 3,600 = 1/2 Q I = 1/2 3,600 0.10P Rs. 12 = Rs.� � � � 2,160 (Total carrying cost) Q = 6,000 = 1/2 6,000 0.10P Rs. 12 = Rs. 3,600� � � (Total Cost) Q = 3,600 = Rs. 2,160 + Rs. 2,160 [ (1) + (3)] [(2) + (4)] Extra cost incurred [(6) (5)] = Rs. 4,320 = Rs. 4,896 = Rs. 4,896 Rs. 4,320 = Rs. 576 =� � 1/2 3,600 bearings 0.10P Rs. 12 ...(5) ...(6) (Total Cost) Q = 6,000 = Rs.� � � 1,296 + Rs. 3,600 ...(4) ...(3)

(c) Minimum inventory holding cost = 1/2 Q I (when Q = 3,600 bearings) = Rs.� 2,160 Illustration Shriram enterprise manufactures a special product ZED . The� � following particulars were collected for the year 2006: (a) Monthly demand of ZED - 1,000 units (b) Cost of placing an order Rs. 100. (c) Annual carrying cost per unit Rs. 15. (d) Normal usage 50 units per week. (e) Minimum usage 25 units per week. (f) Maximum usage 75 units per week. (g) Re-order period 4 to 6 weeks. Compute from the above

2.31

Cost Accounting

(1) Re-order quantity (2) Re-order level (3) Minimum level (4) Maximum level (5) Average stock level. Solution 1. Re-order quantity of units used =

2 AS 2 2,600 Rs.100 = C Rs.15� �

= 186 units (approximately) (Refer to note) where, A S C 2. 3. Re-order level Minimum Level = = = = = = = = 4. Maximum Level = = = 5. Average Stock Level = = = Note: A = = Annual demand of input units Cost of placing an order Annual carrying cost per unit Maximum re-order period maximum usage 6 weeks 75 units = 450� � units Re-order level (normal usage average re-order period). 450 units 50� � � units 5 weeks. 450 units 250 units = 200 units. Re-order level + Re-order� � quantity Minimum usage Minimum order period. 450 units + 186 units 25 units� � � 4 weeks 536 units 1/2 (Minimum stock level + Maximum stock level) 1/2 (200 units� + 536 units) 368 units. Annual demand of input units for 12,000 units of ZED 52� � weeks Normal usage of input units per week�

2.32

Material

= = Illustration

52 weeks 50 units of input per week 2,600 units.�

(a) EXE Limited has received an offer of quantity discounts on its order of materials as under: Price per tonne Rs. 1,200 1,180 1,160 1,140 1,120 Tonnes Nos. Less than 500 500 and less than 1,000 1,000 and less than 2,000 2,000 and less than 3,000 3,000 and above.

The annual requirement for the material is 5,000 tonnes. The ordering cost per order is Rs. 1,200 and the stock holding cost is estimated at 20% of material cost per annum. You are required to compute the most economical purchase level. (b) What will be your answer to the above question if there are no discounts offered and the price per tonne is Rs. 1,500 ? Solution (a)Total annual requirement (S) Ordersize (Units) (q) No. of orders S/q Cost of inventory S Per unit cost (Rs.) Ordering cost S/q Rs. 1200 (Rs.) 1 500 units 2 400� � 500 1000 3 12.5 10 5 4 60,00,000 (5,000 Rs. 1200) 59,00,000 (5,000 Rs. 1180)� � 58,00,000 6,000 12,000 5 15,000 Carrying cost p.u.p.a 1/2 q 20% of cost p.u. (Rs.)� � 6 48,000 (200 Rs. 240) 59,000 (250 Rs. 236) 1,16,000 59,22,000 59,71000 7� � 60,63,000 Total Cost (4+5+6) (Rs.)

2.33

Cost Accounting (5,000 Rs. 1160) 2000 3000 2.5 1666 57,00,000 (5,000 Rs. 1140)� � 56,00,000 (5,000 Rs. 1120) 2,000 3,000 (500 Rs. 232) 2,28,000 (1,000 Rs. 228)� � � 3,36,000 (1,500 Rs. 224) 59,38,000 59,31,000�

The above table shows that the total cost of 5,000 units including ordering and carrying cost is minimum (Rs. 59,22,000) when the order size is 1,000 units. Hence the most economical purchase level is 1,000 units. (b) EOQ = where

2SC O iC 1S is the annual inventory requirement, Co, is the ordering cost per order and iC1 is the carrying cost per unit per annum. =2 2,500units Rs.1,200 20% Rs.1,500� � �

Illustration From the details given below, calculate: (i) (ii) Re-ordering level Maximum level

(iii) Minimum level (iv) Danger level. Recording quantity is to be calculated on the basis of following information: Cost of placing a purchase order is Rs. 20 Number of units to be purchased during the year is 5,000 Purchase price per unit inclusive of transportation cost is Rs. 50 Annual cost of storage per units is Rs. 5.

2.34

Material

Details of lead time : Rate of consumption :

Average 10 days, Maximum 15 days, Minimum 6 days. For emergency purchases 4 days. Average : 15 units per day, Maximum : 20 units per day.

Solution BASIC DATA : Co (Ordering cost per order) S (Number of units to be purchased annually) C 1 (Purchase price per unit inclusive of transportation cost) iC 1 (Annual cost of storage per unit) Computations : (i) (ii) Re-ordering level = (ROL) Maximum level = = = = (iii) Minimum level = = = (iv) Danger level = = Working Notes : 1. ROQ = = Maximum usage per period Maximum re-order period 20� units per day 15 days = 300 units ROL + ROQ [Min. rate of consumption Min.� � � re-order period] (Refer to working notes1 and 2) 300 units + 200 units [10 units� per day 6 days] 440 units ROL Average rate of consumption Average re-� � �orderperiod 300 units (15 units per day 10 days) 150 units Average consumption� � Lead time for emergency purchases 15 units per day 4 days = 60 units = = = =� � Rs. 20 5,000 units Rs. 50. Rs. 5

2SC 0 = iC 1

2 5,000units Rs.1,200 = 200 units 20% Rs.1,500� � �

2.35

Cost Accounting

2.

Minimum rate of Maximum rate of + Av. rate of consumption consumption = consumption 215 units per day or X = =

Xunits/day + 20units per day 2

10 units per day.

Illustration

About 50 items are required every day for a machine. A fixed cost of Rs. 50 per order is incurred for placing an order. The Inventory carrying cost per item amounts to Rs. 0.02 per day. The lead period is 32 days. Compute : (i) (ii) Economic order quantity. Re-order level.

Solution

Annual consumption (S) = 50 items 365 days = 18,250 items Fixed cost per order� (Co) or Ordering cost = Rs. 50 Inventory carrying cost per item per annum (iC1) = Rs. 0.02 365 = Rs. 7.30 (i) (ii) Economic order quantity = 2SC 0 iC 1 =�

2 18,250 units Rs.50 = 500 units Rs.730� �

Re-order level = Maximum usage per day Maximum lead time = 50 items per day 32� � days = 1,600 items

Illustration

M/s. Tubes Ltd. are the manufacturers of picture tubes for T.V. The following are the details of their operation during 2006: Average monthly market demand Ordering cost 2,000 Tubes Rs. 100 per order

2.36

Material

Inventory carrying cost Cost of tubes Normal usage Minimum usage Maximum usage Lead time to supply Compute from the above:

20% per annum Rs. 500 per tube 100 tubes per week 50 tubes per week 200 tubes per week 6 - 8 weeks

(1) Economic order quantity. If the supplier is willing to supply quarterly 1,500 units at a discount of 5%, is it worth accepting? (2) Maximum level of stock. (3) Minimum level of stock. (4) Re-order levelSolution

S Co C1 iC1

= = = = = =

Annual usage of tubes = Normal usage per week 52 weeks 100 tubes 52 weeks =� � 5,200 tubes. Ordering cost per order = Rs. 100/- per order Cost per tube = Rs. 500/Inventory carrying cost per unit per annum 20% Rs. 500 = Rs. 100/- per unit,� per annum 2SC 0 = iC 12 5,200units Rs.1,00 = 102 tubes (approx.) Rs.1,00� �

(1) Economic order quantity E.O.Q =

If the supplier is willing to supply 1500 units at a discount of 5% is it worth accepting?

Total cost (when order size is 1,500 units) = Cost of 5,200 units + Ordering cost + Carrying cost = 5,200 units Rs. 475 +�

5,200 units Rs. 100 + + 1,500 units 20% Rs. 475 1,500 units� � �

2.37

Cost Accounting

= Rs. 24,70,000 + Rs. 346.67 + Rs. 71,250 = Rs. 25,41,596.67 Total cost (when order size is 102 units) = = = 5,200 units Rs. 500 +�

5,200 units Rs. 100 + 102 units 20% Rs. 500 102 units� � � �

Rs. 26,00,000 + Rs. 5,098.03 + Rs. 5,100 Rs. 26,10,198.03

Since, the total cost under quarterly supply of 1,500 units with 5% discount is lower than that when order size is 102 units, therefore the offer should be accepted. While accepting this offer consideration of capital blocked on order size of 1,500 units per quarter has been ignored.(2) Maximum level of stock

= Re-order level + Re-order quantity Min. usage Min. re-order period = 1,600� � units + 102 units 50 units 6 weeks = 1,402 units.� �(3) Minimum level of stock

= Re-order level Normal usage Average reorder period = 1,600 units 100 units� � � 7 weeks = 900 units.�(4) Reorder level

= Maximum consumption Maximum re-order period = 200 units 8 weeks = 1,600� � units.Illustration

The complete Gardener is deciding on the economic order quantity for two brands of lawn fertilizer: Super Grow and Nature s Own. The following information is� collected:Fertilizer Super Grow Nature s Own�

Annual Demand Relevant ordering cost per purchase order Annual relevant carrying cost per bag2.38

2,000 Bags Rs. 1,200 Rs. 480

1,280 Bags Rs. 1,400 Rs. 560

Material

Required :

(i) (ii)

Compute EOQ for Super Grow and Nature s Own. For the EOQ, what is the sum of the� total annual relevant ordering costs and total annual relevant carrying costs for Super Grow and Nature s Own ?�

(iii) For the EOQ Compute the number of deliveries per year for Super Grow and Nature s Own.�Solution (i) EOQ =

2SC 0 * iC 1 S = Annual demand of fertilizer bags. C1 = Cost per bag. C0 = Relevant ordering cost per purchase order iC1 = Annual relevant carrying cost per bag

* Here

EOQ for Super Grow Fertilizer

EOQ for Nature s Own Fertilizer�

2 2,000 bags Rs.1,200 = 100 bags Rs.480� �(ii)

2 1,280 bags Rs.1,400 = 80 bags Rs.560� �

Total annual relevant costs for Super Grow Fertilizer

= Total annual relevant ordering costs + Total annual relevant carrying costs = =

1 S C0 + EOQ iC1 2 EOQ� �

2000 bags 1 Rs. 1,200 + 100 bags Rs. 480 100 bags 2� � �

= Rs. 24,000 + Rs. 24,000 = Rs. 48,000Total annual relevant costs for Nature s Own Fertilizer�

=

1,280 bags 1 Rs. 1,400 + 80 bags Rs. 560 80 bags 2� � �

= Rs. 22,400 + Rs. 22,400 = Rs. 44,800

2.39

Cost Accounting

(iii)

Number of deliveries for Super Grow Fertilizer per year.

2000 bags S = (annual demand of fertiliser bags) = = 20 orders 100 bags EOQNumber of deliveries for Nature s Own fertilizers per year.�

=

1,280 bags = 16 orders 80 bags

Illustration

G. Ltd. produces a product which has a monthly demand of 4,000 units. The product requires a component X which is purchased at Rs. 20. For every finished product, one unit of component is required. The ordering cost is Rs. 120 per order and the holding cost is 10% p.a. You are required to calculate: (i) (ii) Economic order quantity. If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the company has to incur ?

(iii) What is the minimum carrying cost, the company has to incur ?Solution (a) (i) Economic order quantity :

S (Annual requirement or Component X ) C1 (Purchase cost p.u.) C0 (Ordering cost� � per order) i (Holding cost) E.O.Q. =

= 4,000 units per month 12 months = 48,000 units = Rs. 20 = Rs. 120 = 10% per� annum

2 48,000 units Rs.120 S = = 2,400 units 10% Rs.20 EOQ� � �= Total ordering cost + Total carrying cost (when order size is 4,000 units)

(ii) Extra cost incurred by the company

Total cost

2.40

Material

= =

S C0 + q (iC1) Q�

1 48,000 units Rs. 120 + 4,000 units 10% Rs. 20 2 4,000 units� � � �...(a)

= Rs. 1,440 + Rs. 4,000 = Rs. 5,440 Total cost =

1 48,000 units Rs. 120 + 2,400 units 10% Rs. 20 2 2,400 units� � � �...(b)

(when order size is 2,400 units) = Rs. 2,400 + Rs. 2,400 = Rs. 4,800 Extra cost : (a) (b) = Rs. 5,440 Rs. 4,800 = Rs. 640 (incurred by the company)� �(iii) Minimum carrying cost :

Carrying cost depends upon the size of the order. It will be minimum on the least order size. (In this part of the question the two order sizes are 2,400 units and 4,000 units. Here 2,400 units is the least of the two order sizes. At this order size carrying cost will be minimum.) The minimum carrying cost in this case can be computed as under : Minimum carrying cost =Illustration

1 2,400 units 10% Rs. 20 = Rs. 2,400. 2� � �

A Ltd. is committed to supply 24,000 bearings per annum to B Ltd. on a steady basis. It is estimated that it costs 10 paise as inventory holding cost per bearing per month and that the set-up cost per run of bearing manufacture is Rs. 324. (i) (ii) What should be the optimum run size for bearing manufacture ? What would be the interval between two consecutive optimum runs ?

(iii) Find out the minimum inventory cost per annum.

2.41

Cost Accounting

Solution (i) Optimum run size for bearing manufacture

= =

2 Annual supply of bearings Set - up cost per production run Annual holding� � cost per bearing2 24,000 bearings Rs.324 = 3,600 bearings 12 months 0.10P.� � �12 months 12 months = Number of productioon runs per annum ? Annual production ? ? ? ? Optimum run size ? ? ?

(ii) Interval between two consecutive optimum runs

=

=

12 months ? 24,000 bearings ? ? ? 3,600 bearings ? ? ? ?

=

12 months = 1.8 months or 55 days approximately 6.66

(iii) Minimum inventory cost per annum

= Total production run cost + Total carrying cost per annum =

24,000 bearings 1 Rs. 324 + 3,600 bearings 0.10 P 12 months 3,600 bearings� � � � 2

= Rs. 2,160 + Rs. 2,160 = Rs. 4,3202.7.7 Review of slow and non-moving items : Sometimes, due to high value of slow moving and non-moving raw materials, it appears that the concern has blocked huge sum of money unnecessarily in raw materials. To overcome this problem, it is necessary to dispose-off as early as possible, the non-moving items or make arrangements for their exchange with the inventories required by the concern. Besides this no new requisition should be made for the purchase of slow moving items, till the existing stock is exhausted. Computation of inventory turnover ratio may help in identifying slow moving items. 2.7.8 Use of control ratios : (i) Input output ratio : Inventory control can also be exercised by the use of input output ratio analysis. Input-output ratio is the ratio of the quantity of input of material to production and the standard material content of the actual output.

2.42

Material

This type of ratio analysis enables comparison of actual consumption and standard consumption, thus indicating whether the usage of material is favourable or adverse. (ii) Inventory turnover ratio : Computation of inventory turnover ratios for different items of material and comparison of the turnover rates, provides a useful guidance for measuring inventory performance. High inventory turnover ratio indicates that the material in the question is a fast moving one. A low turnover ratio indicates over-investment and locking up of the working capital in inventories. Inventory turnover ratio may be calculated by using the following formulae:Inventory turnover ratio Average stock = =

Cost of materials consumed durjing the period Cost of average stock held during the period1/2 (opening stock + closing stock)

By comparing the number of days in the case of two different materials, it is possible to know which is fast moving and which is slow moving. On this basis, attempt should be made to reduce the amount of capital locked up, and prevent over-stocking of the slow moving items.Illustration The following data are available in respect of material X for the year ended 31st March, 2006. Rs.

Opening stock Purchases during the year Closing stock Calculate : (i) (ii) Inventory turnover ratio, and

90,000 2,70,000 1,10,000

The number of days for which the average inventory is held.

Solution

Inventory turnover ratio (Refer to working note) =

Cost of stock of raw material consumed Average stock of raw material

2.43

Cost Accounting

= = Average number of days for which the average inventory is held =

Rs.2,50,000 Rs.1,00,000

2.5

365days 365 = 2.5 Inventory turnover ratio

= 146Working Note : Rs. 90,000 2,70,000 1,10,000 2,50,000

Opening stock of raw material Add: Material purchases during the year Less: Closing stock of raw material Cost of stock of raw material consumed2.8 VALUATION OF MATERIAL RECEIPTS

The invoice of material purchased from the market sometime contain items such as trade discount, quantity discount, freight, duty, insurance, cost of containers, sales tax, excise duty, cash discount etc. Under such a situation, the general principal is that all costs incurred upto the point of procuring and storing materials should constitute the cost of materials purchased. The amount of trade discount, quantity discount and excise duty (under MODVAT credit scheme) being credit items and are thus deducted from the invoice of material purchased. The transport charges (carriage and freight), sales tax, insurance, cost of containers, customs and excise duty (without MODVAT credit) should be included in the invoice cost of material. The cash discount is considered as financial gain, so it is kept outside the domain of material cost. In case the containers are returnable, their resale value should also be taken in the invoice price of material to correctly ascertain the cost of material purchased. The cost of material purchased so determined may be used for the entry of material in the Stores Ledger.

2.44

Material

Illustration

An invoice in respect of a consignment of chemicals A and B provides the following information:Rs.

Chemical A: 10,000 lbs. at Rs. 10 per lb. Chemical B: 8,000 lbs. at Rs. 13 per lb. Sales tax @ 10% Railway freight Total cost

1,00,000 1,04,000 20,400 3,840 2,28,240

A shortage of 500 lbs. in chemical A and 320 lbs. in chemical B is noticed due to normal breakages. You are required to determine the rate per lb. of each chemical, assuming a provision of 2% for further deterioration.Solution Statement showing computation of effective quantity of each chemical available for use Chemical A lbs. Chemical B lbs.

Quantity purchasedLess : Shortage due to normal breakages Less : Provision for deterioration 2%

10,000 500 9,500 190 9,310Chemical A Rs.

8,000 320 7,680 53.6 7,526.4Chemical B Rs.

Quantity available

Statement showing the computation of rate per lb. of each chemical

Purchase priceAdd : Sales tax (10%)

1,00,000 10,000

1,04,000 10,400

2.45

Cost Accounting

Railway freight (in the ratio of quantity purchased i.e., 5:4) Total cost Rate per 1b. Rate per lb.IllustrationRs.1,12,133 = Rs. 12.04 9,3101bs Rs.1,16,107 = Rs. 15.43 7,526.341bs

2,133 1,12,133

1,707 1,16,107

A: B:

At what price per unit would Part No. A 32 be entered in the Stores Ledger, if the following invoice was received from a supplier: Invoice 200 units Part No. A 32 @ Rs. 5 Less : 20% discountAdd : Excise duty @ 15% Add : Packing charges (5 non-returnable boxes) Notes: Rs. 1,000.00 200.00 800.00 120.00 920.00 50.00 970.00

(i) (ii)

A 2 per cent discount will be given for payment in 30 days. Documents substantiating payment of excise duty is enclosed for claiming MODVAT credit.

Solution

200 units net cost after trade discountAdd : Packing charges

Rs. 800 Rs. 50 Rs. 850

Total cost per 200 units Cost per unit =

Rs.850 = Rs. 4.25 200

2.46

Material

2.9

VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are carried in stock. But the value attached to the stock of any item of material, at any particular point of time may be the result, not of one purchase rate or price but of different purchase rate or prices. In other words, the same material may have been acquired at different prices and its stock at any particular time may comprise materials of more than one lot so that there would be a problem of determining the appropriate rate at which to price out the issues of materials. Several methods of pricing material issues have been evolved in an attempt to satisfactorily answer the problem. These methods may be grouped and explained as follows :2.9.1 Cost Price Methods:

(a) Specific price method. (b) First-in First-out method. (c) Last-in-First-out method. (d) Base stock method.2.9.2 Average Price Methods :

(e) Simple average price method. (f) Weighted average price method. (g) Periodic simple average price method. (h) Periodic weighted average price method. (i) (j) Moving simple average price method. Moving weighted average price method.

2.9.3 Market Price Methods :

(k) Replacement price method. (l) Realisable price method.2.9.4 Notional Price Methods :

(m) Standard price method.

2.47

Cost Accounting

(n) Inflated price methods. (o) Re-use Price Method. We may now briefly discuss all the above methods:(a) Specific Price Method - This method is useful, specially when materials are purchased for a specific job or work order, and as such these materials are issued subsequently to that specific job or work order at the price at which they were purchased. To use this method, it is necessary to store each lot of material separately and maintain its separate account. The advantages and disadvantage of this method are : Advantages :

1. The cost of materials issued for production purposes to specific jobs represent actual and correct costs. 2. This method is best suited for non-standard and specific products.Disadvantage : This method is difficult to operate, specially when purchases and issues are numerous. (b) First-in-First out Method (FIFO) - It is a method of pricing the issues of materials, in the order in which they are purchased. In other words, the materials are issued in the order in which they arrive in the store or the items longest in stock are issued first. Thus each issue of material only recovers the purchase price which does not reflect the current market price. This method is considered suitable in times of falling price because the material cost charged to production will be high while the replacement cost of materials will be low. But, in the case of rising prices, if this method is adopted, the charge to production will be low as compared to the replacement cost of materials. Consequently, it would be difficult to purchase the same volume of material (as in the current period) in future without having additional capital resources. The advantages and disadvantages of the method may be stated as follows : Advantages :

1. 2. 3. 4.

It is simple to understand and easy to operate. Material cost charged to production represents actual cost with which the cost of production should have been charged. In the case of falling prices, the use of this method gives better results. Closing stock of material will be represented very closely at current market price.

2.48

Material

Disadvantages :

1.

If the prices fluctuate frequently, this method may lead to clerical error.

2. Since each issue of material to production is related to a specific purchase price, the costs charged to the same job are likely to show a variation from period to period. 3. In the case of rising prices, the real profits of the concern being low, they may be inadequate to meet the concern s demand to purchase raw� materials at the ruling price. The application of FIFO method is illustrated below :Material Received and Issued Lot Date No. Quantity Lot Kg. Rate No. Amount

1. 2. 3. 4. 5.

July 3 July 13 July 23 August 5 August 6 July 8 July 12 July 22 July 25 August 8

600 800 600 400 1200 400 Kgs. out of (1) 200 Kgs. out of (1) 600 Kgs. out of (2) 200 Kgs. out of (2) 200 Kgs. out of (3) 400 Kgs. out of (3) 400 Kgs. out of (4) 200 Kgs. out of (5)

1.00 1.20 0.90 1.10 0.80 1.00 1.00 1.20 1.20 0.90 0.90 1.10 0.80

600.00 960.00 540.00 440.00 960.00 400.00 200.00 720.00 240.00 180.00 360.00 440.00 160.00

The stock in hand after 8th August will be 1,000 Kgs. This will be out of lot number (5) and its value will be Rs. 800, i.e., @ Re. 0.80 per Kg.(c) Last-in-First out method (LIFO) - It is a method of pricing the issues of materials. This method is based on the assumption that the items of the last batch (lot) purchased are the first to be issued. Therefore, under this method the prices of the last batch (lot) is used for pricing the issues, until it is exhausted, and so on. If however, the quantity of

2.49

Cost Accounting

issue is more than the quantity of the latest lot than earlier (lot) and its price will also be taken into consideration. During inflationary period or period of rising prices, the use of LIFO would help to ensure that the cost of production determined on the above basis is approximately the current one. This method is also useful specially when there is a feeling that due to the use of FIFO or average methods, the profits shown and tax paid are too high. The advantages and disadvantages of LIFO method are as follows :Advantages :

1. The cost of materials issued will be either nearer to and or will reflect the current market price. Thus, the cost of goods produced will be related to the trend of the market price of materials. Such a trend in price of materials enables the matching of cost of production with current sales revenues. 2. The use of the method during the period of rising prices does not reflect undue high profit in the income statement as it was under the first-in-first-out or average method. In fact, the profit shown here is relatively lower because the cost of production takes into account the rising trend of material prices. 3. In the case of falling prices profit tends to rise due to lower material cost, yet the finished products appear to be more competitive and are at market price. 4. Over a period, the use of LIFO helps to iron out the fluctuations in profits. 5. In the period of inflation LIFO will tend to show the correct profit and thus avoid paying undue taxes to some extent.Disadvantages :

1. Calculation under LIFO system becomes complicated and cumbersome when frequent purchases are made at highly fluctuating rates. 2. Costs of different similar batches of production carried on at the same time may differ a great deal. 3. In time of falling prices, there will be need for writing off stock value considerably to stick to the principle of stock valuation, i.e., the cost or the market price whichever is lower. 4. This method of valuation of material is not acceptable to the income tax authorities. (d) Base Stock Method - A minimum quantity of stock under this method is always held at a fixed price as reserve in the stock, to meet a state of emergency, if it arises. This minimum stock is known as base stock and is valued at a price at which the first lot of

2.50

Material

materials is received and remains unaffected by subsequent price fluctuations. Thus, this is more a method of valuing inventory than a method of valuing issues because, with the base of stock valued at the original cost some other method of valuing issues should be adopted. The quantity in excess of the base stock may be valued either on the FIFO or LIFO basis. This method is not an independent method as it uses FIFO or LIFO. Its advantages and disadvantages therefore will depend upon the use of the other method viz., FIFO or LIFO.Illustration :

AT Ltd. furnishes the following store transactions for September, 2006 : 1-9-06� � Opening balance 4-9-06 Issues Req. No. 85 6-9-06 Receipts from B & Co. GRN No. 26 7-9-06 Issues Req. No. 97 10-9-06 Return to B & Co. 12-9-06 Issues Req. No. 108 13-9-06 Issues Req. No. 110 15-9-06 Receipts from M & Co. GRN. No. 33 17-9-06 Issues Req. No. 12 19-9-06 Received replacement from B & Co. GRN No. 38 20-9-06 Returned from department, material of M & Co. MRR No. 4 22-9-06 Transfer from Job 182 to Job 187 in the dept. MTR 6 26-9-06 Issues Req. No. 146 30-9-06 Shortage in stock taking 5 units 10 units 2 units 5 units 10 units 25 units value Rs. 162.50 8 units 50 units @ Rs. 5.75 per unit 12 units 10 units 15 units 20 units 25 units @ Rs. 6.10 per unit 10 units

29-9-06 Transfer from Dept. A to Dept. B MTR 10 5 units Write up the priced� � � � stores ledger on FIFO method and discuss how would you treat the shortage in stock taking.

2.51

Solution : Date 1 1-9-06 4-9-06 6-9-06 7-9-06 GRN No. MRR No. 2 26 Qty.� � � Units 3 50 25 10 5 � � � � � � � � �

10-9-06 12-9-06 13-9-06 15-9-06 33 17-9-06 19-9-06 38 20-9-06 4 26-9-06 � � � � � 30-9-06 �

Stores Ledger of AT Ltd. for the month of September, 2006 (FIFO Method) RECEIPT ISSUE BALANCE Rate Amount Requisi- Qty. Rate Amount Qty. Rate Rs. P Rs. P tion No. Units Rs. P. Rs. P. Units Rs. P. 4 5 6 7 8 9 10 11 25 6.50 85 8� � � � � � � � 6.50 52 17 6.50 5.75 287.50 17 6.50 50} 5.75} 97 12 6.50 78 5 6.50 50}� � � � � � 5.75 Nil 10 5.75 57.50 5 6.50 40} 5.75 108 5 6.50 10} 5.75} 90 30 5.75 � � � � � � 110 20 5.75 115 10 5.75 6.10 152.50 10 5.75 25} 6.10 121 10 5.75 57.50� � � � � � 25 6.10 5.75 57.50 25 6.10 10} 5.75} 5 5.75 5.75 28.75 25 6.10 10}� � � � � � � � 7.75} 146 5 5.75 20 6.10 5} 6.10} 59.29 10} 5.75} Shortage 2 6.10 12.20 18� � � � 6.10 10} 5.75}

Amount Rs. P. 12 162.50 110.50 398.00 320.00 262.00 172.50 57.50 210.00 152.50 210.00 258.75 179.50 167.30

Material

Working Notes :

1.

The material received as replacement from vendor is treated as fresh supply.

2. In the absence of information the price of the material received from within on 20-9-06 has been taken as the price of the earlier issue made on 17-9-06. In FIFO method physical flow of the material is irrelevant for pricing the issues. 3. The issue of material on 26-9-06 is made out of the material received from within. 4. The entries for transfer of material from one job and department to other on 22-9-06 and 29-9-06 are book entries for adjusting the cost of respective jobs and as such they have not been shown in the stores ledger account. 5. The material found short as a result of stock taking has been written off.Illustration :

The following information is provided by SUNRISE INDUSTRIES for the fortnight of April, 2006 :Material Exe :

Stock on 1-4-2006 100 units at Rs. 5 per unit. Purchases 5-4-06 8-4-06 12-4-06 Issues 6-4-06 10-4-06 14-4-06 Required : (A) Calculate using FIFO and LIFO methods of pricing issues : (a) the value of materials consumed during the period (b) the value of stock of materials on 15-4-06. (B) Explain why the figures in (a) and (b) in part A of this question are different under the two methods of pricing of material issues used. You need not draw up the Stores Ledgers. 250 400 500 units units units 300 500 600 units at Rs. 6 units at Rs. 7 units at Rs. 8

2.53

Cost Accounting

Solution

(A) (a) Value of Material Exe consumed during the period1-4-06 to 15-4-06 by using FIFO method. Date Description Units Qty. Rs. Rate Rs. Amount

1-4-06 5-4-06 6-4-06 8-4-06 10-4-06 12-4-06 14-4-06 15-4-06

Opening balance Purchased Issued Purchased Issued Purchased Issued Balance

100 300 100 150 500 150 250 600 250 250 350

5 6 5? ? 6?7

500 1,800 1,400 3,500 2,650 4,800 3,750 2,800

6? ? 7? 8 7? ? 8? 8

Total value of material Exe consumed during the period under FIFO method comes to (Rs. 1,400 + Rs. 2,650 + Rs. 3,750) Rs. 7,800 and balance on 15-4-06 is of Rs. 2,800.Value of Material Exe consumed during the period 1-4-06 to 15-4-06 by using LIFO method Date Description Qty. Units 100 300 250 500 400 600 500 350 Rate Rs. 5 6 6 7 7 8 8 Amount Rs. 500 1,800 1,500 3,500 2,800 4,800 4,000 2,300*�

1-4-06 5-4-06 6-4-06 8-4-06 10-4-06 12-4-06 14-4-06 15-4-062.54

Opening balance Purchased Issued Purchased Issued Purchased Issued Balance

Material

Total value of material Exe issued under LIFO method comes to (Rs. 1,500 + Rs. 2,800 + Rs. 4,000) Rs. 8,300. *The balance 350 units on 15-4-06 of Rs. 2,300, relates to opening balance on 1-406 and purchases made on 5-4-06, 8-4-06 and 12-4-06. (100 units @ Rs. 5, 50 units @ Rs. 6, 100 units @ Rs. 7 and 100 units @ Rs. 8). (b) As shown in (a) above, the value of stock of materials on 15-4-06: Under FIFO method Rs. 2,800 Under LIFO method Rs. 2,300 (B) Total value of material Exe issued to production under FIFO and LIFO methods comes to Rs. 7,800 and Rs. 8,300 respectively. The value of closing stock of material Exe on 15-406 under FIFO and LIFO methods comes to Rs. 2,800 and Rs. 2,300 respectively.The reasons for the difference of Rs. 500 (Rs. 8,300 Rs. 7,800) as shown by the� following table in the value of material Exe, issued to production under FIFO and LIFO are as follows : Date Quantity Issued (Units) Value FIFO Rs. Rs. Total Value LIFO Rs. Rs. Total

6-4-06 10-4-06 1.

250 400

1,400 2,650

1,500 2,800

14-4-06 500 3,750 7,800 4,000 8,300 On 6-4-06, 250 units were issued to production. Under FIFO their value comes to Rs. 1,400 (100 units Rs. 5 + 150� units Rs. 6) and under LIFO Rs. 1,500 (250 Rs. 6). Hence, Rs. 100 was more� � charged to production under LIFO. On 10-4-06, 400 units were issued to production. Under FIFO their value comes to Rs. 2,650 (150 Rs. 6 + 250 Rs. 7) and under� � LIFO Rs. 2,800 (400 Rs. 7). Hence, Rs. 150 was more charged to production under� LIFO. On 14-4-06, 500 units were issued to production. Under FIFO their value comes to Rs. 3,750 (250 Rs. 7 + 250 Rs. 8) and under LIFO Rs. 4,000 (500 Rs.� � � 8). Hence, Rs. 250 was more charged to production under LIFO.

2.

3.

Thus the total excess amount charged to production under LIFO comes to Rs. 500.

2.55

Cost Accounting

The reasons for the difference of Rs. 500 (Rs. 2,800 Rs. 2,300) in the value of� 350 units of Closing Stock of material Exe under FIFO and LIFO are as follows : 1. In the case of FIFO, all the 350 units of the closing stock belongs to the purchase of material made on 12-4-06, whereas under LIFO these units were from opening balance and purchases made on 5-4-06, 8-4-06 and 12-4-06. Due to different purchase price paid by the concern on different days of purchase, the value of closing stock differed under FIFO and LIFO. Under FIFO 350 units of closing stock were valued @ Rs. 8 p.u. Whereas under LIFO first 100 units were valued @ Rs. 5 p.u., next 50 units @ Rs. 6 p.u., next 100 units @ Rs. 7 p.u. and last 100 units @ Rs. 8 p.u.

2.

Thus under FIFO, the value of closing stock increased by Rs. 500.Illustration

The following transactions in respect of material Y occurred during the six months ended 30th June, 2006:Month Purchase (units) Price per unit Rs. Issued units Nil

January February March April May June Required :

200 300 425 475 500 600

25 24 26 23 25 20

250 300 550 800 400

(a) The Chief Accountant argues that the value of closing stock remains the same no matter which method of pricing of material issues is used. Do you agree? Why or why not? Detailed stores ledgers are not required. (b) When and why would you recommend the LIFO method of pricing material issues ?Solution

(a) The Closing Stock at the end of six months period i.e., on 30th June, 2006 will be 200 units, whereas up to the end of May 2006, total purchases coincide with the total2.56

Material

issues i.e., 2,300 units. It means that at the end of May 2006, there was no closing stock. In the month of June 2006, 600 units were purchased out of which 400 units were issued. Since there was only one purchase and one issue in the month of June, 2006 and there was no opening stock on 1st June 2006, the Closing Stock of 200 units is to be valued at Rs. 20 per unit. In view of this, the argument of the Chief Accountant appears to be correct. Where there is only one purchase and one issue in a month with no opening stock, the method of pricing of material issues becomes irrelevant. Therefore, in the given case one should agree with the argument of the Chief Accountant that the value of Closing Stock remains the same no matter which method of pricing the issue is used. It may, however, be noted that the argument of Chief Accountant would not stand if one finds the value of the Closing Stock at the end of each month. (b) LIFO method has an edge over FIFO or any other method of pricing material issues due to the following advantages : (i) The cost of the materials issued will be either nearer or will reflect the current market price. Thus, the cost of goods produced will be related to the trend of the market price of materials. Such a trend in price of materials enables the matching of cost of production with current sales revenues. The use of the method during the period of rising prices does not reflect undue high profit in the income statement, as it was under the first-in-first-out or average method. In fact, the profit shown here is relatively lower because the cost of production takes into account the rising trend of material prices.

(ii)

(iii) In the case of falling prices, profit tends to rise due to lower material cost, yet the finished products appear to be more competitive and are at market price. (iv) During the period of inflation, LIFO will tend to show the correct profit and thus, avoid paying undue taxes to some extent.(c) Simple Average Price Method - Under this method, materials issued are valued at average price, which is calculated by dividing the total of all units rate by the number of unit rate. In other words :

Material issue price =

Total of unit prices of each purchase Total number of purchases

This method is useful under the following circumstances : 1. 2. When the materials are received in uniform lots of similar quantity, otherwise, it will give wrong results. When purchase prices do not fluctuate considerably.

2.57

Cost Accounting

Advantage : It is simple to understand and easy to operate. Disadvantages :

1. Materials issue cost does not represent actual cost price. Since the materials are issued at a price obtained by averaging cost prices, a profit or loss may arise from such type of pricing. 2. In case the prices of material fluctuate considerably, this method will give incorrect results. 3. The prices of materials issues used are determined by averaging prices of purchases without giving consideration to the quantity. Such a price determination is unscientific.(d) Weighted Average Price Method : This method gives due weights to quantities purchased and the purchase price, while, determining the issue price. The average issue price here is calculated by dividing the total cost of materials in the stock by total quantity of materials prior to each issue. The advantages and disadvantages of this method are : Advantages :

1.

It smoothens the price fluctuations if at all it is there due to material purchases.

2. Issue prices need not be calculated for each issue unless new lot of materials is received.Disadvantage :

1. Material cost does not represent actual cost price and therefore, a profit or loss will arise out of such a pricing method.(e) Periodic Simple Average Price Method : This method is similar to Simple Average Price Method except that the average price is calculated at the end of the concerned period. In other words, the price paid during the period for different lots of materials purchased are added up and the total is divided by the number of purchases made during the period. The rate so computed is then used to price all the issues made during the period, and also for valuing the closing inventory of the period. Advantages :

1.

It is simple to operate, as it avoids calculation of issue price after every receipt.

2. This method can usefully be employed in costing continuous processes where each individual order is absorbed into the general cost of producing large quantities of articles.Disadvantages :

1. This method cannot be applied in jobbing industry where each individual job order is to be priced at each stage of its completion. 2. This method is unscientific as it does not take into consideration the quantities

2.58

Material

purchased at different prices. 3. This method also suffers from all those disadvantages of simple average cost method.(f) Periodic Weighted Average Price Method : This method is like weighted average price method, except that the calculations of issue prices are made periodically (say, a month). The rate so arrived is used for the issues made during that period and also for valuing the inventory at the end of the period. Advantage :

1. This method is superior to the periodic simple average price method as it takes into account the quantities also. 2. It overcomes or evens out the effect of fluctuations. 3. In addition to above, the method also possesses all the advantages of the simple weighted average price method.Disadvantage : This method is not suitable for job costing because each job is to be priced at each stage of completion. (g) Moving Simple Average Price Method : Under this method, the rate for material issues is determined by dividing the total of the periodic simple average prices of a given number of periods by the numbers of periods. For determining the moving simple average price, it is necessary to fix up first period to be taken for determining the average. Suppose a six monthly period is decided upon and moving, average rate for the month of June is to be calculated. Under such a situation, we have to make a list of the simple average prices from January to June, add them up, and divide the total by six. To calculate the moving average rate for July, we have to omit simple average rate pertaining to January and add the rate relating to July and divide the total by six. Advantage : This method evens out price fluctuations over a longer period, thus stabilising the charges to work-in-progress. Thus the cost of production will be stable to a significant extent. Disadvantage : A profit or loss arises by the use of moving simple average cost. (h) Moving Weighted Average Price Method : Under this method, the issue, rate is calculated by dividing the total of the periodic weighted average price of a given number of periods by the number of periods. (i) Replacement Price Method: Replacement price is defined as the price at which it is possible to purchase an item, identical to that which is being replaced or revalued. Under this method, materials issued are valued at the replacement cost of the items. This method pre-supposes the determination of the replacement cost of materials at the time of each issue; viz., the cost at which identical materials could be currently purchased. The

2.59

Cost Accounting

product cost under this method is at current market price, which is the main objective of the replacement price method. This method is useful to determine true cost of production and to value material issues in periods of rising prices, because the cost of material considered in cost of production would be able to replace the materials at the increased price.Advantage: Product cost reflects the current market prices and it can be compared with the selling price. Disadvantage: The use of the method requires the determination of market price of material before each issue of material. Such a requirement creates problems. (j) Realisable Price Method: Realisable price means a price at which the material to be issued can be sold in the market. This price may be more or may be less than the cost price at which it was originally purchased. Like replacement price method, the stores ledger would show profit or loss in this method too. (k) Standard Price Method: Under this method, materials are priced at some predetermined rate or standard price irrespective of the actual purchase cost of the materials. Standard cost is usually fixed after taking into consideration the following factors:

(i)

Current prices,

(ii) Anticipated market trends, and (iii) Discount available and transport charges etc. Standard prices are fixed for each material and the requisitions are priced at the standard price. This method is useful for controlling material cost and determining the efficiency of purchase department. In the case of highly fluctuating prices of materials, it is difficult to fix their standard cost on long-term basis.Advantages:

(1) The use of the standard price method simplifies the task of valuing issues of materials. (2) It facilitates the control of material cost and the task of judging the efficiency of purchase department. (3) It reduces the clerical work.Disadvantages:

(1) The use of standard price does not reflect the market price and thus results in a profit or loss. (2) The fixation of standard price becomes difficult when prices fluctuate frequently.

2.60

Statement of receipts and issues by adopting First-in-First-Out Method Date Particulars Units No. Jan. 1 Jan. 20 Jan. 22 Jan. 23 Purchase Purchase Issue to Job W 16 Issue to Job W 17 100 100 Receipts Rate Rs. 1 2 Value Rs. 100 200� � � � Units No. 60 40 20 Date Particulars Units No. Jan. 1 Jan. 20 Jan. 22 Jan.� � � � 23 Purchase Purchase Issue to Job W 16 Issue to Job W 17 40 20} 2 1} 80 20}� � � 100 100 Receipts Rate Rs. 1 2 Value Rs. 100 200 Units No. 60 Issues Rate� � � � � Rs. 1 1 2} Issues Rate Rs. 2 Value Rs. 120 Units No. 100 100 100} 100� � � � � � 40} 80 Value Rs. 60 40 40} 80 2 Balance Rate Rs. 1 1 2} 1 2} 1 Value Rs. 100� � 100 200} 100 80} 80 160 Units No. 100 100 100} 40 100} Balance Rate Rs. 1 1 2} 1 2} Value Rs. 100 100 200} 40 200}

Statement of receipts and issues by adopting Last-In-First-Out method

Statement of Receipt and Issues by adopting Weighted Average method Date Particulars Units No. Jan. 1 Jan. 20 Jan. 22 Jan. 23 Purchase Purchase Issue to Job W 16 Issue to Job W 17 100 100 1 2 Rate Rs. 100 200 Receipts Value� � � � � � Units Rs. 60 60 No. 1.50 1.50 Rate Rs. 90 90 Issues Value Units Rs.� � � � � � 100 200 140 80 No. 1 1.50 1.50 1.50 Balance Rate Rs. Value Rs. 100 300 210 120

Statement of Material Values allocated to Job W 16, Job 17 and Closing Stock, under aforesaid methods FIFO Rs. Material for Job W 16 Material for Job W 17 Closing Stock 60 80 160 300 LIFO Rs. 120 100 80 300 Weighted Average Rs. 90 90 120 300

Material

(n) Inflated Price Method - In case material suffers loss in weight due to natural or climatic factors, e.g., evaporation, the issue price of the material is inflated to cover up the losses. (o) Re-use Price Method - When materials are rejected and returned to the stores or a processed material is put to some other use, then for the purpose it is meant, then such materials are priced at a rate quite different from the price paid for them originally. There is no final procedure for valuing use of material. Illustration :

The following information is extracted from the Stores Ledger:Material X

Opening StockPurchases :

Nil

Jan. 1 Jan. 20Issues :

100 @ Re. 1 per unit 100 @ Rs. 2 per unit 60 for Job W 16 60 for Job W 17

Jan. 22 Jan. 23

Complete the receipts and issues valuation by adopting the First-In-First-Out, Last-InFirst-Out and the Weighted Average Method. Tabulate the values allocated to Job W 16, Job W 17 and the closing stock under the methods aforesaid and discuss from different points of view which method you would prefer.Solution

From the point of view of cost of material charged to each job, it is minimum under FIFO and maximum under LIFO (Refer to Tables on previous pages). During the period of rising prices, the use of FIFO give rise to high profits and that of LIFO low profits. In the case of weighted average there is no significant adverse or favourable effect on the cost of material as well as on profits. From the point of view of valuation of closing stock it is apparent from the above statement that it is maximum under FIFO, moderate under weighted average and minimum under LIFO.

2.63

Cost Accounting

It is clear from the Tables on previous page that the use of weighted average evens out the fluctuations in the prices. Under this method, the cost of materials issued to the jobs and the cost of material in hands reflects greater uniformity than under FIFO and LIFO. Thus from different points of view, weighted average method is preferred over LIFO and FIFO.2.10 VALUATION OF RETURNS & SHORTAGES 2.10.1 Valuation of Materials Returned to the Vendor : Materials which do not meet quantity, dimensional and other specifications and are considered to be unfit for production are usually returned to the vendor. These materials can be returned to the vendor before they are sent to the stores. In case materials reach store and are noticed to be of sub-standard quality, then also they can be returned to vendor. The price of the materials to be returned to vendor should include its invoice price plus freight, receiving and handling charges etc. Strictly speaking, the materials returned to vendor should be returned at the stores ledger price and not at invoice price. But in practice invoice price is only considered, the gap between the invoice price and stores ledger price is charged as overhead.

In Stores ledger the defective or sub-standard materials are shown in the issue column at the rate shown in the ledger, and the difference between issue price and invoice cost is debited to an inventory adjustment account.2.10.2 Valuation of Materials Returned to Stores: When materials requisitioned for a specific job or work-in progress are found to be in excess of the requirement or are unsuitable for the purpose, they are returned to the stores. There are two ways of treating such returns.

(1) Such returns are entered in the receipt column at the price at which they were originally issued, and the materials are kept in suspense, to be issued at the same price against the next requisition. (2) Include the materials in stock as if they were fresh purchases at the original issue price.2.10.3 Valuation of Shortages during Physical Verification: Materials found short during physical verification should be entered in the issue column and valued at the rate as per the method adopted, i.e., FIFO or any other. 2.11 SELECTION OF PRICING METHOD

No hard and fast rule or procedure has been laid down to select a method of pricing2.64

Material

issues of material. However, the ultimate choice of a method of selection may be based on the following considerations. (a) The method of costing used and the policy of management. (b) The frequency of purchases and issues. (c) The extent of price fluctuations. (d) The extent of work involved in recording, issuing and pricing materials. (e) Whether cost of materials used should reflect current or historical conditions?2.12 TREATMENT OF NORMAL AND ABNORMAL LOSS OF MATERIALS

Whichever method may be adopted for pricing materials, certain differences between the book balance and the value of physical stock are bound to occur. These differences, which may be a gain or loss, should be transferred to Inventory Adjustment Account pending investigation. If, upon investigation, they are regarded as normal, they should be transferred to Overhead Control Account; if abnormal, they should be written off to the Costing Profit and Loss Account. In the case of normal losses, an alternative method used to price per unit of material so as to cover the normal loss can be understood with the help of the example considered. Suppose 1,000 metres of gunny cloth are purchased at Rs. 2 per metre. It is expected that 1% would be the normal loss due to issues being made in small lots. The inflated price would be Rs. 2.02 p. i.e., (Rs. 2,000 for 990 metres). The rate of Rs. 2.02 per metre of gunny cloth covers the cost a normal loss as well.2.13 ACCOUNTING AND CONTROL OF WASTE, SCRAP, SPOILAGE AND DEFECTIVES 2.13.1 Waste - It represents the portion of basic raw materials lost in processing having no recoverable value. Waste may be visible - remnants of basic raw materials - or invisible; e.g., disappearance of basic raw materials through evaporation, smoke etc. Shrinkage of material due to natural causes may also be a form of a material wastage.

Normal waste is absorbed in the cost of net output, whereas abnormal waste is transferred to the Costing Profit and Loss Account. For effective control of waste, normal allowances for yield and waste should be made from past experience, technical factors and special features of the material process and product. Actual yield and waste should be compared with anticipated figures and appropriate actions should be taken where necessary. Responsibility should be fixed on

2.65

Cost Accounting

purchasing, storage, maintenance, production and inspection staff to maintain standards. A systematic procedure for feedback of achievement against laid down standards should be established.2.13.2 Scrap - It has been defined as the incidental residue from certain types of manufacture, usually of small amount and low value, recoverable without further processing. Scrap may be treated in cost accounts in the following ways:-

(i) (ii)

Where the value of scrap is negligible, it may be excluded from costs. In other words, the cost of scrap is borne by good units and income scrap is treated as other income. The sales value of scrap net of selling and distribution cost, is deducted from overhead to reduce the overhead rate. A variation of this method is to deduct the net realisable value from material cost. This method is followed when scraps cannot be aggregated job or process-wise.

(iii) When scrap is identifiable with a particular job or process and its value is significant, the scrap account should be charged with full cost. The credit is given to the job or process concerned. The profit or loss in the scrap account, on realisation, will be transferred to the Costing Profit and Loss Account. Control of scrap really means the maximum effective utilisation of raw material. Scrap control does not, therefore, start in the production department; it starts from the stage of product designing. Thus the most suitable type of materials, the right type of equipment and personnel would help in getting maximum quantity of finished product from a given raw material. A standard allowance for scrap should be fixed and actual scrap should be collected, recorded and reported indicating the cost centre responsible for it. A periodical scrap report would serve the purpose where two or more departments or cost centres are responsible for the scrap; the reports should be routed through the departments concerned.2.13.3 Spoilage - It is the term used for materials which are badly damaged in manufacturing operations, and they cannot be rectified economically and hence taken out of process to be disposed of in some manner without further processing. Spoilage may be either normal or abnormal.

Normal spoilage (i.e., which is inherent in the operation) costs are included in costs either charging the loss due to spoilage to the production order or by charging it to production overhead so that it is spread over all products. Any value realised from spoilage is credited to production order or production overhead account, as the case may be.2.66

Material

The cost of abnormal spoilage (i.e., arising out of causes not inherent in manufacturing process) is charged to the Costing Profit and Loss Account. When spoiled work is the result of rigid specification, the cost of spoiled work is absorbed by good production while the cost of disposal is charged to production overhead. To control spoilage, allowance for normal spoilage should be fixed and actual spoilage should be compared with standard set. A systematic procedure of reporting would help control over spoilage. A systematic procedure of reporting would help control over spoilage. A spoilage report should highlight the normal and abnormal spoilage, the department responsible, the causes of spoilage and the corrective action taken, if any.2.13.4 Defectives - It signifies those units or portions of production which can be rectified and turned out as good units by the application of additional material, labour or other service. For example, some mudguards produced in a bicycle factory may have dents; or there may be duplication of pages or omission of some pages in a book. Defectives arise due to sub-standard materials, bad-supervision, bad-planning, poor workmanship, inadequate-equipment and careless inspection. To some extent, defectives may be unavoidable but usually, with proper care it should be possible to avoid defect in the goods produced. Reclamation of loss from defective units - In the case of articles that have been spoiled, it is necessary to take steps to reclaim as much of the loss as possible. For this purpose:

(i) (ii)

All defective units should be sent to a place fixed for the purpose; These should be dismantled;

(iii) Goods and serviceable parts should be separated and taken into stock; (iv) Parts which can be made serviceable by further work should be separated and sent to the workshop for the purpose and taken into stock after the defects have been removed; and (v) Parts which cannot be made serviceable should be collected in one place for being melted or sold. Printed forms should be used to record quantities for all purposes aforementioned.Control - When defectives are found, the Inspector will make out the Defective Work Report, giving particulars of the department, process or job, defective units, normal and abnormal defectives, cost of rectification etc. On receipt of the defective Work Report, it may be decided to rectify the defective work; all costs of rectification are collected against the rectification work order, precaution will be taken to see that number of defectives is

2.67

Cost Accounting

within normal limits. Defectives are generally treated in two ways, either they are brought up to the standard by incurring further costs on additional material and labour or where possible, they are sold as inferior production (seconds) at lower prices. Defectives are generally treated in two ways: either they are brought up to the standard by incurring further costs on additional material and labour or where possible, they are sold as inferior products (seconds) at lower prices. The following illustration is given to explain the accounting procedure followed in either case. Total expenses of manufacture Output Cost of rectifying defectives Cost per unit of production = Rs. 5,000 Good: 450 units Defective: 50 units Rs. 50

Rs.5,000 + Rs.50 = Rs. 10.10 per unit 500

If the defectives are not rectified but sold as second s say, @ Rs. 8 each then� � cost of goods produced will be; =

Rs.5,000 - Rs.400 = Rs. 10.22 per unit. 450

Distinction between spoilage and defectives :

The difference between spoilage and defectives is that while spoilage cannot be repaired or reconditioned, defectives can be rectified and transferred, either back to standard production or to seconds.Treatment of spoilage and defectives in Cost Accounting - 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 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 problem of accounting for defective work is the problem of accounting of the costs of2.68

Material

rectification or rework. 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.

Procedure for the control of Spoilage and Defectives - To control spoilage, allowance for a normal spoilage should be fixed up and actual spoilage should be compared with standard set. A systematic procedure of reporting would help control over spoilage. A spoilage report (as below) would highlight the normal and abnormal spoilage, the department responsible, the causes of spoilage and the corrective action taken if any. Spoilage Report

Units/Deptt. No................................. Production Order No......................Units Produced Units spoiled Normal Spoilage Abnormal Spoilage % Qty. % Qty.

Date.........................Cost of abnormal spoilage Rs. Reason spoilage Action taken

2.69

Cost Accounting

Control of defectives may cover the following two areas: (a) Control over defectives produced (b) Control over reworking costs. For exercising effective control over defectives produced and the cost of reworking, standards, for normal percentage of defectives and reworking costs should be established. Actual performance should be compared with the standards set. Defective Work Report (as shown on below page should be fed back to the respective Centres of Control.)Defective Work Report

Dept................. Causes of defects................. Nature of defects.................Job/ Defective Detail of work to Normal Abnormal be Materials Rs. Labour Rs Overhead Rs. done Re-work Costs Total Rs.

Date.................

Unit Cost of reworking Rs.

Net good output after rewroking

Losses due to obsolete stores - Obsolescence is defined as the loss in the� intrinsic value of an asset due to its supersession . Materials may become� obsolete under any of the following circumstances:

(i) (ii)

where it is a spare part or a component of a machinery used in manufacture and that machinery becomes obsolete ; where it is used in the manufacture of a product which has become obsolete ;

(iii) where the material itself is replaced by another material due to either improved quality or fall in price. In all three cases, the value of the obsolete material held in stock is a total loss and immediate steps should be taken to dispose it off at the best available price. The loss

2.70

Material

arising out of obsolete materials on abnormal loss does not form part of the cost of manufacture. Losses due to obsolescence can be minimised through careful forethought and reduced stocking of spares, etc. Stores records should be continuously gone through to see whether any item is likely to become obsolete. There will be such likelihood if an item has not been used for a long time. (This does not apply to spare parts of machines still in use).2.14 CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like material, labour etc. The management for planning and control must know the cost of using these resources in manufacturing. The consumption of materials takes place say when the material is used in the manufacture of the product. It is important to note that the amount of materials consumed in a period by a cost object need not be equal to the amount of material available with the concern. For example, during any period the total of raw material stock available for use in production may not be equal to the amount of materials actually consumed and assigned to the cost object of the production. The difference between the material available and material consumed represents the stock of material at the end of the period.2.14.1 Identification of Materials: For the identification of consumption of materials with products of cost centres the followings points should be noted:

1. 2.

It is required that the concern should follow coding system for all materials so that each material is identified by unique code number. It is required that each product of a cost centre should be given a unique code number so that the direct material issued for production of particular product of a cost centre can be collected against the code number of that product. However, it may not be possible to allocate all materials directly to individual product of a cost centre e.g. maintenance materials, inspection and testing materials etc. The consumption of these materials are collected for cost centre and then charged to individual product by adopting suitable overhead absorption rate of cost centre. Overhead absorption rate of cost centre =

Cost for cost centre Base relating to cost centre (e.g.labou r hrs. or machine hrs.)

2.71

Cost Accounting

3.

Each issue of materials should be recorded. One way of doing this is to use a material requisition note. This note shows the details of materials issued for product of cost centre and the cost centre which is to be charged with cost of materials. A material return note is required for recording the excess materials returned to the store. This note is required to ensure that original product of cost centre is credited with the cost of material which was not used and that the stock records are updated. A material transfer note is required for recording the transfer of materials from one product of cost centre to other or from one cost centre to other cost centre. The cost of materials issued would be determined according to stock valuation method used.

4.

5. 6.

2.14.2 Monitoring Consumption of Materials: For monitoring consumption of materials a storekeeper should periodically analyse the various material requisitions, material return notes and material transfer notes. Based on this analysis, a material abstract or material issue analysis sheet is prepared, which shows at a glance the value of material consumed in manufacturing each product. This statement is also useful for ascertaining the cost of material issued for each product. Format of Material Abstract

Week Ending............Material requisition or Transfer Note or Returned Note No. Amount Product Nos. Total for Product 101 Rs. Total Rs. 102 Rs. 103 Rs. 104 Rs. 105 Rs. � � � � � � 106 Rs. Rs. Overheads (Indirect Material charged)� � �

The material abstract statement serves a useful purpose. It in fact shows the amount of material to be debited to various products & overheads. The total amount of stores debited to various products & overheads should be the same as the total value of stores issued in any period.2.14.3 Basis for consumption entries in Financial Accounts: Every manufacturing organisation assigns material costs to products for two purposes. Firstly, for external financial accounting requirements in order to allocate the material costs incurred during2.72

Material

the period between cost of goods produced and inventories; secondly to provide useful information for managerial decision making requirements. In order to meet external financial accounting requirements, it may not be necessary to accurately trace material costs to individual products. Some products costs may be overstated and others may be understated but this may not matter for financial accounting purposes as long as total of individual materials costs assigned to cost of production and inventories are equal to total cost of materials. In Financial Accounts the external transactions are recorded i.e. transaction between the firm and other entities are recorded in a manner that facilitates periodical reporting of assets, liabilities, revenue and expenditures for a firm as a whole or for each business segment or geographical segment in which firm operates. In Cost Accounting the internal transactions are recorded i.e., transactions between cost centre within the firm are recorded in a manner that facilitates analysis of costs for assigning them to cost units. The consumption entries in financial accounts are made on the basis of total cost of purchases of materials after adjustment for opening and closing stock of materials. The stock of materials is taken at cost or net realisable value whichever is less.Self-Examination Questions Multiple Choice Questions

(a) Direct material is a (i) Fixed cost (ii) Variable cost (iii) Semi-variable cost. (b) In most of the industries, the most important element of cost is (i) Material (ii) Labour (iii) Overheads. (c) Which of the following is considered to be the normal loss of materials? (i) Loss due to accidents (ii) Pilferage (iii) Loss due to breaking the bulk (iv) Loss due to careless handling of materials (v) All of these.

2.73

Cost Accounting

(d) In which of following methods of pricing, costs lag behind the current economic values? (i) Last-in-first out price (ii) First-in-first out price (iii) Replacement price (iv) Weighted average price. (e) Continuous stock taking is a part of (i) Annual stock taking (ii) Perpetual inventory (iii) ABC analysis. (f) In which of the following methods, issues of materials are priced at pre-determined rate? (i) Inflated price method (ii) Standard price method (iii) Replacement price method (iv) Specific price method. (g) When material prices fluctuate widely, the method of pricing that gives absurd results is (i) Simple average price (ii) Weighted average price (iii) Moving average price (iv) Inflated price. (h) When prices fluctuate widely, the method that will smooth out the effect of fluctuations is (i) Simple average (ii) Weighted average (iii) FIFO (iv) LIFO. (i) Which of the following is considered to be a normal loss of material? (i) Loss due to accidents (ii) Pilferage (iii) Loss due to careless handling of material. (iv) Loss due to breaking the bulk. (j) Continuous stock taking is a part of, (i) Annual stock taking (ii) Perpetual inventory

2.74

Material

(iii) ABC analysis (iv) None of the above. (k) Lead time 5 weeks, average weekly consumption 28 units. What should be the reordering level ? (i) 120 units (ii) 130 units (iii) 140 units (iv) 150 units. (l) Price per unit Rs 150, annual consumption 2,000 units, ordering cost Rs 300 per order and other charges 20% of cost. What should be the quantity of each order? (i) 150 units (ii) 200 units (iii) 225 units (iv) None of the above. (m) Bin card is maintained by the (i) Accounts department (ii) Costing department (iii) Stores (iv) None of the above. (n) Bin card contains (i) Details of the price of raw material lying in the Bin (ii) Details of the price and quantity of raw material lying in the Bin (iii) Details of quantity of material lying in the Bin (iv) None of the above. (o) Which of the following assumptions hold true for the calculation of Economic Order Quantity? (i) Anticipated usage of material in units is known (ii) Cost per unit of material is constant and known (iii) Ordering cost per order is fixed (iv) None of the above. Answers to multiple choice questions (a) (ii); (b) (i); (c) (ii); (e) (ii); (f) (ii); (g) (i); (h) (ii);. (i) ii; (j) ii; (k) iii ; (l) ii; (m) iii ; (n) iii ; (o) iv

2.75

Cost Accounting

Short Answer Type Questions 1. What are the main objectives of material control ? Explain the important requirements to attain these objectives. 2. Give specimen form of the following : (i) Bill of material. (ii) Purchase requisition. 3. State how you would treat the following in cost records : (a) Pricing of materials returned to stores and (b) Pricing of materials returned to suppliers. 4. What do you mean by waste, scrap, spoilage and defectives ? How they are treated in Cost Accounts ? 5. How would you deal the following in Cost Accounts : (i) Carriage inwards on raw materials. (ii) Cost of handling materials. Long Answer Type Questions 1. Define re-ordering level and explain its relationship to maximum and minimum stock levels. What factors may be considered in fixing reordering levels? 2. Discuss the use of perpetual inventory records and continuous stock taking. 3. Explain the concept of ABC Analysis as a technique of inventory control. 4.� � Explain FIFO and LIFO methods of valuation of material issue. Discuss the effect of rising prices and falling prices on these two methods of pricing of material issues. 5. Discuss in detail the procedure followed for procuring material. Numerical Questions 1. The rate of interest is 12%, the price per unit is Rs. 50, the number of units required in a year is 5,000 and the cost of placing one order and receiving the goods once is Rs. 54. How much should be purchased at a time ? 2. The following is the record of an item in a stores ledger Units Amount Units Amount Rs. Rs. Jan. 1 To Balance b/d 10,000 20,000 Jan. 15 By Issue 14,000 30,000 Jan. 10 To Purchase 5,000 12,000 Feb. 8 By Issue 6,000 15,000 Feb. 3 To Purchase 20,000 55,000 Mar. 15 By Issue 22,000 60,000 Mar. 10 To Purchase 10,000 30,000 Mar. 31 By Bal. C/d 3,000 12,000 45,000 1,17,000 45,000 1,17,000

2.76

Material

3.

4.

5.

6.

7.

Comment upon the method followed to price the issues. Find out the value of closing stock assuming issue to have been made for period on (i) FIFO basis, (ii) LIFO basis, and (iii) Weighted average basis. In a printing press, a form of 8 pages was fitted upside down and this was discovered only after 5,000 sheets had been printed. The total print order was for 10,000 sheets, the cost per 1,000 sheets being Rs. 50. Would it be correct to say that the loss is Rs. 250 ? A company ordered 54 tonnes of coal from a colliery. The invoice was for Rs. 1,000, the freight being Rs. 300. The actual quantity received was 52 tonnes. What should be the price per tonne ? Ten tonnes of coal were destroyed by an accident quantity received was 52 tonnes. How should be the loss be treated ? In a section of ready-made garments factory the monthly wages and overhead respectively amounted to Rs. 5,875 and Rs. 3,650. In a period 10,000 metres of cloth were introduced out of which 600 metres still remained in stock. It takes 2 metres to make the garments but in the month, the total output was 4,500 garments. The cost of the cloth is Rs. 3.50 per metre. Ascertain the cost of garment, assuming cuttings were sold for Rs. 125. The purchase Department of your organisation has received an offer of quantity discounts on its orders of materials as under : Price per tonne Tonnes Rs. Nos. 1,400 Less than 500 1,380 500 and less than 1,000 1,360 1,000 and less than 2,000 1,340 2,000 and less than 3,000 1,320 3,000 and above. The annual requirement for the material is 5,000 tonnes. The delivery cost per order is Rs. 1,200 and the annual stock holding cost is estimated at 20% of the average inventory. The Purchase Department wants you to consider the following purchase options and advise which among them will be the most economical ordering quantity, presenting the relevant information in a tabular form. The purchase quantity options to be considered are 400 tonnes, 500 tonnes, 1,000 tonnes, 2,000 tonnes and 3,000 tonnes. Component Pee is made entirely in cost centre 100. Material� � cost is 6 paise per component and each component takes 10 minutes to produce. The machine operator is

2.77

Cost Accounting

8.

paid 72 paise per hour, and the machine hour rate is Rs. 1.50. The setting up of the machine to produce the component Pee takes 2 hours 20 minutes. On the basis� � of this information, prepare a cost sheet showing the production and setting up cost, both in total and per component, assuming that a batch of : (a) 10 components, (b) 100 components, and (c) 1,000 components (d) is produced. From the details given below, calculate : (i) Re-ordering level (ii) Maximum level (iii) Minimum level (iv) Danger level Re-ordering quantity is to be calculated on the basis of following information. cost of placing a purchase order is Rs. 20 Number of units to be purchased during the year is 5,000. Purchase price per unit inclusive of transportation cost is Rs. 50 Annual cost of storage per unit is Rs. 5 Details of lead time : Average 10 days, Maximum 15 days, Minimum 6 days. For emergency purchase 4 days. Rate of consumption Average : 15 units per day. Minimum : 20 units per day.

2.78

CHAPTERLABOURLearning objectives

3

When you have finished studying this chapter, you should be able to ? Understand the need of labour cost control. ? Understand the attendance and the payroll procedure. ? Describe the meaning and accounting treatment of idle time and overtime. ? Understand the concept of labour turnover and the various methods of computing the same. ? Understand various types of systems of wage payment and incentives. ? Describe the efficiency rating procedures. 3.1 INTRODUCTION

Labour cost after material cost is another significant element of cost not only because the wage bill in a modern organisation is generally substantial but also because it has certain peculiar characteristics which other elements of cost do not have. A good cost accountant must understand the special features of labour cost, the most important of which is that there is almost no limit to the increase of output of this most important and wonderful factor of production. 3.2 LABOUR COST CONTROL

Labour costs are associated with human beings. To control labour costs one has to understand why human beings work and what factors motivate them to give best performance. (Here the students may refer to Chapters 2 and 3 in Organisation and Management booklet). Control over labour costs does not imply control over the size of the wage bill; it also does not imply that wages of each worker should be kept as low as possible. Actually if a policy of low wages is adopted, it may turn out to be expensive since the ill-paid workers will be dissatisfied and turn out low output. Low wages are, therefore, often dear wages. The aim should be to keep the wages cost per unit of output as low as possible. This can only be brought about by giving workers optimum wages and then harnessing their energies to optimise output. A well

Cost Accounting

motivated team of workers can bring about wonders. Each concern should, therefore, constantly strive to raise the productivity of labour. The efforts for the control of labour costs should begin from the very beginning. There has to be a concerted effort by all the concerned departments. In a large organisation, generally the following departments are involved in the control of labour costs : 1. Personnel Department - This department is assigned the duty of recruiting workers, training them and maintaining their record. It is the duty of this department to ensure that the persons recruited possess the qualifications and qualities necessary to perform well the concerned jobs. Engineering and Work Study Department - This department prepares plans and specifications for each job, supervises production activities, conducts time and motion studies, undertakes job analysis, etc. Time-keeping Department - This Department is primarily concerned with the maintenance of attendance records of the employees and the time spent by them on various jobs, etc. Payroll Department - This department is responsible for the preparation of payroll of the employees. Cost Accounting Department - This department is responsible for the accumulation and classification etc. of all type of costs. All such data pertaining to labour costs are also collected, analysed and allocated to various jobs, processes, departments, etc., by this department.

2.

3. 4. 5.

3.2.1 Important Factors for the Control of Labour Cost : To exercise an effective control over the labour costs, the essential requisite is efficient utilisation of labour and allied factors. The main points which need consideration for controlling labour costs are the following : (i) (ii) Assessment of manpower requirements. Control over time-keeping and time-booking.

(iii) Time & Motion Study. (iv) Control over idle time and overtime. (v) Control over labour turnover. (vi) Wage systems. (vii) Incentive systems. (viii) Systems of wage payment and incentives. (ix) Control over casual, contract and other workers. (x) Job Evaluation and Merit Rating.

3.2

Labour

(xi) Labour productivity. 3.2.2 Collection of Labour Costs : The task of collecting labour costs is performed by the Cost Accounting Department which record separately wages paid to direct and indirect labour. It is the duty of this department to ascertain the effective wages per hour in each department and to analyse the total payment of wages of each department into : (i) (ii) the amount included in the direct cost of goods produced or jobs completed; the amount treated as indirect labour and thus included in overheads ; and

(iii) the amount treated as the cost of idle time and hence loss. Through this process costs of various jobs are ascertained. Naturally, in this the proper recording of time spent by the workers is essential. Labour cost per hour may be collected through the use of the form given below : A.B.C. Co. Ltd.Department Name of the employee Section Day Work Hrs. O/Time Hours Labour Cost Report Productive Time Total Hours Paid Idle Time Hrs. Total Time Hrs. Time Hrs. O/Time Premium Weekended Wages Paid Bonus Total Cost per Production Hours Rs.

Rs.

Rs.

Rs.

Rs.

3.3

ATTENDENCE & PAYROLL PROCEDURES

3.3.1 Attendance Procedure / Time-keeping : It refers to correct recording of the employees attendance time. Students may note the difference between time� � keeping and time booking . The latter refers to break up of time on various jobs� � � while the former implies a record of total time spent by the workers in a factory. Objectives of Time-keeping : Correct recording of employees attendance time is of� utmost importance where payment is made on the basis of time worked. Where payment is made by results viz; straight piece work, it would still be necessary to correctly record attendance for the purpose of ensuring that proper discipline and adequate rate of production are maintained. In fact the various objectives of time-keeping are as follows: (i) (ii) For the preparation of payrolls. For calculating overtime.

(iii) For ascertaining and controlling labour cost. (iv) For ascertaining idle time.

3.3

Cost Accounting

(v) For disciplinary purposes. (vi) For overhead distribution. Methods of Time-keeping : There are two methods of time-keeping. They are the manual methods and the mechanical methods. The choice of a particular method depends upon the requirements and policy of a firm. But whichever method is followed, it should make a correct record of the time incurring the minimum possible expenditure and should minimise the risk of fraudulent payments of wages. Manual method : The manual methods of time-keeping are as follows : (a) Attendance Register Method, and (b) Metal Disc Method. (a) Attendance Register Method : It is the oldest method of recording time. Under this method, an attendance register is kept in the time office adjacent to the factory gate or in each department for workers employed therein. The attendance register contains such columns as the name of the worker, the worker s number, the department in which he is working, the rate of� wages, the time of arrival and departure, normal time and the overtime. The time of a arrival and departure, may be noted down by an employee know as time-keeper. This method is simple and inexpensive and can be used in small firms where the number of workers is not large. This method may lead to dishonest practice of recording wrong time because there is possibility of collusion between some of the workers and the time-keeper. However, for recording the time of workers who work at customers premises and places which are situated at a distance from the� factory, this may be the only suitable method. (b) Metal Disc Method : Under this method, each worker is allotted a metal disc or a token with a hole bearing his identification number. A board is kept at the gate with pegs on it and all token are hung on this board. These boards can be maintained separately for each department so that the workers could remove their tokens from the board without undue delay. As the workers enter the factory gate, they remove their respective discs or tokens and place them in a box or tray kept near the board. Immediately after the scheduled time for entering the factory, the box is removed and the late comers will have to give their tokens to the timekeeper personally so that the exact time of their arrival could be recorded. The discs or tokens still left on the board represent the absentee workers. Later the time-keeper records the attendance in a register known as Daily Muster Roll which is subsequently passed on to the Pay Roll Department. This method is simple because illiterate workers can very easily recognize their tokens and put them in the box. This method is better than attendance register method and is useful when the number of employees is not large. But it has certain disadvantages of its own as given below : 1.3.4

There are chances that a worker may try to remove his companion s token from the�

Labour

board in order to get his presence marked when he is absent. 2. There are chances of disputes regarding the exact time of arrival of a worker because the time-keeper marking the attendance can commit mistakes deliberately or through carelessness. There is no authentic proof of the presence or absence of the workers. There are chances of inclusion of dummy or ghost workers by the time-keeper in the attendance register or Daily Muster Roll.

3.

Mechanical methods : The mechanical methods that are generally used for the recording of time of workers may be as follows : (a) Time Recording Clocks; and (b) Dial Time Records. (a) Time Recording Clocks : The time recording clock is mechanical device which automatically records the time of the workers. This method has been developed to obviate some of the difficulties experienced in case of manual methods and this method is useful when the number of workers is fairly large. Under this method, each worker is given a Time Card usually of one week duration. Time cards are serially arranged in a tray near the factory gate and as the worker enters the gate, he picks up his card from the tray, puts it in the time recording clock which prints the exact time of arrival in the proper space against the particular day. This process is repeated for recording time of departure for lunch, return from lunch and time of leaving the factory in the evening. Late arrivals, early leavings and overtime are printed in red to attract the attention of the management. A time card may also give such particulars as hourly rate, total gross wages, less deductions and net wages payable. If these particulars are included in the time card, it would be known as combined time and pay-roll card divided into two parts, the upper part being the record of time and the lower one serving as the wage ticket. Wages are calculated on the basis of time recorded in the upper portion and are entered in the lower portion by the pay-roll department. The specimen of a combined time and pay-roll card may be as given below :

3.5

Cost Accounting

COMBINED TIME AND PAY ROLL CARD Name of the worker................. No. of the worker............... Department........................ Regular Day In Monday Tuesday Wednesday Thursday Friday Saturday Sunday A.M. P.M. A.M. P.M. A.M. P.M. A.M. P.M. A.M. P.M. A.M. P.M. A.M. P.M. Normal Time Calculation of Wages Over Time Total Time-keeper....................... Foreman............................. Received the net amount as above...............3.6

Week ending...............

Over Time In Out

Total Time Normal Time Overtime

Out

Hours worked

Rate

Amount

Deductions

Net Amount

Pay Roll Clerk..................... Worker...............

Labour

The main advantage of this method is that there are no chances of disputes arising in connection with recording of time of workers because time is recorded by the time recording clock and not by the time-keeper. There is no scope for partiality or carelessness of the timekeeper as it is in case of manual methods. But this method suffers from the following defects : 1. There are chances that a worker may try to get his friend s time card from the tray in order to get him marked present� in time when he is actually late or get his presence marked when he is absent. This drawback can be removed if the time-keeper does not show carelessness. Sometimes, the time recording clock goes out of order and the work of recording of time is dislocated.

2.

(b) Dial Time Records : The dial time recorder is a machine which has a dial around the clock. This dial has a number of holes (usually about 150) and each hole bears a number corresponding to the identification number of the worker concerned. There is one radial arm at the centre of the dial. As a worker enters the factory gate, he is to press the radial arm after placing it at the hole of his number and his time will automatically be recorded on roll of a paper inside the dial time recorder against the number. The sheet on which the time is recorded provides a running account of the worker s time. This machine allows greater� accuracy and can itself transcribe the number of hours to the wages sheets. This machine can also calculate the wages of the workers and thus avoids much loss of time. However, the high installation cost of the dial time recorder and its use for only a limited of workers are the drawbacks of this method. Requisites of a Good Time-keeping System : A good time-keeping system should have a following requisites : 1. 2. System of time-keeping should be such which should not allow proxy for another worker under any circumstances. There should also be a provision of recording of time of piece workers so that regular attendance and discipline may be maintained. This is necessary to maintain uniformity of flow of production. Time of arrival as well as time of departure of workers should be recorded so that total time of workers may be recorded and wages may be calculated accordingly. As far as possible, method of recording of time should be mechanical so that chances of disputes regarding time may not arise between workers and the time-keeper. Late-comers should record late arrivals. Any relaxation by the time-keeper in this regard will encourage indiscipline. The system should be simple, smooth and quick. Unnecessary queuing at the factory gate should be avoided. Sufficient clocks should be installed keeping in view the number

3. 4. 5. 6.

3.7

Cost Accounting

of workers so that workers may not have to wait for a long period for recording their time of arrivals and departures. 7. A responsible officer should pay frequent visits at the factory gate to see that proper method of recording of time is being followed.

Time-Booking - The clock card is required, essentially, for the correct determination of the amount of wages due to a worker on the basis of time he has put in the factory. It merely records day by day and period by period the total time spent by each individual worker in the factory. But it does not show how that time was put to use in the factory how an individual worker utilised his time in� completing jobs entrusted to him and how long he was kept waiting for one reason or another due to lack of work, lack of material and supplies, lack of instructions, machine breakdowns, power failures and the like. These are all vital pieces of information necessary for the proper collection of cost data and for effective controlling of costs. For the collection of all such information, a separate record, generally known as Time (or Job) card, is kept. The time (or job) card can be of two types one containing analysis of time with reference to each� job and the other with reference to each worker. In case of job card made out according to job a separate job card is employed in respect of a job undertaken; where a job involves several operations, a separate entry is made in respect of each operation. Thus the job card would record the total time spent on a particular job or operation. If a number of people are engaged on the same job or operation, the time of all those workers would be booked on the same card. One obvious advantage of this method is that it provides complete data on the labour content of job or operation collectively so that the computation of labour cost is greatly facilitated. But this method has drawbacks as well. Since a worker s job� timing is scattered over a number of job cards the time spent on all these jobs and idle time must be abstracted periodically for finding each worker s total time� spent on different jobs and the time for which he remained idle during the period. The total of these two times (job and idle) must obviously equal his total attendance time, as shown by his clock card or attendance register. Thus, it would be seen that if the job cards are made out according to job or operation a separate summary has to be prepared for reconciling each worker s job and idle� time with his gate time. It would be quite obvious that such a reconciliation is of great importance from the point of view of labour costs. If on the other hand, one job (or time) card were to be issued for each worker, it would greatly facilitate reconciliation of the worker s job time with his gate time. Under this� system, a card would be issued to each worker for each day or for each week and the time which he spends on different jobs (and also any idle time) would be recorded in the same card so that the card would have a complete history on it as to how his time had been spent during the period. Since all the details would be on one card the total time accounted for in the job card would be readily tallied with the total time put in the Gate Card or attendance register. In this case3.8

Labour

however, a Labour Abstract for different jobs would have to be prepared from the card of individual worker so that total hours (and/or their value) put in by different workers on different jobs during the period could be ascertained and aggregated. It would thus be seen that according to either of the method a process of abstraction and reconciliation is necessary. Specimens of two types of job cards are given below: JOB CARD (1st type) Description of ................................. Department ..................................... Date.............................................. Worker s No. Start Stop Elapsed� time Actual time taken Supervisor s initial JOB (OR TIME) CARD (2nd type) No.� .................... Name of the worker ................................. No............................... Department........................................... Operation............................... Job No. Start Stop Time Elapsed Supervisor s initial Reconciliation of gate and job cards - An advantage of the� introduction of job card is that it enables a reconciliation to be made of the time spent by the worker in each department with the time paid for as per the attendance record. Reconciliation not only helps in locating wastage of time, but also in preventing dummy workers being put on the payroll of workers paid for time not worked by them. The two sets of records serve separate purposes. Where payment to labour is on the time rate basis, the Gate Card is a record of the hours of work that should be paid for. Since the Gate Card merely records the hours during which the worker has been within the premises of the factory and it does not contain any details as to how those hours have been put to use by the worker in his department, a job card must be prepared to provide the necessary information. As we have already seen, the job card may be prepared either worker-wise or job-wise. Time Rate Amount Date.................................... Ticket Rate Amount Job No. ........................................

3.9

Cost Accounting

Objectives of Time-Booking - Objectives of time-booking are as follows: 1. 2. 3. To ensure that time paid for, according to time keeping, has been properly utilised on different jobs or work orders. To ascertain the cost of each job or work order. To provide a basis for the apportionment of overhead expenses over various jobs/work orders when the method for the allocation of overhead depends upon time spent on different jobs.

3.3.2 Payroll procedure : The hours worked by each employee as reflected on the completed clock cards are entered by an accounting department employee (or employees) on the payroll sheet or payroll summary. All employees authorized for employment by the personnel department are first listed on the payroll sheet. Hours and hourly rates are then transferred from the clock cards, and total earnings are computed. Should a clock card for an employee not listed on the payroll sheet be found, investigation of its propriety is required. Likewise, there should be an explanation for any missing clock cards. After the gross earnings (that is, the total amount earned by an employee before any deductions are taken into consideration) have been calculated for every employee, deduction are entered on the payroll sheet, and the net pay of each employee is determined. Under a computerized system, each employee s payroll data would be input into the� computer and it would prepare the entire payroll sheet. Payroll deductions are of two kinds, nontax and tax. Nontax deductions are made at the request of the employee or are required by union contracts. Among the more common examples are union dues, hospitalization insurance, withholding for the purchase of savings bonds, and contributions to charities. Tax deductions are made in compliance with Income Tax Act. Paying the wages : The payroll sheet is the basis for the preparation of a payroll voucher by the accounting department authorizing disbursements for the net amounts payable to employees. If the number of employees is large, payments are usually made from a special payroll account. Using a separate payroll account contributes to good internal control, since the audit trail of payroll activities is easier to follow when a separate account for payroll disbursements is used by a company. In each pay period an amount to cover the net payroll is transferred from the company s general account to a special� payroll account. Cheques payable to the individual employees are then drawn against the payroll account. In a computerized system, the employees paycheques� would be printed out by the computer based on the information within the computer-prepared payroll sheet. In addition to providing a better means of control, use of a separate account for payroll simplifies record keeping by reducing the number of cheques that will clear through the general account. Precautions to ensure proper payment of the payroll should be taken. Payments should be made only to the employees themselves after proper identification. As a control, payroll3.10

Labour

cheques should not be given to factory supervisors or department heads for distribution to the employees under their jurisdiction, since they were probably involved in the process of accumulating the hours worked by their employees. Rather, an individual (or individuals) having no record-keeping functions associated with the payroll (such as the time-keeping function and the preparation of payroll function) should be assigned the job of distributing paycheques. Unclaimed paycheques should be investigated to determine why they have not been picked up by employees. 3.3.3 Overview of Statutory requirements : According to the Factories Act, 1948, every worker is required to work not more than 9 hours a day or 48 hours in a week. If, due to the urgency of the work, a worker is required to work for more than 9 hours a day, excess time over 48 hours i.e. overtime is to be paid to the worker at a higher rate, generally at double the normal wage rate. The excess rate over normal wage rate is called overtime premium. 3.4 IDLE TIME

It is a time during which no production is carried out because the worker remains idle even though they are paid. Idle time can be normal idle or abnormal idle time. Normal idle time : It is inherent in any work situation and cannot be eliminated. Abnormal idle time : Apart from normal idle time, there may be factors which give rise to abnormal idle time. Machines and men cannot be expected to work continuously. In the midst of operations, a machine may have to be stopped for some adjustments being made. Each morning and on the resumption of work in the post-lunch period, some time will be lost before a job can be started. There may also be some waiting time in between the finishing of one job and the starting of another. Similarly, even if a plant operates with a reasonable degree of efficiency, some allowance may be required for loss of time due to occasional power failure, machines or tool break-down, delay in delivery of material and stores or of tools etc. All such reasonable time losses are normal idle time. Normal idle time of direct workers can be treated as a part of the direct cost. This can be done by inflating the wage rates for costing purposes. Suppose 10 minutes per hour of work are treated as normal idle time. If a worker puts in 3 hours on a job, his wages for 3 hours can be charged to the job. Alternatively� the cost of normal idle time may be treated as a part of factory overheads. Losses in excess of the normal idle time are not properly chargeable as overheads; abnormal losses on account of idle time should be written off by being directly debited to the Costing Profit and Loss Account. It is obvious that for establishing abnormal idle time, the normal time required for each product or job will have to be determined. Accurate recording of the idle time in the departments is of great importance from the point of view of cost finding and cost control. For controlling costs, careful analysis and recording of

3.11

Cost Accounting

idle time under significant heads is essential. In order to facilitate identification, the major causes which account for idle time may be grouped under the following two heads : (i) Normal causes : Some idle time is inherent in every situation. The time lost between factory gate and the place of work, the interval between one job and another, the setting up time for the machine, normal fatigue etc. result in normal idle time. (ii) Abnormal causes : Idle time may also arise due to abnormal factors like lack of coordination, power failure, breakdown of machines, non-availability of raw materials, strikes, lockouts, poor supervision, fire, flood etc. The causes for abnormal idle time should be further analysed into controllable and uncontrollable. Controllable abnormal idle time refers to that time which could have been put to productive use had the management been more alert and efficient. All such time which could have been avoided is controllable idle time. However, time lost due to abnormal causes, over which management does not have any control e.g., breakdown of machines, flood etc. may be characterised as uncontrollable idle time. Treatment of idle time in Cost Accounting : Normal idle time is treated as a part of the cost of production. Thus, in the case of direct workers an allowance for normal idle time is built into the labour cost rates. In the case of indirect workers, normal idle time is spread over all the products or jobs through the process of absorption of factory overheads. Abnormal idle time cost is not included as a part of production cost and is shown as a separate item in the Costing Profit and Loss Account so that normal costs are not disturbed. This also helps in drawing the attention of the management towards the exact losses due to abnormal idle time. The cost of abnormal idle time should be further categorised into controllable and uncontrollable. For each category, the break-up of cost due to various factors should be separately shown. This would help the management in fixing responsibility for controlling idle time. Management should aim at eliminating controllable idle time and on a long-term basis reducing even the normal idle time. This would require a detailed analysis of the causes leading to such idle time. Depending upon the particular causes, proper managerial action would be required to reduce the impact of such idle time. Basic control can be exercised through periodical reports on idle time showing a detailed analysis of the causes for the same, the departments where it is occurring and the persons responsible for it, along with a statement of the cost of such idle time. Illustration : X an employee of ABC Co. gets the following emoluments and� � benefits: (a) Basic pay (b) Dearness allowance (c) Bonus (d) Other allowances3.12

Rs. 1,000 p.m. Rs. 200 p.m. Rs. 20% of salary and D.A. Rs. 250 p.m.

Labour

(e) Employee s contribution to P.F. 10% of salary and D.A. X works for 2,400� � � hours per annum, out of which 400 hours are non-productive and treated as normal idle time. You are required to find out the effective hourly cost of employee X .� � Solution Statement showing computation of effective hourly cost of employee X� � (i) Earning of Employee X : Per month Rs. Basic pay Dearness Allowance Bonus� � Employees contribution to provident fund Other allowance (ii) Effective working� hours : Annual working hours Less : Normal idle time Effective working hours Effective hourly cost of X : Rs. 21,720/2,000 3.5 OVERTIME 2,400 400 2,000 10.86� � 1,000 200 240 120 250 1,810 Per annum Rs. 12,000 2,400 2,880 1,440 3,000 21,720

Work done beyond normal working hours is known as overtime work . Overtime has to� � be paid in India at double the rate of wages including dearness allowance and the value of food concession, according to the Factories Act, 1948. This Act as stated earlier also lays down that a worker is entitled to overtime when he works for more than 9 hours on any day or more than 48 hours in a week. Occasional overtime is a healthy sign since it indicates that the firm has the optimum capacity and that the capacity is being fully utilised. But persistent overtime is rather a bad sign because it may indicate either : (a) that the firm needs larger capacity in men and machines, or (b) that men have got into the habit of postponing their ordinary work towards the evening so that they can earn extra money in the form of overtime wages. Overtime work may arise in a department in one of the following circumstances : (1) The customer may agree to bear the entire charge of overtime because of urgency of

3.13

Cost Accounting

work. (2) Overtime may be called for to make up any shortfall in production due to some unexpected development. (3) Overtime work may be necessary to make up a shortfall in production due to some fault of management. (4) Overtime work may be resorted to, to secure an out-turn in excess of the normal output to take advantage of an expanding market or of rising demand. Overtime premium : Overtime payment is the amount of wages paid for working beyond normal working hours. The rate for overtime work is higher than the normal time rate; usually it is at double the normal rates. The extra amount so paid over the normal rate is called overtime premium. Effect of overtime payment on productivity : Overtime work should be resorted to only when it is extremely essential because it involves extra cost. The overtime payment increases the cost of production in the following ways : 1. 2. 3. 4. The overtime premium paid is an extra payment in addition to the normal rate. The efficiency of operators during overtime work may fall and thus output may be less than normal output. In order to earn more the workers may not concentrate on work during normal time and thus the output during normal hours may also fall. Reduced output and increased premium of overtime will bring about an increase in costs of production.

Treatment of overtime premium in Cost Accounting : Under Cost Accounting the overtime premium is treated as follows : (1) If overtime is resorted to at the desire of the customer, then overtime premium may be charged to the job directly. (2) If overtime is required to cope with general production programmes or for meeting urgent orders, the overtime premium should be treated as overhead cost of the particular department or cost centre which works overtime. (3) If overtime is worked in a department due to the fault of another department, the overtime premium should be charged to the latter department. (4) Overtime worked on account of abnormal conditions such as flood, earthquake etc., should not be charged to cost, but to Costing Profit and Loss Account. Steps for controlling overtime : To keep overtime to its minimum, it is necessary to exercise proper control over the overtime work. The suitable procedure which may be adopted for3.14

Labour

controlling overtime comprises the following steps : 1. Watch on the output during normal hours should be maintained to ensure that overtime is not granted when normal output is not obtained during the normal hours, without any special reasons. Statement concerning overtime work be prepared along with justifications, at appropriate places for putting up before the competent authority. Prior sanction about overtime should be obtained from competent authority. Actual rate of output produced during the overtime period should be compared with normal rate of output. Periodical reports on overtime wages should be sent to top management for taking corrective action. If possible an upper limit may be fixed for each category of workers in respect of overtime.

2. 3. 4. 5. 6.

Illustration : It is seen from the job card for repair of the customer s equipment� that a total of 154 labour hours have been put in as detailed below : Worker A� � paid at Rs. 2 per day of 8 hours Monday Tuesday Wednesday Thursday Friday Saturday Total 10 - 1/2 hours 8 10 - 1/2 hours 9 - 1/2 10 - 1/2 - 49 hours Worker B� � � � � paid at Re. 1 per day of 8 hours 8 hours 8 8 8 8 8 48 hours Supervisory� � � � � worker C paid of Rs. 3 per day of 8 hours 10 - 1/2 hrs. 8 10 - 1/2 hours 9 -� � � 1/2 10 - 1/2 8 57 hours� � �

In terms of an award in a labour conciliation, the workers are to be paid dearness allowance on the basis of cost of living index figures relating to each month which works out @ Rs. 96 for the relevant month. The dearness allowance is payable to all workers irrespective of wage rate if they are present or are on leave with wages on all working days. Sunday is a weekly holiday and each worker has to work for 8 hours on all week days and 4 hours on Saturdays; the workers are however paid full wages for Saturday (8 hours for 4 hours worked).

3.15

Cost Accounting

Workers are paid overtime according to the Factories Act for hours worked in excess of normal working hours on each day. Excluding holidays (including 4 hours work to be put in on Saturday) the total number of hours work out to 172 in the relevant month. The company s contribution to Provident Fund and Employees State� Insurance Premium are absorbed into overheads. Work out the wages payable to each worker. Solution (1) Calculation of hours to be paid for worker A : Normal hours Monday Tuesday Wednesday Thursday Friday Saturday 8 8 8 8 8 40 Extra hours 1 1 1 1 4 Overtime hours 1 1 1 5 Equivalent normal overtime 3 3 1 3 10 Total normal� � � � hours 12 8 12 10 12 54

hours of hours

Worker B will get wages for 52 hours i.e., actually worked plus 4 hours worked extra on Saturday. Worker C will get wages for 66 hours the same as for A till� Friday plus 12 hours for work on Saturday. (a) Wages payable : Basic wages per hour (Rs.) Dearness allowance per hour (Rs.) Hourly rate (Rs.) Normal hours Overtime hours Normal wages (Rs.) Overtime wages (Rs.) Total wages payable : (Rs.) A 0.250 0.500 0.750 44 5 33.00 7.50 40.50 B 0.125 0.500 0.625 52 32.50 32.50 C 0.375 0.500 0.875 56 5 49.00 8.75 57.75

3.16

Labour

Illustration In a factory, the basic wage rate is Rs. 10 per hour and overtime rates are as follows : Before and after normal working hours Sundays and holidays During the previous year, the following hours were worked : Normal time Overtime before and after working hours Overtime on Sundays and holidays Total The following hours have been worked on job Z : Normal Overtime before and after� � working hrs. Sundays and holidays : : : 1000 hours. 100 hours. 25 hours. : : : : 1,00,000 hours 20,000 hours 5,000 hours 1,25,000 hours : : 175% of basic wage rate 225% of basic wage rate

Total : 1125 hours. You are required to calculate the labour cost chargeable to jobs Z and overhead in each of the following instances: (a) Where overtime is� � worked regularly throughout the year as a policy due to the labour shortage. (b) Where overtime is worked irregularly to meet the requirements of production. (c) Where overtime is worked at the request of the customer to expedite the job. Solution Workings Computation of average inflated wage rate (including overtime premium) : Basic wage rate Overtime wage rate before and after working hours Overtime wage rate for Sundays and holidays Annual wages for the previous year for normal time Wages for overtime before and after working hours : Rs. 10 per hour : Rs. 10 175% = Rs. 17.50 per hour : Rs. 10 225% =Rs. 22.50 per hour : 1,00,000� � hrs. Rs. 10 = Rs. 10,00,000 : 20,000 hrs. Rs. 17.50=Rs. 3,50,000� �

3.17

Cost Accounting

Wages for overtime on Sundays and holidays Total wages for 1,25,000 hrs. Average inflated wage rate

: 5,000 hrs. Rs. 22.50 = Rs. 1,12,500 = Rs. 14,62,500 : Rs. 14,62,500 = Rs.� 11.70 per hour.

= 1,25,000 hrs. (a) Where overtime is worked regularly as a policy due to labour shortage, the overtime premium is treated as a part of labour cost and job is charged at an inflated wage rate. Hence, Labour cost chargeable to job Z = Total hours Inflated wage rate = 1,125 hrs. Rs. 11.70 = Rs. 13,162.50 (b) Where� � overtime is worked irregularly to meet the requirements of production, basic wage rate is charged to the job and overtime premium is charged to factory overheads as under : Labour cost chargeable to Job Z : 1,125 hours @ Rs. 10 per hour Factory overhead : 100 hrs. Rs. (17.50 10) 25 hrs. Rs. (22.50 10) = = = Rs.� � � � 11,250.00 Rs. Rs. 750.00 312.50

Total factory overhead Rs. 1,062.50 (c) Where overtime is worked at the request of the customer, overtime premium is also charged to the job as under : Rs. Job Z labour cost Overtime premium Total 3.6 LABOUR TURNOVER 1,125 hrs. @ Rs. 10 100 hrs. @ Rs. (17.50 10) 25 hrs. @ Rs. (22.50 10) = = = 11,250.00 750.00 312.50� � 12,312.50

Labour turnover in an organisation is the rate of change in the composition of labour force during a specified period measured against a suitable index. The standard of usual labour turnover in the industry or locality or the labour turnover rate for a past period may be taken as the index or norm against which actual turnover rate is compared. There are three methods of calculating labour turnover which are given below :

3.18

Labour

(i) (ii)

Replacement method = Separation method =

Number of employees replaced 100 Average number of employees on roll�

Number of employees separated during the year 100 Average number of employees on� rolls during the period

(iii) Flux method =

Number of employees separated + number of employees replaced 100 Average number� of employees on rolls during the period

Labour turnover due to new recruitment: Workers joining a business concern on account of its expansion do not account for labour turnover. But these newly recruited workers are certainly responsible for a change in the composition of labour force, due to this feature, some cost accountants measure workers to the extent of new (excluding replacements) joining the labour force as follows :

No. of new workers joining in a period (excluding replacements) 100 Average� number of workers on the roll in a periodThe total number of workers joining, including replacements, are called accessions. The labour turnover rate, in such a case, may also be computed in respect of total number of workers joining (accessions) the business concern, during a given period both on account of replacements and because of expansion is as under :

No.of accessions in a period 100 Average number of workers in a period�When number of accessions are considered for measuring labour turnover, the labour turnover rate by flux method may be computed by using any one of the following expressions :Labour turnover rate (Flux method) = No. of separations + No. of replacements + No. of new recruitments 100 Average number of workers�

OR

No. of separations + No. of accessions 100 Average number of workers�The above rate of labour turnover indicates the total effect of number of workers separated, number of workers replaced and number of new workers recruited and joined the concern on account of its expansion, etc. If in the above computations, the data given is for a period other than a year, the labour turnover rate so computed may be converted into equivalent annual labour turnover rate by the following formula:

3.19

Cost Accounting

Equivalent annual labour turnover rate

=

Turnover rate for the period 365 Number of days in the period�

Causes of labour turnover : The main causes of labour turnover in an organisation/industry can be broadly classified under the following three heads : (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) (ii) Change of jobs for betterment. Premature retirement due to ill health or old age.

(iii) Domestic problems and family responsibilities. (iv) Discontent over the jobs and working environment. In all the above cases the employee leaves the organisation at his will and, therefore, it is difficult to suggest any possible remedy in the first three cases. But the last one can be overcome by creating conditions leading to a healthy working environment. For this, officers should play a positive role and make sure that their subordinates work under healthy working conditions. 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) (ii) Seasonal nature of the business; 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 : (1) Dissatisfaction with job, remuneration, hours of work, working conditions, etc.,

3.20

Labour

(2) Strained relationship with management, supervisors or fellow workers; (3) Lack of training facilities and promotional avenues; (4) Lack of recreational and medical facilities; (5) Low wages and allowances. Proper and timely management action can reduce the labour turnover appreciably so far as avoidable causes are concerned. Effects of labour turnover High labour turnover increases the cost of production in the following ways: (i) (ii) Even flow of production is disturbed; Efficiency of new workers is low; productivity of new but experienced workers is low in the beginning;

(iii) There is increased cost of training and induction; (iv) New workers cause increased breakage of tools, wastage of materials, etc. In some companies, the labour turnover rates are as high as 100%; it means that on the average, all the work is being done by new and inexperienced workers. This is bound to reduce efficiency and production and increases the cost of production. Two types of costs which are associated with labour turnover are : (a) Preventive costs : These include costs incurred to keep the labour turnover at a low level, i.e. cost of medical services, welfare schemes and pension schemes. If a company incurs high preventive costs, the rate of labour turnover is usually low. (b) 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 good work, additional costs will have to be incurred on new workers, i.e., cost of employment, training and induction, abnormal breakage and scrap and extra wages and overheads due to the inefficiency of 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, work out the optimum level of labour turnover keeping in view its personnel policies and the behaviour of replacement cost and preventive costs at various levels of labour turnover rates. Remedial steps to minimise labour turnover - The following steps are useful for minimising labour turnover. 1. Exit interview : An interview be arranged with each outgoing employee to ascertain the

3.21

Cost Accounting

reasons of his leaving the organisation. 2. 3. Job analysis and evaluation : Before recruiting workers, job analysis and evaluation may be carried out to ascertain the requirements of each job. Scientific system of recruitment, placement and promotion - The organisation should make use of a scientific system of recruitment, selection, placement and promotion for employees. Enlightened attitude of management - The management should introduce the following steps for creating a healthy working atmosphere : (i) (ii) 5. Service rules should be framed, discussed and approved among management and workers, before their implementation. Provide facilities for education and training of workers.

4.

(iii) Introduce a procedure for settling worker s grievances. Use of committee :� Issues like control over workers, handling their grievances etc., may be dealt by a committee, comprising of members from management and workers.

Illustration The management of Bina and Rina Ltd. are worried about their increasing labour turnover in the factory and before analyzing the causes and taking remedial steps, they want to have an idea of the profit foregone as a result of labour turnover in the last year. Last year sales amounted to Rs. 83,03,300 and P/V ratio was 20 per cent. The total number of actual hours worked by the Direct Labour force was 4.45 Lakhs. As a result of the delays by the Personnel Department in filling vacancies due to labour turnover, 1,00,000 potentially productive hours were lost. The actual direct labour hours included 30,000 hours attributable to training new recruits, out of which half of the hours were unproductive. The costs incurred consequent on labour turnover revealed, on analysis, the following : Settlement cost due to leaving Recruitment costs Selection costs Rs. 43,820 Rs. 26,740 Rs. 12,750

Training costs Rs. 30,490 Assuming that the potential production lost as a consequence of labour turnover could have been sold at prevailing prices, find the profit foregone last year on account of labour turnover.

3.22

Labour

Solution Determination of contribution foregone Actual hours worked (given) Less : Unproductive training hours Actual productive hours The potentially productive hours lost are 1,00,000 Sales lost for 1,00,000 hours =Rs.83,03,300 1,00,000 hrs = Rs. 19,31,000 4,30,000 hrs�

4,45,000 15,000 4,30,000

Contribution lost for 1,00,000 hrs. Rs.19,31,000 = 20 = Rs.� 3,86,200...........(i) 100 Statement showing profit foregone last year on account of labour turnover of Bina and Rina Ltd. Rs. Contribution foregone as per (i) Settlement cost due to leaving Recruitment cost Selection cost Training costs Profit foregone Illustration The Cost Accountant of Y Ltd. has computed labour turnover rates for the quarter ended 31st March, 2007 as 10%, 5% and 3% respectively under Flux method , Replacement method and Separation method� � � � � � respectively. If the number of workers replaced during that quarter is 30, find out the number of: (1) workers recruited and joined and (2) workers left and discharged. 3,86,200 43,820 26,740 12,750 30,490 5,00,000

3.23

Cost Accounting

Solution Working Note: Average number of workers on roll:

Labour turnover rate under replacement method =5 100

No. of replacements 100 Average number of workers on roll�30 Average number of workers on roll

Or

=

Or Average number of workers on roll =

30 100 = 600 5�

(1) Number of workers recruited and joined : Labour turnover rate = (Flux method) (Refer to Working Note) Or Or

No. of separations * (S) + No. of accessions(A) 100 Average number of workers on� roll

10 = 100A =

18 * + A 600? 6000 ? ? 100 -18? = 42 ? ?

No. of workers recruited and joined 42. (2) Number of workers left and discharged : Labour turnover rate = (Separation method) (Refer to working note)

No. of separations(S) 100 Average number of workers on roll�

3 S = 100 600Or S*3.24

S* = 18

Labour

Hence, number of workers left and discharged comes to 18. 3.7 INCENTIVE SYSTEM

3.7.1 Important factors necessary for introducing an incentive system : An incentive can be defined as the stimulation for effort and effectiveness by offering monetary inducement or enhanced facilities. It may be monetary in the form of a bonus or non-monetary tending to improve living and working conditions. It may be provided individually or collectively. In the first case, the employee gets a reward for his efforts directly and in the second, a group of employees share the reward arising out of their combined effort in equitable production. The main factors that should be taken into account before introducing a scheme of incentives are stated below : (i) The need for producing goods of high quality or those having very good workmanship or finish and the manner this can be ensured. Only if a system of quality control can be relied upon to maintain the quality of goods of the standard required, an incentive scheme should be introduced; otherwise, workers should be paid on time basis. The need to maximise production thus required incentives to be given to workers. But sometimes� workmanship is more important than quantity of output; in such cases, incentive schemes of wage payment are not suitable.

(ii)

(iii) Where the quantity of work done cannot be measured precisely, incentive schemes cannot be offered. (iv) The role of management and workers in achieving greater efficiency, if it is unnecessary for the management to constantly plan work for example, when the work is repetitive, workers should be offered good incentives to achieve high efficiency; but in case management is constantly required to plan the work, as in the case of job work, the management should share the fruits of extra efficiency achieved. This factor determines the choice of a particular incentive scheme. (v) Whether the quantity of output is within the control of the worker and if so, to what extent. Sometimes, as in the case of chain assembly work the output is not dependent on the effort put in by workers; incentive schemes in such cases are not suitable. (vi) The exactitude with which standards of performance can be laid down. Fixation of standard is necessary for the introduction of a scheme of incentives. When this requires heavy expenditure, incentive schemes may be rather costly. (vii) The effect of an incentive scheme for one set of workers on other workers. If for instance, an incentive scheme makes it possible for unskilled workers to earn high wages, the wage rates for skilled workers must also be raised (if they are paid on time basis) to avoid dissatisfaction among them. In that event, the incentive scheme may raise

3.25

Cost Accounting

labour cost instead of lowering it. (viii) The system of wage payment prevailing in other areas and industries or similar occupations. If possible, there should be uniformity. (ix) The attitude of labour and trade unions towards incentive schemes. Workers usually like to have a certain guaranteed time-basis wage but also like to earn extra through an incentive scheme. On the whole, the system of wage payment should be such as would increase production without lowering quality. This will increase the surplus and will enable the employer to pay higher wages which, in turn, will lead to higher output. 3.7.2 Main principles for a sound system of wage incentive : The objective of wage incentives is to improve productivity and increase production so as to bring down the unit cost of production. In order to make the incentive scheme effective and useful, the following general principles have to be considered while designing a sound system of wage incentives. (i) The reward for a job should be linked with the effort involved in that job and the scheme should be just and fair to both employees and employers. This involves the following : (a) The standard required of the workers should be carefully set, if possible through proper time and motion studies. (b) If the work is of repetitive type, the entire benefit of the time saved should be available to the worker but, in the case of non-standardised work or where precise standards cannot be set, the benefit of the time saved, if any, should be shared by the employer, the supervisor and the worker. (ii) The scheme should be clearly defined and be capable of being understood by the employees easily. The standards set should be such that they can be achieved even by average employees. While standards are being set, the workers concerned should be consulted.

(iii) As far as possible, no limit should be placed on the amount of additional earnings, otherwise it will dampen the initiative of the workers. In this regard, what is important is not what actually prevails but what the workers think if they� think, even wrongly, that the employer will stop wages from rising beyond a certain limit, the incentive scheme may not be really effective. (iv) The scheme should be reasonable and stable, and should not be changed or modified too often without consulting the employees. (v) The scheme should take care that the employees are not penalised for reasons beyond their control. (vi) The scheme should provide for inspection of output so that only good pieces qualify for3.26

Labour

incentives. It would even be better not to introduce any incentive scheme if workmanship is of vital importance in sales. (vii) The management should ensure that there is no cause for complaint by the workers that they are sitting idle, say for want of tools or materials. Management has to see that there is, as far as practicable, no interruption of production. (viii) The operation of the scheme should not entail heavy clerical costs. In fact the scheme should facilitate the introduction of budgetary control and standard costing. (ix) It should be capable of improving the morale of the employees and it should be in conformity with the local trade union agreements and other government regulations. (x) There should be a guaranteed wage on time basis which generally works as a good psychological boost to incentive scheme. (xi) Last, but not least, the effect of incentive scheme on those who cannot be covered should be gauged and taken note of. Sometimes, highly skilled workers have perforce to be paid on time basis whereas semiskilled or unskilled workers may be put on incentive scheme. If the latter earn more than former, the incentive schemes on the whole prove harmful. 3.7.3 Essential characteristics of a good incentive system : to recapitulate (i) (ii) It should be just both to the employer and to the employee. It should be positive and not unnecessarily punitive and so operated as to promote confidence. It should be strong both ways i.e. it should have a standard task and a generous return. The latter should be in direct proportion to employee s efforts. It should reflect the� employer s contribution to the success of the company.�

(iii) It should be unrestricted as to the amount of the earning. (iv) It should be reasonable, apart from being simple, for employee to figure out his incentive in relation to his individual performance, as far as practicable. (v) It should be flexible and intimately related to other management controls. (vi) It should automatically assist supervision and, when necessary, aid team work. (vii) It should have employee s support and in no way should it be paternalistic. (viii) It� should have managerial support in so far as production material, quality control, maintenance and non-financial incentives are concerned. (ix) It should not be used temporarily and dropped in recission times as means of wage reduction. 3.7.4 Procedure for laying down an incentive system : An incentive is a reward for effort made; hence correct measurement of the effort involved is a prerequisite for any incentive

3.27

Cost Accounting

system. Measurement of effort is made by time and motion study by specialists appointed for the purpose. Based on its finding and that of job evaluation, the rates of wages are fixed for different operations. The levels of efficiency that must be attained to qualify for incentives are then fixed on a consideration of the factors mentioned above. Having drawn up the broad outlines of the scheme, the next step is to educate the workers as regards the benefits of the proposed scheme. This is done through joint consultation with the leading employees or with union representatives. The scheme is then publicised extensively with the specimen, calculations of the rewards that would arise under it. After the basic scheme has been accepted by all, a decision on two vital points will have to be made viz. how spoiled work will be treated and the intervals at which payment of wages will be made. An incentive system tends to increase the rate of production and consequently increases spoilage. But the very purpose of the scheme would be defeated if spoilage increases beyond a certain limit. It is, therefore, necessary that the method of treating the spoiled work should be agreed upon in advance. The prevention of spoiled work can be encouraged either by making the worker do the job again in his own time or by paying the worker at the time rate for the period covered by spoiled work not giving him credit at all for the spoiled work; of these, the first method is more commonly employed since it is both equitable and deterrent. The incentive should be paid promptly at short intervals of time. This would give the worker immediate satisfaction of having earned something by the extra effort he had put in. If payment is delayed the effect of the incentive would be greatly diminished. 3.8 LABOUR UTILISATION

For identifying utilisation of labour a statement is prepared (generally weekly) for each department / cost centre. This statement should show the actual time paid for, the standard time (inlcuding normal idle time) allowed for production and the abnormal idle time analysed for causes thereof. 3.8.1 Distinction between Direct and Indirect Labour Cost : Any labour cost that is specifically incurred for or can be readily charged to or identified with a specific job, contract,. work order or any other unit of cost, is termed as direct labour cost; it includes : (i) all labour that is engaged in converting raw materials into manufactured articles in the case of manufacturing industries, and (ii) other forms of labour, which although not immediately engaged in converting raw materials into manufactured articles nonetheless is incurred wholly or specifically for any particular unit of production and hence, can be readily identified with the unit of production (Example: A helper attending solely a machine operator in the case of manufacturing industries ; the entire contingent of labour and staff employed on a construction job or project). Any labour that does not meet the above test is indirect, e.g. men generally employed in machine shop such as tool setters, fitters, workers in tool room, stores, etc. Their wages are charged as indirect expenses.3.28

Labour

Page 26 on Landscape file Blank page for insertion�

3.29

Cost Accounting

Thus direct labour is for a specific job or product while indirect labour is for work in general. In a printing press, for example, wages paid to compositors will be direct while wages paid to the cleaners of machines will be indirect. The distinction is one relative to each particular firm or industry. Labour which is direct in one unit may indeed be indirect in another where the work or process or method of manufacture is different in nature. The importance of the distinction lies in the fact that whereas direct labour can be identified with and charged to the job, indirect labour cannot be so charged and has therefore to be treated as part of the factory overheads to be included in the cost of production on some suitable basis of apportionment and absorption. 3.8.2 Identification of utilisation of labour with cost centres : For the identification of utilisation of labour with the cost centre a wage analysis sheet is prepared. Wage analysis sheet is a columnar statement in which total wages paid are analysed according to cost centre, jobs, work orders etc. The data for analysis is provided by wage sheet, time card, piece work cards and job cards. The preparation of such sheet serves the following purposes : (i) (ii) It analyse the labour time into direct and indirect labour by cost centres, jobs, work orders. It provides details of direct labour cost comprises of wages, overtime to be charged as production cost of cost centre, jobs or work orders. Wage Analysis Sheet No. week- Department/ ending cost centre Total Work in progress Factory control A/c Administration A/c Selling & Distribution overhead control Account Overhead Overhead control

(iii) It provides information for treatment of indirect labour cost as overhead expenses.

3.30

Labour

ABC & CO. Wages Analysis Sheet (Sharing break up of work in progress)�Job No. 1 Clock No. Hrs. Job No. 2 Amount Clock No. Hrs. Amount Job No. 3 Clock No. Hrs. Amount Job No. Hrs. Summary Cost Ledger Folio Amount Total

Total

3.8.3 Identification of labour hours with work order or batches or capital job : For identification of labour hours with work order or batches or capital jobs or overhead work orders the following points are to be noted : (i) The direct labour hours can be identified with the particular work order or batches or capital job or overhead work orders on the basis of details recorded on source document such as time sheet or job cards. The indirect labour hours cannot be directly identified with the particular work order or batches or capital jobs or overhead work orders. Therefore, they are traced to cost centre and then assigned to work order or batches or capital jobs or overhead work orders by using overhead absorption rate. SYSTEMS OF WAGE PAYMENT AND INCENTIVES

(ii)

3.9

There exist several systems of employee wage payment and incentives, which can be classified under the following heads :

3.31

Cost Accounting

SYSTEMS OF WAGE PAYMENT & INCENTIVESTime Rate Systems Payment by Results

Time Rate System

High Wage Plan

Measured Day Work

Differential Time Rate

Piece Work

Combination of Time and Piece Work

Premium Bonus Methods

Group System of wage payment

System of Incentive Schemes for Indirect Workers

Straight Piece Work

Differential Piece Work

Halsey Rowan and Halsey System Weir Systems Merrick System

Barth System

Taylor System Gantt Task and Bonus System

Emerson s Efficiency System�

Points Scheme

Accelerated Premium System

Beadaux Syst.

Haynes Syst.

One should remember that Provident Fund, Employees State Insurance Corporation Premium and bonus are payable on the basic wages, dearness allowance and value of food concession. 3.9.1 Time rate system : It is perhaps the oldest system of remunerating labour. It is also known by other names such as time work, day work, day wages and day rates. Under this system, the worker is paid by the hour, day, week, or month. The amount of wages due to a worker are arrived at by multiplying the time worked (as shown by the gate card) by the appropriate time rate. The time rate here is fixed after taking into account the rates relevant in the particular industrial locality for similar trade and skill. The rate may be either fixed or may be a progressive one, starting from a minimum and rising upto a maximum, in stages, through periodical increments.

3.32

Labour

Merits :

(i) Simple to understand and to calculate wages. (ii) Reduces temptation on the part of workers to increase the output at the cost of quality.

Demerits: (i) No monetary incentive to raise the level of production. (ii) No distinction between the slow and the efficient worker. (iii) The tendency is for the fall in output; this raises the cost per unit (because both labour and fixed expenses will be spread over a smaller number of units). (iv) A firm cannot be sure of labour costs per unit under this method and, hence, may suffer a loss on quotations if already submitted. In the following cases, time rates are to be preferred. (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 chemical plants. 3.9.2 High wage plan : This plan was first introduced by Ford Motor Company (in USA) in order to induce workers to exercise extra effort in their work. Under this plan a worker is paid a wage rate which is substantially higher than the rate prevailing in the area or in the industry. In return, he is expected to maintain a very high level of performance, both quantitative and qualitative. As a result, high rate men are not as costly or expensive as they might appear at first sight. High wage plan is suitable where high quality of work and also increased productivity are required. The advantage which may accrue from the implementation of this plan are : (1) It is simple and inexpensive to operate. (2) It helps in attracting highly skilled and efficient workers by providing suitable incentive. (3) It reduces the extent of supervision. (4) Increased productivity may result in reduction of unit labour cost. 3.9.3 Measured day work : According to this method the hourly rate of the time worker consists of two parts viz, fixed and variable. The fixed element is based on the nature of the job i.e. the rate for this part is fixed on the basis of job requirements. The variable portion varies for each worker depending upon his merit rating and the cost of living index. The aggregate of fixed and variable part for a day is termed as Measured day s work rate of a worker.�

3.33

Cost Accounting

As the rate is based on two different elements, there are separate time rates not only for each worker but also for each job. This method does not find much favour with workers due to the following : 1. 2. The rates fixed are not easily understood by the workers. Merit rating tends to be arbitrary and unless changed at rapid intervals, the ratings will not reflect the correct ranking of the qualities of a worker.

3.9.4 Differential time rate : According to this method, different hourly rates are fixed for different levels of efficiency. Up to a certain level of efficiency the normal time or day rate is paid. Based on efficiency level the hourly rate increases gradually. The following table shows different differential rates : Up to, say 75% efficiency From 76% to 80% efficiency From 81% to 90% efficiency From 91% to 100% efficiency From 101% to 120% efficiency Normal (say Rs. N per hr.) 1.10 N 1.20 N 1.30 N 1.40 N� � � �

As this method is linked with the output and efficiency of workers, therefore, it cannot be strictly called as a time rate method of wage payment. This method in fact is similar to differential piece work system. 3.9.5 Payment by result : Under this system the payment made has a direct relationship with the output given by a worker. The attendance of the worker or the time taken by him for doing a job has no bearing on the payment. The system of payment by results may be classified into the following four categories : (a) Systems in which the payment of wages is directly proportionate to the output given by workers. (b) Systems in which the proportion of the wage payment to the worker increases progressively with increase in production. (c) Systems in which payment rate decreases with the increase in output. (d) Systems with earnings varying in proportions which differ at different levels of production. 3.9.6 Straight piece work system : Under this system of wage payment, each operation, job or unit of production is termed a piece. A rate of payment, known as the piece rate or piece work rate is fixed for each piece. The wages of the worker depend upon his output and rate of each unit of output; it is in fact independent of the time taken by him. The wages paid to a worker are calculated as :

3.34

Labour

Wages = Number of units produced Piece rate per unit. Considerable care and� judgment are called for fixing the piece rate. If the rate fixed is too high or too low, it would operate to the disadvantage of either the employer or the employee. Any attempt on the part of the management to revise a piece rate, erroneously set too high, is likely to lead to friction and conflict with labour. If on the other hand, it is too low, it would fail in its objective. The only way all this may be avoided is by employing scientific methods of job evaluation and time and motion study for the purpose of setting the rates. Advantages : 1. 2. 3. The system is simple to operate and also easy to understand. The incentive provided is quite effective as the workers get the full benefit of any increase in production and the employer also gains by saving on overhead costs. Labour cost per unit being constant, these can be calculated in advance and quotations can be confidently submitted. The quality of output usually suffers. Maintenance of detailed statistics as regards production of individual workers is necessary. Maintenance of satisfactory discipline in the matter of arrival and departure of workers becomes somewhat difficult. In the anxiety to produce as large a quantity as possible, workers may damage the machines and may also increase wastage of materials. Skilled workers and supervisors (who are often paid on time basis) may resent higher wages to unskilled workers paid on the piece basis.

Disadvantages : 1. 2. 3. 4. 5.

3.9.7 Differential piece work system : This system provide for higher rewards to more efficient workers. The main feature of all differential piece-work systems is that several piece rates on a slab scale are fixed for a job or operation which is put on piece-work. For different levels of output below and above the standard, different piece rates are applicable. Taylor Differential Piece Work System and Merrick Differential Piece Rate System are two important differential piece work systems discussed briefly as below: (a) Taylor s differential piece work system -� The Taylor s Differential Piece Rate System aims at rewarding efficient workers by� providing increased piece rate beyond certain level of output. Under this system two widely differing piece-rates are prescribed for each job. The lower rate is 83% of the normal piece rate and the higher rate is 125% of the normal piece rate. In other words the higher rate is 150% of the lower rate. The lower rate is given to a

3.35

Cost Accounting

worker when his efficiency level is less than 100%. The higher rate is offered at efficiency level of either 100% or more. Due to the existence of the two piece rates, the system is known as differential piece rate system. Note: Some authors also use 80% and 120% of the piece rates as lower and higher rates respectively at the efficiency levels, as indicated in the above paragraph. Advantages: 1. 2. 3. It is simple to understand and operate. The incentive is very good and attractive for efficient workers. It has a beneficial effect where overheads are high as increased production has the effect of reducing their incidence per unit of production.

This system is quite harsh to workers, as a slight reduction in output may result in a large reduction in the wages earned by them. This system is no longer in use in its original form, though the main idea behind it is used in many wage schemes. Illustration : Using Taylor s differential piece rate system, find the earnings of� the Amar, Akbar and Ali from the following particulars: Standard time per piece Normal rate per hour In a 8 hour day Amar produced Akbar produced Ali produced Solution Earnings under Differential piece rate system Workers Amar Standard output per day (units) Actual output per day (units) Efficiency (%) 24 23 95.83% Akbar 24 24 100% Ali 24 30 125% : : : : : 20 minutes Rs. 9.00 23 units 24 units 30 units

Actual output 100 Standarad output�

23 unit 100 24 unit�



3.36

Labour

* Earning rate per unit

83% of the piece rate

125% of the piece rate 3.75 (125% of Rs.3) 90.00

125% of the piece rate 3.75 (125% of Rs.3) 112.50

Earning rate per unit (Rs.) (Refer to working note) Earnings (Rs.)

2.49 (83% of Rs.3) 57.27

(23 units Rs. 2.49) ( 24 units Rs. 3.75) (30 units Rs. 3.75) * Under� � � Taylor s Differential price rate system, two widely differing price rates are� prescribed for each job. The lower rate is 83% of the normal piece rate and is applicable if efficiency of the worker is below 100%. The higher piece rate is 125% of the normal piece rate and is applicable if work completed is at efficiency level of 100% and above. Working Note: Normal rate per hour Normal rate per unit = = = Rs. 9.00

Rs.9.00 Rs.9.00 = Standard production per hour 3 unitsRs. 3

(b) Merrick differential piece rate system - Under this system three piece rates for a job are fixed. None of the fixed rates is below the normal. These three piece rates are as below: Efficiency Upto 83% Above 83% and upto 100% Above 100% Piece rate applicable Normal rate, 10% above normal rate. 20% or 30% above normal rate.

This system is an improvement over Taylor s Differential Piece Rate System.� Illustration Refer to the statement of previous Illustration and compute the earnings of workers under Merrick Differential Piece Rate System.

3.37

Cost Accounting

Solution Workers * Earning rate per unit (Refer to previous illustration) Amar 10% above the normal rate Akbar 10% above the normal rate Ali 20% above the normal rate or 30% above the normal Earning rate per unit (Rs.) Earnings (Rs.) 3.30 75.90 3.30 79.20 3.60 or 3.90 108 or 117 or (30 units Rs. 3.90) 3.9.8 Gantt task and� bonus system : This system is a combination of time and piece work system. According to this system a high standard or task is set and payment is made at time rate to a worker for production below the set standard. If the standards are achieved or exceeded, the payment to the concerned worker is made at a higher piece rate. The piece rate fixed under this system also includes an element of bonus the extent of 20%. The figure of bonus to such workers is calculated over the time rate of the workers. Thus in its essence, the system consists of paying a worker on time basis if he does not attain the standard and on piece basis if he does. Wages payable to workers under this plan are calculated as under : Output (i) (ii) Output below standard Output at standard Payment Guaranteed time rate. Time rate plus bonus of 20% (usually) of time rate. High piece rate on worker s� whole output. It is so fixed, so as to include a bonus of 20% of the time rate. Advantages : 1. It provides good incentive for efficient workers and at the same time protects the less efficient by guaranteeing the time rate.

(23 units Rs. 3.30)(24 units Rs. 3.30)(30 units Rs. 3.60)� � �

(iii) Output above standard

3.38

Labour

2. 3.

It is simple to understand and operate. It encourages better supervision and planning.

Disadvantage The guaranteed time rate may have the effect of weakening the urge of slower worker to increase his output. Illustration : In a factory the standard time allowed for completing a given task (50 units), is 8 hours. The guaranteed time wages are Rs. 20 per hour. If a task is completed in less than the standard time, the high rate of Rs. 4 per unit is payable. Calculate the wages of a worker, under the Gantt system, if he completes the task in (i) 10 hours; (ii) 8 hours, and (iii) in 6 hours. Also ascertain the comparative rate of earnings per hour under the three situations. Solution (i) (ii) When the worker performs the task in 10 hours, his earnings will be at the time wage rate i.e. 10 hours Rs. 20 per� hour = Rs. 200. When the worker performs the task is standard time i.e. in 8 hours, his earning will be: 8 hours Rs. 20 Total earnings = Rs. 160 Rs. 32 Rs.� 192 Bonus @ 20% of time wages =

(iii) When the worker performs the task in less than the standard time his earning will be at piece rate i.e. 50 units Rs. 4 per hour = Rs. 200 The comparative� rate of earnings per hour under the above three situations is: (i) (ii) Rs. 200/10 hrs. = Rs. 20 per hour Rs. 192/8 hrs. = Rs. 24 per hour

(iii) Rs. 200/6 hrs. = Rs. 33.33 per hour 3.9.9 Emerson s efficiency system :� Under this system minimum time wages are guaranteed. But beyond a certain efficiency level, bonus in addition to minimum day wages is given. A worker who is able to attain efficiency, measured by his output equal to 2/3rd of the

3.39

Cost Accounting

standard efficiency, or above, is deemed to be an efficient worker deserving encouragement. The scheme thus provides for payment of bonus at a rising scale at various levels of efficiency, ranging from 66.67% to 150%. For a performance below 66.67% only time rate wages without any bonus are paid. Above 66?% to 100% efficiency, bonus varies between 0.01% and 20%. Above 100% efficiency bonus of 20% of basic wages plus 1% for each 1% increase in efficiency is admissible. This system is superior to one to the differential piece rate in so far as it encourages the slow worker to do a little better than before. Also it does not presuppose a high degree of average performance. Wages on time basis are guaranteed. Illustration From the following information you are required to calculate the bonus and earnings under Emerson Efficiency System. The relevant information is as under: Standard working hours Standard output per hour in units Daily wage rate Actual output in units Worker A Worker B Worker C Solution Workers Actual output in units Standard output in units Efficiency level (%)? Actual output ? ? Standarad output 100? ? ? Rate of bonus�

: : :

8 hours a day 5 Rs. 50

25 units 40 units 45 units

Statement showing bonus and earnings under Emerson Efficiency System A 25 40 62.5% B 40 40 100% C 45 40 112.50%

No bonus 50 Nil 50

20% 50 10 (20% of Rs. 50) 60

Time wages (Rs.) Bonus (Rs.) Total earnings (Rs.)

32.50% (20% + 12.5%) 50 16.25 (32.5% of Rs. 50) 66.25

3.40

Labour

3.9.10 Points scheme or Bedeaux system : Under this scheme, firstly the quantum of work that a worker can perform is expressed in Bedaux points or B s. There points� represent the standard time in terms of minutes required to perform the job. The standard number of points in terms of minutes are ascertained after a careful and detailed analysis of each operation or job. Each such minute consists of the time required to complete a fraction of the operation or the job, and also an allowance for rest due to fatigue. Workers who are not able to complete tasks allotted to them within the standard time are paid at the normal daily rate. Those who are able to improve upon the efficiency rate are paid a bonus, equal to the wages for time saved as indicated by excess of B s earned (standard minutes for work done)� over actual time. Workers are paid 75% of the time saved. Illustration Calculate the earnings of worker from the following information under Bedeaux system : Standard time for a product A-30 seconds plus relaxation allowance of 50%. Standard time for a product B-20 second plus relaxation allowance of 50%. During 8 hour day for Actual output of product for A Actual output of product B Wage rate Solution Bedeaux point per unit of product A : 30 seconds + 15 seconds 45 = = 0.75 B s 60 60 Bedeaux point per unit of product B: 500 units. 300 units Rs. 10 per� hour

15 seconds + 10 seconds 30 = = 0.50 B s 60 60�Total production in terms of B s: 500 0.75 + 300 0.50 = 525 B s Standard B s� � � � � (8 hours 60) = 480 B s No. of B s saved (525 B s 480 B s) = 45 B s Earnings =� � � � � � � Hrs. worked rate per hour + 75/100 � �

45 Rs. 10 = Rs. 80 + Rs. 5.63 = Rs. 85.63 60�

3.41

Cost Accounting

3.9.11 Hayne s system : Under this system also the standard is set in minutes. The� standard time for the job is expressed in terms of the standard man-minutes called as MANIT . Manit stands for man-minute. In the case of repetitive work the time� � saved is shared between the worker and the foreman in the ratio 5 : 1. If the work is of non-repetitive nature, the worker, the employer and the foreman share the value of time saved in the ratio of 5 : 4 : 1. Each worker is paid according to hourly rate for the time spent by him on the job. 3.9.12 Accelerated premium system : Under this system earnings increase with output; the rate of increase of earnings itself increases progressively with output; in fact the earnings increase in greater proportion than the increase in production. This system acts as a strong incentive for skilled workers to earn high wages by increasing output and for production beyond standard. 3.9.13 Premium bonus methods : Under these methods, standard time is established for performing a job. The worker is guaranteed his daily wages (except in Barth System), if his output is below and upto standard. In case the task is completed in less than the standard time, the saved time is shared between the employee and the employer. There are two types of time-sharing plans in use viz., constant sharing plans and variable sharing plans. 3.9.14 Halsey and Halsey Weir systems : Under Halsey system a standard time is fixed for each job or process. If there is no saving on this standard time allowance, the worker is paid only his day rate. He gets his time rate even if he exceeds the standard time limit, since his day rate is guaranteed. If, however, he does the job in less than the standard time, he gets a bonus equal to 50 percent of the wages of time saved; the employer benefits by the other 50 percent. The scheme also is sometimes referred to as the Halsey fifty percent plan. Formula for calculating wages under Halsey system = Time taken Time rate + 50% of time saved� Time rate. The Halsey Weir System is the same as the Halsey System except that� the bonus paid to workers is 30% of the time saved. Advantages: 1. 2. Time rate is guaranteed while there is opportunity for increasing earnings by increasing production. The system is equitable in as much as the employer gets a direct return for his efforts in improving production methods and providing better equipment. Incentive is not so strong as with piece rate system. In fact the harder the worker works, the lesser he gets per piece. The sharing principle may not be liked by employees.

Disadvantages: 1. 2.3.42

Labour

Illustration Calculate the earning of a worker under Halsey System. The relevant data is as below : Time Rate (p.h.) Time allowed Time taken Time saved Solution Calculation of total earnings : 6 hrs. Re. 0.6 + 1/2 (2 hrs. Re. 0.60) or� � � Rs. 3.60 + Re. 0.60 = Rs. 4.20 Of his total earnings, Rs. 3.60 is on account of the time worked and Re. 0.60 is on account of his share of the premium bonus. 3.9.15 Rowan system : According to this system a standard time allowance is fixed for the performance of a job and bonus is paid if time is saved. Under Rowan System the bonus is that proportion of the time wages as time saved bears to the standard time. Formula for calculating wages under Rowan system = Time taken � Rate per hour + Advantages : 1. 2. 3. 1. 2. 3. It is claimed to be a fool-proof system in asmuch as a worker can never double his earnings even if there is bad rate setting. It is admirably suitable for encouraging moderately efficient workers as it provides a better return for moderate efficiency than under the Halsey Plan. The sharing principle appeals to the employer as being equitable. The system is a bit complicated. The incentive is weak at a high production level where the time saved is more than 50% of the time allowed. The sharing principle is not generally welcomed by employees. Re. 0.6 8 hours 6 hours 2 hours

Time Saved Time taken Rate per hour Time allowed� �

Disadvantages:

3.43

Cost Accounting

Illustration Calculate the earnings of a worker under Rowan System. The relevant data is given as below: Time rate (per Hour) Time allowed Time taken Time saved Solution Calculation of total earnings: = Time taken Rate per hour + = 6 hours � � Rs. 0.60 + Re. 0.6 8 hours. 6 hours. 2 hours.

Time Saved Time taken Rate per hour Time allowed� �

2 hours 6 hours 0.60 8 hours� �

= Rs. 3.60 + Rs. 0.90 = Rs. 4.50 3.9.16 Barth system : The formula used for calculating the remuneration under this system is as follows : Earnings = Hourly rate �

Standard hours Hours worked�

The system is particularly suitable for trainees and beginners and also for unskilled workers. The reason is that for low production efficiency, the earnings are higher than in the piece-work system but as the efficiency increases, the rate of increase in the earnings falls. Illustration A factory having the latest sophisticated machines wants to introduce an incentive scheme for its workers, keeping in view the following: (i) (ii) The entire gains of improved production should not go to the workers. In the name of speed, quality should not suffer.

(iii) The rate setting department being newly established are liable to commit mistakes. You are required to devise a suitable incentive scheme and demonstrate by an illustrative numerical example how your scheme answers to all the requirements of the management. Solution

3.44

Labour

Rowan Scheme of premium bonus (variable sharing plan) is a suitable incentive scheme for the workers of the factory. If this scheme is adopted, the entire gains due to time saved by a worker will not pass to him. Another feature of this scheme is that a worker cannot increase his earnings or bonus by merely increasing its work speed. The reason for this is that the bonus under Rowan Scheme is maximum when the time taken by a worker on a job is half of the time allowed. As this fact is known to the workers, therefore, they work at such a speed which helps them to maintain the quality of output too. Lastly, Rowan System provides a safeguard in the case of any loose fixation of the standards by the rate-setting department. It may be observed from the following illustration that in the Rowan Scheme the bonus paid will be low due to any loose fixation of standards. Workers cannot take undue advantage of such a situation. The above three features of Rowan Plan can be discussed with the help of the following illustration: (i) Time allowed Time taken Time saved Rate Bonus = = = = = = 4 hours 3 hours 1 hour Rs. 5 per hour

Time taken Time saved Rate Time allowed� �

3 hours 1 hour Rs. 5 = Rs. 3.75 4 hours In the above illustration time saved� � is 1 hour and, therefore, total gain is Rs. 5. Out of Rs. 5 according to Rowan Plan only Rs. 3.75 is given to the worker in the form of bonus and the remaining Rs. 1.25 remains with the management. In other words a worker is entitled for 75 percent of the time saved in the form of bonus.(ii) The figures of bonus in the above illustration when the time taken is 2 hours and 1 hour respectively are as below: Bonus =

Time taken Time saved Rate Time allowed 2 hours 2 hours Rs. 5 = Rs. 5 4� � � � hours

=

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Cost Accounting

=

1 hours 3 hours Rs. 5 = Rs. 3.75 4 hours� �

The above figures of bonus clearly show that when time taken is half of the time allowed, the bonus is maximum. When the time taken is reduced from 2 to 1 hour, the bonus figure fell by Rs. 1.25. Hence, it is quite apparent to workers that it is of no use to increase speed of work. This feature of Rowan Plan thus protects the quality of output. (iii) If the rate-setting department erroneously sets the time allowed as 10 hours instead of 4 hours, in the above illustration; then the bonus paid will be as follows: Bonus =

3 hours 7 hours Rs. 5 = Rs. 10.50 10 hours� �

The bonus paid for saving 7 hours thus is Rs. 10.50 which is approximately equal to the wages of 2 hours. In other words the bonus paid to the workers is low. Hence workers cannot take undue advantage of any mistake committed by the time setting department of the concern. Illustration (a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved equals the bonus paid under the Rowan System. When will this statement hold good ? (Your answer should contain the proof). (b) The time allowed for a job is 8 hours. The hourly rate is Rs. 8. Prepare a statement showing: (i) (ii) The bonus earned The total earnings of labour and

(iii) Hourly earnings. Under the Halsey System with 50% bonus for time saved and Rowan System for each hour saved progressively. Solution (a) Bonus under Halsey Plan = Standard wage rate 50/100 Time saved ...(i) Bonus under Rowan Plan =� � Standard wage rate �

Time taken Time taken Time allowed�

...(ii)

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Labour

Bonus under Halsey Plan will be equal to the Bonus under Rowan Plan when the following condition holds good = Standard wage rate 50/100 Time saved =� � Standard wage rate or or�

Time taken Time saved Time allowed�

1 Time taken = 2 Time allowedTime taken =

1 of time allowed. 2

Hence, when the time taken is 50% of the time allowed, the bonus under Halsey and Rowan Plans is equal. (b) Statement of Bonus, Total earnings of Labour and hourly earnings under Halsey and Rowan SystemsTime allowed Time taken Time saved Basic Wages Bonus under Halsey System Bonus under Rowan system Total earning under Total earning under Hourly earning under Halsey System Hourly earning under Rowan System

Halsey Rowan System System

B Rs. 8 C A B C =(A-B)� �

50 100

Rs. 8 E�

C B Rs. 8 D+E A� �F G H I J

D

hours 8 8 8 8 8 8 8 8

hours 8 7 6 5 4 3 2 1

hours 1 2 3 4 5 6 7

Rs. 64 56 48 40 32 24 16 8

Rs. 4 8 12 16 20 24 28

Rs. 7 12 15 16 15 12 7

Rs. 64 60 56 52 48 44 40 36

Rs. 64 63 60 55 48 39 28 15

Rs. 8.00 8.57 9.33 10.40 12.00 14.67 20.00 36.00

Rs. 8.00 9.00 10.00 11.00 12.00 13.00 14.00 15.00

Illustration Mr. A. is working by employing 10 skilled workers. He is considering the introduction of some

3.47

Cost Accounting

incentive scheme - either Halsey Scheme (with 50% bonus) or Rowan Scheme - of wage payment for increasing the labour productivity to cope with the increased demand for the product by 25%. He feels that if the proposed incentive scheme could bring about an average 20% increase over the present earnings of the workers, it could act as sufficient incentive for them to produce more and he has accordingly given this assurance to the workers. As a result of the assurance, the increase in productivity has been observed as revealed by the following figures for the current month : Hourly rate of wages (guaranteed) Average time for producing 1 piece by one worker at the previous performance (This may be taken as time allowed) No. of working days in the month No. of working hours per day for each worker Actual production during the month Required : 1. 2. 3. Calculate effective rate of earnings per hour under Halsey Scheme and Rowan Scheme. Calculate the savings to Mr. A in terms of direct labour cost per piece under the schemes. Advise Mr. A about the selection of the scheme to fulfil his assurance. 25 8 1,250 units 2 hours Rs. 2.00

Solution Working Notes: 1. Total time wages of 10 workers per month : = No. of working days in the month No. of working hours per day of each worker Hourly� � rate of wages No. of workers = 2. 25 days 8 hrs. Rs. 2 10 workers Time� � � � saved per month : Time allowed per piece by a worker No. of units produced during the month by 10 workers Total time allowed to produce 1,250 pieces (1,250 2� hours) 2 hours 1,250 pieces 2,500 hours = Rs. 4,000

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Labour

Actual time taken to produce 1,250 pieces Time saved (2,500 hours 2,000 hours)� 3. Bonus under Halsey scheme to be paid to 10 workers : Bonus = (50% of time saved) hourly rate of wages = 50/100 500 hours Rs. 2 = Rs. 500� � �

2,000 hours 500 hours

Total wages to be paid to 10 workers are (Rs. 4,000 + Rs. 500) Rs. 4,500, if Mr. A considers the introduction of Halsey Incentive Scheme to increase the labour productivity. 4. Bonus under Rowan Scheme to be paid to 10 workers : Bonus =

Time taken Time wages = Rs. 4,000 = Rs. 800 Time allowed� �

Total wages to be paid to 10 workers are (Rs. 4,000 + Rs. 800) Rs. 4,800, if Mr. A considers the introduction of Rowan Incentive Scheme to increase the labour productivity. 1. (i) Effective hourly rate of earnings under Halsey scheme : (Refer to Working Notes 1, 2 and 3) = =

Total time wages of 10 workers + Total bonus under Halsey scheme Total hours worked

Rs.4,000 + Rs.500 = Rs. 2.25 2,000 hours

(ii) Effective hourly rate of earnings under Rowan scheme : (Refer to Working Notes 1, 2 and 4) = = 2. (i)

Total time wages of 10 workers + Total bonus under Rowan scheme Total hours worked

Rs.4,000 + Rs.800 = Rs. 2.40 2,000 hours

Saving in terms of direct labour cost per piece under Halsey scheme : (Refer to Working Note 3) Labour cost per piece (under time wage scheme) = 2 hours Rs. 2 =� Rs. 4.

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Cost Accounting

Labour cost per piece (under Halsey scheme) =

Total wages paid under the scheme Rs.4,500 = = Rs. 3.60 Total number of units produced 1,250= Re. 0.40.

Saving per piece : (Rs. 4 Rs. 3.60) (Refer to Working Note 4)�

(ii) Saving in terms of direct labour cost per piece under Rowan Scheme : Labour cost per piece under Rowan scheme = Rs. 4,800/1,250 units = Rs. 3.84 Saving per piece = Rs. 4 Rs. 3.84 = Re. 0.16. 3. From the labour cost per piece under� Halsey scheme (Rs. 3.60) and Rowan scheme (Rs. 3.84), it is quite clear that Halsey scheme brings about more saving than Rowan scheme to the concern. But Halsey scheme does not fulfil the assurance given to the workers about 20% increase in their earnings as it secures only 12.5% [500/4,000] 100 increase.�

On the other hand, Rowan scheme secures 20% [800/4,000] 100 increase in the� earnings and it fulfils the assurance. Therefore, Rowan scheme may be adopted. Illustration Wage negotiations are going on with the recognised Labour Union and the Management wants you as the Cost Accountant of the Company to formulate an incentive scheme with a view to increase productivity. The case of three typical workers Achyuta, Ananta and Govida who produce respectively 180, 120 and 100 units of the company s product in a normal day of 8 hours is taken up for study.� Assuming that day wages would be guaranteed at 75 paise per hour and the piece rate would be based on a standard hourly output of 10 units, calculate the earnings of each of the three workers and the labour cost per 100 pieces under (i) Day wages, (ii) Piece rate, (iii) Halsey scheme, and (iv) The Rowan scheme. Also calculate under the above schemes the average cost of labour for the company to produce 100 pieces. Solution Calculation of earnings of each of the three workers and the labour cost per 100 pieces under different wage schemes. (i) Day wages Name of workers Day wages Actual output (units) Labour cost per 100 pieces

3.50

Labour

Rs. Achyuta Ananta Govinda Total 6.00 6.00 6.00 18.00 180 120 100 400

Rs. 3.33 5.00 6.00

Average cost of labour for the company to produce 100 pieces :

Rs.18 Total wages paid 100 = 100 = Rs. 4.50 400 Total output� �(ii) Piece rate Name of workers Actual output (units) Achyuta Ananta Govinda Total 180 120 100 400 Piece rate Rs. 0.075 0.075 0.075 Wages earned Rs. 13.50 9.00 7.50 30.00 Labour cost per 100 pieces Rs. 7.50 7.50 7.50

Average cost of labour for the company to produce 100 pieces : = 7.50 (iii) Halsey Scheme Name of workers Acutal output (units) Std. time for actual output Hrs. Achyuta Ananta Govinda 180 120 100 18 12 10 Actual time for actual output Hrs. 8 8 8 10 4 2 Time saved Hrs. Bonus Hrs. (50% of time saved Hrs.) 5 2 1

Rs.30 100 = Rs. 400�

Total including Bonus* Rs. 9.75 7.50 6.75

Labour 100 pieces Rs. 5.42 6.25 6.75

wages cost per

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Cost Accounting

24.00

Average cost of labour for the company to produce 100 pieces = 100 = Rs.6.00 *Total wages =

Rs.30 (Rs. 24/400) 400�

(Actual hours worked + bonus hours) Rate per hour�

Hence total wages of Achyuta are: (8 + 5) Rs. 0.75 = Rs. 9.75 Similarly, the� total wages of Ananta and Govinda are Rs. 7.50 and Rs. 6.75 respectively. (iv) Rowan Scheme:Name of workers Actual output (units) Std. time for actual output (hrs.) Actual time taken hours Time saved (hours) Bonus* Wages for hrs. actual hrs. @ 75 P per hr. Rs. (1) Achyuta Ananta Govinda (2) 180 120 100 (3) 18 12 10 (4) 8 8 8 (5) 10 4 2 (6) 4.44 2.67 1.6 (7) 6.00 6.00 6.00 Bonus @ 75 P per Bonus hour Rs. Rs. Total earnings Labour cost per 100 pieces Rs

(8) (7)+(8)=(9) (10) 3.33 2.00 1.20 9.33 8.00 7.20 24.53 5.18 6.67 7.20

Average cost of labour to the = company for 100 pieces *Bonus hours = Time taken � Bonus hours of Achyuta =

Rs.24.53 100 = Rs. 6.13 400�

Time saved Time allowed

8 hours 10 hours = 4.44 18 hours�

Similarly, bonus hours of Ananta and Govinda are 2.67 hours and 1.6 hours respectively. 3.9.17 Group System of wage payment : Certain jobs or operations are required to be performed collectively by a number of workers. Under such cases each man s work depends on the work performed by one or more of his colleagues and� as such it is not possible to measure separately the output of each worker.

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Labour

The workers constituting a group or a team here are considered as a composite unit and the combined output of such a unit is measured for the purpose of wage calculation. The methods usually used for distributing wages to each worker are the following : 1. 2. 3. 4. 5. Equally, if all the workers of the group are of the same grade and skill, same rate of pay and has worked for same duration. Prorata to the time-rate of each worker where the time spent by the individual worker is the same. On the basis of the time rates and attendance of each worker. On a specified percentage basis; the percentage applicable to a worker is predetermined on the basis of the skill, rate of pay etc. In a group of unskilled and skilled workers, a method of distribution is to pay the unskilled workers at their time rates. The balance amount remaining out of the total earnings after payment to the unskilled workers is distributed among the skilled workers by any of the methods discussed above.

Group Bonus - Group Bonus refers to the bonus paid for the collective efforts made by a group of workers. The amount of bonus is distributed among the individual members of the group on some agreed basis. Group Bonus Schemes - Under a group bonus scheme, bonus is paid to a team/group of employees working together. Such a scheme is introduced generally where individual efficiency cannot be established for the payment of bonus. For example, in the construction work, it is the team work of masons and labourers which produces results. If any incentive is to be offered, it should be offered to the team as a whole and not to an individual. Group bonus is based on the combined output of the team as a whole. The quantum of bonus is determined on the basis of the productivity of the team and the bonus is shared by individual workers in specified proportions, often in the proportion of wages on time basis. Objectives of Group Bonus Schemes: The objectives of a group bonus scheme are the following :(i) (ii) To create collective interest and team spirit among workers. To create interest among supervisors to improve performance.

(iii) To reduce wastage in materials and idle time. (iv) To achieve optimum output at minimum cost. (v) To encourage individual members of the group, team where only the output of the team as a whole can be measured. Advantages of Group Bonus Schemes :

3.53

Cost Accounting

1. 2. 3. 4.

They create a sense of team spirit since all the workers in a group realise that their personal incentives are dependent upon group effort. A spirit of healthy competition amongst various groups doing identical jobs is also created. This results is the elimination of excessive waste of materials. The operators and supervisors also feel interested in raising the production to higher levels. The scheme is usually easier to understand and entails less costing and accounting work. It is easier to set up group activity targets, since the performance unit is large.

Schemes of group bonus - There are five schemes of group bonus as discussed below : (1) Priestman s Production Bonus : This method was adopted by Priestman Bros.� Ltd., in 1917. According to this method when the actual production in units or points exceeds the standard fixed, a bonus is paid to the workers as additional wages equivalent to the percentage of actual output over the standard output. (2) Cost Efficiency Bonus : Under this scheme, the amount of bonus is calculated when the cost is reduced below the normal established targets. Targets of cost, for example, material cost, labour cost and overhead cost etc., per unit are fixed. If the measurement of actual performance shows a saving in the total labour and material cost or a reduction in the total cost per unit, a fair percentage of the saving is distributed among the staff. Three popular schemes usually used for calculating the amount to be distributed to workers as Bonus are as below : (i) Nunn-Bush Plan : According to this plan a norm of direct labour cost is fixed and expressed as a percentage of the sales value. The amount calculated at this percentage is credited to a fund. The actual labour cost is debited to this fund and the balance remaining to the credit of this fund is distributed as bonus to all the workers and employees. Scanlon Plan : Here also a fund is created for the normal cost of wages and salaries. This fund is debited with the actual labour costs. Two-thirds to threefourths of the credit balance, if any, is distributed as bonus, the balance is kept as reserve for future set-backs.

(ii)

(iii) Rucker Plan : This plan is quite similar to Nunn-Bush Plan except that the percentage for crediting the fund is based on the total value added by manufacturer (i.e. the total cost less the value of the material) and not on total sales value. (3) Town Gain Sharing Plan : Under this plan bonus is dependent upon a saving in the labour cost as compared to standard. The bonus is calculated at 50% of the saving achieved.

3.54

Labour

(4) Budgeted Expense Bonus : Bonus is determined in advance and paid as a percentage of savings effected in the actual total expenses as compared to the budgeted expense. It is payable to indirect workers also. (5) Waste Reduction Bonus : Bonus becomes payable under this scheme if the team of workers brings about a reduction in the percentage of material wastages as compared to the standard set. It is applicable to industries where the material cost assumes a greater proportion of the total cost. Many times group bonus schemes do not enjoy the approval of workers. Some workers tend to feel that their personal incentives are low merely because some members of the group are lazy or inefficient. Such workers believe that it is better to provide incentives on individual basis, if it is possible. 3.9.18 System of Incentive schemes for Indirect Workers: Since the setting of work standards and measurement of output in the case of indirect workers is not an easy task in respect of maintenance, internal transport, inspection, packing and cleaning, therefore the introduction of a system of payment by results for indirect workers is difficult. In spite of the aforesaid difficulty, it has been felt necessary to provide for incentives to indirect workers, due to the following reasons: 1. 2. 3. 4. 5. Payment of incentive bonus to direct workers and time rate to indirect workers leads to dissatisfaction and labour unrest. Indirect workers are as much entitled to bonus as direct workers. Bonus payment to indirect workers creates team spirit. An incentive system for indirect workers assists in maintaining the efficiency of services such as plant repairs, stores maintenance, material handling etc. The efficiency of direct workers is reduced where their work is dependent upon the service rendered by the indirect workers. Incentive to supervisors and foremen : Supervisors and foremen are an important link between the management and the workers. Incentive payment to these persons would assist in maintaining all round efficiency. Incentive to supervisors and foremen may be provided in the form of non-financial benefits. Incentive can also be provided to these workers in the form of Bonus. The extent of bonus which will be distributed as incentive will depend on the savings effected over the standards. (ii) Incentive to maintenance and repairs staff : Under mass production work, repair and maintenance duties can be considered as routine and repetitive for which percentage of

A few examples of incentive schemes to indirect workers are as below : (i)

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Cost Accounting

efficiency can be evaluated. In case such an evaluation is not possible or practicable, a group bonus system may be established, on the basis of reduction in breakdown or on the number of complaints. Illustration A, B and C were engaged on a group task for which a payment of Rs. 725 was to be made. A s time basis wages� are Rs. 8 per day, B s Rs. 6 per day and C s Rs. 5 per day. A worked for 25 days;� � B worked for 30 days; and C for 40 days. Distribute the amount of Rs. 725 among the three workers. Solution Total wages on time basis : A B C 25 @ Rs. 8 30 @ Rs. 6 40 @ Rs. 5 Rs. 200 180 200 580 Payment for the task Bonus : (Rs. 725 Rs. 580)� or, 25% of the time-basis wages. Earnings of each worker Worker A B C Illustration Both direct and indirect labour of a department in a factory are entitled to production bonus in accordance with a group incentive scheme, the outline of which is as follows : (a) For any production in excess of the standard rate fixed at 16,800 tonnes per month (of 28 days) a general incentive of Rs. 15 per tonne is paid in aggregate. The total amount payable to each separate group is determined on the basis of an assumed percentage of such excess production being contributed by it, namely @ 65% by direct labour, @ 15% Wages on time basis Rs. 200 180 200 580 Group task Bonus 25% Rs. 50 45 50 145 Total Rs. 250 225 250 725 145 725

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Labour

by inspection staff, @ 12% by maintenance staff and @ 8% by supervisory staff. (b) Moreover, if the excess production is more than 20% above the standard, direct labour also get a special bonus @ Rs. 5 per tonne for all production in excess of 120% of standard. (c) Inspection staff are penalized @ Rs. 20 per tonne for rejection by customer in excess of 2% of production. (d) Maintenance staff are also penalized @ Rs. 20 per hour for breakdown. From the following particulars for a month, work out production bonus earned by each group : (a) Actual working days (b) Production (c) Rejection by customer (d) Machine breakdown Solution 1. Standard output per day = = 2. : 25 : 21,000 tonnes : 500 tonnes : 40 hours

Standard output per month Budgeted number of days in a month 16,800 tonnes = 600 tonnes 28 days

Standard output for 25 days = 600 tonnes 25 days = 15,000 tonnes (a) General� Incentive (i) (ii) Standard output Actual output : : : 15,000 tonnes 21,000 tonnes 21,000 15,000 = 6,000 tonnes 40%�

(iii) Excess output over standard : (iv) Percentage of excess

production to standard output : (v) Aggregate general incentive (vi) Allocation of general incentive Direct labour : : :

6,00 tonnes 100 15,000 tonnes�= Excess output Rs. 15 = 6,000 tonnes Rs.15 = Rs. 90,000 65% of Rs. 90,000 Rs.� � 58,500

3.57

Cost Accounting

Inspection staff : Maintenance staff : Supervisory staff : Total (b) Special bonus to direct workers (i) (ii) (i) (ii)

15% of Rs. 90,000 Rs. 13,500 12% of Rs. 90,000 Rs. 10,800 8% of Rs. 90,000 Rs. 7,200 Rs. 90,000

20% is the excess output over 120% of standard output or 3,000 tonnes (15,000 tonnes 20%) Special incentive = 3,000 tonnes Rs. 5 = Rs. 15,000 Normal� � rejection = 2% of production = 2% of 21,000 tonnes = 420 tonnes Actual rejection = 500 tonnes

(c) Penalty imposed on inspection staff

(iii) Excess rejection over normal rejection = 500 420 = 80 tonnes (iv) Penalty� = 80 tonnes Rs. 20 per tonne = Rs. 1,600 (d) Penalty imposed on maintenance� staff (i) (ii) Breakdown hours = 40 hours Penalty = 40 hours Rs. 20 per hour =� Rs. 800 Statement of production bonus earned by each group Particulars Direct labour (Rs.) 1 Aggregate general incentive Special bonus Penalty Production bonus 58,500 15,000 73,500 13,500 (1,600) 11,900 10,800 (800) 10,000 7,200 7,200 90,000 15,000 (2,400) 1,02,600 Inspection staff (Rs.) 2 Maintenance Supervisory staff (Rs.) 3 staff (Rs.) 4 (Rs.) 5 Total

3.9.19 Profit-sharing and Co-partnership schemes - A profit-sharing scheme implies that the net profit of business would be shared between the workers and the shareholders or the partners in a pre-determined ratio. Co-partnership, on the other hand, implies that the workers3.58

Labour

shall own the business jointly with the shareholders. In this case, usually the workers share of profits is given in the form of shares. Some employers in our country originally introduced profit-sharing schemes with a view of stimulating interest among workers for increasing production. But the schemes have not been successful on account of unwillingness on the part of the management to consult workers. Even a demand for copies of final accounts of the business to be shown to them has been considered by some employers to be an unwarranted interference. The question of bonus has thus been one of the major causes of industrial disputes in recent years. (Payment of compulsory bonus is now governed by the payment of Bonus Act.) Though profit sharing has become a normal feature of the industrial life in this country, copartnership is comparatively unknown. Nevertheless it must be pointed out that in England and other Western countries, a number of successful concerns have been allotting shares to their workers in proportion to their shares of bonus. Some of them have advanced loans to them to purchase shares. Both these forms of benefit have been quite popular with labour. Advantages : (i) Employees are made to feel that they too have a stake in the well-being of the undertaking and have a contribution to make in earning of profits by improving production and operations. Labour turnover may be reduced, particularly if a minimum period of service is laid down as a condition for participating in such schemes. Profit may fluctuate from year to year; there is thus an element of uncertainty in such schemes. Profit depends upon many factors of which labour efficiency is only one. Insufficiency of bonus may lead to dissatisfaction instead of promoting good relations, if the good work done by labour is nullified by other factors.

(ii)

Disadvantages : (i) (ii)

(iii) The reward may be too remote to sustain continued interest in and zeal for work. (iv) There may be doubt and suspicion about the profit disclosed. (v) Since all are entitled to participate in such schemes, there is no recognition of individual merit. (vi) The individual share of profit may be too meagre to be appealing. (vii) Since in practice bonus has to be fought in India, so it has become an important cause of labour disputes. Treatment in Costing : In foreign countries bonus is an ex-gratia payment and hence it is

3.59

Cost Accounting

regarded as an appropriation of profit not to be included in costs. In fact trade unions there do not look upon bonus with favour. In India however, payment of bonus is compulsory under the Payment of Bonus Act under which 8.33% of wages earned or Rs. 100 whichever is higher, is the minimum bonus payable, the maximum being 20%. Hence bonus must be treated as part of costs in India. There can be two methods of dealing with bonus. It may be treated as part of overheads; in any case, this must be so for bonus paid to indirect workers. In the case of direct workers the bonus payable may be estimated beforehand and wage rates for costing purposes suitably inflated by including the bonus that would be paid. Suppose, a worker gets Rs. 800 p.m. as wages and it is expected that he will be paid two months s wages as bonus. His total earning will be Rs. 11,200 (Rs. 9,600 + Rs.� 1,600). If the worker works for 2,400 hours in a year the wage rate for costing purposes will be : Rs. 4.67, i.e., Rs. 11,200/2,400 hours. Illustration A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of Rs. 30 per hour. The standard time per unit for a particular product is 4 hours. P, a machineman, has been paid wages under the Rowan Incentive Plan and he had earned an effective hourly rate of Rs. 37.50 on the manufacture of that particular product. What could have been his total earnings and effective hourly rate, had been put on Halsey Incentive Scheme (50%) ? Solution Let T hours be the total time worked in hours by the skilled worker (machineman P); Rs. 30/is the rate per hour; standard time is 4 hours per unit and effective hourly earning rate is Rs. 37.50 then Earnings = Hours worked � Rage per hour + (Under Rowan incentive plan) Rs. 37.5 T = T Rs. 30 +�

Time saved Time taken Rate per hour Time allowed� �

(4 - T ) T Rs. 30� �4

Rs. 37.5 = Rs. 30 + (4 T) Rs. 7.5 Or Or T Rs. 7.5 T = Rs. 22.5 = 3 hours� �

Total earnings and effective hourly rate of skilled worker (machineman P) under Halsey Incentive Scheme (50%)3.60

Labour

Total earnings = Hours worked Rate per hour + (Under 50% Halsey incentive� Scheme) = 3 hours Rs. 30 +�

1 Time saved Rage per hour 2�

1 1 hour Rs. 30 = Rs. 105 2� �

Effective hourly rate Illustration

=

Time earnings Rs.105 = = Rs. 35 Time allowed 3 hours

During audit of account of G Company, your assistant found errors in the calculation of the wages of factory workers and he wants you to verify his work. He has extracted the following information : (i) The contract provides that the minimum wage for a worker is his base rate. It is also paid for downtimes i.e., the machine is under repair or the worker is without work. The standard work week is 40 hours. For overtime production, workers are paid 150 percent of base rates. Straight Piece Work The worker is paid at the rate of 20 paise per piece.�

(ii)

(iii) Percentage Bonus Plan Standard quantities of production per hour are� established by the engineering department. The workers average hourly production,� determined from his total hours worked and his production, is divided by the standard quantity of production to determine his efficiency ratio. The efficiency ratio is then applied to his base rate to determine his hourly earnings for the period. (iv) Emerson Efficiency Plan A minimum wages is paid for production upto� 66-2/3% of standard output or efficiency. When the workers production exceeds 66-2/3% of the standard output, he is paid bonus as per the following table : Efficiency Level Upto 66 Bonus Nil 10% 20% 45%

2 % 3 2 % to 79 % 3

Above 66

80% 99% 100% 125%� �

3.61

Cost Accounting

Your assistant has produced the following schedule pertaining to certain workers of a weekly pay roll :Workers Wage Incentive Plan Total Hours Down Time Hours Units Produced Standard Units Base Rate Gross Wages as per Book Rs. 85 95 85 120 93 126

Rs. Rajesh Mohan* John Mahesh Anil (40 hours production) Straight piece work Straight piece work Straight piece work Emerson Emerson 40 46 44 40 40 40 5 4� � 400 455 425 250 240 600 200 300 500 1.80 1.80 1.80 2.20 2.10 2.00� � � � �

Harish Percentage bonus plan

* Total hours of Mohan include 6 overtime hours. Prepare a schedule showing whether the above computation of workers wages are correct or not. Give details.� Solution Schedule showing the correct figure of minimum wages, gross wages and wages to be paidWorkers Wage Minimum Gross wages incentive wages computed as per plan Incentive plan (Rs.) Rajesh Mohan John Harish Straight piece work Straight piece work Straight piece work 72.00 88.20 82.80 (Refer to W. Note 1) 91.00 85.00 110.00 95 85 120 91.00 85.00 110.00 (Refer to W. Note 2) (Refer to W. Note 3) Percentage bonus plan 88.00 (Refer to W. Note 4) (Rs.) 80.00 Gross wage Wages to be paid as per book are Maximum of : minimum and gross computed wages (Rs.) (Rs.) 85 80.00

3.62

Labour Mahesh Anil Emerson Emerson 84.00 80.00 100.80 116.00 93 126 100.80 116.00

(Refer to W. Note 5) (Refer to W. Note 6)

Working notes : 1. Minimum wages Gross wages (computed) as per incentive plan 2. Minimum wages hours = Total normal hours rate per hour = 40 hours Rs. 1.80 =� � � Rs. 72 = No. of units rate per unit = 400 units Rs. 0.20 = Rs. 80 = Total� � normal hours Rate per hour + Overtime Overtime rate per hour = 40 hours Rs.� � 1.80 + 6 hours Rs. 2.70 = Rs. 72 + Rs. 16.20 = Rs. 88.20 Gross wages (computed)� as per incentive plan 3. Minimum wages Gross wages (computed) as per incentive plan 4. Minimum wages Efficiency of worker = 40 hours Re. 2.20 = Rs. 88 = =� Hourly rate Gross wages (computed) as percentage of bonus plan 5. Minimum wages = 40 hours Rs. 2.75 = Rs. 110/= 40 hours Rs. 2.10 = Rs. 84 = 455 units Re.� � � 0.20 = Rs. 91.00 = 40 hours Rs. 1.80 + 4 hours Rs. 2.70 = Rs. 72 + Rs. 10.80 =� � Rs. 82.80 = 425 units Rs. 0.20 = Rs. 85�

Actual production per hour 100 Standard productiion per hour (250 units/40� hours) 100 = 125% (200 units/40 hours)�

= Rate per hour Efficiency of worker = Rs. 2.20 125% = Rs. 2.75� �

3.63

Cost Accounting

Efficiency of worker

=

(240 units/40 hours) 100 = 80% (300 units/40 hours)�

Bonus (as per Emerson s plan) = Total minimum wages Bonus percentage = Rs. 84 � � � 20% = Rs. 16.80 Gross wages (computed) as per Emerson s Efficiency plan 6. Minimum� wages Efficiency of worker = Minimum wages + Bonus = Rs. 84 + Rs. 16.80 = Rs. 100.80 = 40 hours Rs. 2 = Rs. 80 =�

600 100 = 120% 500�

Bonus (as per Emerson s plan) = Rs. 80 45% = Rs. 36 Gross wages (computed) as� � per Emerson s Efficiency plan Illustration The present output details of a� manufacturing department are as follows : Average output per week Saleable value of output Contribution made by output towards fixed expenses and profit Rs. 2,40,000 The Board of Directors plans to introduce more mechanisation into the department at a capital cost of Rs. 1,60,000. The effect of this will be to reduce the number of employees to 120, and increasing the output per individual employee by 60%. To provide the necessary incentive to achieve the increased output, the Board intends to offer a 1% increase on the piece work rate of Re. 1 per unit for every 2% increase in average individual output achieved. To sell the increased output, it will be necessary to decrease the selling price by 4%. Calculate the extra weekly contribution resulting from the proposed change and evaluate for the Board s information, the desirability of introducing the change. 48,000 units from� 160 employees Rs. 6,00,000 = Rs. 80 + Rs. 36 = Rs. 116

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Labour

Solution 1. Present average output per employee and total future expected output per week Present average output per employees per week = =

Total present output Total number of present employees 48,000 units = 300 units 160 employees

Total Future expected output per week= Total number of future employees(present output + 60% of present output per employee) = 120 employees (300 units + 60% � 300 units) = 57,600 units 2. Present and proposed piece work rate Present piece work rate Proposed piece work rate = Re 1.00 per unit = Present piece work rate + 30% Re. 1 = Re. 1.00 + 0.30 P = Rs. 1.30 per unit 3. Present and proposed sale� price per unit Present sales price per unit (Rs. 6,00,000/48,000 units) Proposed sale price per unit (Rs. 12.50 4% Rs. 12.50) 4. Present marginal cost� � (excluding wages) per unit : = = Rs. 12 = Rs. 12.50

Present sales value - Fixed expenses & profit - Contribution towards present wages Present outputa (units)

=

Rs.6,00,000 - Rs.2,40,000 - Rs.48,000 = Rs. 6.50 per unit 48,000units

3.65

Cost Accounting

Statement of extra weekly contribution (Information resulting from the proposed change of mechanisation meant for Board s evaluation) Expected sales units (Refer� to Working note 1) Rs. Sales value : (A) (57,600 units Rs. 12) (Refer to Working� note 3) Marginal costs (excluding wages) : (B) (57,600 units Rs. 6.50) (Refer to� Working note 4) Wages : (C) (57,600 units Rs. 1.30) (Refer to Working note 2)� Total marginal cost : (D) = {(B) (C)} Marginal contribution : {(A) (D)} Less :� � Present contribution Increase in contribution (per week) 4,49,280 2,41,920 2,40,000 1,920 74,880 3,74,400 Rs. 6,91,200 57,600

Evaluation: Since the mechanisation has resulted in the increase of contribution to the extent of Rs. 1,920 per week, therefore the proposed change should be accepted. 3.10 ABSORPTION OF WAGES 3.10.1 Elements of wages: In common parlance, the term wages represents monetary payment which an employee receives at regular� � intervals for the services rendered. Strictly speaking, however, from the point of view of the employer and the cost to the industry, wages should be taken to include also non-monetary benefits which an employee receives by virtue of employment. Such non-monetary benefits may include: (i) (ii) medical facilities; educational and training facilities;

(iii) recreational and sports facilities; (iv) housing and social welfare; and (v) cost of subsidised canteen and co-operative societies. Such benefits are generally given in an industrial establishment. In some cases the provision of benefits is compulsory. Therefore, while computing the wage cost per worker, the monetary3.66

Labour

value of such non-monetary benefits should also be taken into account. The monetary part of a worker s remuneration includes the basic wages, dearness� allowance, overtime wages, other special allowance, if any, production bonus, employer s contribution to the provident fund, Employees State Insurance� Corporation premium, contribution to pension fund, leave pay, etc. The basic wage is the payment for work done, measured in terms of hours attended or the units produced, as the case may be. The basic wage rate is not normally altered unless there is a fundamental change in the working conditions or methods of manufacture. Dearness allowance is an allowance provided to cover the increase in cost of living from one period to another. This allowance is calculated either as percentage of the basic wage or as a fixed amount for the days worked. In either case, the percentage or the fixed amount is subject to revision whenever the cost of living index rises or falls by a certain figure as agreed to by the employer with the labour union. When permanent rise in the cost of living index occurs, a part of the dearness allowance is often absorbed in the basic wage. Overtime allowance is an allowance paid for the extra hours worked at the rates laid down in the Factories Act. In certain industries, where special allowance for the working conditions, tool maintenance, etc., are paid they are also considered as part of wages. Production bonus is an incentive payment made to workers for efficiency that results in production above the standard. There are different methods of computing incentives. Under the Payment of Bonus Act, a worker is entitled to compulsory bonus of 8.33% wages earned in the relevant year or Rs. 100 (whichever is greater). The bonus may be upto 20% of wages depending upon the quantum of profits calculated as per the Act. Contributions to provident fund and to E.S.I. schemes are compulsory. Under the first mentioned scheme, the employer contributes to the provident fund a sum equal to 8?% of the basic wages together with the dearness allowance. Under the E.S.I. scheme, the employer contributes a fixed amount per month per worker calculated on the amount of wages as prescribed by the E.S.I. Act. The payments by the employer under these schemes are payable at the time, wages are paid for the relevant period; these payments form a part of the wages for the period. 3.10.2 Component of wages cost or wages for costing purposes : In addition to wages (including allowances, such as D.A.) that are paid to workers, a firm may have to spend on many other items (such as premium to the Employees State Insurance Corporation or provident fund or bonus). Further, the worker does not spend all the time for which he is paid on productive work. This is because he is entitled to weekly holiday and various type of leave. There is also a certain amount of unavoidable idle time. The question is : to what extent such additional payment or cost in respect of labour can be charged directly to unit of cost as part of direct labour cost? Of course, in the case of indirect labour, all such payments as also the

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Cost Accounting

wages paid to them, must be treated as part of overheads. But in the case of direct workers, two alternatives are possible. The additional charges may be treated as overheads. Alternatively, the wage rates being charged to job may be computed by including such payments; automatically then, such payments will be charged to the work done alongwith wages of the worker. (It should be remembered that such wage rate will be only for costing purposes and not for payment to workers). The total of wages and additional payment should be divided by effective hours of work to get such wage rates for costing purposes. Illustration A worker is paid Rs. 100 per month and a dearness allowance of Rs. 200 p.m. There is a provident fund @ 8?% and the employer also contributes the same amount as the employee. The Employees State Insurance Corporation premium is 1 % of wages of� which % is paid by the employees. It is the firm s practice to pay 2 months� � � wages as bonus each year. The number of working days in a year are 300 of 8 hours each. Out of these the worker is entitled to 15 days leave on full pay. Calculate the wage rate per hour for costing purposes. Solution Wages paid to worker during the year *Add Provident Fund @ 8.33% *E.S.I. Premium 1% Bonus at 2 months wages� Total Effective hours per year: 285 8 = 2,280 Rs. 3,600 300 36 600 4,536�

Wage-rate per hour (for costing purpose): Rs. 4,536/2,280 hours = Rs. 1.989 Illustration : Calculate the earnings of A and B from the following particulars for a month and allocate the labour cost to each job X, Y and Z: A (i) (ii) Basic wages Dearness allowance (on basic wages) Rs. 100 50% 8% 2% Hours 10 B 160 50% 8% 2%

(iii) Contribution to provident fund (on basic wages) (iv) Contribution to employees state insurance (on basic wages) (v) Overtime�

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Labour

The normal working hours for the month are 200. Overtime is paid at double the total of normal wages and dearness allowance. Employer s contribution to State� Insurance and Provident Fund are at equal rates and employees contributions. The� two workers were employed on jobs X, Y and Z in the following proportions: Jobs X Worker A Worker B Overtime was done on job Y. Solution Statement showing Earnings of Workers A and B Workers Basic wages Dearness allowance (50% of basic wages) Overtime wages (Refer to working note 1) Gross wages earned Less: - Provident fund-8% of basic wages - ESI-2% of basic wage Net wages paid Statement of Labour cost Gross wages (excluding overtime) Employer s contribution to P.F. and E.S.I.� Ordinary wages Labour rate per hour Rs. 150 10 160 0.80 (Rs.160/200) Rs. 240 16 256 1.28 (Rs. 256/200) 10 155 16 224 A Rs. 100 50 15 165 B Rs. 160 80 240 40% 50% Y 30% 20% Z 30% 30%

3.69

Cost Accounting

Statement showing allocation of wages to jobs Total Wages Rs. Worker A : Ordinary wages: (4:3:3) Overtime Worker B : Ordinary wages: (5:2:3) Working Notes Normal wages are considered as basic wages Overtime = 2 256 431 128 192 51.20 114.2� 76.8 124.8 160 15 64 48 15 48 X Rs. Jobs Y Rs. Z Rs.� �

(Basic + D.A.) 10 hours 200�= Rs.15

= 2 (Rs. 150/200) 10 hours Illustration� �

In a factory working six days in a week and eight hours each day, a worker is paid at the rate of Rs. 100 per day basic plus D.A. @ 120% of basic. He is allowed to take 30 minutes off during his hours shift for meals-break and a 10 minutes recess for rest. During a week, his card showed that his time was chargeable to : Job X Job Y Job Z 15 hrs. 12 hrs. 13 hrs.

The time not booked was wasted while waiting for a job. In Cost Accounting, how would you allocate the wages of the workers for the week?

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Labour

Solution Working notes: (i) (ii) Total effective hours in a week : [(8 hrs. (30� mts. + 10 mts.)] 6 days Total wages for a week : (Rs. 100 + 120% of Rs. 100) 6� � days (iii) Wage rate per hour : (iv) Time wasted waiting for job (Abnormal idle time): Allocation of wages in Cost Accounting Rs. Allocated to Job X Allocated to Job Y Allocated to Job Z Charged to Costing Profit & Loss A/c Total : 15 hours � Rs. 30 : 12 hours Rs. 30 : 13 hours Rs. 30 : 4 hours Rs. 30 = = = = 450 360� � � 390 120 1,320 = 44 hrs. (15 hrs. + 12 hrs. + 13 hrs.) = 4 hrs. = Rs. 1,320 = Rs.� 30 = 44 hours

3.10.3 Holiday and leave wages : One alternative to account for wages paid on account of paid holiday and leave can be to include them as departmental overheads. In such a case, it is necessary to record such wages separately from worked for wages . Such a segregation can be made possible by providing a� � separate column in the payroll for holiday and leave wages in the same way as there are columns for dearness allowance, provident fund deductions, etc. If, however, a separate or additional column cannot be provided for this purpose it would be necessary to analyse the payroll periodically to ascertain how much of the total payment pertains to worked for wages and how much is attributed to� � leave and holiday wages. Another way could be to inflate the wage rate for costing purposes to include holiday and leave wages. This can be done only in the case of direct workers.

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Cost Accounting

Illustration Calculate the labour hour rate of a worker X from the following data : Basic pay D.A. Fringe benefits Rs. 1,000 p.m. Rs. 300 p.m. Rs. 100 p.m.

Number of working days in a year 300. 20 days are availed off as holidays on full pay in a year. Assume a day of 8 hours. Solution (a) (i) Effective working hour/days in a year Less : Leave days on full pay Effective working days Total effective working hours (280 days 8 hours) (ii) Total wages paid in a year Basic� pay D.A. Fringe benefits 300 20 280 days 2,240 Rs. 12,000 3,600 1,200 16,800 (iii) Hourly rate : Rs. 16,800/2,240 hours Rs. 7.50

3.10.4 Night shift allowance: In some cases, workers get extra payment if they work at night. Since the extra payment is not for any particular job, therefore such a payment should be treated as part of overheads. 3.10.5 Principles of remuneration: The term remuneration has been defined as the reward for labour� � and service. It is the result of the agreement between the employer and the employee, whereby for a specified work or service rendered by the employee the employer agrees to pay a specified sum of money. Apart from this an employee by virtue of the fact that he is an employee becomes entitled to certain non-monetary benefits. The method of remuneration adopted varies from industry to industry and, in certain cases, even among different units in the same industry. Whatever be the variation, the method of fixing remuneration payable to the various categories of employees has to be based on certain accepted principles. These are:

3.72

Labour

(i)

Wage-rates in an industry should be fixed in conformity with the general wage-levels in the geographical area i.e. the rate should be more or less the same for similar efforts and skill. The wage-level in an area would in turn depend upon demand for labour, the availability of labour, the cost of living in the area, the wage levels in neighbouring industrial area, and the capacity of the particular industry to pay. Wage-rates should be related to the degree of skill, effort, initiative and responsibility that the employee is expected to assume in respect of the various jobs he may be called upon to perform. There should be generally equal pay for equal work.

(ii)

(iii) Wage-rates should guarantee a minimum wage regardless of the existence of factors listed under (ii) above, particularly when the working conditions are difficult and dangerous. (iv) Wage-rates are considered satisfactory only if they enable the workers to maintain a reasonable standard of living. (v) Separate wage rates should be fixed for different classes of employees since each class expects to maintain a different standard of living; also the education, physical and mental efforts and responsibility required for performing different jobs are not the same. (vi) It should be possible for worker to increase his earnings through extra effort and by increasing output. If he alone is responsible, he should have the full benefit of the increased productivity. Otherwise, if increased output has resulted from co-operation between management and workers both should share the benefit. It is important that these basic principles should be recognised in fixing the wage rate of workers; otherwise, there will be dissatisfaction among the employees and, consequently, there will be higher labour turnover. Satisfactory employer-employee relationship is a primary necessity for industrial development and this has to be ensured to a very great degree, by satisfactory schemes of remunerating labour. The aim should be to keep labour cost per unit of output (or service) as low as possible. It is not the same as keeping wages at low levels. There is a definite correlation between wages and productivity; high wages often lead to such an increase in productivity that wages per unit of output fall. However, this rule is also subject to diminishing returns a point is reached at� which any further increase in wage rates does not bring about a corresponding increase in efficiency. But generally, higher wages result in lower cost per unit. Wages affect the national economy through cost of goods produced. If an increase in wages outpaces the corresponding increase in productivity, goods become costlier and cannot compete with those of other countries in the world markets. From the point of view of an expert it is necessary to keep wages in check like other costs. The safe rule is to link up wages with productivity.

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Cost Accounting

3.10.6 Absorption rates of labour cost: Labour cost as stated above include monetary compensation and non-monetary benefits to workers. Monetary benefits include, basic wages, D.A., overtime pay, incentive or production bonus contribution to employee provident fund, House Rent Allowance, Holiday and vacation pay etc. The non-monetary benefits include medical facilities, subsidized canteen services, subsidized housing, education and training facilities. Accounting of monetary and non-monetary benefits to indirect workers does not pose any problems because the total of monetary and non-monetary benefits are treated as overhead and absorbed on the basis of rate per direct labour hour, if overheads are predominantly labour oriented. For direct workers, the ideal method is to charge jobs or units produced by supplying per hour rate calculated as below : Rate per hour =

Total of estimated monetary benefits and cost of non - monetary benefits Budgeted direct labour hours - Normal idle time

Another alternative method is to treat the monetary benefits other than basic wages and dearness allowance as well as cost of non-monetary benefits as overheads. 3.11 EFFICIENCY RATING PROCEDURES Efficiency is usually related with performance and may be computed by comparing the time taken with the standard time allotted to perform the given job/task. If the time taken by a worker on a job equals or less than the standard time, then he is rated efficient. In case he takes more time then the standard time he is rated as inefficient. It may be computed as follows : Efficiency in % =

Time allowed as per std. 100 Time taken�

For efficiency rating of employees the following procedures may be followed : 1. Determining standard time/performance standards : The first step is to determine the standard time taken by a worker for performing a particular job/task. The standard time can be determined by using Time & Motion study or Work study techniques. While determining the standard time for a job/task a heterogeneous group of workers is taken and contingency allowances are added for determining standard time. 2. Measuring Actual Performance of workers : For computing efficiency rating it is necessary to develop a procedure for recording the actual performance of workers. The system developed should record the output of each worker along with the time taken by him. 3. Computation of efficiency rating : The efficiency rating of each worker can be computed by using the above mentioned Formula.3.74

Labour

3.11.1 Need for efficiency rating : 1. As discussed earlier when a firm follows a system of payment by results, the payment has a direct relationship with the output given by a worker. The firm for making payment to worker is required to ascertain his efficiency level. For instance, under Taylor's differential piece work system the lower rate i.e. 83% of piece rate is given to a worker when his efficiency rating is less than 100% and higher rate viz., 125% of piece rate is offered at efficiency level of either 100% or more. Similarly under Emersion efficiency plans bonus is paid at rising scale at various level of efficiency, ranging from 66.67% to 150%. The efficiency rating also helps the management in preparing labour requirement budget or for preparing manpower requirements. For example, let P Ltd. manufactures two products by using one grade of labour. The following estimates are available : Product A Budgeted production (units) Std. hrs. allowed per product 3,480 5 Product B 4,000 4

2.

It is further worked out that the efficiency rating (efficiency ratio) for productive hours worked by direct workers in actually manufacturing the production is 80% then the exact standard labour requirement can be worked out as follows : Product A Budgeted production (in units) Std. hours allowed for budgeted production 3,480 17,400 (3,480 units 5 hours) Product B 4,000 16,000 (4,000� units 4 hours) 33,400 Total�

Since efficiency ratio is given as 80% therefore Std. labour hours required for 100% efficiency 100 ? ? level are ? 33,400 hours ? = 41,750 hours. 80 ? ? Labour� productivity : Productivity is generally determined by the input/output ratio. In the case of labour it is calculated as below :

Standard time for doing actual amount of work Actual time taken to do workLabour productivity is an important measure for measuring the efficiency of individual workers. It is an index of efficiency and a sign of effectiveness in the utilisation of resources-men, materials, capital, power and all kinds of services and facilities. It is measured by the output in relation to input. Productivity can be improved by reducing the input for a certain quantity or3.75

Cost Accounting

value of output or by increasing the output from the same given quantity or value of input. Factors for increasing labour productivity : The important factors which must be taken into consideration for increasing labour productivity are as follows: 1. 2. 3. 4. 5. Employing only those workers who possess the right type of skill. Placing a right type of man on the right job. Training young and old workers by providing them the right types of opportunities. Taking appropriate measures to avoid the situation of excess or shortage of labour at the shop floor. Carrying out work study for the fixation of wage rate, and for the simplification and standardisation of work.

Self Examination Questions Multiple Choice Questions 1. The input-output ratio in case of labour means the ratio of (a) the value of output to the wages paid. (b) standard time of the production to the actual time paid for. (c) abnormal idle time to normal idle time. (d) number of workers employed to the sanctioned strength. 2. Job specification is (a) the list of operations to be performed for completing the concerned job (b) the requirement in terms of goods to be produced or work to be done. (c) the list of qualities and qualifications which the employees concerned should have to do the job well. (d) the name of the employees who will be assigned to a job. 3. Job specification is (a) the list of operations to be performed for completing the concerned job (b) the requirement in terms of goods to be produced or work to be done. (c) the list of qualities and qualifications which the employees concerned should have to do the job well. (d) the name of the employees who will be assigned to a job.

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Labour

4.

Direct labour means (a) labour completing the work manually, (b) labour which is recruited directly and not through contractors, (c) permanent labour in the production department, (d) labour which can be conveniently associated with a particular cost unit.

5.

Time and motion study is essential for (a) a rational promotion policy, (b) completing a job on time, (c) determining the standard-time and correct method of completing a task, (d) determining prices of products.

6.

For reducing the labour cost per unit, which of the following factors is the most important? (a) low wage rates, (b) higher input-output ratio, (c) strict control and supervision, (d) longer hours of work.

7.

Which of the following statements are true ? (a) Productivity of workers can be improved only if they are supervised closely. (b) It is no use paying higher wages to labour because they would spend their money on drinking and smoking. (c) A well satisfied team of workers can raise productivity to a large extent. (d) None of the above

8.

Labour turnover is measured by, (a) Replacement method. (b) Separation method. (c) Flux method. (d) All of the above.

3.77

Cost Accounting

9.

Salary of a foreman should be classified as, (a) Fixed overhead. (b) Variable overhead. (c) Semi fixed or semi variable overhead. (d) None of the above.

10. For reducing the labour cost per unit, which of the following factors is the most important? (a) Low wage rates. (b) Higher input output ratio. (c) Strict control. (d) Long hours of work. Answers To Multiple Choice Questions 1.(b);2.(c);3.(a) ;4.(d);5.(c);6.(b);7.(c);8.(d);9.(c);10 (b) Short Answer Type Questions 1. Describe briefly the functions of the following departments in relation to labour : (a) Personnel department. (b) Engineering department. (c) Cost Accounting department. 2. Distinguish between : (a) Time keeping and Time booking (b) Time study and motion study. 3. 4. 5. Discuss briefly the important factors for the control of labour cost. Discuss briefly the objectives of time keeping. Discuss briefly the various factors necessary for introducing an incentive system.

Long Answer Type Questions 1. What is idle time? Explain the causes leading to idle time and its treatment in Cost Accounts.

3.78

Labour

2. 3. 4. 5.

What do you mean by overtime premium? What are the causes of overtime? How would you treat overtime premium in Cost Accounts ? What do you understand by labour turnover? How is it measured? What are its causes? What steps should be taken to check the increasing rate of labour turnover? Define job evaluation and distinguish it from merit rating. Explain the methods and objectives of job evaluation. Explain the factors to be considered in introducing an incentive system.

Numerical Questions 1. Calculate the number of hours worked as overtime by the following workers in a week: Ram Monday Tuesday Wednesday Thursday Friday Saturday 8 7 4.5 8 10 9 46.5 Shyam 8 9 8 7 9 9 50

2.

Three workers A, B and C are put on a common task for which the total remuneration is Rs. 150. A works for 40 hours, B works for 60 hours and C works for 44 hours on the job. The hourly rate is Re. 0.75 of A per hour, B gets Re. 0.80 per hour while C s remuneration is Re. 0.50 per hour. What should each man get ? A worker is paid� @ 50 paise per hour plus a dearness allowance of Rs. 60 per month. The provident fund contribution both by the employee and the worker is 6 % each. The worker is� entitled to 15 days leave with full wages. His normal working per month is 25 days of 8 hours each. (a) the wages per hour for costing purposes; and (b) the amount to be paid to him for a week in which he puts in 52 hours of work.

3.

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Cost Accounting

4.

The following particulars are available to you in respect of a worker: Job No.Time Allowed 1844 1826 26 hours 30 hours Time Taken 20 hours 20 hours 8 hours 48 hours

Idle time (waiting)

The basic rate is Rs. 2 per day of 8 hours in addition there is a dearness allowance of Rs. 12 per week of 48 hours. Calculate the wage of the worker on (1) Time Basis (2) Piece Rate Basis (3) Halsey Plan Basis and (4) Rowan Plan Basis. 5. A worker is paid 10% bonus on the hourly rate if he completes his work in the time allotted for it and a further 1% on hourly rate for each 1% in excess of 100% efficiency. His hourly rate is Rs. 5 per hour and he completed a job in 45 hours whereas the time allowed for it was 50 hours. Ascertain the wages earned by this worker. From the following data, calculate the labour turnover rate by applying : (i) (ii) Separation method Accession method

6.

(iii) Flux method Number of workers on the payroll At the beginning of the month At the end of the month 1,800 2,200

During the month 20 workers left, 80 workers were discharged and 500 workers were recruited. Of these 50 workers were recruited in the vacancies of those separated, while the rest were engaged due to expansion. 7. The company has a suggestion of box scheme and an award equivalent to one and a half months saving in labour cost is passed on to the employee whose suggestion is accepted. Suggestion of an employee to use a Jig for a manufacturing operation of a component is accepted. The cost of the Jig which has a life of one year is Rs. 1,000 and the use of the Jig will reduce the standard time by 8 minutes. Compute from the following data the amount of award payable to the employee who has given the suggestion. (i)3.80

Number of pieces to be produced in the year :

15,000

Labour

(ii)

Standard time per piece before use of Jig

:

80 minutes

(iii) Average wage rate of workmen Rs. 160 per day of 8 hours. (iv) Average efficiency of workmen : 80%. 8. The existing incentive system of a certain factory is : Normal working week Rate of payment Additional bonus payable Average output per operative for 54 hour week, i.e, normal working hours plus 3 hours late sitting for 3 days : : : : 120 articles 5 days of 9 hours each plus Resorting to overtime of 3 hours for 3 days. For day work - Rs. 20 per hour. For overtime Rs. 30 per hour. Rs. 25 per day if worker is not resorting to overtime. Rs. 40 per day if worker resorts to overtime.

In order to increase output and eliminate overtime it was decided to switch on to a system of payment by results. The factory considering the introduction of some incentive scheme or to make payment on piece work basis. Assuming that 135 articles are produced in a 45 hour week and the additional bonus under the existing system will be discontinued in the proposed incentive scheme. You are required to calculate : (i) Weekly earnings; (ii) labour cost per article for an operative under the following systems: (a) Existing time-rate system (b) Straight piece-work system (c) Rowan system (d) Halsey system The following information is obtained. Time rate (as usual) Basic time allowed Piece work rate Premium bonus : : : : Rs. 20 per hour for 15 articles 5 hours Add 20% to price Add 50% to time

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Cost Accounting

9.

The unit has a strength of 20 workmen worked for 300 working days of 8 hours each with half an hour break based on the earlier years trend, it is forecast that average absenteeism per workman would be 8 days, in addition to the eligibility of 30 days annual leave. The following details regarding actual working of the unit are available for the year ending on 31st March, 1998. (i) (ii) The factory worked 2 extra days to meet the production targets, but one additional paid holiday had to be declared. There was a severe breakdown of a major equipment leading to a loss of 300 man hours.

(iii) Total overtime hours (in addition to 2 extra days worked) amounted to 650 hours. (iv) The actual average absenteeism per workman was 8 days. (v) Basic rate is Rs. 10 per hour and overtime is paid at double rate. You are required to calculate. (a) Actual working hours of the unit. (b) In Cost Accounting how would you treat the wages of workmen for (ii) & (iii) above ? 10. A job can be executed either through workman A or B. A takes 32 hours to complete the job while B finishes it in 30 hours. The standard time to finish the job is 40 hours. The hourly wage rate is same for both the workers. In addition workman A is entitled to receive bonus according to Halsey plan (50%) sharing while B is paid bonus as per Rowan plan. The works overheads are absorbed on the job at Rs. 7.50 per labour hour worked. The factory cost of the job comes to Rs. 2,600 irrespective of the workman engaged. Find out the hourly wage rate and cost of raw materials input. Also show cost against each element of cost included in factory cost.

3.82

CHAPTER

4

OVERHEADSLearning objectives When you have finished studying this chapter, you should be able to ? Differentiate between direct costs and overheads. ? Understand the meaning of allocation, apportionment and absorption of overheads. ? Identify, whether overheads are under absorbed or over absorbed ? Understand the accounting and control of administrative, selling and distribution overheads. 4.1 INTRODUCTION

Besides direct expenditure, i.e., expenditure which can be conveniently traced to or identified with any particular unit of production, e.g., direct materials, direct wages and direct expenses, every form of production involves expenses that cannot be conveniently traced to or identified with the articles produced or services provided. Such expenses are incurred for output generally and not for a particular work order e.g., wages paid to watch and ward staff, heating and lighting expenses of factory etc. Expenses of these nature are known as overhead or indirect expenses. Often in a manufacturing concern, overheads exceed direct wages or direct materials and at times even both put together. On this account, it would be a grave mistake to ignore overheads either for the purpose of arriving at the cost of a job or a product or for controlling total expenditure. Overheads also represent expenses that have been incurred in providing certain ancillary facilities or services which facilitate or make possible the carrying out of the production process; by themselves these services are not of any use. For instance, a boiler house produces steam so that machines may run and, without the generation of steam, production would be seriously hampered. But if machines do not run or do not require steam, the boiler house would be useless and the expenses incurred would be a waste. Apart from the overheads incurred in the factory, overheads also arise on account of administration, selling and distribution.

Cost Accounting

4.2

CLASSIFICATION OF OVERHEADS

4.2.1 Classification of overheads by function : Overheads principally are of four types: (i) Factory or Manufacturing Overheads; (ii) Office and Administrative Overheads; (iii) Selling and Distribution Overheads; (iv) Research and Development. Whether an expense belongs to one class or another depends entirely on the benefit derived from it. For instance, salaries of clerks will be (i) factory or manufacturing expenses, when the clerks concerned work in the factory office; (ii) office and administrative expense when the clerks work in the general office; and (iii) selling and distribution expense when the clerks work in the sales office. Small concerns may not distinguish between office and selling expenses and still smaller concerns may treat all overhead, of whatever class, together. Big concerns may have even a more detailed classification to be able to exercise better control. A detailed classification of such expenses is given below: (i) Factory or Manufacturing Expenses: (a) Stores overheads (expenses connected with purchasing and handling of materials); (b) Labour overheads (expenses connected with labour); and (c) Factory administration overheads (expenses connected with administration of the factory). (ii) Office and Administration Expenses: (a) Administrative expenses (expenses incurred on managerial personnel - their salaries, costs of facilities provided to them and salaries of their personal staff); and (b) Office expenses (expenses on the routine office work). (iii) Selling and Distribution Expenses : (a) Selling expenses (expenses incurred to persuade customers to purchase the firm s products� and, or engage its services, that is to maintain and expand the market); and (b) Distribution expenses are those which are incurred to execute orders. One should note that many people use the two terms selling and distribution as� � � � synonymous. Following are the definitions given by the Institute of Cost and Management Accountants of England.

4.2

Overheads

Production Cost - The cost of the sequence of operations which begins with supplying materials, labour and service and ends with the primary packing of the product. Selling Cost - The cost of seeking to create and stimulate demand sometimes termed (marketing) and of securing orders. Distribution Cost - The cost of the sequence of operations which begins with making the packed product� � available for despatch and ends with making the reconditioned returned empty package, if any, available for re-use. As well as including expenditure incurred in moving articles to central or local storage, distribution cost includes expenditure incurred in moving articles to and from prospective customers as in the case of goods on sale or return basis. In the gas, electricity and water industries Distribution means pipes, mains and services which may be regarded as� � equivalent to packing and transportation. Administration cost - The cost of formulating the policy, directing the organisation and controlling the operations of an undertaking which is not related directly to production, selling, distribution, research or development activity or function. Research and Development Expenses : The Terminology defines research expenses as the expenses� of searching for new or improved products, new application of materials, or new or improved methods. Similarly, development expenses is defined as the expenses of� � the process which begins with the implementation of the decision to produce a new or improved product. If research is conducted in the methods of production, the� research expenses should be charged to the production overhead; while the expenditure becomes a part of the administration overhead if research relates to administration. Similarly, market research expenses are charged to the selling and distribution overhead. Development costs incurred in connection with a particular product should be charged directly to that product. Such expenses are usually treated as deferred revenue expenses, and recovered as a cost per unit of the� � product when production is fully established. General research expenses of a routine nature incurred on new or improved methods of manufacture or the improvement of the existing products should be charged to the general overhead. Even in this case, if the amount involved is substantial it may be treated as a deferred revenue expenditure, and spread over the period during which the benefit would accrue. Expenses on fundamental research, not relating to any specific product, are treated as a part of the administration overhead. Where research proves a failure, the cost associated with it should be excluded from costs and charged to the costing Profit and Loss Account. A list (not exhaustive) of various items under three principal classes of overheads is presented on the next page.

4.3

Factory Expenses Buildings : Rent, repairs, depreciation and insurance of factory premises, lighting of factory premises. : Depreciation, repairs and maintenance and insurance of plant and equipment; power used for machines. Wages of indirect workers; normal idle time (unless wage rates are inflated suitably); Employees� State Insurance premium; Provident Fund contribution, leave pay, maternity pay; etc. Salaries to foremen, departmental superintendents and Works Manager; Technical Director s fees. Purchasing and store keeping expenses, cost of� consumable stores and supplies, normal losses of materials unless prices are suitably inflated, etc. Factory office telephone, stationery, factory office clerks salaries, etc.�

Machinery

Office and Administration Expenses Administration : Fees to Directors Salary to� General Manager, Managing Director, Finance Manager, Chief Accountant, Secretary, their immediate personal staff and other expenses like air conditioning of office;

Labour

:

Supervision

:

Materials

:

Office : Salaries paid to other people working in the office; stationery, postage, etc. lighting of office, rent, rates, and taxes on office premises. Depreciation, power, insurance repairs and maintenance of office equipment, etc.

Selling and Distribution Expenses Selling: Fees to Director who looks after sale and marketing salary of Sales Manager; salesmen and sales office clerks; commission to agents, advertising catalogues, price lists. samples, show room expenses; entertainment of customers; stationery, postage etc., used in the office. Distribution: Finished goods godown expenses-salary, rent, insurance lighting etc. packing; carriage outwards; insurance, in transit; delivery expenses; expenses on receiving and reconditioning, returnable empties.

Misc

:

Overheads

Expenses that are not taken into account - The undermentioned expenses are usually not included in overheads or, for that matter in cost : (a) Expenses or income of purely financial nature like dividends received, rent received, cash discount allowed, etc. (b) Expenses or profits of capital nature like profit or loss on sale of investments, plant and equipment, etc. (c) Items not representing actual costs but dependent on arbitrary decisions of the management, e.g., an unreasonably high salary to the managing director, providing for depreciation at a rate exceeding the economic rate. (d) Appropriation of profits for dividends, payment of income tax and transfers to reserves. 4.2.2 Classification of overheads by nature : On a change in the level of activity different expenses behave differently. On this consideration, expenses are classified under the following three categories: (i) Fixed or Constant : These are expenses that are not affected by any variation in the volume of activity, e.g., managerial remuneration, rent, that part of depreciation which is dependent purely on efflux of time, etc. Fixed or constant expenses remain the same from one period to another except when they are deliberately changed, e.g., on increments being granted to staff or additional staff being engaged. (ii) Variable : Expenses that change in proportion to the change in the volume of activity; when output goes up by 10% the variable expenses also go up by 10%. Correspondingly, on a decline of the output, these expenses also decline proportionately e.g., power consumed; consumable stores; repairs and maintenance and depreciation are dependent on the use of assets. Variable expenses are generally constant per unit of output or activity. Suppose variable expenses amount to Rs. 10,000 for a production of 2,000 units i.e., Rs. 5 per unit. When output goes upto 2,200 units, i.e., an increase of 10% the variable expenses amount to Rs. 11,000. i.e., 10,000 plus 10%. The cost per unit will be the same as before. (iii) Semi variable : The expenses that either (a) do not change when there is a small change in the level of activity but change whenever there is a slightly big change. In other words, they change by small steps; or (b) change in the same direction as change in the level of activity but not in the same proportion. An expense for example, may not change if output goes up or comes down by 5% but may change by 3% when there is an increase in production between 5% and 10%. Similarly, another item of expense may change by 1% for every 2% change in activity. Examples of such expenses are : delivery van expenses,

4.5

Cost Accounting

telephone charges, depreciation as a whole. Semi-variable expenses usually have two parts fixed and variable. For instance, the amount of depreciation usually� depends on two factors one on time (fixed) and the other on wear and tear� (variable). The two together make depreciation (as a whole) semivariable. A careful study can make it possible for all semi-variable expenses to split up into two parts. Fundamentally, therefore, there are only two type of expenses fixed and� variable. Graphically the three type of expenses may be shown as below:

One must note that fixed expenses remain unchanged upto the limit of the present capacity. If output goes beyond the capacity limit, fixed expenses will record a jump. Suppose a factory works one shift and produces 10,000 units in the shift. For all levels of output of 10,000 units, fixed expenses will remain unchanged; if the output goes beyond 10,000 units, a second shift will become necessary and this will mean a big increase in fixed expenses such as salary for foremen, lighting etc. Methods of segregating Semi-variable costs into fixed and variable costs � For a detailed understanding please refer to chapter 1. Advantages of Classification of Overheads into Fixed and Variable : The primary objective of segregating semi-variable expenses into fixed and variable is to ascertain marginal costs. Besides this, it has the following advantages also. (a) Controlling expenses : The classification of expenses into fixed and variable components helps in controlling expenses. Fixed costs are generally policy costs, which cannot be easily reduced. They are incurred irrespective of the output and hence are more or less non controllable. Variable expenses vary with the volume of activity and the responsibility for incurring such an expenditure is determined in relation to the output. The management can control these costs by giving proper allowances in accordance with the

4.6

Overheads

output achieved. (b) Preparation of budget estimates : The segregation of overheads into fixed and variable part helps in the preparation of flexible budget. It enables a firm to estimate costs at different levels of activity and make comparison with the actual expenses incurred. Suppose in October, 2005 the output of a factory was 1,000 units and the expenses were: Rs. Fixed Variable Semi-variable (40% fixed) 5,000 4,000 6,000

15,000 In November, 2005 the output was likely to increase to 1,200 units. In that case the budget or estimate of expenses will be : Rs. Fixed Variable 5,000 4,800

? Rs.4,000 1,200 units ? ? ? 1,000 units ? ?�Semi-variable

Fixed, 40% of Rs. 6,000 ? Rs.3,600 1,200 units ? Variable : ? ? 4,320 1,000� units ? ?

2,400 6,720

16,520 It would be a mistake to think that with the output going up from 1,000 units to 1,200 units the expenses would increase proportionately to Rs. 18,000. This would be wrong budgeting. (c) Decision making : The segregation of semi variable cost between fixed and variable overhead also helps the management to take many important decisions. For example, decisions regarding the price to be charged during depression or recession or for export market. Likewise, decisions on make or buy, shut down or continue, etc., are also taken after separating fixed costs from variable costs. In fact, when any change is contemplated, say, increase or decrease in production, change in the process of manufacture or distribution, it is necessary to know the total effect on cost (or revenue) and that would be

4.7

Cost Accounting

impossible without a correct segregation of fixed and variable costs. The technique of marginal costing, cost volume profit relationship and break-even analysis are all based on such a segregation.4.3 ACCOUNTING AND CONTROL OF MANUFACTURING OVERHEADS

We have already seen that overheads are by nature those costs which cannot be directly related to a product or to any other cost unit. Yet for working out the total cost of a product or a unit of service, the overheads must be included. Thus we have to find out a way by which the overheads can be distributed over the various units of production. One method of working out the distribution of overheads over the various products could be to ascertain the amount of actual overheads and distribute them over the products. This however, creates a problem since the actual amount of overheads can be known only after the financial accounts are closed. If we wait that long, the cost sheets lose their main advantages and utility to the management. All the decisions for which cost sheets are prepared are immediate decisions and cannot be postponed till the actual overheads are known. Therefore, some method has to be found by which overheads can be included in the cost of the products, as soon as prime cost, the cost of raw materials, labour and other direct expenses, is ascertained. One method is to work out pre-determined rates for absorbing overheads. These rates are worked out before an accounting period begins by estimating the amount of overheads and the level of activity in the ensuing period. Thus, as soon as the prime cost of a product or a job is available, the various overheads are charged by these rates. Of course, this implies that the overheads are charged on an estimated basis. Later, when the actual overheads are known, the difference between the overheads charged to the products and actual overheads is worked out and adjusted. Manufacturing Overheads : Generally manufacturing overheads form a substantial portion of the total overheads. It is important, that such overheads should be properly absorbed over the cost of production. The following procedure may be adopted in this regard. The steps given below shows how factory overhead rates are estimated and overheads absorbed on that basis and the last one shows how actuals are compared with the absorbed amount.(Students should carefully note the distinction between the various terms used).

1. Estimation and collection of manufacturing overheads : The first stage is to estimate the amount of overheads, keeping in view the past figures and adjusting them for known future changes. There are four main sources available for the collection of factory overheads viz., (a) Invoices; (b) Stores requisition ; (c) Wage analysis book ; (d) Journal entries. 2. Cost allocation : The term allocation implies relating overheads directly to the various departments. The� � estimated amount of various items of manufacturing overheads4.8

Overheads

should be allocated to various cost centres or departments. The salary of the works manager cannot be directly allocated to any one department since he looks after the whole factory. It is, therefore, obvious that many overhead items will remain unallocated after this step. 3. Cost apportionment : At this stage, those items of estimated overheads (like the salary of the works manager) which cannot be directly allocated to the various departments and cost centres are apportioned. Apportionment implies the allotment of proportions of items of cost to cost� centres or departments . It implies that the unallocable expenses are to be spread� over the various departments or cost centres on an equitable basis. After this stage, all the overhead costs would have been either allocated to or apportioned over the various departments. 4. Re-apportionment : The next stage is to re-apportion the overhead costs of service departments over production departments. Service departments are those departments which do not directly take part in the production of goods. Such departments provide ancillary services. Examples of such departments are boiler house, canteen, stores, time office, dispensary etc. The overheads of these departments are to be re-apportioned over the production departments since service departments operate primarily for the purpose of providing services to production departments. At this stage, all the factory overheads are collected under production departments. 5. Absorption : The production department overheads are absorbed over production units. The overhead expenses can be absorbed by estimating the overhead expenses and then working out an absorption rate. When overheads are estimated, their absorption is carried out by adopting a pre-determined overhead absorption rate. This rate can be calculated by using any one method as discussed in this chapter at the end. As the actual accounting period begins, each unit of production automatically absorbs a certain amount of factory overheads through pre-determined rates. During the year a certain amount will be absorbed over the various products. This is known as the total amount of absorbed overheads. 6. Treatment of over and under absorption of overheads : After the year end the total amount of actual factory overheads is known. There is bound to be some difference between the actual amount of overheads and the absorbed amount of overheads. The difference has to be adjusted keeping in view of such differences and the reasons therefor. Students will thus see that the whole discussion as above is meant to serve the following two purposes : (a) to charge various products and services with an equitable portion of the total amount of factory overheads ; and

4.9

Cost Accounting

(b) to charge factory overheads immediately as the product or the job is completed without waiting for the figures of actual factory overheads.4.4 STEPS FOR THE DISTRIBUTION OF OVERHEADS

The various steps for the distribution of overheads have been discussed in detail as below:4.4.1 Estimation and Collection of Manufacturing Overheads : The amount of factory overheads is required to be estimated. The estimation is usually done with reference to past data adjusted for known future changes. The overhead expenses are usually collected through a system of standing orders. Standing Orders : In every manufacturing business, expenses are incurred on direct materials and direct labour in respect of several jobs or other units of production, manufacture of which is undertaken. The incurring of these expenses is authorised by production orders or work orders. The work order numbers are not ordinarily fixed or permanent. They are generally allotted in a serial order according to the number of manufacturing jobs undertaken by the business. In addition, indirect expenses are incurred in connection with the rendering of services to the production departments, or to the manufacturing process. The term Standing Order denotes� � sanction for indirect expenses under various heads of expenditure.

In large factories, usually the classification of indirect expenditures is combined with a system of Standing Orders (sometimes also referred as Service Orders ). It is a system under which a number is allotted to each item of expense� � for the purpose of identification, and the same is continued from year to year. All the indirect expenditure in such a case, is charged to one or the other of the Standing Orders and periodical summaries, giving total of each Standing Order, are prepared for comparison with budgets, as well as for apportioning them among the various departments. The extent of such analysis and the nomenclature adopted are settled by the management according to the needs of the industry.4.4.2 Allocation of overheads over various Departments or Departmentalisation of Overheads : Most of the manufacturing processes functionally are different and are performed by different departments in the factory. Where such a division of functions had been made, some of the departments should be engaged in actual production of goods, and others in providing services ancillary thereto. At this stage, the factory overheads which can be directly related to the various production or service departments are allocated in this manner.

It may, sometime, become necessary to sub-divide a manufacturing organisation into several cost centres, so that a closer distribution of expenses and a more detailed control is practicable.4.10

Overheads

It is thus obvious that the principal object of setting up cost centres is to collect data, in respect of similar activities more conveniently. This avoids a great deal of cost analysis. When costs are collected by setting up cost centres, several items can be ascertained definitely and the element of estimation is reduced considerably. For instance, the allowance of the normal idle time or the amount to be spent on consumable stores, etc. There are two main type of cost centres - machine or personal - depending on whether the process of manufacture is carried on at a centre by man or machine. For the convenience of recording of expenditure, cost centres are sometimes allotted a code number.Advantages of Departmentalisation : The collection of overheads departmentwise gives rise to the following advantages :

(a) Some expenses which relate to the departments will be estimated almost on an exact basis and, to that extent, the accuracy of estimation of overheads will be higher. (b) For the purpose of controlling expenses in a department, it is obviously necessary that the figures in relation to each department should be separately available. It is one of the main principles of control that one should know for each activity how much should have been spent and how much is actually spent. If information about expenses is available only for factory as a whole, it will not be possible to know which department has been over spending. (c) From the point of view of ascertaining the cost of each job, the expenses incurred in the departments through which the job or the product has passed should be known. It is only then that the cost of the job or the product can be charged with the appropriate share of indirect expenses. It is not necessary that a job must pass through all the departments or that the work required in each department should be the same for all jobs. It is, therefore, necessary that only appropriate charge in respect of the work done in the department is made. This can be done only if overheads for each department are known separately. (d) A suitable method of costing can be followed differently for each department e.g., batch costing when a part is manufactured, but single or output costing when the product is assembled.4.4.3 & 4.4.4 Apportioning overhead expenses over various departments and reapportioning service department overheads over production department : After the allocable overheads are related to the departments, expenses incurred for several departments have to be apportioned over each department, e.g. rent, power, lighting, insurance and depreciation. For distributing these overheads over different departments benefiting thereby, it is necessary at first to determine the proportion of benefit received by each department and then distribute the total expenditure proportionately on that basis. But the same basis of apportionment cannot be followed for different items of overheads

4.11

Cost Accounting

since the benefit of service to a department in each case has to be measured differently. Some of the basis that are generally adopted for the apportionment of expenses are stated below :Basis Expense items

Area or cubic measurement of department Rent, rates, lighting Direct labour hours or, where wage rates are maintenance Supervision more or less uniform, total direct wages of department. Number of employees in departments Cost of material used by departments Value of assets Horse power of machines Supervision Material handling charges Depreciation and insurance Power

and

building

Other basis of apportioning overhead costs : We have considered already that the benefit received by the department generally is the principal criterion on which the costs of service departments or common expenses are apportioned. But other criteria are equally valid. Three of them are mentioned below :

(a) Analysis or survey of existing conditions. (b) Ability to pay. (c) Efficiency or incentive. A single concern may have only one criterion under consideration predominantly or may use all (including the service or benefit criterion) for different phases of its activity.Analysis or Survey of existing conditions : At times it may not be possible to determine the advantage of an item of expenses without undertaking an analysis of expenditure. For example, lighting expenses can be distributed over departments only on the basis of the number of light points fixed in each department. Ability to pay : It is a principle of taxation which has been applied in cost accounting as well for distributing the expenditure on the basis of income of the paying department, on a proportionate basis. For example, if a company is selling three different products in a territory, it may decide to distribute the expenses of the sales organisation to the amount of sales of different articles in these territories. This basis, though simple to apply, may be inequitable since the expenditure charged to an article may have no relation to the actual effort involved in selling it. Easy selling lines thus may have to bear the largest proportion of expenses while, on the other hand, these should bear the lowest charge. Efficiency or Incentives : Under this method, the distribution of overheads is made on the4.12

Overheads

basis of pre-determined levels of production or sales. When distribution of overhead cost is made on this basis and if the level of production exceeds the pre-determined level of production the incidence of overhead cost gets reduced and the total cost per unit of production or of sales, lowered. The opposite is the effect if the assumed levels are not reached. Thus the department whose sales are increasing is able to show a greater profit and thereby is able to earn greater goodwill and appreciation of the management than it would have if the distribution of overheads was made otherwise.Inter-departmental service costs : At first, expenses of all departments are complied without making a distinction between production and service departments. Then the expenses of the service departments are apportioned among the production departments on a suitable basis. This is because ultimately the overheads are to be absorbed over goods produced or jobs completed in the production departments.

The re-apportionment of service department expenses over the production departments may be carried out by using any one of the following methods : (i) Direct re-distribution method. (ii) Step method of secondary distribution or non-reciprocal method. (iii) Reciprocal Service method.Direct re-distribution method: Service department costs under this method are apportioned over the production departments only, ignoring the services rendered by one service department to the other. To understand the application of this method go through the illustration which follows. Illustration XL Ltd., has three production departments and four service departments. The expenses for these departments as per Primary Distribution Summary are as follows :

Production Departments : A B C 30,000 26,000 24,000

Rs.

Rs;

80,000Rs. Rs.

Service Departments :

Stores Time-keeping and Accounts Power Canteen

4,000 3,000 1,600 1,000

_____

9,600

4.13

Cost Accounting

The following information is also available in respect of the production departments :Dept. A Dept. B Dept. C

Horse power of Machine Number of workers

300 20

300 15

200 15 1,000

Value of stores requisition in (Rs.) 2,500 1,500 Apportion the costs of service departments over the production departments.Solution Secondary Overhead Distribution Statement Item of cost (as per primary distribution summary) Rs. Basis of apportionment A Rs. B Rs. Total

Production Depts C Rs.

Cost as per primary distribution summary Stores Value of stores requisition : (5:3:2) Time-keeping and Accounts (4:3:3) Power (3:3:2) Canteen (4:3:3) No. of workers H.P. of M/c s No. of workers�

80,000

30,000

26,000

24,000

4,000

2,000

1,200

800

3,000

1,200

900

900

1,600

600

600

400

1,000

400

300

300

89,600 34,200 29,000 26,400 (ii) Step Method or Non-reciprocal method : This method gives cognizance to the service rendered by service department to another service department. Therefore, as

4.14

Overheads

compared to previous method, this method is more complicated because a sequence of apportionments has to be selected here. The sequence here begins with the department that renders service to the maximum number of other service departments. In other words the cost of the service department which serves the largest number of other service and production departments, is distributed first. After this, the cost of service department serving the next largest number of departments is apportioned. This process continues till the cost of last service department is apportioned. The cost of last service department is apportioned among production departments only.Some authors are of the view that the cost of service department with largest amount of cost should be distributed first. Refer to the illustration which follows to understand this method. Illustration

Suppose the expenses of two production departments A and B and two service departments X and Y are as under :Amount Rs. Y A Apportionment Basis B

X Y A BSolution

2,000 1,500 3,000 3,200

25% �

40% 40%

35% 60%

Summary of Overhead Distribution

Departments Amount as given above Expenses of X Dept. apportioned over Y,A and B Dept. in the ratio (5:8:7) Expenses of Y Dept. apportioned over A

XRs.

YRs.

ARs.

BRs.

2,000

1,500

3,000

3,200

2,000�

500

800

700

4.15

Cost Accounting

and B Dept. in the ratio (2:3) Total Nil

2,000�Nil

800 4,600

1,200 5,100

(iii) Reciprocal Service Method : This method recognises the fact that where there are two or more service 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 service departments. The methods available for dealing with reciprocal services are : (a) Simultaneous equation method ; (b) Repeated distribution method ; (c) Trial and error method. (a) Simultaneous equation method : According to this method firstly, the costs of service departments are ascertained. These costs are then re-distributed to production departments on the basis of given percentages. (Refer to the following illustration to understand the method)Illustration

Service departments expensesRs.

Boiler House Pump Room The allocation is :Production Departments A B

3,000 600 3,600Boiler House Pump Room

Boiler House Pump RoomSolution

60% 10%

35% 40%

50%�

5% �

The total expenses of the two service departments will be determined as follows :

Let B stand for Boiler House expenses and P for Pump Room expenses.

4.16

Overheads

Then B = 3,000 + 1/2 P P = 600 + 1/20 B Substituting the value of B, P = 600 + 1/20 (3,000 + 1/2 P) = 600 + 150 + 1/40 P = 750 + 1/40 P 40 P = 30,000 + P 39 P = 30,000 P = Rs. 769 (approx.) The total of expenses of the Pump Room are Rs. 769 and that of the Boiler House is Rs. 3,385 i.e., Rs. 3,000 + 1/2 Rs. 769. The� expenses will be allocated to the production departments as under :Production departments : A Rs. B Rs.

Boiler House (60% and 35% of Rs. 3,385) Pump Room (10% and 40% of Rs. 769) Total The total of expenses apportioned to A and B is Rs. 3,600.

2,031 77 2,108

1,185 307 1,492

(b) Repeated distribution method : Under this method, service departments costs are distributed to other service and production departments on agreed percentages and this process continues to be repeated, till the figures of service departments are either exhausted or reduced to too small a figure. (Refer to the following illustration to understand this method)Illustration

PH Ltd., is a manufacturing company having three production departments, A , B� � � � and C and two service departments X and Y . The following is the budget for� � � � � � December 2005 :Total Rs. A Rs. B Rs. C Rs. X Rs. Y Rs.

Direct material Direct wages

1,000 5,000

2,000 2,000

4,000 8,000

2,000 1,000

1,000 2,000

4.17

Cost Accounting

Factory rent Power Depreciation Other overheads

4,000 2,500 1,000 9,000

Additional information : Area (Sq. ft.) 500 250 500 250 500 Capital value (Rs. lacs) of assets 20 40 20 10 10 Machine hours 1,000 2,000 4,000 1,000 1,000 Horse power of machines 50 40 20 15 25 A technical assessment of the apportionment of expenses of service departments is as under : A B C X Y

% Service Dept. X Service Dept. Y Required : (i) 45 60� � � �

% 15 35

% 30 �

% 5�

% 10 �

A statement showing distribution of overheads to various departments.

(ii) A statement showing re-distribution of service departments expenses to production departments. (iii) Machine hour rates of the production departments A , B and C .� � � � � �Solution (i) Overhead Distribution Summary Basis Total Rs. 4,000 A Rs. � � � � 1,000 B Rs. 500 C Rs. 1,000 X Rs. 2,000 1,000 500 Y Rs. 1,000 2,000 1,000� � � �

Direct materials Direct Direct Direct wages Area Factory rent Power H.P. M/c� Hrs. Depreciation Cap., value Other overheads M/c hrs.

2,500 1,000 9,000

500 200 1,000 2,700

800 400 2,000 3,700

800 200 4,000 6,000

150 100 1,000 4,750

250 100 1,000 5,350

4.18

Overheads

(ii) Redistribution of Service Department s expenses : A Rs. B Rs. C Rs. X Rs. Y� Rs.

Total overheads Dept. X overhead apportioned in the ratio (45:15:30: :10) Dept. Y� overhead apportioned in the ratio (60: 35: :5) Dept. X overhead apportioned in� � the ratio (45:15:30: :10) Dept. Y overhead apportioned in the ratio (60:35: :5: )� � � Dept. X overhead apportioned in the ratio (45:15:30: :10)�

2,700 2,138 3,495 131 17 1 8,482

3,700 712 2,039 44 10 - 6,505

6,000 1,425 - 87 - 1 7,513

4,750 4,750 291 291 2 2 -� � �

5,350 475 5,825 29 29 - -� �

(iii) Machine hour rate :

Machine hours Machine hour rate (Rs.)

1,000 8.48

2,000 3.25

4,000 1.88

(Rs. 8,482/1,000 hrs) (Rs. 6,505/2,000 hrs.) (Rs. 7,513/4,000 hrs.) (c) Trial and error method - According to this method the cost of one service Cost Centre is apportioned to another service Cost Centre. The cost of another service centre plus the share received from the first Cost Centre is again apportioned to the first cost centre. This process is repeated till the amount to be apportioned becomes negligible. (Refer to the following illustration to understand this method.)

4.19

Cost Accounting

Illustration

The ABC Company has the following account balances and distribution of direct charges on 31st March, 2005.Total Production Depts. Machine Shop Allocated Overheads : Rs. Rs. Rs. Packing Service Depts. Gen. Plant Rs. Store & Maintenanace Rs.

Indirect labour Maintenance material Misc. supplies Superintendent s salary Cost &� payroll salary Power Rent Fuel and heat Insurance Taxes Depreciation

14,650 5,020 1,750 4,000 10,000 8,000 12,000 6,000 1,000 2,000 1,00,000 1,64,420�

4,000 1,800 400 � �

3,000 700 1,000 4,000 �

2,000 1,020 150 10,000�

5,650 1,500 200 �

Overheads to be apportioned :

6,200

4,700

17,170

7,350

The following data were compiled by means of the factory survey made in the previous year :Floor Space Radiator Sections No. of Employees Investment Rs. H.P hours

Machine Shop Packing General Plant Store & Maint.

2,000 Sq. ft. 800 400 1,600 4,800 � � � � � � � �

45 90 30 60 225

20 10 3 5 38

6,40,000 2,00,000 10,000 1,50,000 10,00,000

3,500 500 1,000 5,000�

4.20

Overheads

Expenses charged to the stores and maintenance departments are to be distributed to the other departments by the following percentages : Machine shop 50%; Packing 20%; General Plant 30% ; General Plant overheads is distributed on the basis of number of employees : (a) Prepare an overhead distribution statement with supporting schedules to show computations and basis of distribution including distribution of the service department expenses to producing department. (b) Determine the service department distribution by the method of continued distribution. Carry through 3 cycles. Show all calculations to the nearest rupee.Solution (a) Overhead Distribution Statement Production Departments Machine Packing Shop Rs. Rs. Service Departments General Stores & Plant Maintenance Rs. Rs.

Allocated Expenses:

Indirect labour Maintenance material Superintendent s salary Misc. supplies Cost &� payroll salaries Total Apportioned expenses (See schedule below) TotalItem Basis

4,000 1,800 - 400 - 6,200 77,720

3,000 700 - 1,000 - 4,700 25,800

2,000 1,020 4,000 150 10,000 17,170 2,830

5,650 1,500 - 200 - 7,350 22,650 30,000Stores & Maintenance Rs.

83,920 30,500 20,000 Schedule of Apportioned ExpensesMachine Shop Rs. Rs. Packing General Plant Rs.

Power Rent Fuel & Heat

Horse Power Hrs. 5,600 Floor Space Radiator Secs. 5,000 1,200

800 2,000 2,400

1,000 800�

1,600 4,000 1,600

4.21

Cost Accounting

Insurance Taxes Depreciation Total (b)

Investment Investment Investment

640 1,280 64,000 77,720

200 400 20,000 25,800

10 20 1,000 2,830

150 300 15,000 22,650

Distribution of Service Department Expenses Production Departments Machine Rs. Packing Rs. Service Departments General Plant Rs. Stores & Maintenance Rs.

Total Expense [as per (a)] Transfer from Stores & Maintenance Transfer from General Plant Transfer from Stores & Maintenance Transfer from General Plant Transfer from Stores & Maintenance Transfer from General Plant TotalIllustration

83,920 15,000 16,571 2,072 710 88 35 1,18,396

30,500 6,000 8,286 829 355 36 18 46,024

20,000 9,000 29,000 1,242 1,242 53 53 � � � �

30,000 30,000 4,143 4,143 177 177 � � � � �

Modern Manufactures Ltd. have three Production Departments P1, P2, P3 and two Service Departments S1 and S2 details pertaining to which are as under :P1 P2 P3 S1 S2

Direct wages (Rs.) Working hours Value of machines (Rs.) H.P. of machines Light points Floor space (sq. ft.)4.22

3,000 3,070 60,000 60 10 2,000

2,000 4,475 80,000 30 15 2,500

3,000 2,419 1,00,000 50 20 3,000

1,500 5,000 10 10 2,000

195 5,000 5 500

Overheads

The following figures extracted from the Accounting records are relevant:Rs.

Rent and Rates General Lighting Indirect Wages Power Depreciation on Machines

5,000 600 1,939 1,500 10,000

Sundries 9,695 The expenses of the Service Departments are allocated as under :P1 P2 P3 S1 S2

S1 S2

20% 40%

30% 20%

40% 30%

10%

10% -

Find out the total cost of product X which is processed for manufacture in Departments P1, P2 and P3 for 4, 5 and 3 hours respectively, given that its Direct Material Cost is Rs. 50 and Direct Labour Cost is Rs. 30.Solution Statement Showing Distribution of Overheads of Modern Manufacturers Ltd. Particulars Basis Total Rs. Production Depts P1 Rs. P2 Rs. P3 Rs. Service Depts. S1 Rs. S2 Rs.

Rent & Rates General lighting Indirect wages Power Depreciation of machines Sundries

Area Light points Direct wages H.P. Value of machines

5,000 600 1,939 1,500 10,000 ______ 28,734

1,000 100 600 600 2,400 3,000 _____ 7,700

1,250 150 400 300

1,500 200 600 500

1,000 100 300 100 200 1,500 _____ 3,200

250 50 39 - 200 195 ____ 734

3,2004,000 2,0003,000 _____ 7,300 _____ 9,800

Direct Wages 9,695

4.23

Cost Accounting

Redistribution of Service Department s Expenses Over Production Departments�Production Depts. Total Rs. Total Overheads Dept. S1 Overheads apportioned in the ratio (20:30:40: :10) Dept. S2 Overheads apportioned in the ratio (40:20:30:10: )� � Dept. S1 Overheads apportioned in the ratio (20:30:40: :10) Dept. S2 Overheads� apportioned in the ratio (40:20:30:10: ) Dept. S1 Overheads apportioned in the� ratio (20:30:40: :10) Dept. S2 Overheads apportioned in the ratio (40:20:30:10: )� � Total Working hours Rate per hour 8,787.16 3,075.00 2.86 8,504.87 11,441.79 4,475.00 2,419.00 1.90 4.73 1.05 0.10 0.21 0.05 0.32 0.02 0.42 0.03 1.0 50.10� � -0.10 10.54 4.22 2.11 3.16 1.05 10.54 105.40 21.08 31.62 42.16 105.40 10.54� � 1,054.00 421.60 210.80 316.20 105.40 1,054 28,734 3,200 P1 Rs. 7,700 640 P2 Rs.� 7,300 960 P3 Rs. 9,800 1,280 Service Depts. S1 Rs. 3,200 3,200 S2 Rs. 734 320�

(See Working Note 1) Cost of the product X Rs.� �

Direct material cost Direct labour cost Overhead costWorking Note :

50.00 30.00 35.13 115.13

1.

Working rate per hour for production department

P1 =

Rs.8,787.16 = Rs. 2.86 3,075

4.24

Overheads

Similarly production rate for production departments P2 and P3 are Rs. 1.90 and Rs. 4.73. 2.Overhead cost

Rs. 2.86 4 hrs. + Rs. 1.90 5 hrs. + Rs. 4.73 3 hrs. = Rs. 11.44 + Rs. 9.50 +� � � Rs. 14.19 = Rs. 35.13Note The service departments have only indirect costs which are to be absorbed by production departments. However if the direct wages appearing in the question are assumed to be incurred on the service departments only, which have not been accounted for, by any other activity carried on in the service departments, then total expenses of the service departments including the aforesaid direct wages should be charged in the respective production departments. If this assumption holds good the alternative solution can appear as under. Alternative Solution Statement Showing Distribution of Overheads of Modern Manufactures Ltd. Production Departments Particulars Basis Total P1 P2 P3 Rs. Rs. Rs. Rs.

Service Departments S1 S2 Rs. Rs.

Direct wages Rent & rates General lighting Indirect wages Power Depreciation of machines Sundries

Actual Area Light points Direct wages H.P. Value

1,695 5,000 600 1,939 1,500

1,000 100 600 600 2,400 3,000 7,700

1,250 150 400 300 3,200 2,000 7,300

1,500 200 600 500 4,000 3,000 9,800

1,500 1,000 100 300 100 200 1,500 4,700

195 250 50 39 - 200 195 929

of machines 10,000 Direct wages 9,695 30,429

4.25

Cost Accounting

Redistribution of Service Department s Expenses over Production Departments�Total Rs. Total Overheads Dept. S1 Overheads apportioned in the ratio: (20:30:40: :10) Dept. S2 overheads apportioned in the ration :(40:20:30:10: )� � Dept. S1 overheads apportioned in the ratio (20:30:40: :10) Dept. S2 overheads� apportioned in the ratio (40:20:30:10: ) Dept. S1 overheads apportioned in the� ratio (20:30:40: :10) Dept. S2 overheads apportioned in the ratio (40:20:30:10: )� � Total Working hours Working rate per hour 9,233.52 3,070.00 3.00 9,035.02 12,160.47 4,475.00 2,419.00 2.02 5.03 0.14 0.06 0.03 0.05 0.14 1.40 0.28 0.42� 0.56 1.40 0.14 13.99 5.60 2.80 4.20 1.40 13.99 139.90 27.98 41.97 55.96 139.90� � � 13.99 1,399.00 559.60 279.80 419.70 139.90 1,399.00 30,429 4,700 P1 Rs. 7,700 940� P2 Rs. 7,300 1,410 P3 Rs. 9,800 1,880 S1 Rs. 4,700 4,700 S2 Rs. 929 470�

Cost of the Product X� �

Direct material cost Direct labour cost Overhead cost (See working note)Working note : Overhead cost :

Rs. P. 50.00 30.00 37.19

117.25

Rs. 3 4 hrs. + Rs. 2.02 5 hrs. + Rs. 5.03 3 hrs. = Rs. 12 + Rs. 10.10 + Rs.� � � 15.09 = Rs. 37.19Illustration :

Deccan Manufacturing Ltd., have three departments which are regarded as4.26

Overheads

production departments. Service departments costs are distributed to these� production departments using the Step Ladder Method of distribution. Estimates� � of factory overhead costs to be incurred by each department in the forthcoming year are as follows. Data required for distribution is also shown against each department:Department Factory overhead Rs. Direct labour hours No. of employees Area in sq.m.

Production: X Y Z Service: P Q R 45,000 75,000 1,05,000 1,000 5,000 6,000 10 50 40 500 1,500 1,000 1,93,000 64,000 83,000 4,000 3,000 4,000 100 125 85 3,000 1,500 1,500

S 30,000 3,000 50 1,000 The overhead costs of the four service departments are distributed in the same order, viz., P,Q,R and S respectively on the following basis.Department Basis

P Q R SYou are required to :

Number of employees Direct labour hours Area in square metres Direct labour hours

(a) Prepare a schedule showing the distribution of overhead costs of the four service departments to the three production departments; and (b) Calculate the overhead recovery rate per direct labour hour for each of the three production departments.

4.27

Cost Accounting

Solution

(a)

Deccan Manufacturing Limited Schedule Showing the Distribution of Overhead Costs among Departments Service ProductionP Rs. Overhead costs Distribution of overhead cost of Dept. P Distribution of� � overhead costs of Dept. Q Distribution of overhead cost of Dept. R� � � � Distribution of overhead costs of Dept. S Total (A) - (66,000) 24,000 18,000� � 24,000 3,00,000 1,35,000, 1,60,000 - (1,33,000) 19,000 57,000 28,500 28,500 - (80,000) 24,000 12,000 16,000 12,000 16,000 (45,000) 5,000 4,000 5,000 10,000 12,500 8,500 Q Rs. R Rs. 1,05,000 S Rs. X Rs. Y Rs. 64,000 Z Rs. 83,000

45,000 75,000

30,000 1,93,000

(b) Direct labour hours (B) Overhead recovery rate per hourIllustration

4,000

3,000 Rs. 45

4,000 Rs. 40

( A) (B)

Rs. 75

A Ltd., manufactures two products A and B. The manufacturing division consists of two production departments P 1 and P 2 and two service departments S 1 and S 2 . Budgeted overhead rates are used in the production departments to absorb factory overheads to the products. The rate of Department P 1 is based on direct machine hours, while the rate of Department P 2 is based on direct labour hours. In applying overheads, the pre-determined rates are multiplied by actual hours. For allocating the service department costs to production departments, the basis adopted is as follows : (i) Cost of Department S 1 to Department P 1 and P 2 equally, and (ii) Cost of Department S 2 to Department P 1 and P 2 in the ratio of 2 : 1 respectively.4.28

Overheads

The following budgeted and actual data are available:Annual profit plan data :

Factory overheads budgeted for the year:Rs. Rs.

Departments

P1 P2

25,50,000 21,75,000

S1 S2

6,00,000 4,50,000

Budgeted output in units :

Product A 50,000; B 30,000.Budgeted raw-material cost per unit :

Product A Rs. 120; Product B Rs. 150.Budgeted time required for production per unit :

Department P1 : Department P2 :

Product A : 1.5 machine hours Product B : 1.0 machine hour Product A : 2 Direct labour hours Product B : 2.5 Direct labour hours

Average wage rates budgeted in Department P2 are :

Product A - Rs. 72 per hour and Product B Rs. 75 per hour. All materials are� used in Department P1 only. Actual data : (for the month of July, 2005)Units actually produced : Product A : 4,000 units

Product B : 3,000 unitsActual direct machine hours worked in Department P1 :

On product A 6,100 hours, Product B 4,150 hours.Actual direct labour hours worked in Department P2 :

on product A 8,200 hours, Product B 7,400 hours.

4.29

Cost Accounting

Costs actually incurred:Product A Rs. Product B Rs.

Raw materials Wages Overheads : Department

4,89,000 5,91,900Rs.

4,56,000 5,52,000Rs.

P1 2,31,000 P2 2,04,000

S1 60,000 S2 48,000

You are required to :

(i)

Compute the pre-determined overhead rate for each production department.

(ii) Prepare a performance report for July, 2005 that will reflect the budgeted costs and actual costs.Solution : (i) Computation of predetermined overhead rate for each production department from budgeted data Production Deptts. Service Deptts. P1 P2 S1 S2

Budgeted factory overheads for the year in (Rs.) Allocation of service department S1 s costs to production departments P1 and P2 equally in (Rs.) Allocation of� service department S2 s costs to production departments P1 and P2 in the ratio of� 2:1 in (Rs.) Total (Rs.) Budgeted machine hours in department P1 (Refer to working note 1)4.30

25,50,000

21,75,000

6,00,000

4,50,000

3,00,000

3,00,000

6,00,000�

�

3,00,000 31,50,000 1,05,000

1,50,000 26,25,000

�Nil

4,50,000�Nil

Overheads

Budgeted labour hours in department P2 (Refer to working note 2) Budgeted machine hour rate (Rs. 31,50,000/1,05,000) Budgeted labour hour rate (Rs. 26,25,000/1,75,000)(ii)

1,75,000

Rs. 30 Rs. 15Performance report for July, 2005

(When 4,000 and 3,000 units of products A and B respectively were actually produced) Budgeted Rs. Raw materials used in department P1 Actual Rs.

A : 4,000 units Rs. 120 B : 3,000 units Rs. 150� �Direct labour

4,80,000 4,50,000

4,89,000 4,56,000

Cost on the basis of labour hours worked in department P2 A : 4,000 units 2 hrs.� Rs. 72 B : 3,000 units 2.5 hrs. Rs. 75 A : 4,000 units 1.5 hrs. Rs. 30 B� � � � � : 3,000 units 1 hr. Rs. 30 A : 4,000 units 2 hrs. Rs. 15 B : 3,000 units � � � � � 2.5 hrs. Rs. 15 * (Refer to working note 4) ** (Refer to working note 5)� 5,76,000 5,62,500 1,80,000 90,000 1,20,000 1,12,500 25,71,000 5,91,900 5,52,000 1,74,400* 1,18,649 1,31,364 ** 1,18,548 26,31,861

Overhead absorbed on machine hour basis in department P1

Overhead absorbed on labour hour basis in department P2

4.31

Cost Accounting

Working notes : Product A Product B Total

1.

Budgeted output (in units) Budgeted machine hours in department P1 Budgeted labour hours in department P2

50,000 75,000 (50,000 1.5 hrs.) 1,00,000 (50,000 2 hrs.) Product A� �

30,000 30,000 (40,000 1 hr.) 75,000 (30,000 2.5 hrs.) Product B 3,000 4,150 7,400� � 10,250 15,600 Total 1,75,000 1,05,000

2.

Actual output (in units) Actual machine hours utilised in department P1 Actual labour hours utilised in department P2

4,000 6,100 8,200

3.

Computation of actual overhead rates for each production department from actual data Production Deptts. P1 P2 Service Deptts. S1 S2

Actual factory overheads for the month of July, 2005 in (Rs.) Allocation of service department S1 s costs in (Rs.) over production departments P1 and P2� equally Allocation of service department S2 s costs in (Rs.) over production� departments P1 and P2 in the ratio 2 : 1 Total (Rs.) 32,000 2,93,000 16,000 2,50,000 -Nil

2,31,000

2,04,000

60,000

48,000

30,000

30,000

60,000�

-

48,000�Nil

4.32

Overheads

Actual machine hours in department P1(Refer to working note 2) Actual labour hours in department P2

10,250

-

-

-

-

15,600

- - -

- - -

(Refer to working note 2) Machine hour rate Rs. 28.59 - (Rs. 2,93,000/10,250) Labour hour/rate - Rs. 16.02 (Rs. 2,50,000/15,600) 4. Actual overheads absorbed (based on machine hours)

A : 6,100 hrs Rs. 28.59 = B : 4,150 hrs Rs. 28.59 = 5. A : 8,200 hrs Rs.� � � 16.02 = B : 7,400 hrs Rs. 16.02 =�

Rs. 1,74,400 (say) Rs. 1,18,649 (say) Rs. 1,31,364 Rs. 1,18,548

Actual overheads absorbed (based on labour hours)

4.4.5 Absorbing overheads over cost units, products, etc.: Collection of the figure of overheads for the factory as a whole or for various departments is not enough. It is clearly necessary to ascertain how much of the overheads is debitable to the cost of the various jobs, products etc. This process is called absorbing the overhead to cost units. We take up below the various implications of this process. However, if only one uniform type of work is done, the task is easy and under such a situation the overhead expenses to be absorbed may be calculated by dividing actual overheads by the number of units of work done or estimated overheads by the estimated output. Normal and pre-determined overhead rates : Various items of overhead expenses generally are not incurred uniformly throughout the accounting period e.g., insurance premium are paid annually, rates and taxes quarterly, etc. The monthly total of overhead expenses for each department or cost centre, therefore, may fluctuate from month to month. As such, monthly totals cannot be regarded as satisfactory. It being necessary to absorb the overhead costs in the cost of production of each lot or batch of production, as soon as its manufacture is complete an estimate of the total amounts of annual overhead expenses must be made in advance. Likewise, an advance estimate of the annual volume of production (in terms of the amount of direct wages, number of direct labour hours, etc.) must be made and, on that basis, a pre-determined overhead rate is calculated.

4.33

Cost Accounting

The overhead rate of expenses for absorbing them to production may be estimated on the following three basis. (1) The figure of the previous year or period may be adopted as the overhead rate to be charged to production in the current year. The assumption is that the value of production as well as overheads will remain constant or that the two will change, proportionately. (2) The overhead rate for the year may be determined on the basis of estimated expenses and anticipated volume of production activity. For instance, if expenses are estimated at Rs. 10,000 and output at 4,000 units, the overhead rate will be Rs. 250 per unit. (3) The overhead rate for a year may be fixed on the basis of the normal volume of the business. If, in the example given above, the normal capacity is 5,000 units, the overhead rate will be Rs. 2. The first method is rather crude and is not likely to yield satisfactory results unless the undertaking is small and output and expenses are fairly constant over the period. In large concerns, conditions are rarely static and, hence, expenses fluctuate from one period to another. Therefore, so far as a large enterprise is concerned, the overhead rates of the past periods may not have much relevance for the purpose of arriving at the cost of production in the current period. The second method is based on the assumption that all expenses shall have to be recovered irrespective of the volume of output. From such an assumption, it follows that, if in any period there is a large idle or unused capacity, the entire amount of the overhead expenses shall have to be absorbed over the reduced volume of the output. A sizeable portion of the overhead expenses is made up of the fixed charges; if those fixed charges have to be included in the costs of the reduced output the incidence of overheads per unit of production would necessarily be high. Similarly, if the volume of output in any period exceeds the normal level, the incidence of fixed overheads per unit will be comparatively lower. The effect of this method is that during periods of falling production (and perhaps of falling prices), the cost of production would be higher and, correspondingly, during a period of rising production and perhaps rising prices), the cost of production would be low. This would be illogical idleness or a level of activity above the normal capacity is abnormal and should not affect costs; the Costing Profit and Loss Account is the place where the effect of such abnormal factors should be shown. It is also possible that when output falls and total cost per unit goes up (if expenses are absorbed over actual output), the firm may demand a price above the market price and may find itself without customers. On this consideration, the most appropriate basis for the computation of4.34

Overheads

predetermined rate of overhead cost is the normal capacity of production. Estimation on this basis as suggested in the third method, has many advantages over the other two methods. It enables not only the computation of correct costs but also true cost to be recovered. In a competitive economy, the concept of costs is essentially that of normal costs. Normal costs should be the yard stick against which the efficiency or otherwise, of the competing unit should be measured. A cost that is correct need not necessarily be true. True costs are in a sense notional cost and the term normal is derived from the concept of normal costs.� � Hence, the use of normal overhead rates has a two fold advantage. It enables the true as well as correct costs to be calculated; at the same time by highlighting differences between the amount of overhead expenses actually incurred and those absorbed in production it provides useful guidance to the management in taking decisions as regards production and sales.Blanket and departmental overhead rates: Blanket overhead rate refers to the computation of one single overhead rate for the whole factory. It is to be distinguished from the departmental overhead rate which refers to a separate rate for each individual cost centre or department. The use of blanket rate may be proper in certain factories producing only one major product in a continuous process (e.g., chemical factories) or where the work performed in every department is fairly uniform or standardised. Where, however, the product lines are varied or machinery is used to a varying degree in the different departments, that is, where conditions throughout the factory are not uniform, the use of departmental rates is to be preferred. The working condition in the last mentioned case would be such that varying amount of expenses would be continually incurred by the several service departments and hence, the incidence of overhead cost of each department would be different. Since not all products would ordinarily undergo the same type or of different type of operations in different departments, the charging of a single overhead rate in such a case would give misleading results.

It may therefore, be concluded that a blanket rate should be applied. (1) where only one major product is being produced. (2) where several products are produced, but (a) all products pass through all departments; and (b) all products are processed for the same length of time in each department. Where these conditions do not exist, departmental rates should be used.4.5 METHODS OF ABSORBING OVERHEADS TO VARIOUS PRODUCTS OR JOBS

Before we describe various methods, it would be better to know how to judge whether a method will give good results or not. The method selected for charging overheads to

4.35

Cost Accounting

products or jobs should be such as will ensure : (i) that the total amount charged (or recovered) in a period does not differ materially from the actual expenses incurred in the period. In other words, there should not be any significant over or under recovery of overhead; and that the amount charged to individual jobs or products is equitable. In case of factory overhead, this means : (a) that the time spent on completion of each job should be taken into consideration; (b) that a distinction should be made between jobs done by skilled workers and those done by unskilled workers. Usually, the latter class of workers needs more supervision, causes greater wear and tear of machines and tools and waste a larger quantity of materials. Hence jobs done by such workers should bear a correspondingly higher burden for overheads; and (c) that jobs done by manual labour and those done by machines should be distinguished. It stands to reason that no machine expenses should be charged to jobs done by manual labour. In addition, the methods should (i) (ii) be capable of being used conveniently; and yield uniform result from period to period as far as possible; any change that is apparent should reflect a change in the underlying situation such as substitution of human labour by machines.

(ii)

Several methods are commonly employed either individually or jointly for computing the appropriate overhead rate to be employed. The more common of these are : (1) Percentage of direct materials. (2) Percentage of prime cost. (3) Percentage of direct labour cost. (4) Labour hour rate. (5) Machine hour rate.4.5.1 & 4.5.2 Percentage of direct material and prime cost

Suppose for a given period, actual figures are estimated as follows :Rs.

Direct materials

2,00,000

4.36

Overheads

Direct labour Factory overheads

1,00,000 90,000

The percentage of factory overheads to direct materials will be 45%, to prime cost 30% and to direct labour 90%. If, on a job, material cost is Rs. 10,000 and direct labour is Rs. 7,000 the cost, after absorbing factory overhead, will be as follows : (i) (ii) Rs. 17,000 + 45% Rs. 10,000 or Rs. 21,500, Rs. 17,000 + 30% Rs. 17,000 or Rs. 22,100, and

(iii) Rs. 17,000 + 90% Rs. 7,000 or Rs. 23,300. One can see how, with a different method, the works cost comes out to be different. Of these methods, the first and second are generally considered to be unsuitable on account of the following reasons : (i) Manufacturing overhead expenses are mostly a function of time i.e., time is the determining factor for the incurrence and application of manufacturing overhead expenses. That they are so would be clear if we recall that overhead expenses, specially manufacturing expenses, can in the ultimate analysis be regarded as expenditure incurred in providing the necessary facilities and service to workers employed in the productive process. The question of facilities and service made available to workers naturally is dependent on the length of time during which workers make use of the facilities. It may, therefore, be said that the job or product on which more time has been spent would entail larger manufacturing expenses than the job requiring less time. The factor is ignored altogether by the first method and largely by the second method. (ii) Overheads are neither related to the prime cost nor to direct material cost except to a very small extent. Thus, if the percentage of material cost is used when there are two jobs requiring the same operational time but using material having varying prices, their manufacturing overhead cost would be different whereas this should not normally be so. The method of absorbing overhead costs on the basis of prime cost also does not take into consideration the time factor. The fact that the amount includes labour cost in addition to material cost does not render the prime cost to be more suitable; infact, the results are liable to be more misleading because of the cumulative error of using both the labour and material cost as the basis of allocation of overhead expenses, on neither of which they are already dependent. (iii) Since material prices are prone to frequent and wide fluctuations, the manufacturing overheads, if based on material cost or prime cost, also would fluctuate violently from period to period. (iv) The skill of the workers involved and whether machines were used or not, are

4.37

Cost Accounting

ignored when these methods are used. Percentage of materials cost may, however, be used for the limited purpose of absorbing material handling and store overheads.4.5.3 Percentage of direct labour cost : This method also fails to give full recognition to the element of the time which is of prime importance in the accounting for and treatment of manufacturing overhead expenses except in so far as the amount of wages is a product of the rate factor multiplied by the time factor. Thus, the time factor is taken into consideration only indirectly or partially in the computation of the overhead percentage rate. This method therefore, cannot be depended upon to produce very accurate results where the same type of work is performed in the same time by different type of workers, skilled and unskilled, with varying rates of pay. Also no distinction is made between jobs done by manual labour and those done by machines.

Inspite of the inaccuracies which may arise under this method it is widely used in actual practice because it is simple and does not involve much calculation. If on the other hand, a more scientific method is employed e.g., the direct labour hour rate or the machine hour rate, more complexities in the overhead accounting procedure would be introduced, though the selected method will give proper allowance to time element. Thus, the advantage of elimination of a small error in practice may involve a heavy price on account of introduction of complexities.Advantages:

(i)

The method is simple and economical to apply.

(ii) The time factor is given recognition even if indirectly. (iii) Total expenses recovered will not differ much from the estimated figure since total wages paid are not likely to fluctuate much.Disadvantages:

(i)

It gives rise to certain inaccuracies due to the time factor not being given full importance.

(ii) Where machinery is used to some extent in the process of manufacture, an allowance for such a factor is not made. (iii) It does not provide for varying skills of workers.4.5.4 Labour hour rate: This method is an improvement on the percentage of direct wage basis, as it fully recognises the significance of the element of time in the incurring and absorption of manufacturing overhead expenses. This method is admirably suited to operations which do not involve any large use of machinery. To calculate labour hour rate, the amount of factory overheads is divided by the total number of direct labour hours.4.38

Overheads

Suppose factory overheads are estimated at Rs. 90,000 and labour hours at 1,50,000. The overhead absorption rate will be Re. 0.60. If 795 direct labour hours are spent on a job, Rs. 477 will be absorbed as overhead. It can be calculated for each category of workers.4.5.5 Machine hour rate : By the machine hour rate method, manufacturing overhead expenses are charged to production on the basis of number of hours machines are used on jobs or work orders. There is a basic similarity between the machine hour and the direct labour hour rate method insofar as both are based on the time factor. The choice of one or the other method is conditioned by the actual circumstance of the individual case. In respect of departments or operations in which machines predominate and the operators perform relatively a passive part, the machine hour rate is more appropriate. This is generally the case for operations or processes performed by costly machines, which are automatic or semi-automatic and where operators are essential merely for feeding them rather than for regulating the quantity of the output. In such case, the machine hour rate method alone can be depended on to correctly absorb the manufacturing overhead expenses to different items of production. What is needed for computing the machine hour rate is to divide overhead expenses for a specific machine or group of machines for a period by the operating hours of the machine or the group of machines for the period.

Usually, the computation is made on the basis of the estimated expenses or the normal expenses for the coming period. Thus the machine hour rate usually is a predetermined rate. It is desirable to work out a rate for each individual machine; where a number of similar machines are working in a group, there may be single rate for the whole group. There are two methods of computing the machine hour rate. According to the first method, only the expenses directly or immediately connected with the operation of the machine are taken into account e.g., power, depreciation, repairs and maintenance, insurance, etc. The rate is calculated by dividing the estimated total of these expenses for a period by the estimated number of operational hours of the machines during the period. It will be obvious, however, that in addition to the expenses stated above there may still be other manufacturing expenses such as supervision charges, shop cleaning and lighting, consumable stores and shop supplies, shop general labour, rent and rates, etc. incurred for the department as a whole and, hence, not charged to any particular machine or group of machines. In order to see that such expenses are not left out of production costs, one should include a portion of such expenses to compute the machine hour rate. Alternatively, the overheads not directly related to machines may be absorbed on the basis of Productive Labour Hour Rate Method or any other suitable method.

4.39

Cost Accounting

Illustration

A machine costing Rs. 10,000 is expected to run for 10 years. At the end of this period its scrap value is likely to be Rs. 900. Repairs during the whole life of the machine are expected to be Rs. 18,000 and the machine is expected to run 4,380 hours per year on the average. Its electricity consumption is 15 units per hour, the rate per unit being 5 paise. The machine occupies one-fourth of the area of the department and has two points out of a total of ten for lighting. The foreman has to devote about one sixth of his time to the machine. The monthly rent of the department is Rs. 300 and the lighting charges amount to Rs. 80 per month. The foreman is paid a monthly salary of Rs. 960. Find out the machine hour rate, assuming insurance is @ 1% p.a. and the expenses on oil, etc., are Rs. 9 per month.Solution Fixed expenses per month Rs.

Rent (one fourth of the total) Lighting (one fifth of the total) Foreman s salary� (one sixth of the total) Sundry expenses oil, waste etc. Insurance (1% on the� value of the machine per year) Total constant expenses per month Total number of hours per annum Total number of hours per month 4,380 365Rs.

75.00 16.00 160.00 9.00 8.33 268.33

Rs.

Fixed expenses per hourVariable expenses per hour : Depreciation : Cost of the machine Less: Scrap value

Rs. 268.33 365 hrs.

0.735

Depreciation per annum Depreciation per hour:

10,000 900 9,100 910 0.208

910 4,380 hrs.

4.40

Overheads

Repairs for the whole life for one hour

18,000 0.411 0.750 2.104

Rs.18,000 4,380 10 years�

Electricity for one hour : 15 units @ 0.05 P Machine hour rate :Illustration

Gemini Enterprises undertakes three different jobs A, B and C. All of them require the use of a special machine and also the use of a computer. The computer is hired and the hire charges work out to Rs. 4,20,000 per annum. The expenses regarding the machine are estimated as follows : Rent for the quarter Depreciation per annumRs. 17,500

2,00,000

Indirect charges per annum 1,50,000 During the first month of operation the following details were taken from the job register:Job A B C

Number of hours the machine was used : (a) Without the use of the computer (b) With the use of the computerYou are required to compute the machine hour rate :

600 400

900 600

1,000�

(a) For the firm as a whole for the month when the computer was used and when the computer was not used. (b) For the individual jobs A, B and C.Solution Working notes:

(i) (ii)

Total machine hours used (600 + 900 + 400 + 600 + 1,000) Total machine hours without the use of computers (600 + 900)

3,500 1,500

4.41

Cost Accounting

(iii)

Total machine hours with the use of computer (400 + 600 + 1,000)

2,000Rs.

(iv) Total overheads of the machine per month Rent (Rs. 17,500 3 months)� Depreciation (Rs. 2,00,000 12 months) Indirect Charges (Rs. 1,50,000 12� � months) Total (v) Computer hire charges for a month = Rs. 35,000 (Rs. 4,20,000 � 12 months) (vi) Overheads for using machines without computer =

5,833.33 16,666.67 12,500.00 35,000.00

Rs. 35,000 1,500 hrs. = Rs. 15,000 3,500 hrs.�

(vii) Overheads for using machines with computer =

Rs. 35,000 2,000 hrs. + Rs. 35,000 = Rs. 55,000 3,500 hrs. Rs. 55,000 = Rs. 27.50 per hour 2,000 hours Rs. 35,000 = Rs. 10 per hour 3,500 hrs.Rate per hr. A Hrs. Rs. Job B Hrs. Rs. Rate per hr. C Hrs. Rs.

(a) Machine hour rate of Gemini Enterprises for the firm as a whole for a month. (1) When the Computer was used :

(2) When the computer was note used :

(b) Machine hour rate for individual job

Rs. Overheads Without Computer With computer

10.00 27.50

600 400 1,000

Machine hour rate4.42

6,000 11,000 17,000 Rs. 17

900 600 1,500

9,000 16,500 25,500 Rs. 17

- - 1,000 27,500 1,000 27,500 Rs. 27.50

Overheads

Illustration

A machine shop has 8 identical Drilling machines manned by 6 operators. The machine cannot be worked without an operator wholly engaged on it. The original cost of all these machines works out to Rs. 8 lakhs. These particulars are furnished for a 6 months period: Normal available hours per month Absenteeism (without pay) hours Leave (with pay) hours Normal idle time unavoidable-hours Average rate of wages per worker for 8 hours a day. Production bonus estimated Value of power consumed Supervision and indirect labour Lighting and electricity 208 18 20 10 Rs. 20 Rs. 8,050 Rs. 3,300 Rs. 1,200 15% on wages

These particulars are for a year Repairs and maintenance including consumables 3% of value of machines. Insurance Rs. 40,000 Depreciation 10% of original cost. Other sundry works expenses Rs. 12,000 General management expenses allocated Rs. 54,530. You are required to work out a comprehensive machine hour rate for the machine shop.Solution Computation of comprehensive machine hour rate of machine shop Rs.

Operator s wages (Refer to working note 2) Production bonus (15% on wages) Power� consumed Supervision and indirect labour Lighting and electricity

17,100 2,565 8,050 3,300 1,200

4.43

Cost Accounting

Repairs and maintenance Insurance Depreciation Sundry works expenses General management expenses

12,000 20,000 40,000 6,000 27,265 1,37,480

Machine hour rate

=

Total overheads of machine shop Hours of machines operationRs.1,37,480 (Refer to working note 1) 5.760 hours

=

= Rs. 23.87Working notes.

1.

Computation of hours, for which 6 operators are available for 6 months.

Normal available hours p.m. per operator.Less: Absenteeism hours Less: Leave hours Less: Idle time hours

208 18 20 10 48

Utilisable hours p.m. per operator 160 Total utilisable hours for 6 operators and for 6 months are = 160 6 6 = 5,760 hours As machines cannot be worked without� � an operator wholly engaged on them therefore, hours for which 6 operators are available for 6 months are the hours for which machines can be used. Hence 5,760 hours represent total machine hours. 2. Computation of operator s wages Average� rate of wages :

Rs. 20 = Rs. 2.50 per hour 8 hours

4.44

Overheads

Hours per month for which wages are paid to a worker (208 hours 18 hours) = 190� hours. Total wages paid to 6 operators for 6 months = 190 hours 6 6 Rs. 2.50� � � = Rs. 17,100Advantages of Machine Hour Rate : (1) Where machinery is the main factor of production, it is usually the best method of charging machine operating expenses to production. (2) The under-absorption of machine overheads would indicate the extent to which the machines have been idle. (3) It is particularly advantageous where one operator attends to several machines (e.g. automatic screw manufacturing machine), or where several operators are engaged on the machine e.g. the belt press used in making conveyer belts. Disadvantages : (1) Additional data concerning the operation time of machines, not otherwise necessary, must be recorded and maintained. (2) As general department rates for all the machines in a department may be suitable, the computation of a separate machine hour rate for each machine or group of machines would mean further additional work. Note: Some people even prefer to add the wages paid to the machine operator in order to get a comprehensive rate of working a machine for one hour. If all expenses are not allocated to machines, it will be necessary to calculate another rate for charging the general department expenses to production. This second rate can be calculated on the basis of direct labour hours. In effect therefore, both the machine hour and the direct labour hour rate will be applied, though separately. Illustration Job No. 198 was commenced on October 10, 2005 and completed on November 1, 2005. Materials used were Rs. 600 and labour charged directly to the job was Rs. 400. Other information is as follows:

Machine No. 215 used for 40 hours, the machine hour rate being Rs. 3.50. Machine No. 160 used for 30 hours, the machine hour rate being Rs. 4.00. 6 welders worked on the job for five days of 8 hours each : the Direct labour hour per welder is 20P. Expenses not included for calculating the machine hour or direct labour hour rate totalled

4.45

Cost Accounting

Rs. 2,000,total direct wages for the period being Rs. 20,000. Ascertain the works costs of job No. 198.Solution Rs.

Materials Direct labour Factory overheads : Machine No. 215 : 40 hours @ Rs. 3.50 Machine No. 160 : 30 hours @ Rs. 4.00 2401 hours of welders @ 20 P. per hr. General2 10% of wages Works cost 1. 6 5 8=240 2.� �Rs.

600.00 400.00 1,000.00 140.00 120.00 48.00 40.00 348.00 1,348.00

Unapportioned expenses Rs. 2,000 which works out at 10% of direct wages.

4.6 TREATMENT OF UNDER-ABSORBED AND OVER-ABSORBED OVERHEADS IN COST ACCOUNTING :

Overhead expenses are usually applied to production on the basis of pre-determined rates. Production overheads are to be determined in advance as follows for fixing selling price, quote tender price and to formulate budgets etc. Pre-determined overhead rate =

Estimated/Normal overheads for the period Budgeted Number of units during the period

The actual overhead rate will rarely coincide with the pre-determined overhead rate, due to variation in pre-determined overhead rate and actual overhead rate. Such a variation may arise due to any one of the following situations: (i) Estimated overheads for the period under consideration may remain the same or they coincide with actual overheads but the number of units produced during the period is either more or less in comparison with budgeted figure. In the former case actual overhead rate will be less and in the latter case, actual overhead rate will be more than the pre-determined overhead rate, hence over-absorption and under-absorption will occur respectively.

(ii) Similarly, if the number of units actually produced during the period remains the4.46

Overheads

same as budgeted figure but the actual overheads incurred are more or less than the estimated overheads for the period, then a situation of under-absorption or overabsorption will arise respectively. (iii) If changes occur in different proportion both in the actual overheads and in the number of units produced during the period, then a situation of under or overabsorption (depending upon the situation) will arise. (iv) If the changes in the numerator (i.e. in actual overheads) and denominator (i.e. in number of units produced) occur uniformly (without changing the proportion between the two) then a situation of neither under nor of over-absorption will arise. Such over or under-absorption as arrived at under different situations may also be termed as overhead variance. The amount of over-absorption being represented by a credit balance in the account and conversely, the amount of under-absorption being a debit balance. As regards the treatment of such debit or credit balances, the general view is that if the balances are small they should be transferred to the Costing Profit and Loss Account and the cost of individual products should not be increased or reduced as these would be representing normal cost. Where, however the difference is large and due to wrong estimation, it would be desirable to adjust the cost of products manufactured, as otherwise the cost figures would convey a misleading impression. Such adjustments usually take the form of supplementary rates where there is a debit balance in the overhead account and a credit in the other case. Now, the production of any period can be identified in three forms, goods finished and sold, goods finished but held in stock (not yet sold) and semi-finished goods (work in progress). So far as the first category of goods is concerned, it is arguable that the postmortem of the costs of individual products long after they have been sold may have some academic utility but it is frequently devoid of any practical significance. Therefore, it is suggested that the total variance concerning goods finished and sold should be adjusted by transferring the amount to the Cost of Sale Account, the costs of the individual items of such goods not being affected. As regards the variance pertaining to goods finished and held in stock (i.e. not yet sold), it would be necessary to adjust the value of the stock; similarly the value of work-in-progress should be adjusted. However, over or under recovery of overheads due to abnormal reasons (such as abnormal over or under capacity utilisation) should be transferred to the Costing Profit and Loss Account.

4.47

Cost Accounting

Illustration

A light engineering factory fabricates machine parts to customers. The factory commenced fabrication of 12 Nos. machine parts to customers specifications and� the expenditure incurred on the job for the week ending 21st August, 2005 is given below:Rs. Rs.

Direct materials (all items) Direct labour (manual) 20 hours @ Rs. 1.50 per hour Machine facilities : Machine No. I : 4 hours @ Rs. 4.50 Machine No. II : 6 hours @ Rs. 6.50 Total Overheads @ Rs. 0.80 per hour on 20 manual hours Total cost 18.00 39.00

78.00 30.00

57.00 165.00 16.00 181.00

The overhead rate of Re. 0.80 per hour is based on 3,000 man hours per week; similarly, the machine hour rates are based on the normal working of Machine Nos. I and II for 40 hours out of 45 hours per week. After the close of each week, the factory levies a supplementary rate for the recovery of full overhead expenses on the basis of actual hours worked during the week. During the week ending 21st August, 2005, the total labour hours worked was 2,400 and Machine Nos. I and II had worked for 30 hours and 32 hours respectively. Prepare a Cost Sheet for the� job for the fabrication of 12 Nos. machine parts duly levying the supplementary rates.Solution Fabrication of 12 Nos. machine parts (job No......) Date of commencement : 16 August, 2005 Date of Completion. Cost sheet for the week ending, August 21, 2005 : Rs. Materials 78.00 Labour 20 hours @ Rs. 1.50 30.00 Machine facilities : Rs. Machine No. I : 4 hours @ Rs. 4.50 18.00 Machine No. II : 6 hours @ Rs. 6.50 39.00 57.004.48

Overheads

Overheads 20 hours @ 0.80 P. per hourSupplementary Rates

16.00 181.00 4.00 6.00 9.00 19.00 200.00

Overheads 20 hours @ 20. P. per hour Machine facilities : Machine No. I - 4 hours @ Re. 1.50 Machine No. II - 6 hours @ Re. 1.50 Cost Rs.Working notes:

Overheads budgeted : 3,000 hours @ 80 P. or Rs. 2,400Actual hours : 2,400 Actual rate per hour Rs. 2,400/2,400 hours = Re. 1

Supplementary charge Re. 1 less 80 P, or 20 P per hourMachine facilities :

Machine No. I Budgeted Actual number of hours Actual rate per hour Supplementary rate per hourIllustration

Machine No. II (40 Rs. 6.50) = Rs. 260 32 Rs. 8 (Rs. 8.00 Rs. 6.50)� � �

(40 Rs. 4.50) = Rs. 180 30 Rs. 6 (Rs. 6.00 Rs. 4.50)� �

In a factory, overheads of a particular department are recovered on the basis of Rs. 5 per machine hour. The total expenses incurred and the actual machine hours for the department for the month of August were Rs. 80,000 and 10,000 hours respectively. Of the amount of Rs. 80,000, Rs. 15,000 became payable due to an award of the Labour Court and Rs. 5,000 was in respect of expenses of the previous year booked in the current month (August). Actual production was 40,000 units, of which 30,000 units were sold. On analysing the reasons, it was found that 60% of the under-absorbed overhead was due to defective planning and the rest was attributed to normal cost increase. How would you treat the under-absorbed overhead in the cost accounts?

4.49

Cost Accounting

Solution Under-absorbed overhead expenses during the month of August Rs. 80,000

Total expenses incurred in the month of August :Less: The amount paid according to labour

court award (Assumed to be non-recurring) Expenses of previous year Net overhead expenses incurred for the month Overhead recovered for 10,000 hours @ Rs. 5 per hour Under-absorbed overheadsTreatment of under-absorbed overhead in the Cost Accounts

Rs. 15,000 Rs. 5,000 20,000 60,000 50,000 10,000

It is given in the question that 40,000 units were produced out of which 30,000 units were sold. It is also given that 60% of the under-absorbed overhead was due to defective planning and the rest was attributed to normal cost increase. Rs. 1. 60 percent of under-absorbed overhead is due to defective planning. This being abnormal, should be debited to Profit and Loss A/c (60% of Rs. 10,000) 2. Balance 40 percent of under-absorbed overhead should be distributed over, Finished Goods and Cost of Sales by supplementary rate (40% of Rs. 10,000) Rs. 4,000 may be distributed over Finished Goods and Cost of Sales as follows : Finished Goods*Working notes

6,000

4,000 10,000

*Rs. 1,000

Cost of Sales *Rs. 3,000 Under-absorbed overhead Units produced : : Rs. 4,000 40,000 Re. 0.10 per unit

Rate of under-absorbed overhead recover4.50

Overheads

Amount of under-absorbed overheads charged to finished goods (10,000 0.10P)� Amount of under-absorbed overheads charged to cost of sales : (30,000 0.10P)�Illustration

Rs. 1,000 Rs. 3,000

In a manufacturing unit, factory overhead was recovered at a pre-determined rate of Rs. 25 per man-day. The total factory overhead expenses incurred and the man-days actually worked were Rs. 41.50 lakhs and 1.5 lakh man-days respectively. Out of the 40,000 units produced during a period, 30,000 were sold. On analysing the reasons, it was found that 60% of the unabsorbed overheads were due to defective planning and the rest were attributable to increase in overhead costs. How would unabsorbed overheads be treated in Cost Accounts ?Solution Computation of unabsorbed overheads

Man-days worked Overhead actually incurredLess: Overhead absorbed @ Rs. 25 per man-day

1,50,000Rs.

41,50,000 37,50,000 ________ 4,00,000 2,40,000 1,60,000

(Rs. 25 1,50,000) Unabsorbed overheads Unabsorbed overheads due to defective� planning (i.e. 60% of Rs. 4,00,000) Balance of unabsorbed overheadTreatment of unabsorbed overheads in Cost Accounts

(i)

The unabsorbed overheads of Rs. 2,40,000 due to defective planning to be treated as abnormal and therefore be charged to Costing Profit and Loss Account. (ii) The balance unabsorbed overheads of Rs. 1,60,000 be charged to production i.e., 40,000 units at the supplementary overhead absorption rate i.e., Rs. 4 per unit (Refer to Working Note)

4.51

Cost Accounting

Charge to Costing Profit and Loss Account as part of the cost of unit sold (30,000 units @ Rs. 4 p.u.)Add: To closing stock of finished goods

Rs.

1,20,000 40,000 _______ 1,60,000

(10,000 units @ Rs. 4 p.u.) TotalWorking note :

Supplementary overhead absorption rate =Illustration

Rs.1,60,000 = Rs. 4 p.u. 40,000 units

A factory has three production departments. The policy of the factory is to recover the production overheads of the entire factory by adopting a single blanket rate based on the percentage of total factory overheads to total factory wages. The relevant data for a month are given below :Department Direct materials Rs. Budget Direct wages Rs. Factory overheads Rs. Direct labour Hour Machine hours

Machining Assembly PackingActuals

6,50,000 1,70,000 1,00,000

80,000 5,50,000 70,000

3,60,000 1,40,000 1,25,000

20,000 1,00,000 50,000

80,000 10,000 -

Machining Assembly Packing

7,80,000 1,36,000 1,20,000

96,000 2,70,000 90,000

3,90,000 84,000 1,35,000

24,000 90,000 60,000

96,000 11,000 -

4.52

Overheads

The details of one of the representative jobs produced during the month are as under: Job No. CW 7083 : Department Direct Direct Direct Machine materials wages labour hours Rs. Rs. hours Machining 1,200 240 60 180 Assembly 600 360 120 30 Packing 300 60 40 - The factory adds 30% on the factory cost to cover administration and selling overheads and profit. Required : (i) Calculate the overhead absorption rate as per the current policy of the company and determine the selling price of the Job No. CW 7083.

(ii) Suggest any suitable alternative method(s) of absorption of the factory overheads and calculate the overhead recovery rates based on the method(s) so recommended by you. (iii) Determine the selling price of Job CW 7083 based on the overhead application rates calculated in (ii) above. (iv) Calculate the departmentwise and total under or over recovery of overheads based on the company s current policy and the method(s) recommended by you.�Solution (i) Department Computation of overhead absorption rate (as per the current policy of the company) Budgeted factory overheads Rs. Budgeted direct wages Rs.

Machinery Assembly Packing Total Overhead absorption rate =

3,60,000 1,40,000 1,25,000 6,25,000

80,000 3,50,000 70,000 5,00,000

Budgeted factory overheads 100 Budgeted direct wages�

4.53

Cost Accounting

= =

Rs. 6,25,000 100 Rs. 5,00,000�125% of Direct wages

Selling Price of the Job No. CW-7083Rs.

Direct materials (Rs. 1,200 + Rs. 600 + Rs. 300) Direct wages (Rs. 240 + Rs. 360 + Rs. 60) Overheads (125% Rs. 660) Total factory cost�Add: Mark-up (30% Rs. 3,585)�

2,100.00 660.00 825.00 3,585.00 1,075.50 4,660.50

Selling price

(ii) Methods available for absorbing factory overheads and their overhead recovery rates in different departments

1.

Machining Department

In the machining department, the use of machine time is the predominant factor of production. Hence machine hour rate should be used to recover overheads in this department. The overhead recovery rate based on machine hours has been calculated as under:�Machine hour rate =

Budgeted factory overheads Budgeted machine hours=

Rs. 3,60,000 = Rs. 4.50 per hour 80,000 hours

2.

Assembly Department

In this department direct labour hours is the main factor of production. Hence direct labour hour rate method should be used to recover overheads in this department. The overheads recovery rate in this case is: Direct labour hour rate =

Budgeted factory overheads Budgeted direct labour hours

4.54

Overheads

= 3.Packing Department :

Rs. 1,40,000 = Rs. 1.40 per hour 1,00,000 hours

Labour is the most important factor of production in this department. Hence direct labour hour rate method should be used to recover overheads in this department. The overhead recovery rate in this case comes to: Budgeted factory overhead Direct labour hour rate =

Budgeted factory overheads Direct labour hours

=(iii)

Rs. 1,25,000 = Rs. 2.50 per hour 50,000 hours

Selling Price of Job CW-7083 [based on the overhead application rates calculated in (ii) above] (Rs.)

Direct materials Direct wages Overheads (Refer to Working note) Factory costAdd: Mark up (30% of Rs. 3,838)

2,100.00 660.00 1,078.00 3,838.00 1,151.40 4,989.40

Selling priceWorking note : Overhead Summary Statement Dept. Basis Hours

Rate Rs.

Overheads Rs.

Machining Assembly Packing

Machine hour Direct labour hour Direct labour hour

180 120 40

4.50 1.40 2.50 Total

810 168 100 1,078

4.55

Cost Accounting

(iv) Departmentwise statement of total under or over recovery of overheads

(a) Under current policyDepartments Machining Assembly Rs. Rs. Packing Rs. Total Rs.

Direct wages (Actual) Overheads recovered @ 125% of Direct wages: (A) Actual overheads: (B) (Under)/Over recovery of overheads : (A B) (b) As per methods� suggested

96,000 1,20,000 3,90,000 (2,70,000)

2,70,000 3,37,500 84,000 2,53,500

90,000 1,12,500 1,35,000 (22,500) 5,70,000 6,09,000 (39,000)

Basis of overhead recovery Machine Direct labour Direct labour hours hours hours Total Rs.

Hours worked Rate/hour (Rs.) Actual overheads (Rs.) : (B) (Under)/Over recovery: (A-B)Illustration

96,000 4.50 3,90,000 42,000

90,000 1.40 1,26,000 84,000 42,000

60,000 2.50 1,50,000 1,35,000 15,000 7,08,000 6,09,000 99,000

Overhead recovered (Rs.): (A) 4,32,000

The total overhead expenses of a factory are Rs. 4,46,380. Taking into account the normal working of the factory, overhead was recovered in production at Rs. 1.25 per hour. The actual hours worked were 2,93,104. How would you proceed to close the books of accounts, assuming that besides 7,800 units produced of which 7,000 were sold, there were 200 equivalent units in work-in-progress ? On investigation, it was found that 50% of the unabsorbed overhead was on account of increase in the cost of indirect materials and indirect labour and the remaining 50% was due to factory inefficiency. Also give the profit implication of the method suggested.

4.56

Overheads

Solution

Actual factory overhead expenses incurred Less : Overheads recovered from production (2,93,104 hours Rs. 1.25) Unabsorbed overheads�Reasons for unabsorbed overheads (i) 50% of the unabsorbed overhead was on account of increased in the cost of indirect materials and indirect labour

Rs. 4,46,380 3,66,380

80,000 40,000

(ii)

50% of the unabsorbed overhead was due to factory inefficiency.

40,000

Treatment of unabsorbed overheads in Cost Accounting

1.

Unabsorbed overhead amounting to Rs. 40,000, which were due to increase in the cost of indirect material and labour should be charged to units produced by using a supplementary rate. Supplementary rate =

Rs. 40,000 = Rs. 5 per unit (7,800 + 200) units

The sum of Rs. 40,000 (unabsorbed overhead) should be distributed by using a supplementary rate among cost of sales, finished goods and work-in progress as below : Cost of sales (7,000 units Rs. 5) Finished goods (800 units Rs. 5)� � Work-in progress (200 units Rs. 5)�Rs. 35,000

4,000 1,000 40,000

The use of cost of sales figure, would reduce the profit for the period by Rs. 35,000 and will increase the value of stock of finished goods and work-in-progress by Rs. 4,000 and Rs. 1,000 respectively.

4.57

Cost Accounting

2.

The balance amount of unabsorbed overheads viz. of Rs. 40,000 due to factory inefficiency should be charged to Costing Profit & Loss Account, as this is an abnormal loss.

Illustration

ABC Ltd. manufactures a single product and absorbs the production overheads at a predetermined rate of Rs. 10 per machine hour. At the end of financial year 2005-06, it has been found that actual production overheads incurred were Rs. 6,00,000. It included Rs. 45,000 on account of written off obsolete stores and Rs. 30,000� � being the wages paid for the strike period under an award. The production and sales data for the year 2005-06 is as under :Production :

Finished goods Work-in-progress (50% complete in all respects)Sales :

20,000 units 8,000 units

Finished goods 18,000 units The actual machine hours worked during the period were 48,000. It has been found that one-third of the under-absorption of production overheads was due to lack of production planning and the rest was attributable to normal increase in costs. (i) Calculate the amount of under-absorption of production overheads during the year 2005-06; and

(ii) Show the accounting treatment of under-absorption of production overheads.Solution (i) Amount of under-absorption of production overheads during the year 2005-06 Rs.

Total production overheads actually incurred during the year 2005-06Less : Written off obsolete stores� �

6,00,000 Rs. 45,000 Rs. 30,000 75,000 5,25,000

Wages paid for strike period Net production overheads actually incurred : (A) Production overheads absorbed by 48,000 machine4.58

Overheads

hours @ Rs. 10 per hour : (B) Amount of under absorption of production overheads� : [(A) (B)]�

4,80,000 45,000

(ii) Accounting treatment of under absorption of production overheads It is given in the statement of the question that 20,000 units were completely finished and 8,000 units were 50% complete, one third of the under-absorbed overheads were due to lack of production planning and the rest were attributable to normal increase in costs.

1.

(33 1/3% of Rs. 45,000) i.e., Rs. 15,000 of under-absorbed overheads were due to� lack of production planning. This being abnormal, should be debited to the Profit and Loss A/c. Balance (66 2/3% of Rs. 45,000) i.e., Rs. 30,000 of under-absorbed� overheads should be distributed over work-in-progress, finished goods and cost of sales by using supplementary rate. Total under-absorbed overheads

Rs.

15,000

2.

30,000 45,000

Apportionment of unabsorbed overheads of Rs. 30,000 over, work-in progress, finished goods and cost of sales Equivalent Rs. Completed Units

Work-in-Progress (4,000 units Rs. 1.25) (Refer to working note) Finished goods� (2,000 units Rs. 1.25) Cost of sales (18,000 units Rs. 1.25)� �Working Note:

4,000 2,000 18,000 24,000Rs.30,000 = Rs. 1.25 24,000

5,000 2,500 22,500 30,000

Supplementary rate per unit =4.7

ACCOUNTING AND CONTROL OF ADMINISTRATIVE OVERHEADS

Definition - According to I.C.M.A. Terminology, Administrative overhead is defined as The sum of those costs of general management and of secretarial accounting and�

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Cost Accounting

administrative services, which cannot be directly related to the production, marketing, research or development functions of the enterprise. According to this� definition, administrative overhead constitutes the expenses incurred in connection with the formulation of policy directing the organisation and controlling the operations of an undertaking. These overheads are also collected and classified in the same way as the factory overheads.4.8.1 Accounting of Administrative overheads : There are three distinct methods of accounting of administrative overheads, which are briefly discussed below :

(a) Apportioning Administrative Overheads between Production and Sales Departments : According to this method administrative overheads are apportioned over production and sales departments. The reason for the apportionment of overhead expenses over these departments, recognises the fact that administrative overheads are incurred for the benefit of both of these departments. Therefore each department should be charged with the proportionate share of the same. When this method is adopted, administrative overheads lose their identity and get merged with production and selling and distribution overheads.Disadvantages :

(1) It is difficult to find suitable bases of administrative overhead apportionment over production and sales departments. (2) Lot of clerical work is involved in apportioning overheads. (3) It is not justified to apportion total administrative overheads only over production and sales departments when other equally important department like finance is also there. (b) Charging to Profit and Loss Account - According to this method administrative overheads are charged to Costing Profit & Loss Account. The reason for charging to Costing Profit & Loss are firstly, the administrative overheads are concerned with the formulation of policies and thus are not directly concerned with either the production or the selling and distribution functions. Secondly, it is difficult to determine a suitable basis for apportioning administrative overheads over production and sales departments. Lastly, these overheads are the fixed costs. In view of these arguments, administrative overheads should be charged to Profit and Loss Account.Disadvantages :

(1) Cost of products are understated as administrative overheads are not charged to costs. (2) The exclusion of administrative overheads from cost of products is against sound accounting principle.4.60

Overheads

(c) Treating Administrative Overheads as a separate addition to Cost of Production/Sales : This method considers administration as a separate function like production and sales and, as such costs relating to formulating the policy, directing the organisation and controlling the operations are taken as a separate charge to the cost of the jobs or a product, sold along with the cost of other functions. The basis which are generally used for apportionment are : (i) Works cost (ii) Sales value or quantity (iii) Gross profit on sales (iv) Quantity produced (v) Conversion cost, etc. 4.8.2 Control of Administrative Overheads - Mostly administrative overheads are of fixed nature, and they arise as a result of management policies. These fixed overheads are generally non-controllable. But at the same time these overheads should not be allowed to grow disproportionately. Some degree of control has to be exercised over them. The methods usually adopted for controlling administrative overheads are as follows : (i) Classification and analysis of overheads by administrative departments according to their functions, and a comparison with the accomplished results: According to this method the expenses incurred by each administrative department are collected under standing order numbers for each class of expenditure. These are compared with similar figures of the previous period in relation to accomplishment. Such a comparison will reveal efficiency or inefficiency of the concerned department. However, this method provides only a limited degree of control and comparison does not give useful results if the level of activity is not constant during the periods under comparison. To overcome this difficulty, overhead absorption rates may also be compared from period to period; the extent of over or under absorption will reveal the efficiency or otherwise of the department. It may be possible to compare the cost of a service department with that of similar services obtainable from outside and a decision may be taken whether it is economical to continue the department or entrust the work to outsiders. (ii) Control through Budgets - According to this method, administration budgets (monthly or annually) are prepared for each department. The budgeted figures are compared with actual ones to determine variances. The variances are analysed and responsibility assigned to the concerned department to control these variances. (iii) Control through Standard - Under this method, standards of performance are fixed for each administrative activity, and the actual performance is compared with the standards set. In this way, standards serve not only as yardstick of performance but also facilitate control of costs.

4.61

Cost Accounting

Illustration

In an engineering company, the factory overheads are recovered on a fixed percentage basis on direct wages and the administrative overheads are absorbed on a fixed percentage basis on factory cost. The company has furnished the following data relating to two jobs undertaken by it in a period:Job 101 Rs. Job 102 Rs.

Direct materials Direct wages Selling price Profit percentage on Total Cost Required :

54,000 42,000 1,66,650 10%

37,500 30,000 1,28,250 20%

Computation of percentage recovery rates of factory overheads and administrative overheads. (ii) Calculation of the amount of factory overheads, administrative overheads and profit for each of the two jobs. (iii) Using the above recovery rates fix the selling price of job 103. The additional data being: Direct materials Direct wages Profit percentage on selling priceSolution (i)

(i)

Rs. 24,000 Rs. 20,000 12- %�

Let factory overhead recovery rate, as percentage of direct wages be F and administrative overheads recovery rate, as percentage of factory cost be A.Factory Cost of Jobs :

Job 101 =

Rs. 96,000 + Rs. 42,000F

Job 102 = Rs. 67,500 + Rs. 30,000F Total Cost of Production of Jobs : Job 101 = (Rs. 96,000 + Rs. 42,000F) + (Rs. 96,000+ Rs. 42,000F)A = Rs. 1,51,500 Job-102 = Rs. 67,500 + Rs. 30,000F) + (Rs. 67,500+ Rs. 30,000F)A = Rs. 1,06,875(Refer to working note)4.62

Overheads

On solving above relations: F = 0.60 and A = 0.25 Hence, percentage recovery rates of factory overheads and administrative overheads are 60% and 25% respectively.Working note: Job 101 Job 102

Total cost of production (Rs.)

1,51,500 (Rs. 1,66,650/110%)

1,06,875 (Rs. 1,28,250/120%)

Selling price (100% + Percentage of profit)(ii)

Statement of jobs, showing amount of factory overheads, administrative overheads and profit Job 101 Rs. Job 102 Rs.

Direct materials Direct wages Prime costFactory overheads

54,000 42,000 96,000 25,200 1,21,200 30,300 1,51,500 15,150 1,66,650Selling price of Job 103

37,500 30,000 67,500 18,000 85,200 21,375 1,06,875 21,375 1,28,250Rs. 24,000

60% of direct wages Factory costAdministrative overheads

25% of factory cost Total costProfit (balancing figure)

Selling price(iii)

Direct materials Direct wages Prime cost Factory overheads (60% of Direct Wages)

20,000 44,000 12,000

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Cost Accounting

Factory cost Administrative overheads (25% of factory cost) Total cost Profit margin (balancing figure) Selling price4.8

56,000 14,000 70,000 10,000 80,000

Total Cost 87.5%

ACCOUNTING AND CONTROL OF SELLING AND DISTRIBUTION OVERHEADS

Selling cost or overhead expenses are the expenses incurred for the purpose of promoting the marketing and sales of different products. Distribution expenses, on the other hand, are expenses relating to delivery and despatch of goods sold. Examples of selling and distribution expenses have been considered earlier in this booklet. From the definitions it is clear that the two type of expenses represent two distinct type of functions. Some concerns group together these two type of overhead expenses into one composite class, namely, selling and distribution overhead, for the purpose of Cost Accounting.4.8.1 Accounting of selling and distribution overheads: The collection and accumulation of each expense is made by means of appropriate standing order numbers in the usual way. Where it is decided to apportion a part of the administrative overhead to the selling division the same should also be collected through appropriate standing order numbers.

As in the case of administrative overheads, it is not easy to determine an entirely satisfactory basis for computing the overhead rate for absorbing selling overheads. The bases usually adopted are : (a) Sales value of goods; (b) Cost of goods sold; (c) Gross Profit on sales; and (d) Number of orders or units sold. It is considered that the sale value is ordinarily the most logical basis, there being some connection between the amount of sales and the amount of expenses incurred to achieve them. The cost of production, however, is not so satisfactory on basis as it is difficult to conceive of any relationship even remote, between the cost of production of any article and its selling cost. Articles having a high cost of production may require little effort in their sale and vice versa. The basis of gross profit on sales results in a larger share of the selling overhead being applied to goods yielding a large margin of profit and vice versa. The basis therefore follows the principle of ability to pay , it may not reflect costs or� � incurred efforts.An estimated amount per unit - The best method for absorbing selling and distributing expenses over various products is to separate fixed expenses from variable expenses. Apportion the fixed expenses according to the benefit derived by each product and thus4.64

Overheads

ascertaining the fixed expenses per unit. We give below some of the fixed expenses and the basis of apportionment :Expenses Basis

Salaries in the Sales Department and of the sales men. Advertisement

Estimated time devoted to the sale of various products. Actual amount incurred for each product since these days it is usual to advertise each product separately; common expenses, such as in an exhibition, should be apportioned on the basis of advertisement expenditure on each product. Average space occupied by each product. Average quantities delivered during a period.

Show Room expenses Rent of finished goods godowns and Expenses on own delivery vans

If a suitable basis for apportioning expenses does not exist it may be apportioned in the proportion of sales of various products. The total of fixed expenses apportioned in this manner, divided by the number of units sold or likely to be sold, will give the fixed expenses per unit. To this should be added the variable expenses which will be different for each product. These expenses are, packaging, freight outwards, insurance in transit, commission payable to salesmen, rebate allowed to customers, etc. All these items will be worked out per unit for each product separately. These items added to fixed expenses per unit will give an estimated amount of the selling and distribution expenses per unit.4.8.2 Control of Selling & Distribution Overheads - Control of selling and distribution expenses is a difficult task. The reasons for this are as follows :

1.

The incidence of selling and distribution overheads depends mainly on external factors, such as distance of market, extent and nature of competition, terms of sales, etc. which are beyond the control of management. These overheads are dependent upon the customers, behaviour, their liking and disliking, tastes etc. Therefore, as such control over the overheads may result in loss of customers. These expenses being of the nature of policy costs, are not amenable to control. Comparison with past performance - According to this method, selling and

2.

3. (a)

In spite of the above difficulties, the following methods may be used for controlling them.

4.65

Cost Accounting

distribution overheads are compared with the figures of the previous period. Alternatively, the expenses may be expressed as a percentage of sales, and the percentages may be compared with those of the past period. This method is suitable for small concerns. (b) Budgetary Control - A budget is set up for selling and distribution expenses. The expenses are classified into fixed and variable. If necessary, a flexible budget may be prepared indicating the expenses at different levels of sales. The actual expenses are compared with the budgeted figures and in the case of variances suitable actions are taken. (c) Standard Costing - Under this method standards are set up in relation to the standard sales volume. Standards may be set up for salesmen, territories, products etc. Once the standards are set up, comparison is made between the actuals and standards : variances are enquired into and suitable action taken.Illustration

A company which sells four products, some of them unprofitable, proposes discontinuing the sale of one of them. The following information is available regarding income, costs and activity for the year ended 31st March, 2006.Products A B C D

Sales (Rs.) Cost of sales (Rs.) Area of storage (Sq.ft.) Number of parcels sent

3,00,000 2,00,000 50,000 1,00,000

5,00,000 4,50,000 40,000 1,50,000

2,50,000 2,10,000 80,000 75,000 60,000

4,50,000 2,25,000 30,000 1,75,000 1,20,000

Number of invoices sent 80,000 1,40,000 Selling and Distribution overheads and the basis of allocation are :Fixed Costs

Basis of allocation

Rs. to products

Rent & Insurance Depreciation Salesmen s salaries & expenses Administrative wages� and salariesVariable Costs :

30,000 10,000 50,000 50,000

Sq.Ft. Parcel Sales Volume No. of invoices

Packing wages & materials

20 paise per parcel

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Overheads

Commission Stationery

4% of sales 10 P. per invoice

You are required to prepare Profit & Loss Statement, showing the percentage of profit or loss to sales for each product.Solution Statement of Profit or Loss on Various Products during the year ended March 31, 2006. Products Total Rs. A Rs. B Rs. C Rs. D Rs.

SalesVariable costs

15,00,000 10,85,000 60,000 1,00,000 40,000 12,85,000 2,15,000 30,000 10,000 60,000 50,000 1,50,000 65,000 4.3

3,00,000 2,00,000 12,000 20,000 8,000 2,40,000 60,000 7,500 2,000 12,000 10,000 31,500 28,500 9.5

5,00,000 2,50,000 4,50,000 2,10,000 20,000 30,000 14,000 10,000 15,000 6,000

4,50,000 2,25,000 18,000 35,000 12,000 2,90,000 1,60,000 4,500 3,500 18,000 15,000 41,000 1,19,000 26.4

Cost of sales Commissions 4% of sales Packing wages & materials @ 20 P. per parcel Stationery @ 10 P. per invoice Total variable costs Contribution (Sales variable� cost)Fixed Costs

5,14,000 2,41,000 14,000 6,000 3,000 20,000 17,500 46,500 60,500 12.1 9,000� � � 12,000 1,500 10,000 7,500 31,000 22,000 8.8� �

Rent & Insurance Depreciation Salesmen s salaries & expenses Administrative wages� & salaries Total Fixed costs Profit or Loss (Contribution fixed Costs) Percentage� of profit or Loss on sales

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Cost Accounting

4.9

CONCEPTS RELATED TO CAPACITY Rated capacity : It refers to the capacity of a machine or a plant as indicated by its manufacturer. In fact this capacity is the maximum possible productive capacity of a plant. It is also known as installed capacity of a plant. Due to the loss of operating time of a plant it is difficult to achieve this rated capacity. In other words, it is only a theoretical capacity and is therefore, seldom achieved.

(i)

(ii) Practical capacity : It is defined as actually utilised capacity of a plant. It is also known as operating capacity. This capacity takes into account loss of time due to repairs, maintenance, minor breakdown, idle time, set up time, normal delays, Sundays and holidays, stock taking etc. Generally, practical capacity is taken between 80 to 90% of the rated capacity. It is also used as a base for determining overhead rates. Practical capacity is also called net capacity or available capacity. (iii) Normal capacity : It is the capacity of a plant which is expected to be utilised over a long period based on sales expectancy. The determination of this capacity considers the average utilisation of plant capacity during one full business cycle which may extend over 2 to 3 years. It is also known as average capacity and is used to compute overhead recovery rate. (iv) Capacity based on sales expectancy : It is the capacity of a plant utilised based on sales expectancy. (v) Actual capacity : It is the capacity actually achieved during a given period. This capacity may lie between practical capacity and capacity based on sales expectancy. (vi) Idle capacity : It is that part of the capacity of a plant, machine or equipment which cannot be effectively utilised in production. In other words, it is the difference between the practical or normal capacity and capacity utilisation based on expected sales. For example, if the practical capacity of production of a machine is to the tune of 10,000 units in a month, but is used only to produce 8,000 units, because of market demand of the product, then in such a case, 2,000 units will be treated as idle capacity of the machine. The idle capacity may arise due to lack of product demand, non-availability of raw material, shortage of skilled labour, absenteeism, shortage of power fuel or supplies, seasonal nature of product etc.Idle capacity cost : Costs associated with idle capacity are mostly fixed in nature. These include depreciation, repairs and maintenance charges, insurance premium, rent, rates, management and supervisory costs. These costs remain unabsorbed or unrecovered due

4.68

Overheads

to under-utilisation of plant and service capacity. Idle capacity cost can be calculated as follows : Idle capacity cost =

Aggregate overhead related to plant Normal plant capacity

Treatment of Idle capacity costs : Idle capacity costs can be treated in product costing, in the following ways :

(a) If the idle capacity cost 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 the production capacity utilised. (b) If the idle capacity cost is due to avoidable reasons such as faulty planning, power failure etc.; the cost should be charged to profit and loss account. (c) If the idle capacity cost is due to seasonal factors, then, the cost should be charged to the cost of production by inflating overhead rates. (vii) Idle facility : The term facility has a wider connotation which may� � also include prediction capacity. Facilities may be provided by fixed assets such as building space, plants equipment capacity, etc. or by various service functions such as material services, production services, personal services etc. If a firm fails to make full use of the facilities of its disposal, the firm may be said to have idle facilities. Thus idle facilities refer to that part of total facilities which remains unutilised due to any reason such as non-availability of raw material, power, lack of demand etc. In Cost Accounting idle facilities are treated in the same way as those of idle capacity.4.10 TREATMENT OF CERTAIN ITEMS IN COSTING 4.10.1 Treatment of interest and financial charges : There is controversy whether financial charges, specially interest, should be included in the costs or not. The following arguments are generally advanced in favour of interest to be included in overhead expenses.

(1) Computation of total cost is impossible unless interest is taken into account. Interest is an element of cost and therefore, should be included in cost. This is specially true in business where raw materials in different stages can be used. Thus a timber merchant, if he buys standing trees and seasons the timber himself, would incur a large amount of costs as interest. Another merchant who buys his timber already seasoned would automatically have to pay a higher price; obviously, this price includes interest.

4.69

Cost Accounting

(2) Interest is the cost to be paid for the use of capital; capital is also a factor of production just as labour. Thus, if wages are included in cost of production, why not interest ? (3) If interest is not included in cost calculation, a number of managerial decisions may be taken wrongly. Thus, where a decision involves replacement of labour with expensive machinery, the question of interest assumes importance, since, if interest is not included, the cost accountant may conclude that machinery is cheaper. (4) Inclusion of interest also allows comparison of profit on different jobs. Thus, if a job takes 3 months and another takes 6 months the cost of the jobs must include a charge by way of interest before profit can be compared. (5) In inventory control, interest is an important item to be considered. Where large stocks are kept, the advantage of one time purchase is offset by increase in interest charges. (6) While submitting tenders for cost plus contracts, etc., interest must be taken into account. However, many cost accountants argue that interest should not be included in cost accounts since it is not an item of cost and would vary with different methods of financing. Some of the arguments are listed below : (1) Payment of interest depends entirely on the financing policies and financing pattern. A firm working with proprietor s capital only will have no interest to pay whereas a firm working� with borrowed capital will have to pay a large amount of interest. In reality, whether a firm raises a certain sum of money from the proprietor or borrows from the outside does not make any difference as far as production efficiencies are concerned. If we compare the two firms and include interest as an item of cost, the firm, which works on the proprietor s capital will here is only an� insignificant risk of failure of the company to repay the amount at maturity). Cash flows exclude movements between items that constitute cash or cash equivalent because these components are part of the cash management of an enterprise rather than part of its operating, investing and financing activities. Cash management includes the investment of excess cash in cash equivalents.2.7 PRESENTATION OF CASH FLOW STATEMENT

The cash flow statement should report cash flows during the period classified by operating, investing and financing activities. An enterprise presents its cash flows from operating, investment and financing activities in a manner which is most appropriate to its business. Classification by activity provides information that allows users to assess the impact of those activities on the financial position of the enterprise and the amount of its cash and cash equivalents. This information may also be used to evaluate the relationships among those activities. A single transaction may include cash flows that are classified differently. For example, when the instalment paid in respect of a fixed asset acquired on deferred payment basis includes both interest and loan, the interest element is classified under financing activities and the loan element is classified under investing activities.2.7.1 Operating Activities

The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external sources of financing. Information about the specific components of historical operating cash flows is useful, in conjunction with other information, in forecasting future operating cash flows. Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss. Examples of cash flows from operating activities are: (a) Cash receipts from the sale of goods and the rendering of services;

Financial Management

(b) Cash receipts from royalties, fees, commissions and other revenue; (c) Cash payments to suppliers for goods and services; (d) Cash payments to and on behalf of employees; (e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits; (f) Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and

(g) Cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes. Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of net profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities. An enterprise may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made by financial enterprises are usually classified as operating activities since they relate to the main revenue-producing activity of that enterprise.2.7.2 Investing Activities

The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Examples of cash flows arising from investing activities are: (a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalized research and development costs and self-constructed fixed assets; (b) Cash receipts from disposal of fixed assets (including intangibles); (c) Cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes); (d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes);

3.46

Financial Analysis and Planning

(e) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise); (f) Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise); (g) Cash payments for futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities; and (h) Cash receipts from futures contracts, forward contracts, option contacts and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities. When a contract is accounted for as a hedge of an identifiable position, the cash flows of the contract are classified in the same manner as the cash flows of the position being hedged.2.7.3 Financing Activities

The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise. Examples of cash flows arising from financing activities are: (a) Cash proceeds from issuing shares or other similar instruments; (b) Cash proceeds from issuing debentures, loans, notes, bonds and other short or long-term borrowings; and (c) Cash repayments of amounts borrowed. In addition to the general classification of three types of cash flows, AS-3 (Revised) provides for the treatment of the cash flows of certain special items as under:Foreign Currency Cash Flows

Cash flows arising from transactions in a foreign currency should be recorded in an enterprises reporting currency. The reporting should be done by applying the exchange rate at the date of cash flow statement. A rate which approximates the actual rate may also be used. For example, weighted average exchange rate for a period may be used for recording foreign currency transactions. The effect of changes in exchange rates on cash and cash equivalents held in foreign currency should be reported as a separate part in the form of reconciliation in order to reconcile cash and cash equivalents at the beginning and end of the period.

3.47


Unrealised gains and losses arising from changes in foreign exchange rates are not cash flows. The difference of amount raised due to changes in exchange rate should not be included in operating investing and financing activities. This shall be shown separately in the reconciliation statement.2.7.4 Extraordinary Items

Any cash flows relating to extraordinary items should as far as possible classify them into operating, investing or financing activities and those items should be separately disclosed in the cash flow statement. Some of the examples for extraordinary items is bad debts recovered, claims from insurance companies, winning of a law suit or lottery etc. The above disclosure is in addition to disclosure mentioned in AS-5, ‘Net Profit or Loss for the period, prior period items and changes in accounting policies.’2.7.5 Interest and Dividends

Cash flows from interest and dividends received and paid should each be disclosed separately. The treatment of interest and dividends, received and paid, depends upon the nature of the enterprise i.e., financial enterprises and other enterprises. In case of financial enterprises, cash flows arising from interest paid and interest & Dividends received, should be classified as cash flows from operating activities.In case of other enterprises

Cash outflows arising from interest paid on terms loans and debentures should be classified as cash outflows from financing activities. Cash outflows arising from interest paid on working capital loans should be classified as cash outflow from operating activities. Interest and dividends received should be classified as cash inflow from investing activities. Interest and dividends received should be classified as cash inflow from investing activities. Dividend paid on equity and preference share capital should be classified as cash outflow from financing activities.Taxes on Income

Cash flows arising from taxes on income should be separately disclosed. It should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.

3.48


When tax cash flows are allocated over more than one class of activity, the total amount of taxes paid is disclosed.2.7.6 Investments in Subsidiaries, Associates and Joint Ventures

Any such investments should be reported in the cash flow statement as investing activity. Any dividends received should also be reported as cash flow from investing activity.2.7.7 Non-Cash Transactions

Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a cash flow statement. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities. The exclusion of non-cash transactions from the cash flow statement is consistent with the objective of a cash flow statement as these do not involve cash flows in the current period. Examples of non-cash transactions: (a) The acquisition of assets by assuming directly related liabilities. (b) The acquisition of an enterprise by means of issue of shares. (c) Conversion of debt into equity.2.8 PROCEDURE IN PREPARATION OF CASH FLOW STATEMENT

The procedure used for the preparation of cash flow statement is as follows:Calculation of net increase or decrease in cash and cash equivalents accounts: The difference between cash and cash equivalents for the period may be computed by comparing these accounts given in the comparative balance sheets. The results will be cash receipts and payments during the period responsible for the increase or decrease in cash and cash equivalent items. Calculation of the net cash provided or used by operating activities: It is by the analysis of Profit and Loss Account, Comparative Balance Sheet and selected additional information. Calculation of the net cash provided or used by investing and financing activities: All other changes in the Balance sheet items must be analysed taking into account the additional information and effect on cash may be grouped under the investing and financing activities. Preparation of a Cash Flow Statement: It may be prepared by classifying all cash inflows and outflows in terms of operating, investing and financing activities. The net cash flow provided or used in each of these three activities may be highlighted.

Ensure that the aggregate of net cash flows from operating, investing and financing activities is equal to net increase or decrease in cash and cash equivalents.

3.49


Report any significant investing financing transactions that did not involve cash or cash equivalents in a separate schedule to the Cash Flow Statement.2.8.1 Reporting of Cash Flow from Operating Activities

The purpose for determining the net cash from operating activities is to understand why net profit/loss as reported in the Profit and Loss account must be converted. The financial statements are generally prepared on accrual basis of accounting under which the net income will not indicate the net cash provided by or net loss will not indicate the net cash used in operating activities. In order to calculate the net cash flows in operating activities, it is necessary to replace revenues and expenses with actual receipts and payments in cash. This is done by eliminating the non-cash revenues and/non-cash expenses from the given earned revenues and incurred expenses. There are two methods of converting net profit into net cash flows from operating activities(i) (ii) Direct method, and Indirect method.

(i) Direct Method: Under direct method, cash receipts from operating revenues and cash payments for operating expenses are arranged and presented in the cash flow statement. The difference between cash receipts and cash payments is the net cash flow from operating activities. It is in effect a cash basis Profit and Loss account. In this case, each cash transaction is analysed separately and the total cash receipts and payments for the period is determined. The summarized data for revenue and expenses can be obtained from the financial statements and additional information. We may convert accrual basis of revenue and expenses to equivalent cash receipts and payments. Make sure that a uniform procedure is adopted for converting accrual base items to cash base items. Under direct method, items like depreciation, amortisation of intangible assets, preliminary expenses, debenture discount, etc. are ignored from cash flow statement since the direct method includes only cash transactions and non-cash items are omitted. Likewise, no adjustment is made for loss or gain on the sale of fixed assets and investments. (ii) Indirect Method: In this method the net profit (loss) is used as the base and converts it to net cash provided or used in operating activities. The indirect method adjusts net profit for items that affected net profit but did not affect cash. Non-cash and non-operating charges in the Profit and Loss account are added back to the net profit while non-cash and non-operating credits are deducted to calculate operating profit before working capital changes. It is a partial conversion of accrual basis profit to cash basis profit. Necessary adjustments are made for increase or decrease in current assets and current liabilities to obtain net cash from operating activities.

3.50


2.8.2

Other Disclosure Requirements

If any significant cash and cash equivalent balances held by the enterprise are not available for use by it, it should be disclosed in the cash flow statement. For example cash held by the overseas branch which is not available for use by the enterprise due to exchange control regulations or due to other legal restrictions. Any additional information to understand the financial position and liquidity position of an enterprise should be disclosed. For example: The amount of undrawn borrowing facilities that may be available for future operating activities and to settlement of capital commitments, indicating any restrictions on the use of these facilities; and The aggregate amount of cash flows that represent increases in operating capacity separately from those cash flows that are required to maintain operating capacity. A reconciliation of cash and cash equivalents given in its cash flow statement with equivalent items reported in the Balance Sheet. An enterprise should disclose the policy which it adopts in determining the composition of cash and cash equivalent. The effect of any change in the policy for determining components of cash and cash equivalents should be reported in accordance with AS-5, ‘Net Profit or Loss for the period, Prior period items, and Changes in accounting policies’.2.8.3 Format of Cash Flow Statement

AS 3 (Revised) has not provided any specific format for the preparation of cash flow statements, but a general idea can be had from the illustration given in the appendix to the Accounting Standard. There seems to be flexibility in the presentation of cash flow statements. However, a widely accepted format under direct method and indirect method is given below:Cash Flow Statement (Direct Method) Rs.

Cash Flow from Operating Activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Income tax paid Cash flow before extraordinary items Proceeds from earthquake disaster settlement etc xxx (xxx) xxx (xxx) xxx xxx

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Net cash from Operating Activities Cash Flows from Investing Activities Purchase of fixed assets Proceeds from sale of equipment Interest received Dividend received Net cash from investing Activities Cash Flows from Financing Activities Proceeds from issuance of share capital Proceeds from long-term borrowings Repayments of long-term borrowings Interest paid Dividend paid Net cash from Financing Activities Net increase (decrease) in Cash and Cash Equivalent Cash and Cash Equivalents at beginning of period Cash and Cash Equivalent at end of period Cash Flow Statement (Indirect Method) Cash Flow from Operating Activities Net profit before tax and extraordinary items Adjustments for: - Depreciation - Foreign exchange - Investments - Gain or loss on sale of fixed assets - Interest/dividend Operating profit before working capital changes Adjustments for: - Trade and other receivables

(a) (xxx) xxx xxx xxx (b) xxx xxx (xxx) (xxx) (xxx) (c) (a+b+c)

xxx

xxxRs.

xxx xxx xxx xxx(Rs.)

xxx xxx xxx xxx (xxx) xxx xxx xxx

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- Inventories - Trade payable Cash generation from operations - Interest paid - Direct Taxes Cash before extraordinary items Deferred revenue Net cash from Operating Activities Cash Flow from Investing Activities Purchase of fixed assets Sale of fixed assets Purchase of investments Interest received Dividend received Loans to subsidiaries Net cash from Investing Activities Cash Flow from Financing Activities Proceeds from issue of share capital Proceeds from long term borrowings Repayment to finance/lease liabilities Dividend paid Net cash from Financing Activities Net increase (decrease) in Cash and Cash Equivalents Cash and Cash Equivalents at the beginning of the year Cash and Cash Equivalents at the end of the year (c) (a+b+c) (b) (a)

(xxx) xxx xxx (xxx) (xxx) xxx xxx xxx (xxx) xxx xxx (xxx) xxx xxx xxx xxx xxx (xxx) (xxx) xxx xxx xxx xxx

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Cash from Operations

(Rs.)

Funds from OperationsAdd:

xxx (excluding Bank Overdraft) (excluding cash & bank balance) (excluding cash & bank balance) (excluding bank overdraft) xxx xxx xxx xxx xxx xxx xxx

Increase in Current Liabilities Decrease in Current Assets

Less:

Increase in Current Assets Decrease Liabilities in Current

Cash from Operations2.9 FUNDS FLOW STATEMENT VERSUS CASH FLOW STATEMENT

Both funds flow and cash flow statements are used in analysis of past transactions of a business firm. The difference between these two statements is given below: Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statements all transactions effecting the cash or cash equivalents only is taken into consideration. Funds flow statement analyses the sources and application of funds of long-term nature and the net increase or decrease in long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or decrease in current assets and current liabilities in calculating the cash flow of funds from operations. Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and correcting the current liquidity problems of the firm. Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement starts with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and uses. The concept and technique of preparing a Cash Flow Statement will be clear with the help of illustrations given in the following pages.Illustration 1: From the following information prepare a Cash Flow Statement according to (a) Direct Method (b) Indirect Method as per AS-3 (Revised). Working notes would from part of your answer

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(1)

BALANCE SHEET AS ON 31.12. 2005 (Rs. in ‘000) 2005 2004 25 135 1,200 -1,950 2,500 1,910 (1,060) 730 6,800 2005 850 6,660 2004

Assets

Cash on hand and balances with banks Short-term investments Sundry debtors Interest receivable Inventories Long-term investments Fixed assets at costLess: Accumulated depreciation 2,180 (1,450)

200 670 1,700 100 900 2,500

Fixed assets (net)Total Assets

Liabilities

Sundry creditors Interest payable Income taxes payable Long-term debtTotal liabilities

150 230 400 1,110 1,890 1,500 3,410 4,910 6,800

1,890 100 1,000 1,040 4,030 1,250 1,380 2,630 6,660

Shareholders’ funds Share capital Reserves Total shareholders’ fundsTotal Liabilities and Shareholders’ funds

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(2)

STATEMENT OF PROFIT AND LOSS for the period ended 31.12. 2005 (Rs. in ‘000)

Sales Cost of sales Gross profit Depreciation Administrative and selling expenses Interest expense Interest income Dividend income Foreign exchange loss Net profit before taxation and extraordinary item Extraordinary itemInsurance proceeds from earthquake disaster settlement Net profit after extraordinary item Income tax Net Profit Additional Information: (Figures in Rs. ‘000).

30,650 (26,000) 4,650 (450) (910) (400) 300 200 (40) 3,350 180 3,530 (300) 3,230

(a) An amount of 250 was raised from the issue of share capital and a further 250 was raised from long-term borrowings. (b) Interest expense was 400 of which 170 was paid during the period. 100 relating to interest expense of the prior period was also paid during the period. (c) Dividends paid were 1,200. (d) Tax deducted at source on dividends received (included in the tax expense of 300 for the year) amounted to 40. (e) During the period, the enterprise acquired fixed assets for 350. The payment was made in cash. (f) Plant with original cost of 80 and accumulated depreciation of 60 was sold for 20. (g) Foreign exchange loss of 40 represents the reduction in the carrying amount of a short-

3.56


term investment in foreign currency designated bonds arising out of a change in exchange rate between the date of acquisition of the investment and the balance sheet date. (h) Sundry debtors and sundry creditors include amounts relating to credit sales and credit purchases only.Solution CASH FLOW STATEMENT (Direct Method) (Rs. in ‘000) 2005 Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Income taxes paid Cash flow before extraordinary item Proceeds from earthquake disaster settlement Net cash from operating activities Cash flows from investing activities Purchase of fixed assets Proceeds from sale of equipment Interest received Dividend received Net cash from investing activities Cash Flows from financing activities Proceeds from issuance of share capital Proceeds from long-term borrowings Repayments of long-term borrowings Interest paid Dividend paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period (See Note 1) Cash and cash equivalents at end of period (See Note 1) Notes to the Cash Flow Statement (Direct & Indirect Method)

30,150 (27,600) 2,550 (860) 1,690 180 1,870 (350) 20 200 160 30 250 250 (180) (270) (1,200) (1,150) 750 160 910

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1. Cash and cash equivalents: Cash and cash equivalents consist of cash on hand and balances with banks, and investments in money-market instruments. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts. 2005 2004

Cash on hand and balances with banks Short-term investments Cash and cash equivalents Effects of exchange rate changes Cash and cash equivalents as restated

200 670 870 40 910

25 135 160 -160

Cash and cash equivalents at the end of the period include deposits with banks of 100 held by a branch which are not freely permissible to the company because of currency exchange restrictions. The company has undrawn borrowing facilities of 2,000 of which 700 may be used only for future expansion. 2. Total tax paid during the year (including tax deducted at source on dividends received) amounted to 900.CASH FLOW STATEMENT (Indirect Method) (Rs. in ‘000) 2005 Cash flows from operating activities

Net profit before taxation, and extraordinary item Adjustments for: Depreciation Foreign exchange loss Interest income Dividend income Interest expense 450 40 (300) (200) 400

3,350

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Operating profit before working capital changes Increase in sundry debtors Decrease in inventories Decrease in sundry creditors Cash generated from operations Income taxes paid Cash flows before extraordinary item Proceeds from earthquake disaster settlementNet cash from operating activities Cash flows from investing activities

3,740 (500) 1,050 (1,740) 2,550 (860) 1,690 180 1,870 (350) 20 200 160 30 250 250 (180) (270) (1,200) (1,150) 750 160 910

Purchase of fixed assets Proceeds from sale of equipment Interest received Dividends receivedNet cash from investing activities Cash flows from financing activities

Proceeds from issuance of share capital Proceeds from long-term borrowings Repayment of long-term borrowings Interest paid Dividends paidNet cash used in financing activities

Net increase in cash and cash equivalentsCash and cash equivalents at beginning of period (See Note 1) Cash and cash equivalents at end of period (See Note 1)

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Alternative Presentation (Indirect Method)

As an alternative, in an indirect method cash flow statement, operating profit before working capital changes is sometimes presented as follows: Revenues excluding investment income Operating expenses excluding depreciation Operating profit before working capital changesWorking Notes:

30,650 (26,910) 3,740

The working notes given below do not form part of the cash flow statement. The purpose of these working notes is merely to assist in understanding the manner in which various figures in the cash flow statement have been derived. (Figures are in Rs.’000). 1.Cash receipts from customers

SalesAdd: Sundry debtors at the beginning of the year Less: Sundry debtors at the end of the year

30,650 1,200 31,850 1,700 30,150

2.

Cash paid to suppliers and employees

Cost of sales Administrative & selling expenses

26,000 910 26,910

Add: Sundry creditors at the beginning of the year

1,890 900 150 1,950 2,100 27,600 2,790 29,700

Inventories at the end of the yearLess: Sundry creditors at the end of the year

Inventories at the beginning of the year

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3.

Income taxes paid (including tax deducted at source from dividends received)

Income tax expense for the year (including tax deducted at source from dividends receivedAdd: Income tax liability at the beginning of the year Less: Income tax liability at the end of the year

300

1,000 1,300 400 900

Out of 900, tax deducted at source on dividends received (amounting to 40), is included in cash flows from investing activities and the balance of 860 is included in cash flows from operating activities. 4.Repayment of long-term borrowings

Long-term debt at the beginning of the yearAdd: Long-term borrowings made during the year Less: Long-term borrowings at the end of the year

1,040 250 1,290 1,110 180

5.

Interest paid

Interest expense for the yearAdd: Interest payable at the beginning of the year Less: Interest payable at the end of the year

400 100 500 230 270

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Illustration 2: Swastik Oils Ltd. has furnished the following information for the year ended 31st March, 2006: (Rs. in lakhs)

Net profit Dividend (including interim dividend paid) Provision for income-tax Income-tax paid during the year Loss on sale of assets (net) Book value of assets sold Depreciation charged to P&L Account Profit on sale of investments Interest income on investments Value of investments sold Interest expenses Interest paid during the year Increase in working capital (excluding cash and bank balance) Purchase of fixed assets Investments on joint venture Expenditure on construction work-in-progress Proceeds from long-term borrowings Proceeds from short-term borrowings Opening cash and bank balances Closing cash and bank balances

37,500.00 12,000.00 7,500.00 6,372.00 60.00 277.50 30,000.00 150.00 41,647.50 3,759.00 15,000.00 15,780.00 84,112.50 21,840.00 5,775.00 69,480.00 38,970.00 30,862.50 11,032.50 2,569.50

You are required to prepare the cash flow statement in accordance with AS-3 for the year ended 31st March, 2006. (Make assumptions wherever necessary).

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Solution SWASTIK OILS LIMITED Cash Flow Statement for the Year Ended 31st March, 2006 Cash Flows from Operating Activities (Rs. in lakhs)

Net profit before taxation (37,500 + 7,500) Adjustment for: Depreciation charged to P&L A/c Loss on sale of assets (net) Profit on sale of investments Interest income on investments Interest expenses Operating profit before working capital changes Increase (change) in working capital (excluding cash balance) Cash generated from operations Income tax paid Net cash used in operating activities (A)(b) Cash Flow from investing Activities

45,000.00 30,000.00 60.00 (150.00) (3,759.00) 15,000.00 86,151.00 and bank (84,112.50) 2,038.50 (6,372.00) (4,333.50) 217.50 41,797.50 3,759.00 (21,840.00) (5,775.00) (69,480.00) (51,321.00) 38,970.00 30,862.50 (15,780.00) (12,000.00)

Sale of Assets (277.50-60.00) Sale of Investments (41,647.50+150) Interest Income on investments (assumed) Purchase of fixed assets Investments in Joint Venture Expenditure on construction work-in-progress Net Cash used in investing activities (B)(c) Cash Flow from Financing Activities

Proceeds from long-term borrowings Proceeds from short-term borrowings Interest paid Dividends (including interim dividend paid)

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Net cash from financing activities (C) Net increase in cash and cash equivalents (A) + (B) + (C) Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the yearSelf Examination Questions A. Objective Type Questions

42,052.50 (13,602.00) 11,032.50 2,569.50

1.

The term cash includes (a) Cash and Bank Balances (b) All the Current Assets (c) All the Current Liabilities (d) None of the above.

2.

“Cash flow statement reveals the effects of transactions involving movement of cash”. This statement is (a) Correct (b) Incorrect (c) Partially Correct (d) Irrelevant.

3.

The Preparation of Cash flow statement is governed by AS-3 (Revised). This statement is (a) False (b) True (c) Partially true (d) Cannot say.

4.

A cash flow statement is like an income statement (a) I agree (b) I disagree

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(c) I cannot say (d) The statement is ambiguous. 5. Funds flow statement and cash flow statement are one and the same (a) True (b) False (c) I cannot say (d) The statement is irrelevant. 6. Increase in the amount of bills payable results in (a) Increase in cash (b) Decrease in cash (c) No change in cash (d) I cannot say. 7. Cash from operations is equal to (a) Net profit plus increase in outstanding expenses (b) Net profit plus increase in debtors (c) Net profit plus increase in stock (d) None of the above. 8. Cash equivalents are short term highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. (a) I agree (b) I do not agree (c) I cannot say (d) Irrelevant. 9. For an investment to qualify as a cash equivalent, it must be readily convertible to a known amount of (a) Gold (b) Cash

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(c) Investment (d) Real estate. 10. Non-cash transactions (a) Form part of cash flow statement (b) Do not form part of cash flow statement (c) May or may not form part of cash flow statement (d) I cannot say whether they are part of cash flow statement.Answers to Objective Type Questions 1. (a); 2. (a); 3. (b) 4. (b); 5. (b); 6. (a); 7. (a); 8. (a); 9. (b); 10. (a);

B. Long Answer Type Questions

1. 2. 3. 4. 5.

What is a cash flow statement? Discuss briefly its major classification. Distinguish between Funds flow statement and Cash flow statement. Outline the Importance of cash flow statement in managing cash flows of a business organization. Explain the technique of preparing a cash flow statement with imaginary figures. Explain the difference between direct and indirect methods of reporting cash flows from operating activities as per AS-3 (Revised).

C. Practical Problems 1.

From the following Summary Cash Account of X Ltd. prepare Cash Flow Statement for the year ended 31st March, 2006 in accordance with AS-3 (Revised) using the direct method. The Company does not have any cash equivalents.Summary Cash Account for the year ended 31.3.2006

Balance on 1-4-2005 Issue of Equity Share Receipts from Customers Sale of Fixed Assets

50 Payment of Suppliers 300 Purchase of Fixed Assets 2,800 Overhead expense 100 Wags and Salaries Taxation

2,000 200 200 100 250

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Dividend Repayment of Bank Loan Balance on 31-3-2006 3,2502.

50 300 150 3,250

Ms. Jyoti of Star Oils Limited has collected the following information for the preparation of cash flow statement for the year 2005:(Rs. in lakhs)

Net Profit Dividend (including dividend tax) paid Provision for Income-tax Income-tax paid during the year Loss on sale of assets (net) Book value of the assets sold Depreciation charged to Profit & Loss Account Amortisation of Capital grant Profit on sale of Investments Carrying amount of Investment sold Interest income on investments Interest expenses Interest paid during the year Increase in Working Capital (excluding Cash & Bank balance) Purchase of fixed assets Investment in joint venture Expenditure on construction work-in-progress Proceeds from calls in arrear Receipt of grant for capital projects

25,000 8,535 5,000 4,248 40 185 20,000 6 100 27,765 2,506 10,000 10,520 56,075 14,560 3,850 34,740 2 12

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Proceeds from long-term borrowings Proceeds from short-term borrowings Opening cash and Bank balance Closing Cash and Bank balance

25,980 20,575 5,003 6,988

Required: Prepare the Cash Flow Statement for the year 2005 in accordance with AS-3, Cash Flow Statements issued by the Institute of Chartered Accountants of India. (Make necessary assumption). 3.

The summarized Balance Sheets of XYZ Ltd. as at 31st December, 2004 and 2005 are given below:(Rs.) Particulars Liabilities 2004 2005

Share capital General Reserve Profit and Loss account Creditors Provision for tax Mortgage loan

4,50,000 3,00,000 56,000 1,68,000 75,000 --10,49,000

4,50,000 3,10,000 68,000 1,34,000 10,000 2,70,000 12,42,000

Assets

Fixed assets Investments Stock Debtors Bank

4,00,000 50,000 2,40,000 2,10,000 1,49,000 10,49,000

3,20,000 60,000 2,10,000 4,55,000 1,97,000 12,42,000

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Additional information:

(a) Investments costing Rs.8,000 were sold during the year 2005 for Rs.8,500. (b) Provision for tax made during the year was Rs.9,000. (c) During the year, part of the fixed assets costing Rs.10,000 was sold for Rs.12,000 and the profit was included in profit and loss account. (d) Dividend paid during the year amounted to Rs.40,000. You are required to prepare a Statement of Sources and Uses of cash. 4. The following are the changes in the account balances taken from the Balance Sheets of P Q Ltd. as at the beginning and end of the year:Changes in Rupees in debit or credit

Equity share capital 30,000 shares of Rs.10 each issued and fully paid Capital reserve 8% debentures Debenture discount Freehold property at cost/revaluation Plant and machinery at cost Depreciation on plant and machinery Debtors Stock and work-in-progress Creditors Net profit for the year Dividend paid in respect of earlier year Provision for doubtful debts Trade investments at cost Bank You are informed that:

0 (49,200) (50,000) 1,000 43,000 60,000 (14,400) 50,000 38,500 (11,800) (76,500) 30,000 (3,300) 47,000 (64,300) 0

(a) Capital reserve as at the end of the year represented realized profits on sale of one freehold property together with surplus arising on the revaluation of balance of freehold properties.

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(b) During the year plant costing Rs.18,000 against which depreciation provision of Rs.13,500 was lying was sold for Rs.7,000. (c) During the middle of the year Rs.50,000 debentures were issued for cash at a discount of Rs.1,000. (d) The net profit for the year was after crediting the profit on sale of plant and charging debenture interest. You are required to prepare a cash flow statement which will explain, why bank borrowing has increased by Rs.64,300 during the year end. Ignore taxation.5.

Given below are the condensed Balance Sheets of M.M. Kusha Ltd. for two years and the statement of Profit and Loss for one year:(Rs. lakhs)

As at 31st March Share Capital In Equity shares of Rs.100 each 10% Redeemable Preference Shares of Rs.100 each Capital Redemption Reserve General Reserve Profit and Loss Account balance 8% Debentures with Convertible Option Other Term Loans Fixed assets less Depreciation Long-Term Investments Working Capital

2005 150 10 10 15 30 20 15 250 130 40 80 250

2004 110 40 -10 20 40 30 250 100 50 100 250

Statement of Profit and Loss for the year ended 31st March, 2005 (Rs. lakhs)

Sales Less: Cost of sale Establishment charges 30

600 400 200

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Selling and distribution expenses Interest expenses Loss on sale of equipment (Book value Rs.40 lakhs) Interest income Dividend income Foreign exchange gain Damages received for loss of reputation Depreciation Taxation Dividends Net Profit carried to Balance Sheet

60 5 15 4 2 10 14

110 90

30 120 50 70 30 40 15 25

You are informed by the accountant that ledgers relating to debtors, creditors and stock for both the years were seized by the income-tax authorities and it would take at least two months to obtain copies of the same. However, he is able to furnish the following data:(Rs. lakhs)

Particulars Dividend receivable Interest receivable Cash on hand and with bank Investments maturing within two months Interest payable Taxes payable Current ratio Acid test ratio

2005 2 3 7 3 15 4 6 10 1.5 1.1

2004 4 2 10 2 18 5 3 8 1.4 0.8

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It is also gathered that debenture-holders owning 50% of the debentures outstanding as on 31-3-2004 exercised the option for conversion into equity shares during the financial year and the same was put through. You are required to prepare a direct method cash flow statement for the financial year, 2005 in accordance with Accounting Standard (AS 3) revised.

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CHAPTER

4

FINANCING DECISIONSUNIT – I : COST OF CAPITAL Learning Objectives After studying this unit you will be able to learn 1.1 What is cost of capital? How to measure the cost of♦ ♦ ♦ ♦ each component of capital? What is weighted average cost of capital (WACC) and marginal cost of capital? and; How cost of capital is important in financial management? INTRODUCTION

The financing decision relates to the composition of relative proportion of various sources of finance. The financial management weighs the merits and demerits of different sources of finance while taking the financing decision. A business can be financed from either the shareholders funds or borrowings from outside agencies. The shareholders funds include equity share capital, preference share capital and the accumulated profits whereas borrowings from outsiders include borrowed funds like debentures and loans from financial institutions. The borrowed funds have to be paid back with interest and some amount of risk is involved if the principal and interest is not paid. Equity has no fixed commitment regarding payment of dividends or principal amount and therefore, no risk is involved. It is the decision of the business to decide the ratio of borrowed funds and owned funds. However, most of the companies use a combination of both the shareholders funds and borrowed funds. Whether the companies choose shareholders funds or borrowed funds, each type of fund carries a cost. Borrowed funds involve interest payment whereas equities, as such do not have any fixed obligation but definitely they involve a cost. The cost of equity is the minimum return the shareholders would have received if they had invested elsewhere. Both types of funds incur cost and this is the cost of capital to the company. This means, cost of capital is the minimum return expected by the company. The financing decision is an important managerial decision. It influences the shareholder’s return and risk. As a result, the market value of the share may be affected by the financing decision. Subsequently, whenever funds are to be raised to finance investments, capital


structure decision is involved. The process of financing or capital structure decision is depicted in the figure below. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors governing the decision. The company’s policy to retain or distribute earnings affects the shareholders claims. Retention of earnings strengthens the shareholders position. The debt-equity mix of the company is also affected by the new financing decision of the company. The financing mix (debt-equity mix) has implications for the shareholders’ earnings and risk, which in turn, will affect the cost of capital and the market value of the firm.

Financing Decision Process

4.2

Financing Decisions

1.2

DEFINITION OF COST OF CAPITAL

Cost of capital maybe defined as the cut off rate for determining estimated future cash proceeds of a project and eventually deciding whether the project is worth undertaking or not. It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of share at its current level. It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock. It can also be said as the required return necessary to make a capital budgeting project - such as building a new factory - worthwhile. Cost of capital includes the cost of debt and the cost of equity. The cost of capital determines how a company can raise money maybe through a stock issue, borrowing, or a mix of the two. This is the rate of return that a firm would receive if it invested its money someplace else with similar risk. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor’s opportunity cost), investors will not invest in the firm’s debt and equity. As a result, the firm’s value (both their debt and equity) will decline. The total capital for a firm is the value of its equity plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). The cost of capital is given as: Kc= (1- )Ke+ Kd Where, Kc Ke = = = Weighted cost of capital for theδ δ δ firm Debt to capital ratio, D / (D + E) Cost of equity

4.3


Kd D E 1.3

= = =

After tax cost of debt Market value of the firm's debt, including bank loans and leases Market value of all equity (including warrants, options, and the equity portion of convertible securities)

MEASUREMENT OF COST OF CAPITAL

The cost of capital is useful in determining a financial plan. A company has to employ a combination of creditor’s and owner’s funds. As more than one type of capital is used in a company, the composite cost of capital can be determined after the cost of each type of funds has been obtained. The first step is, therefore, the calculation of specific cost which is the minimum financial obligation required to secure the use of capital for a particular source. In order to calculate the specific cost of each type of capital, recognition should be given to the explicit and the implicit cost. The explicit cost of any source of capital may be defined as the discount rate that equals that present value of the cash inflows that are incremental to the taking of financing 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. Now the different components of cost of capital i.e. each source of finance have been discussed in detail. 1.3.1 COST OF DEBT A bond is a long term debt instrument or security. Bonds issued by the government do not have any risk of default. The government honour obligations on its bonds. Bonds of the public sector companies in India are generally secured, but they are not free from the risk of default. The private sector companies also issue bonds, which are also called debentures in India. A company in India can issue secured or unsecured debentures. In the case of a bond or debenture, the rate of interest is generally fixed and known to investors. The principal of a redeemable bond or bond with a maturity is payable after a specified period, called maturity period. The chief characteristics of a bond or debenture are as follows: Face value: Face value is called par value. A bond or debenture is generally issued at a par value of Rs. 100 or Rs. 1,000, and interest is paid on face value.

4.4

Financing Decisions

Interest rate: Interest rate is fixed and known to bondholders or debenture holders. Interest paid on a bond or debenture is tax deductible. The interest rate is also called coupon rate. Coupons are detachable certificates of interest. Maturity: A bond or debenture is generally issued for a specified period of time. It is repaid on maturity. Redemption value: The value that a bondholder or debenture holder will get on maturity is called redemption or maturity value. A bond or debenture may be redeemed at par or at premium (more than par value) or at discount (less than par value). Market value: A bond or debenture may be traded in a stock exchange. The price at which it is currently sold or bought is called the market value of the bond or debenture. Market value may be different from par value or redemption value. 1.3.1.1 Cost of Debentures: The cost of debentures and long term loans is the contractual interest rate adjusted further for the tax liability of the company. When the firm employs debt, it must ensure that common shareholder’s earnings are not diluted. To keep the earnings unchanged, the firm must earn a return equal to the interest rate of debt. If the firm earns less than the interest rate, market share price would be adversely affected. In calculating weighted (average) cost of capital, cost of debt (after tax) should be used. For a company, the higher the interest charges, the lower the amount of tax payable by the company. An illustration will help you in understanding this point. Illustration 1: Consider two companies X and Y: Company X Earnings before interest and taxes (EBIT) Interest (I) Profit before tax (PBT) Tax (T) 1 Profit after tax (PAT) Assume an effective rate of tax of 35 percent Solution A comparison of the two companies shows that an interest payment of 40 in company Y results in a tax shield of 14 - that is 40 multiplied by 0.35, the corporate tax rate. The important point to remember, while calculating the average cost of capital, is that the posttax cost of debt must be used and not the pre-tax cost of debt.4.5

Company Y 100 40 60 21 39

100 100 35 65


1.3.1.1.1 Cost of Irredeemable Debentures: Cost of debentures not redeemable during the life time of the company.

Kd =Where, Kd I t = = =

1 (1 − t ) NP

Cost of debt after tax Annual interest rate Net proceeds of debentures Tax rate

NP =

Suppose a company issues 1,000, 15% debentures of the face value of Rs. 100 each at a discount of Rs. 5. Suppose further, that the under-writing and other costs are Rs. 5,000/- for the total issue. Thus Rs. 90,000 is actually realised, i.e., Rs. 1,00,000 minus Rs. 5,000 as discount and Rs. 5,000 as under-writing expenses. The interest per annum of Rs. 15,000 is therefore the cost of Rs. 90,000, actually received by the company. This is because interest is a charge on profit and every year the company will save Rs. 7,500 as tax, assuming that the income tax rate is 50%. Hence the after tax cost of Rs. 90,000 is Rs. 7,500 which comes to 8.33%. 1.3.1.1.2 Cost of Redeemable Debentures: If the debentures are redeemable after the expiry of a fixed period, the cost of debentures would be:Kd = I(I − t ) + (RV − NP) / N RV + NP 2

Where,

I NP t N

= = = =

Annual interest payment Net proceeds of debentures Redemption value of debentures Tax rate Life of debentures.

RV =

Illustration 2: A company issued 10,000, 10% debentures of Rs. 100 each on 1.4.2006 to be matured on 1.4.2011. If the market price of the debentures is Rs. 80. Compute the cost of debt assuming 35% tax rate.

4.6

Financing Decisions

Solution

Kd =

I (1 − t) +

RV − NP N RV + NP 2

100 − 80 10 (1 − .35) + 5 Kd = 100 + 80 2⎛ ⎞ ⎜ ⎟ ⎠ ⎝

=

6.5 + 4 90

= 0.1166 = 0.12 1.3.1.2 Value of Bonds: It is comparatively easy to find out the present value of a bond since its cash flows and the discount rate can be determined easily. If there is no risk of default, then there is no difficulty in calculating the cash flows associated with a bond. The expected cash flows consist of annual interest payments plus repayment of principal. The appropriate capitalisation or discount rate would depend upon the risk of the bond. The risk in holding a government bond is less than the risk associated with a debenture issued by a company. Therefore, a lower discount rate would be applied to the cash flows of the government bond and a higher rate to the cash flows of the company debenture. 1.3.1.2.1 Amortisation of Bond: A bond may be amortised every year i.e. principal is repaid every year rather than at maturity. In such a situation, the principal will go down with annual payments and interest will be computed on the outstanding amount. The cash flows of the bonds will be uneven. The formula for determining the value of a bond or debenture that is amortised every year is as follows:

VB =

Cn C2 C1 + + ......... + 2 1 (1 + k d ) n (1 + k d ) (1 + k d )n t =1

VB = ∑

Ct (1 + k d ) t

Illustration 3: Reserve Bank of India is proposing to sell a 5-year bond of Rs. 5,000 at 8 per cent rate of interest per annum. The bond amount will be amortised equally over its life. What4.7


is the bond’s present value for an investor if he expects a minimum rate of return of 6 per cent? Solution The amount of interest will go on declining as the outstanding amount of bond will be reducing due to amortisation. The amount of interest for five years will be: First year: Second year: Third year: Fourth year: Fifth year: Rs. 5,000 × 0.08 = Rs. 400; (Rs. 5,000 – Rs. 1,000) × 0.08 = Rs. 320; (Rs. 5,000 – Rs. 1,000) × 0.08 = Rs. 240; (Rs. 5,000 – Rs. 1,000) × 0.08 = Rs. 160; and (Rs. 5,000– Rs.1,000) × 0.08 = Rs. 108.

The outstanding amount of bond will be zero at the end of fifth year. Since Reserve Bank of India will have to return Rs. 1,000 every year, the outflows every year will consist of interest payment and repayment of principal: First year: Third year: Fourth year: Fifth year: Rs. 1000 + Rs. 400 = Rs. 1,400; Rs. 1000 + Rs. 240 = Rs. 1,240; Rs. 1000 + Rs. 160 = Rs. 1,160; and Rs. 1000 + Rs. 108 = Rs. 1,108. Second year: Rs. 1000 + Rs. 320 = Rs. 1,320;

Referring to the present value table at the end of the study material, the value of the bond is calculated as follows:VB = 1,400 1,320 1,240 1,160 1,080 + + + + 1 2 3 4 (1.06) (1.06) (1.06) (1.06) (1.06) 5

= 1,400 × 0.943 + 1,320 × 0.890 + 1,240 × 0.840 + 1,160 × 0.792 + 1,080 × 0.747 = 1,320.20 + 1,174.80 + 1,041.60 + 918.72 + 806.76 = Rs. 5,262.08 1.3.2 COST OF PREFERENCE SHARES The cost of preference share capital is the dividend expected by its holders. Though payment of dividend is not mandatory, non-payment may result in exercise of voting rights by them. The payment of preference dividend is not adjusted for taxes as they are paid after taxes and

4.8

Financing Decisions

is not deductible. The cost of preference share capital is calculated by dividing the fixed dividend per share by the price per preference share. Illustration 4: If Reliance Energy is issuing preferred stock at Rs.100 per share, with a stated dividend of Rs.12, and a floatation cost of 3% then, what is the cost of preference share? SolutionKp = Pr eferred stock dividend Market price of preferred stock (1 − floatation cos t )

=

Rs.12 = 12.4% Rs.100(1 − 0.03)

1.3.2.1 Cost of Irredeemable Preference Shares: Cost of irredeemable preference shares PD = PO Where, PD = Annual preference dividend PO = Net proceeds in issue of preference shares. Illustration 5: XYZ & Co. issues 2,000 10% preference shares of Rs. 100 each at Rs. 95 each. Calculate the cost of preference shares. Solution

Kp =Kp =

PD PO

(10 × 2,000 ) (95 × 2,000 )10 95

=

= 0.1053 1.3.2.2 Cost of Redeemable Preference Shares: If the preference shares are redeemable after the expiry of a fixed period the cost of preference shares would be:

4.9


Kp =

PD + (RV − NP) / N RV + NP 2

Where, PD = RV = NP = N = Annual preference dividend Redemption value of preference shares Net proceeds on issue of preference shares Life of preference shares.

However, since dividend of preference shares is not allowed as deduction from income for income tax purposes, there is no question of tax advantage in the case of cost of preference shares. It would, thus, be seen that both in the case of debt as well as preference shares, cost of capital is calculated by reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account in working out the cost of capital. Illustration 6: Referring to the earlier question but taking into consideration that if the company proposes to redeem the preference shares at the end of 10th year from the date of issue. Calculate the cost of preference share? SolutionKp = PD + (RV − NP) / N RV + NP 2

100 − 95 10 + 10 Kp = 100 + 95 2 ⎛ ⎞ ⎜ ⎟ ⎝ ⎠ ⎛ ⎞ ⎜ ⎟ ⎠ ⎝1.3.3 COST OF EQUITY

= .107 (approx.)

It may prima facie appear that equity capital does not carry any cost. But this is not true. The market share price is a function of return that equity shareholders expect and get. If the company does not meet their requirements, it will have an adverse effect on the market share price. Also, it is relatively the highest cost of capital. Since expectations of equity holders are high, higher cost is associated with it.

4.10

Financing Decisions

Cost of equity capital is the rate of return which equates the present value of expected dividends with the market share price. The calculation of equity capital cost raises a lot of problems. Its purpose is to enable the corporate manager, to make decisions in the best interest of equity holders. In theory the management strives to maximize the position of equity holders and the effort involves many decisions. Different methods are employed to compute the cost of equity capital. (a) Dividend Price Approach: Here, cost of equity capital is computed by dividing the current dividend by average market price per share. This dividend price ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors. However, this method cannot be used to calculate cost of equity of units suffering losses.

Ke =Where,

D1 Po

Ke = Cost of equity D1 = Annual dividend Po = Market value of equity (ex dividend) This model assumes that dividends are paid at a constant rate to perpetuity. It ignores taxation. (b) Earning/ Price Approach: The advocates of this approach co-relate the earnings of the company with the market price of its share. Accordingly, the cost of ordinary share capital would be based upon the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests.

Thus, if an investor expects that the company in which he is going to subscribe for shares should have at least a 20% rate of earning, the cost of ordinary share capital can be construed on this basis. Suppose the company is expected to earn 30% the investor will be 30 prepared to pay Rs. 150 Rs. ×100 for each⎞ ⎛ ⎜ ⎟ share of Rs. 100. This approach is similar to 20 the dividend price approach;⎠ ⎝ only it seeks to nullify the effect of changes in the dividend policy. This approach also does not seem to be a complete answer to the problem of determining the cost of ordinary share since it ignores the factor of capital appreciation or depreciation in the market value of shares.(c) Dividend Price + Growth Approach: Earnings and dividends do not remain constant and the price of equity shares is also directly influenced by the growth rate in dividends.4.11


Where earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows: Ke = (D/P) + G Where, D = Current dividend per share P = Market price per share G = Annual growth rate of earnings of dividend. Illustration 7: A company has paid dividend of Rs. 1 per share (of face value of Rs. 10 each) last year and it is expected to grow @ 10% next year. Calculate the cost of equity if the market price of share is Rs. 55. Solution

Ke = =

D +G P 1 (1 + .10) + .10 55

= .1202 (approx.)(d) Earnings Price + Growth Approach: This approach is an improvement over the earlier methods. But even this method assumes that dividend will increase at the same rate as earnings, and the equity share price is the regulator of this growth as deemed by the investor. However, in actual practice, rate of dividend is recommended by the Board of Directors and shareholders cannot change it. Thus, rate of growth of dividend subsequently depends on director’s attitude. The dividend method should, therefore, be modified by substituting earnings for dividends. So, cost of equity will be given by: Ke = (E/P) + G Where, E = Current earnings per share P = Market share price G = Annual growth rate of earnings. The calculation of ‘G’ (the growth rate) is an important factor in calculating cost of equity capital. The past trend in earnings and dividends may be used as an approximation to predict the future growth rate if the growth rate of dividend is fairly stable in the past.

4.12

Financing Decisions

G = 1.0 (1+G)n where n is the number of years (e) Realized Yield Approach: According to this approach, the average rate of return realized in the past few years is historically regarded as ‘expected return’ in the future. The yield of equity for the year is:

Yt =Where, Yt Dt Pt = = =

D t + Pt −1 Pt −1Yield for the year t Dividend for share for end of the year t Price per share at the end of the year t Price per share at the beginning and at the end of the year t

Pt – 1 =

Though, this approach provides a single mechanism of calculating cost of equity, it has unrealistic assumptions. If the earnings do not remain stable, this method is not practical. (f) Capital Asset Pricing Model Approach (CAPM): 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 ) through fitting regression equation betweenβ return of a security and the return on a market portfolio.

Cost of Equity under CAPM

4.13


Thus, the cost of equity capital can be calculated under this approach as:

Ke = Rf + b (Rm − Rf)Where,

Ke Rfb

= = =

Cost of equity capital Rate of return on security Beta coefficient Rate of return on market portfolioEquity Shares

Rm =

10 Pref.Shares 9 8 7 6 5 4 3 2 1 0 Govt. Bonds Corp. Debts

Risk Return relationship of various securities 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. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-

4.14

Financing Decisions

free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.The shortcomings of this approach are: (a) Estimation of betas with historical data is unrealistic; and (b) Market imperfections may lead investors to unsystematic risk. Despite these shortcomings, the capital asset pricing approach is useful in calculating cost of equity, even when the firm is suffering losses. The basic factor behind determining the cost of ordinary share capital is to measure the expectation of investors from the ordinary shares of that particular company. Therefore, the whole question of determining the cost of ordinary shares hinges upon the factors which go into the expectations of particular group of investors in a company of a particular risk class. Illustration 8: Calculate the cost of equity capital of H Ltd., whose risk free rate of return equals 10%. The firm’s beta equals 1.75 and the return on the market portfolio equals to 15%. Solution

Ke = Rf + b (Rm − Rf) Ke = .10 + 1.75 (.15 − .10) = .10 + 1.75 (.05) = .18751.3.4 COST OF RETAINED EARNINGS Like another source of fund, retained earnings involve cost. It is the opportunity cost of dividends foregone by shareholders. The given figure depicts how a company can either keep or reinvest cash or return it to the shareholders as dividends. (Arrows represent possible cash flows or transfers.) If the cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

4.15


Cost of Retained Earnings There are two approaches to measure this opportunity cost. One approach is by using discounted cash flow (DCF) method and the second approach is by using capital asset pricing model. (a) By DCF : Where, D1 P0 G Where, = = = Dividend Current market price Growth rate. Ks =

D1 +G P0

(b) By CAPM :

Ks = Rf + b (Rm − Rf)Cost of equity capital Rate of return on security Beta coefficient Rate of return on market portfolio

Ks Rfb

= = =

Rm = D0 = Rs. 4.19

Illustration 9: ABC Company provides the following details:

P0

Rs. 50

G = 5%

Calculate the cost of retained earnings based on DCF method.

4.16

Financing Decisions

Solution

Ks

= = = = =

D1 +G P0 D 0 (1 + G) +G P0

Rs. 4.19 (1.05) + 0.05 Rs.500.088 + 0.05 13.8% b = 1.20 RM - Rf = 6%

Illustration 10: ABC Company provides the following details:

Rf = 7%Solution

Calculate the cost of retained earnings based on CAPM method. Ks = = = Ks = Rf + b (RM – Rf) 7% + 1.20 (6%) 7% + 7.20 14.2%

1.3.5 COST OF DEPRECIATION

Depreciation provisions may be considered in a similar manner to retained earnings - they have an opportunity cost and represent an increased stake in the firm by its shareholders. However, a distribution of depreciation provisions would produce a capital reduction, probably requiring outstanding debts to be repaid due to the depletion of the capital base, the security against which the debt was obtained. This indicates a proportional combination between the cost of debt repaid and the cost of retained earnings to calculate the cost of capital in the form of depreciation provisions.1.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

As you know the capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so weighted average cost of capital tells the return that both stakeholders -

4.17


equity owners and lenders - can expect. 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 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 new building. 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 Where, K0 Ki 1–t Kp Ke = = = = = Overall cost of capital Before tax cost of debt 1 – Corporate tax rate Cost of preference capital Cost of equity % of debt in capital structure % of preference share in capital structure % of equity share in capital structure.

% Dmkt = %Psmkt = % Cs =

The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. To be representative, therefore, cost of capital should take into account the relative proportions of different sources of finance. 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. Let's say a4.18

Financing Decisions

company produces a return of 20% and has a WACC of 11%. By contrast, if the company's return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere. Therefore, WACC serves as a useful reality check for investors.1.4.1 CALCULATION OF WACC Capital Component Retained Earnings Common Stocks Preferred Stocks Bonds Total Cost 10% 11% 9% 6% Times X X X X % of capital structure 25% 10% 15% 50% Total 2.50% 1.10% 1.35% 3.00% 7.95%

So the WACC of this company is 7.95%. But there are problems in determination of weighted average cost of capital. These mainly relate to computation of equity capital and the assignment of weights to the cost of specific source of financing. Assignment of weights can be possible either on the basis of marginal weighting or historical weighting. The most serious limitation of marginal weighting is that it does not consider the long run implications of firm’s current financing. The validity of the assumption of historical weighting is that choosing between the book value weights and market value weights. While the book value weights may be operationally convenient, the market value basis is theoretically more consistent, sound and a better indicator of firm’s capital structure. The desirable practice is to employ market weights to compute the firm’s cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities – stocks as well as bonds – to finance projects, and that these securities are issued at market value, not at book value.Illustration 11: Calculate the WACC using the following data by using:

(a) Book value weights (b) Market value weights

4.19


The capital structure of the company is as under:Rs.

Debentures (Rs. 100 per debenture) Preference shares (Rs. 100 per share) Equity shares (Rs. 10 per share) The market prices of these securities are: Debenture Preference Equity Rs. 105 per debenture Rs. 110 per preference share Rs. 24 each.

5,00,000 5,00,000 10,00,000 20,00,000

Additional information:

(1) Rs. 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10 year maturity. (2) Rs. 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 year maturity. (3) Equity shares has Rs. 4 floatation cost and market price Rs. 24 per share. The next year expected dividend is Rs. 10 with annual growth of 5%. The firm has practice of paying all earnings in the form of dividend. Corporate tax rate is 50%.Solution

Cost of equity

Cost of equity = K e =

10 + .05 20

= .05 + .05 = .10 Cost of debt = K d = 10(1 − .5) + (100 − 96) 10 (100 + 96) 2

4.20

Financing Decisions

5 + .4 = × 2 = .055 (approx.) 196 ⎛ ⎞ ⎜ ⎟ ⎝ ⎠2 5+ 10 Cost of preference shares = K p = 198 2⎞ ⎛ ⎜ ⎟ ⎟ ⎜ ⎜ ⎟ ⎟ ⎜ ⎝ ⎠ 5.2 = q = .053 (approx.) ⎛ ⎞ ⎜ ⎟ ⎜ ⎟ ⎠ ⎝

Calculation of WACC using book value weights Source of capital Book Value Specific cost (K%) Total cost

10% Debentures 5% Preference shares Equity shares

5,00,000 5,00,000 10,00,000 20,00,000K0 = Rs. 1,54,000 = 0.077 (approx.) Rs. 20,00,000

.055 .053 .10

27,500 26,500 1,00,000 1,54,000

Calculation of WACC using market value weights Source of capital Book Value Specific cost (K%) Total cost

10% Debentures 5% Preference shares Equity shares

5,25,000 5,50,000 24,00,000 34,75,000K0 = Rs. 2,98,025 = 0.08576 (approx.) Rs.34,75,000

.055 .053 .10

28,875 29,150 2,40,000 2,98,025

1.5

MARGINAL COST OF CAPITAL

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

4.21


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. 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. For example, the cost of debt may remain 7% (after tax) till Rs. 10 lakhs of debt is raised, between Rs. 10 lakhs and Rs. 15 lakhs, the cost may be 8% and so on. Similarly, if the firm has to use the external equity when the retained profits are not sufficient, the cost of equity will be higher because of the floatation costs. When the components cost start rising, the average cost of capital will rise and the marginal cost of capital will however, rise at a faster rate.Illustration 12: ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March, 2006. Rs.

14% debentures 11% Preference shares Equity (10,000 shares)

30,000 10,000 1,60,000 2,00,000

The company share has a market price of Rs. 23.60. Next year dividend per share is 50% of year 2006 EPS. The following is the trend of EPS for the preceding 10 years which is expected to continue in future.Year EPS (Rs.) Year EPS Rs.)

1997 1998 1999 2000 2001

1.00 1.10 1.21 1.33 1.46

2002 2003 2004 2005 2006

1.61 1.77 1.95 2.15 2.36

4.22

Financing Decisions

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is Rs. 96. Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) were also issued. The company is in 50% tax bracket. (A) Calculate after tax: (i) (ii) Cost of new debt Cost of new preference shares

(iii) New equity share (consuming new equity from retained earnings) (B) Calculate marginal cost of capital when no new shares are issued. (C) How much needs to be spent for capital investment before issuing new shares? 50% of the 2006 earnings are available as retained earnings for the purpose of capital investment. (D) What will the marginal cost of capital when the funds exceeds the amount calculated in (C), assuming new equity is issued at Rs. 20 per share?Solution (A) (i) Cost of new debt

Kd = =(ii)

I (1 − t) N

16 (1 − .5) = .0833 96 P O

Cost of new preference shares

Kp = =

1.1 = .12 9.2D1 +G P0

(iii) Cost of new equity shares

Ke =

=

1.18 + 0.10 = 10.10 = 0.15 23.604.23


Calculation of D1

D1 = 50% of 2006 EPS = 50% of 2.36 = Rs. 1.18(B) Type of Capital (1) Proportion (2) Specific Cost (3) Product (2) × (3) = (4)

Debt Preference Equity

0.15 0.05 0.80 Marginal cost of capital

0.0833 0.12 0.15

0.0125 0.0060 0.1200 0.1385

(C) The company can spend the following amount:

Retained earnings = (.50) (2.36 × 10,000) = Rs. 11,800 The ordinary equity is 80% of total capital

Capital investment =(D)

Rs. 11,800 = Rs. 14,750 .80

If the company require fund in excess of Rs. 14,750 it will have to issue new shares. The cost of new issue will be

Ke =

Rs. 1.18 + .10 = .159 20Proportion (2) Specific Cost (3) Product (2) × (3) = (4)

The marginal cost of capital will beType of Capital (1)

Debt Preference Equity (New)

0.15 0.05 0.80

0.0833 0.1200 0.1590

0.0125 0.0060 0.1272 0.1457

1.6

CONCLUSION

The determination of cost of capital is thus beset with a number of problems in dynamic world4.24

Financing Decisions

of today. Conditions which are present now may not remain static in future. Therefore, howsoever cost of capital is determined now, it is dependent on certain conditions or situations which are subject to change. Firstly, the firms’ internal structure and character change. For instance, as the firm grows and matures, its business risk may decline resulting in new structure and cost of capital. Secondly, capital market conditions may change, making either debt or equity more favourable than the other. Thirdly, supply and demand for funds may vary from time to time leading to change in cost of different components of capital. Fourthly, the company may experience subtle change in capital structure because of retained earnings unless its growth rate is sufficient to call for employment of debt on a continuous basis. Because of these reasons the firm should periodically re-examine its cost of capital before determining annual capital budget.

4.25


UNIT – II : CAPITAL STRUCTURE DECISIONS Learning Objectives

After studying this unit you will be able to learn ♦ ♦ ♦2.1

What is capital structure? What are optimal capital structure, and the theories relating to the value of firm; and Understand EBIT-EPS break even or indifference analysis and construct and interpret an EBIT-EPS chart.MEANING OF CAPITAL STRUCTURE

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 capitalisation”. The decisions regarding the forms of financing, their requirements and their relative proportions in total capitalisation are known as capital structure decisions. In arriving at and accomplishing this goal, the finance manager must take extreme care and prudence keeping in mind factors under which the company has to operate as also certain guiding principles of financing. Accordingly, he should choose a pattern of capital which minimises cost of capital and maximises the owners’ return.2.2 CHOICE OF CAPITAL STRUCTURE

A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. It can: (a) Exclusively use debt, or (b) Exclusively use equity capital, or (c) Exclusively use preference capital, or (d) Use a combination of debt and equity in different proportions, or (e) Use a combination of debt, equity and preference capital in different proportions, or (f) Use a combination of debt and preference capital in different proportions. The choice of the combination of these sources is called capital structure mix. But the question is which of the pattern should the firm choose? Well, while choosing a suitable financing pattern, certain fundamental principles should be kept in mind, which are discussed below:

4.26

Financing Decisions

(a) Cost Principle: According to this principle an ideal pattern or capital structure is one that minimises cost of capital structure and maximises earnings per share (EPS). Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, where no such deduction is allowed for dividends. Consequently effective rate of interest which the company has to bear would be less than the nominal rate at which debentures are issued. This requires the mix of debt finance with equity finance so as to reduce the aggregate cost of capital. (b) Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt and preference capital affects share values and in unfavourable situation share prices may consequently drop. There are two risks associated with this principle:

(i) Business risk: It is an unavoidable risk because of the environment in which the firm has to operate and business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm products, variations in prices and proportion of fixed cost in total cost. (ii) Financial risk: It is a risk associated with the availability of earnings per share caused by use of financial leverage. It is also unavoidable if firm does not use debt in its capital structure. Generally, a firm should neither be exposed to high degree of business risk and low degree of financial risk or vice-versa, so that shareholders do not bear a higher risk.(c) Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed. Issue of new equity will dilute existing control pattern and also it involves higher cost. Issue of more debt causes no dilution in control, but causes a higher degree of financial risk. This concern over dilution of control is mostly felt in closely-held companies. (d) Flexibility Principle: By flexibility it means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too. In attaining flexibility cost considerations should be kept in mind. If the company is loaded with a debt of 18% and funds are available at 15%, it can return old debt with new debt, at a lesser interest rate.

Besides these principles, other factors such as nature of industry, timing of issue and competition in the industry are also being considered. Timing of raising capital should take into account the state of economy and capital market. Industries facing severe competition also resort to more equity than debt. Thus a finance manager in designing a suitable pattern of capital structure must bring about

4.27


satisfactory compromise between these militant principles. The compromise can be reached by assigning weights to these principles in terms of various characteristics of the company.2.3 SIGNIFICANCE OF CAPITAL STRUCTURE

The capital structure decisions are so significant in financial management, as they influence debt – equity mix which ultimately affects shareholders return and risk. Since cost of debt is cheaper, firm prefers to borrow rather than to raise from equity. The value of equity depends on earnings per share. So long as return on investment is more than the cost of borrowing, extra borrowing increases the earnings per share. However, beyond a limit, it increases the risk and share price may fall because shareholders may assume that their investment is associated with more risk. But the effect of fall in share price due to heavy load of debt is difficult to measure. Market factors are so highly psychological and complex as they hardly follow these theoretical considerations. However, an appropriate debt -equity mix can be determined empirically within the company taking into consideration the following factors:2.3.1 Leverages

There are two leverages associated with the study of capital structure, namely operating leverage and financial leverage. Operating leverage exists when a firm has a fixed cost that must be defrayed regardless of volume of business. The contrast to the operating leverage, financial leverage refers to mix of debt and equity in the capitalisation of a firm. In order to decide proper financial policy, operating leverage may also be taken into consideration, as the financial leverage is a superstructure built on the operating leverage. The operating profits otherwise known as earnings before interest and tax (EBIT), serves as a fulcrum in defining these two leverages. Financial leverage represents the relationship between firms earnings before interest and tax and earnings available for equity holders. When there is an increase in EBIT, there is a corresponding increase in market price of equity share. However, increased use of debt in the capital structure which proportionately increases EBIT has certain limitations. If debt is employed in greater proportions, marginal cost of debt will also increase and share price may fall down as investors feel it is risky. On the other, in spite of increased risk, market share price may increase because investors speculate future profits. Thus before using financial leverage, its impact on EPS must be weighed. The degree of financial leverage can be found out as:Percentage change in Earnings per share (EPS) Percentage change in Earnings before interest and tax (EBIT)

A company having higher operating leverage should be accompanied by a low financial leverage and vice versa, otherwise it will face problems of insolvency and inadequate liquidity.4.28

Financing Decisions

Thus a combination of both the leverages is a challenging task.2.3.2 Trading on Equity

The term ‘trading on equity’ is derived from the fact that debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earnings and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with the firms earnings before interest and tax, a magnified effect is produced on earnings per share. Whether the leverage is favourable in the sense increase in earnings per share more proportionately to the increased earnings before interest and tax depends on the profitability of investment proposals. If the rate of return on investment exceeds their explicit cost financial leverage is said to be positive. However, the determination of optimal level of debt is a formidable task and is a major policy decision. Determination of optimal level of debt involves equalising between return and risk. Though, there are number of approaches to determine the level of debt, they cannot be considered as satisfactory and as such can serve only as a guideline. Whatever approaches may be followed for determining the optimal level of debt, the objective of maximising share price should be borne in mind. EBIT-EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remain unchanged irrespective of debt level equity mix. For example indifference point for the capital mix (equity share capital and debt) can be determined as follows: (EBIT − I1 )(1 − T ) (EBIT − I2 )(1 − T ) = E1 E2 Where, EBIT = E1 E2 I1 12 T = = = = = Indifference point Number of equity shares in Alternative 1 Number of equity shares in Alternative 2 Interest charges in Alternative 1 Interest charges in Alternative 2 Tax-rate

Alternative 1= All equity finance Alternative 2= Debt-equity finance.

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The chief deficiency of this method is that it does not take into account the implicit cost associated with debt. The concepts of leverages and EBIT-EPS analysis would be dealt in detail separately for better understanding.2.3.3 Coverage Ratio

The ability of the firm to use debt in the capital structure can also be judged in terms of coverage ratio namely EBIT/Interest. Higher the ratio, greater is the certainty of meeting interest payments.2.3.4 Cash flow analysis

It is a good supporting tool for EBIT-EPS analysis in framing a suitable capital structure. To determine the debt capacity, cash flow under adverse conditions should be examined. A high debt equity ratio is not risky if the company has the ability to generate cash flows. It would, therefore be possible to increase the debt until cash flows equal the risk set out by debt. The main drawback of this approach is that it fails to take into account uncertainty due to technological developments or changes in political climate. These approaches as discussed above do not provide solution to the problem of determining an appropriate level of debt. However, with the information available a range can be determined for an optimum level of debt in the capital structure.2.4 OPTIMAL CAPITAL STRUCTURE

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. Therefore, the company should select its appropriate capital structure with due consideration to the factors mentioned above.2.5 EBIT-EPS ANALYSIS

The basic objective of financial management is to design an appropriate capital structure which can provide the highest earnings per share (EPS) over the firm’s expected range of earnings before interest and taxes (EBIT). EPS measures a firm’s performance for the investors. The level of EBIT varies from year to year and represents the success of a firm’s operations. EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.

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Financing Decisions

2.5.1

Financial Break-even and Indifference Analysis

Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e. interest and preference dividends. It denotes the level of EBIT for which the firm’s EPS equals zero. If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would be preferred. EBIT-EPS breakeven analysis is used for determining the appropriate amount of debt a firm might carry. Another method of considering the impact of various financing alternatives on earnings per share is to prepare the EBIT chart or the range of Earnings Chart. This chart shows the likely EPS at various probable EBIT levels. Thus, under one particular alternative, EPS may be Rs. 2 at a given EBIT level. However, the EPS may go down if another alternative of financing is chosen even though the EBIT remains at the same level. At a given EBIT, earnings per share under various alternatives of financing may be plotted. A straight line representing the EPS at various levels of EBIT under the alternative may be drawn. Wherever this line intersects, it is known as break-even point. This point is a useful guide in formulating the capital structure. This is known as EPS equivalency point or indifference point since this shows that, between the two given alternatives of financing (i.e., regardless of leverage in the financial plans), EPS would be the same at the given level of EBIT. The equivalency or indifference point can also be calculated algebraically in the following manner. (EBIT − I1 )(1 − T ) (EBIT − I2 )(1 − T ) = E1 E2 Where, EBIT = E1 E2 I1 12 T = = = = = Indifference point Number of equity shares in Alternative 1 Number of equity shares in Alternative 2 Interest charges in Alternative 1 Interest charges in Alternative 2 Tax-rate

Alternative 1= All equity finance Alternative 2= Debt-equity finance.

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The indifference point can also be depicted graphically as:

Debt-Equity Indifference Point Illustration 1: Best of Luck Ltd., a profit making company, has a paid-up capital of Rs. 100 lakhs consisting of 10 lakhs ordinary shares of Rs. 10 each. Currently, it is earning an annual pre-tax profit of Rs. 60 lakhs. The company's shares are listed and are quoted in the range of Rs. 50 to Rs. 80. The management wants to diversify production and has approved a project which will cost Rs. 50 lakhs and which is expected to yield a pre-tax income of Rs. 40 lakhs per annum. To raise this additional capital, the following options are under consideration of the management:

(a) To issue equity capital for the entire additional amount. It is expected that the new shares (face value of Rs. 10) can be sold at a premium of Rs. 15. (b) To issue 16% non-convertible debentures of Rs. 100 each for the entire amount. (c) To issue equity capital for Rs. 25 lakhs (face value of Rs. 10) and 16% non-convertible debentures for the balance amount. In this case, the company can issue shares at a premium of Rs. 40 each. You are required to advise the management as to how the additional capital can be raised, keeping in mind that the management wants to maximise the earnings per share to maintain its goodwill. The company is paying income tax at 50%.

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Financing Decisions

Solution Calculation of Earnings per share under the three options: Particulars Option I (Issue of equity only) (Rs. in lakhs) Option II (Issue of debentures only) (Rs in lakhs) Option III (Issue of equity and debentures equally) (Rs in lakhs)

Number (lakhs): Existing

of

Equity

Shares 10 2 12 Nil 10 10 Rs. 50 lakhs 10.00 0.50 10.50 Rs. 25 lakhs

Now issued Total 16% debentures Estimated total income: From current operations From new projectsLess: Interest debentures

60 40 100

60 40 100 8 92 46 46 Rs. 4.60

60 40 100 4 96 48 48 Rs. 4.57

on

16%

100 50 50 Rs. 4.17

Profit before tax Tax at 50% Profit after tax EPSAdvise: share. 2.6

Option II i.e. issue of 16% debentures is most suitable to maximize the earnings perCOST OF CAPITAL, CAPITAL STRUCTURE AND MARKET PRICE OF SHARE

The financial leverage has a magnifying effect on earnings per share, such that for a given level of financial percentage increases with EBIT beyond the point of financial indifference, there will be more than proportionate change in the same direction in the earnings per share. The financing decision of the firm is one of the basic conditions oriented to the achievement of4.33


maximisation for the shareholders wealth. The capital structure should be examined from their view point of its impact on the value of the firm. If the capital structure affects the total value of the firm, a firm should select such a financing mix (a combination of debt and equity) which will maximise the market value of the firm. Such an optimum leverage not only maximises the value of the company and wealth of its owners, but also minimises the cost of capital. As a result, the company is able to increase its economic rate of investment and growth. In theory, capital structure can affect the value of the firm by affecting either its expected earnings or cost of capital or both. While financing mix cannot affect the total earnings, it can affect the share of earnings belonging to the share holders. But financial leverage can largely influence the value of the firm through the cost of capital.2.7 CAPITAL STRUCTURE THEORIES

The following approaches explain the relationship between cost of capital, capital structure and value of the firm: (a) Net income approach (b) Net operating income approach (c) Modigliani-Miller approach (d) Traditional approach. However, the following assumptions are made to understand this relationship. There♦ ♦ ♦ ♦ ♦ ♦ are only two kinds of funds used by a firm i.e. debt and equity. Taxes are not considered. The payout ratio is 100% The firm’s total financing remains constant Business risk is constant over time The firm has perpetual life.

(a) Net Income Approach (NI): 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 equity shares.

4.34

Financing Decisions

From the above diagram, ke and kd are assumed not to change with leverage. As debt increases, it causes weighted average cost of capital to decrease. 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 D = Market value of debt Market value of equity (S) = Where, 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 :

NI Ke

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Overall cos t of capital =

EBIT Value of the 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.Illustration 2: Rupa Company’s EBIT is Rs. 5,00,000. The company has 10%, 20 lakh debentures. The equity capitalization rate i.e. Ke is 16%.

You are required to calculate: (i) (ii) (i) Net operating income/EBITLess: Interest on debentures (10% of Rs. 20,00,000)

Market value of equity and value of firm Overall cost of capital.Statement showing value of firm Rs.

Solution

5,00,000 2,00,000 3,00,000 16% 18,75,000 20,00,000 38,75,000

Earnings available for equity holders i.e. NI Equity capitalisation rate (Ke) Market value of equity (S) = Market value of debt (D) Total value of firm V = S + D NI 3,00,000 = × 100 K e 16.00 ⎛ ⎞ ⎜ ⎟ ⎝ ⎠

(ii)

Overall cost of capital =

EBIT 5,00,000 = = 12.90% Value of firm 38,75,000

(b) Net Operating Income Approach (NOI): NOI means earnings before interest and tax. 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 to4.36

Financing Decisions

the existence of fixed return securities in the capital structure.

The above diagram shows that Ko (Overall capitalisation rate) and (debt – capitalisation rate) are constant and Ke (Cost of equity) increases with leverage.Illustration 3: Amita Ltd’s. operating income is Rs. 5,00,000. The firms cost of debt is 10% and currently firm employs Rs. 15,00,000 of debt. The overall cost of capital of the firm is 15%.

You are required to determine: (i) (ii) (i) Total value of the firm. Cost of equity.Statement showing value of the firm Rs.

Solution

Net operating income/EBITLess: Interest on debentures (10% of Rs. 15,00,000)

5,00,000 1,50,000 3,50,000 15%

Earnings available for equityholders Total cost of capital (K0) (given)

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Value of the firm V = (ii)

EBIT 5,00,000 = k0 0.15

33,33,333

Calculation of cost of equity

Ke =

Earnings available for equity holders Value of equity(s)Rs.

Market value of debt (D) Market value of equity (s) S = V − D = 33,33,333 – 15,00,000Cost of equity (K e ) = Earnings availabe for equityholders Market value of equity == =

15,00,000 18,33,333

Or,

EBIT − Interest paid on debt Market value of equity5,00,000 − 1,50,000 18,33,333 Rs. 3,50,000 = 19.09% 18,33,333

S D Ko = Ke + Kd V V D V Ke = Ko − Kd S S⎛ ⎞ ⎛ ⎞ ⎜ ⎟ ⎜ ⎟ ⎝ ⎠ ⎝ ⎠ ⎛ ⎞ ⎛ ⎞ ⎜ ⎟ ⎜ ⎟ ⎝ ⎠ ⎝ ⎠ 33,33,333 15,00,000 = 0.15 − 0.10 18,33,333 18,33,333 ⎛ ⎞ ⎛ ⎞ ⎜ ⎟ ⎜ ⎟ ⎝ ⎠ ⎝ ⎠= 1 [(0.15 × 33,33,333) − (0.10 × 15,00,000)] 18,33,333

=

1 [5,00,000 − 1,50,000] = 19.09% 18,33,333

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Financing Decisions

(c) Modigliani-Miller Approach (MM): The NOI approach is definitional or conceptual and lacks behavioural significance. It does not provide operational justification for irrelevance 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: (i) (ii)♦ ♦ ♦ ♦ 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. 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. The expected yield on equity is equal to the risk free rate plus a premium determined as per the following equation: Kc = Ko + (Ko– Kd) B/S

Based on the above assumptions, Modigliani-Miller derived the following three propositions.

(iii) Average cost of capital is not affected by financial decision.

4.39


It is evident from the above diagram that the average cost of the capital (Ko) is a constant and not affected by leverage. 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. According to MM, since the sum of the parts must equal the whole, therefore, regardless of the financing mix, the total value of the firm stays the same as shown in the figures below:

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 and4.40

Financing Decisions

presence of corporate income taxes. However in their 1963 article, they recognised that the value of the firm will increase or cost of capital will decrease where corporate taxes exist. As a result there will be some difference in the earnings of equity and debt-holders in an levered and unlevered firm and value of levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate.Illustration 4: When value of levered firm is more than the value of unlevered firm

There are two firms N and M, having same earnings before interest and taxes i.e. EBIT of Rs. 20,000. Firm M is levered company having a debt of Rs. 1,00,000 @ 7% rate of interest. The cost of equity of N company is 10% and of M company is 11.50%. Find out how arbitrage process will be carried on?Solution Firms N M

NOI/EBIT Debt Ke Kd Value of equity (S) =

Rs. 20,000 − 10% −

Rs. 20,000 Rs. 1,00,000 11.50% 7%

NOI − Interest Cost of equity

SN =

20,000 10%

= Rs. 2,00,000

SM =

20,000 − 7,000 = Rs. 1,13,043 11.50%

VN = Rs. 2,00,000 VM = 1,13,043 + 1,00,000 {V = S + D} = Rs. 2,13,043 Assume you have 10% share of levered company. i.e. M. Therefore, investment in 10% of equity of levered company = 10% × 1,13,043 = Rs. 11,304.3 Return will be 10% of (20,000 – 7,000) = Rs. 1,400.

4.41


Alternate Strategy will be:

Sell your 10% share of levered firm for Rs. 11,304.3 and borrow 10% of levered firms debt i.e. 10% of Rs. 1,00,000 and invest the money i.e. 10% in unlevered firms stock: Total resources /Money we have = 11,304.3 + 10,000 = 21,304.3 and you invest 10% of 2,00,000 = Rs. 20,000 Surplus cash available with you is = 21,304.3 – 20,000 = Rs. 1,304.3 Your return = 10% EBIT of unlevered firm – Interest to be paid on borrowed funds i.e. = 10% of Rs. 20,000 – 7% of Rs. 10,000 = 2,000 – 700 = Rs. 1,400 i.e. your return is same i.e. Rs. 1,400 which you are getting from ‘N’ company before investing in ‘M’ company. But still you have Rs. 1,304.3 excess money available with you. Hence, you are better off by doing arbitrage.Illustration 5: When value of unlevered firm is more than the value of levered firm

There are two firms U and L having same NOI of Rs. 20,000 except that the firm L is a levered firm having a debt of Rs. 1,00,000 @ 7% and cost of equity of U & L are 10% and 18% respectively. Show how arbitrage process will work.Solution Firms U L

NOI/EBIT Debt capital Kd Ke

Rs. 20,000 − − 10%

Rs. 20,000 Rs. 1,00,000 7% 18%

EBIT − Interest Value of equity capital (s) = Ke ⎛ ⎞ ⎟ ⎜ ⎜ ⎟ ⎝ ⎠=

20,000 0.10

20,000 − 7,000 0.18Rs. 72,222 Rs. 72,222 + 1,00,000 = Rs. 1,72,222

= Rs. 2,00,000 Total value of the firm V=S+D Rs. 2,00,000

4.42

Financing Decisions

Assume you have 10% share of unlevered firm i.e. investment of 10% of Rs. 2,00,000 = Rs. 20,000 and Return @ 10% on Rs. 20,000. Investment will be 10% of earnings available for equity i.e. 10% × 20,000 = Rs. 2,000.Alternative strategy:

Sell your share in unlevered firm for Rs. 20,000 and buy 10% share of levered firm’s equity plus debt i.e. 10% equity of levered firm 10% debt of levered firm Total investment Your resources are Rs. 20,000 Surplus cash available = Surplus – Investment = 20,000 – 17,222 = Rs. 2,778 Your return on investment is: 7% on debt of Rs. 10,000 10% on equity i.e. 10% of earnings available for equity holders i.e. (10% × 13,000) Total return 700 1,300 2,000 = 7,222 = 10,000 = 17,222

i.e. in both the cases the return received is Rs. 2,000 and still you have excess cash of Rs. 2,778. Hence, you are better off i.e you will start selling unlevered company shares and buy levered company’s shares thereby pushing down the value of shares of unlevered firm and increasing the value of levered firm till equilibrium is reached.(d) Traditional Approach: This approach favours that as a result of financial leverage up to some point, cost of capital comes down and value of firm increases. However, beyond that point, reverse trends emerge.

The principle implication of this approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimises cost of capital. At the optimal capital structure, the real marginal cost of debt and equity is the same. Before the optimal point, the real marginal cost of debt is less than real marginal cost of equity and beyond this point the real marginal cost of debt is more than real marginal cost of equity.

4.43


The above diagram suggests that cost of capital is a function of leverage. It declines with Kd (debt) and starts rising. This means that there is a range of capital structure in which cost of capital is minimised. The net income approach argues that leverage always affects overall cost of capital and value of the firm. Optimum capital structure occurs at the point where value of the firm is highest and the cost of capital at the lowest. According to net operating income approach capital structure decisions are totally irrelevant. Modigliani-Miller supports the net operating income approach but provides behavioural justification. The traditional approach strikes a balance between these extremes. According to this approach the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of the both debt and equity in capital structure. At the optimal capital structure the overall cost of capital will be minimum and the value of the firm is maximum. It further states that the value of the firm increases with financial leverage upto a certain point. Beyond this point the increase in financial leverage will increase its overall cost of capital and hence the value of firm will decline. This is because the benefits of use of debt may be so large that even after off setting the effect of increase in cost of equity, the overall cost of capital may still go down. However, if financial leverage increases beyond a acceptable limit the risk of debt investor may also increase, consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase.Illustration 6: Indra company has EBIT of Rs. 1,00,000. The company makes use of debt and equity capital. The firm has 10% debentures of Rs. 5,00,000 and the firm’s equity

4.44

Financing Decisions

capitalization rate is 15%. You are required to compute: (i) (ii) Current value of the firm Overall cost of capital.

Solution

(i) EBIT

Calculation of total value of the firm Rs.

1,00,000 50,000 50,000 15%

Less: Interest (@10% on Rs. 5,00,000)

Earnings available for equity holders Equity capitalization rate i.e. Ke Value of equity holders = = 50,000 = Rs. 3,33,333 0.15 Earnings available for equity holders Ke

Value of Debt (given) D Total value of the firm V = D + S {5,00,000 + 3,33,333)

5,00,000 8,33,333

(ii)

S D Overall cost of capital = K o = K e + K d V V⎛ ⎞ ⎛ ⎞ ⎜ ⎟ ⎜ ⎟ ⎝ ⎠ ⎝ ⎠ 5,00,000 3,33,333 = 0.15 + 0.10 8,33,333 8,33,333 ⎛ ⎞ ⎛ ⎞ ⎜ ⎟ ⎟ ⎜ ⎝ ⎠ ⎝ ⎠= 1 [50,000 + 50,000] 8,33,333

= 12.00%

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2.8

CAPITAL STRUCTURE AND TAXATION

The leverage irrelevance theorem of MM is valid if the perfect market assumptions underlying their analysis are satisfied. However, in the face of imperfections characterising the real world capital markets, the capital structure of a firm may affect its valuation. Presence of taxes is a major imperfection in the real world. This section examines the implications of corporate and personal taxes for the capital structure.2.8.1 Corporate Taxes

When taxes are applicable to corporate income, debt financing is advantageous. This is because dividends and retained earnings are not deductible for tax purposes; interest on debt is a tax-deductible expense. As a result, the total income available for both stockholders and debt-holders is greater when debt capital is used.Illustration 7: There are two firms Company A and B having net operating income of Rs. 15,00,000 each. Company B is a levered company whereas Company A is all equity company. Debt employed by Company B is of Rs. 7,00,000 @ 11%. The tax rate applicable to both the companies is 25%. Calculate earnings available for equity and debt for both the firms. Solution Statement of calculation of earnings available to equity holders and debt holders Company A 15,00,000 − 15,00,000 3,75,000 11,25,000 11,25,000 B 15,00,000 77,000 14,23,000 3,55,750 10,67,250 10,67,250 + 77,000 =11,44,250

Net operating income Less: Interest on Debt (11% of Rs. 7,00,000) Profit before taxes Less: Tax @ 25% Profit after tax/Earnings available in equity holders Total earnings available to equity holders + Debt holders

As we can see that the earnings in case of Company B is more than the earnings of Company A because of tax shield available to shareholders of Company B due to the presence of debt structure in Company B. The interest is deducted from EBIT without tax deduction at the corporate level; equity holders also get their income after tax deduction due to which income of both the investors increase to the extent of tax saving on the interest paid i.e. tax shield i.e. 25% × 77,000 = 19,250 i.e. difference in the income of two companies’ earnings i.e. 11,44,250 – 11,25,000 = Rs. 19,250.4.46

Financing Decisions

UNIT – III : BUSINESS RISK AND FINANCIAL RISK Learning Objectives

After studying this unit, you will be able to ♦ ♦ ♦ ♦ ♦3.1

Define, discuss, and quantify “business risk” and “financial risk”; Define operating and financial leverage and identify causes of both; Define, calculate, and interpret a firm’s degree of operating, financial, and total leverage; Calculate a firm’s operating break-even (quantity) point and break-even (sales) point; and Understand what is involved in determining the appropriate amount of financial leverage for a firm?INTRODUCTION

A firm can finance its operations through common and preference shares, with retained earnings, or with debt. Usually a firm uses a combination of these financing instruments. The proportion of short and long-term debt is considered when analyzing capital structure. Capital structure refers to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk. Firms can obtain their long-term financing from either debt or equity or some combination of debt and equity. Capital structure decisions by firms will have an effect on the expected profitability of the firm, the risks facing debt holders and shareholders, the probability of failure, the cost of capital and the market value of the firm. Risk facing the common shareholders is a function of i.e. is affected by two types of risks, namely business risk and financial risk. Risk Facing Common Shareholders = f {Business Risk, Financial Risk}3.1.1 BUSINESS RISK AND FINANCIAL RISK

Business risk refers to the risk associated with the firm's operations. It is the uncertainty about the future operating income (EBIT), i.e. how well can the operating income be predicted? Business risk can be measured by the standard deviation of the Basic Earning Power ratio.

4.47


Financial risk refers to the additional risk placed on the firm's shareholders as a result of debt use i.e. the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Financial risk can be measured by ratios such as the firm's financial leverage multiplier, total debt to assets ratio or degree of financial leverage. A company's risk is composed of financial risk, which is linked to debt, and risk, which is often linked to economic climate. If a company is entirely financed by equity, it would pose almost no financial risk, but, it would be susceptible to business risk or changes in the overall economic climate. Leverage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance returns to the owners. In other words, leverage is the amount of debt that a firm uses to finance its assets. The use of various financial instruments or borrowed capital, to increase the potential return of an investment. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unlevered.3.2 DEBT VERSUS EQUITY FINANCING

Financing a business through borrowing is cheaper than using equity. This is because: Lenders require a lower rate of return than ordinary shareholders. Debt♦ financial securities present a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. A profitable business effectively pays less for debt capital than equity for another reason: the debt interest can be offset against pre-tax profits before the calculation of the

♦

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Financing Decisions

corporate tax, thus reducing the tax paid. Issuing and transaction costs♦ associated with raising and servicing debt are generally less than for ordinary shares.

These are some benefits from financing a firm with debt. Still firms tend to avoid very high gearing levels. One reason is financial distress risk. This could be induced by the requirement to pay interest regardless of the cash flow of the business. If the firm goes through a rough period in its business activities it may have trouble paying its bondholders, bankers and other creditors their entitlement. The relationship between Expected return (Earnings per share) and the level of gearing can be represented as:

Relationship between leverage and risk

Leverage can occur in either the operating or financing portions of the income statement. The effect of leverage is to magnify the effects of changes in sales volume on earnings. Leverage serves to increase both expected return and risk to the firm's stockholders. Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would have been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of Rs. 50 lakhs from investors, the equity in

4.49


the company is Rs. 50 lakhs - this is the money the company uses to operate. If the company uses debt financing by borrowing Rs. 200 lakhs, the company now has Rs. 250 lakhs to invest in business operations and more opportunity to increase value for shareholders.3.3 TYPES OF LEVERAGE

The term Leverage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc. There are three commonly used measures of leverage in financial analysis. These are: (i) (ii) Operating Leverage Financial Leverage

(iii) Combined Leverage3.3.1 OPERATING LEVERAGE

Operating leverage (OL) maybe defined as the employment of an asset with a fixed cost in the hope that sufficient revenue will be generated to cover all the fixed and variable costs. The use of assets for which a company pays a fixed cost is called operating leverage. With fixed costs the percentage change in profits accompanying a change in volume is greater than the percentage change in volume. The higher the turnover of operating assets, the greater will be the revenue in relation to the fixed charge on those assets.

Operating leverage is a function of three factors: (i) Rupee amount of fixed cost,

4.50

Financing Decisions

(ii)

Variable contribution margin, and

(iii) Volume of sales. Operating leverage is the ratio of net operating income before fixed charges to net operating income after fixed charges. Degree of operating leverage is equal to the percentage increase in the net operating income to the percentage increase in the output.OL = N(P − V ) N(P − V ) − F

Where, OL N P V F = = = = = Operating leverage Number of units sold Selling price per unit Variable cost per unit Fixed cost

Degree of operating leverage =

Percentage increase in net operating income Percentage increase in output

Operating leverage is directly proportional to business risk. More operating leverage leads to more business risk, for then a small sales decline causes a big profit. This can be illustrated graphically as:

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Illustration 1: A Company produces and sells 10,000 shirts. The selling price per shirt is Rs. 500. Variable cost is Rs. 200 per shirt and fixed operating cost is Rs. 25,00,000.

(a) Calculate operating leverage. (b) If sales are up by 10%, then what is the impact on EBIT?Solution

(a)

Statement of Profitability Rs.

Sales Revenue (10,000 × 500)Less: Variable Cost (10,000 × 200)

50,00,000 20,00,000 30,00,000 25,00,000 5,00,000

ContributionLess: Fixed Cost

EBIT

Operating Leverage =(b)

Contribution 30 lakhs = = 6 times 5 lakhs EBIT

OL =6=

% ∆ in EBIT % ∆ in sales

x / 5,00,000 5,00,000 50,00,000

x = 30,000 ∆EBIT = 30,000/5,00,000 = 6%∴3.3.2 FINANCIAL LEVERAGE

Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase earnings per share.’ In other words, it is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders. Degree of financial leverage is the ratio of the percentage increase in earning per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT).

Degree of financial leverage =

Percentage increase in earning per share (EPS) Percentage increase in earnings before interest and tax (EBIT)

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Financing Decisions

FL =Or, Where,

Y Y −I EBIT EBIT − Interest

FL =

Y = EBIT at a point for which the degree of financial leverage is being calculated I = Amount of interest chargesIllustration 2: Suppose there are two firms with the same operating leverage, business risk, and probability distribution of EBIT and only differ with respect to their use of debt (capital structure). Firm U Firm L

No debt 40% tax rateFirm U: Unleveraged

Rs. 10,000 of 12% debt 40% tax rateEconomy Bad Avg. Good

Rs. 20,000 in assets Rs. 20,000 in assets

Probability EBIT Interest EBIT Taxes (40%) NIFirm L: Leveraged

0.25 Rs. 2,000 0 Rs. 2000 800 Rs. 1,200

0.50 Rs. 3,000 0 Rs. 3,000 1,200 Rs. 1,800

0.25 Rs. 4,000 0 Rs. 4,000 1,600 Rs. 2,400

Probability EBIT Interest EBIT

Bad 0.25 Rs. 2,000 1,200 Rs. 800

Economy Avg. 0.50 Rs. 3,000 1,200 Rs. 1,800

Good 0.25 Rs. 4,000 1,200 Rs. 2,800

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Taxes (40%) NI *Same as for Firm U.

320 Rs. 480

720 Rs.1080

1,120 Rs. 1,680

Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg. Good

BEP(=EBIT/TOTAL ASSETS) ROE(=PAT/NETWORTH) TIE(INTEREST COVERAGE RATIO (=EBIT/INTEREST)

10.0% 6.0% ∞

15.0% 9.0% ∞

20.0% 12.0% ∞

FIRM L

Bad

Avg.

Good

BEP ROE TIE

10.0% 4.8% 1.67%

15.0% 10.8% 2.50%

20.0% 16.8% 3.30%

Risk and return for leveraged and unleveraged firms Expected Values:

Firm U E(BEP) E(ROE) E(TIE)Risk Measures:

Firm L 15.0% 10.8% 2.5x Firm L 4.24% 0.39

15.0% 9.0% ∞ Firm U

ROE CVROEσ

2.12% 0.24

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Financing Decisions

Thus, the effect of leverage on profitability and debt coverage can be seen from the above example. For leverage to raise expected ROE, BEP must be greater than kd i.e. BEP > kd because if kd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = kdD). Thus, it can be concluded that the basic earning power (BEP) is unaffected by financial leverage. Firm L has higher expected ROE because BEP > kd and it has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.3.3.3 DEGREE OF COMBINED LEVERAGE

Combined leverage maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm. Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the sales changes will have on EPS.

Degree of combined leverage = Degree of operating leverage × Degree of financial leverageDCL = DOL × DFLWhere, DCL = Degree of combined leverage DOL = Degree of operating leverage DFL = Degree of financial leverage

Degree of combined leverage =Illustration 3: A firm’s details are as under:

Percentage change in EPS Percentage change in sales

Sales (@100 per unit) Variable Cost Fixed Cost

Rs. 24,00,000 50% Rs. 10,00,000

It has borrowed Rs. 10,00,000 @ 10% p.a. and its equity share capital is Rs. 10,00,000 (Rs. 100 each)

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Calculate: (a) Operating Leverage (b) Financial Leverage (c) Combined Leverage (d) Return on Investment (e) If the sales increases by Rs. 6,00,000; what will the new EBIT?Solution Rs.

SalesLess: Variable cost

24,00,000 12,00,000 12,00,000 10,00,000 2,00,000 1,00,000 1,00,000 50,000 50,000 10,000 512,00,000 = 6 times 2,00,000

ContributionLess: Fixed cost

EBITLess: Interest

EBTLess: Tax (50%)

EAT No. of equity shares EPS (a) Operating Leverage = (b) Financial Leverage =

2,00,000 = 2 times 1,00,000

(c) Combined Leverage = OL × FL = 6 × 2 = 12 times. (d) R.O.I =50,000 × 100 = 5% 10,00,000

(e) Operating Leverage = 6

6=

∆ EBIT .25

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Financing Decisions

∆ EBIT =

6 ×1 = 1.5 4

Increase in EBIT = Rs. 2,00,000 × 1.5 = Rs. 3,00,000 New EBIT = 5,00,000Illustration 4: Betatronics Ltd. has the following balance sheet and income statement information: Balance Sheet as on March 31st Liabilities (Rs.)

Assets

(Rs.)

Equity capital (Rs. 10 per share) 10% Debt Retained earnings Current liabilities

8,00,000 Net fixed assets 6,00,000 Current assets 3,50,000 1,50,000 19,00,000

10,00,000 9,00,000

19,00,000

Income Statement for the year ending March 31 (Rs.)

Sales Operating expenses depreciation) EBITLess: Interest

3,40,000 (including Rs. 60,000 1,20,000 2,20,000 60,000 1,60,000 56,000 1,04,000

Earnings before taxLess: Taxes

Net Earnings (EAT)

(a) Determine the degree of operating, financial and combined leverages at the current sales level, if all operating expenses, other than depreciation, are variable costs. (b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 percent, what will be the earnings per share at the new sales level?

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Solution (a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages (DCL).DOL = Rs.3,40,000 − Rs.60,000 Rs.2,20,000 Rs.2,20,000 Rs.1,60,000

= 1.27DFL =

= 1.37 DCL = DOL×DFL = 1.27×1.37 = 1.75(b) Earnings per share at the new sales level Increase by 20% (Rs.) Decrease by 20% (Rs.)

Sales levelLess: Variable expenses Less: Fixed cost

4,08,000 72,000 60,000 2,76,000 60,000 2,16,000 75,600 1,40,400 80,000 1.75

2,72,000 48,000 60,000 1,64,000 60,000 1,04,000 36,400 67,600 80,000 0.84

Earnings before interest and taxesLess: Interest

Earnings before taxesLess: Taxes

Earnings after taxes (EAT) Number of equity shares EPSWorking Notes:

(i) (ii)

Variable Costs = Rs. 60,000 (total cost − depreciation) Variable Costs at:

(a) Sales level, Rs. 4,08,000 = Rs. 72,000 (b) Sales level, Rs. 2,72,000 = Rs. 48,0004.58

Financing Decisions

Illustration 5: Calculate the operating leverage, financial leverage and combined leverage from the following data under Situation I and II and Financial Plan A and B:

Installed Capacity Actual Production and Sales Selling Price Variable Cost Fixed Cost: Under Situation I Under Situation-IICapital Structure:

4,000 units 75% of the Capacity Rs. 30 Per Unit Rs. 15 Per Unit Rs. 15,000 Rs.20,000

Financial Plan A Rs. B Rs.

Equity Debt (Rate of Interest at 20%)

10,000 10,000 20,000

15,000 5,000 20,000

Solution Operating Leverage: Situation-I Rs. 90,000 Situation-II Rs. 90,000

Sales (s) 3000 units @ Rs. 30/- per unit Less: Variable Cost (VC) @ Rs. 15 per unit Contribution (C) Less: Fixed Cost (FC) Operating Profit (OP) (EBIT)

45,000 45,000 15,000 30,000

45,000 45,000 20,000 25,000

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(i)

Operating Leverage

C = OP= (ii)

Rs.

45,000 30,000

Rs. 1.8

45,000 25,000

1.5

Financial Leverages A (Rs.) Situation 1 B (Rs.)

Operating Profit (EBIT)Less: Interest on debt

30,000 2,000 28,000

30,000 1,000 29,000

PBT

Financial Leverage =

OP 30,000 = Rs. PBT 28,000

= 1 . 07

Rs.

30,000 24,000

= 1 . 04

A (Rs.) Situation-II Operating Profit (OP) (EBIT) Less: Interest on debt PBT

B (Rs.)

25,000 2,000 23,000

25,000 1,000 24,000

Financial Leverage = (iii) Combined Leverages

OP 25,000 = Rs. = 1.09 PBT 23,000

Rs.

25,000 = 1.04 24,000

(a) (b)

Situation I Situation II

A (Rs.) 1.5 x 1.07 =1.6 1.8 x 1.09 =1.96

B (Rs.) 1.5 x 1.04 = 1.56 1.8 x 1.04 =1.87

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Financing Decisions

Self Examination Questions A. Objective Type Questions

1.

A firm's cost of capital is the: (a) Cost of borrowing money (b) Cost of issuing stock (c) Cost of bonds (d) Overall cost of financing to the firm.

2.

The cost of debt financing is generally __________ the cost of preferred or common equity financing. (a) Less than (b) More than (c) Equal to (d) Not enough information to tell.

3.

The cost of issuing new stock is called: (a) (b) The cost of equity Flotation costs

(c) Marginal cost of capital (d) None of the above. 4. The cost of each component of a firm's capital structure multiplied by its weight in the capital structure is called the: (a) Marginal cost of capital (b) The cost of debt (c) 5. Weighted average cost of capital (d) None of the above. When establishing their optimal capital structure, firms should strive to: (a) Minimize the weighted average cost of capital (b) Minimize the amount of debt financing used (c) Maximize the marginal cost of capital (d) None of the above.

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6.

The ____________________ is the percentage change in operating income that results from a percentage change in sales. (a) Degree of financial leverage (b) Breakeven point (c) Degree of operating leverage (d) Degree of combined leverage.

7.

If interest expenses for a firm rise, we know that firm has taken on more ______________. (a) Financial leverage (b) Operating leverage (c) Fixed assets (d) None of the above.

8.

The ________________ is the percentage change in earnings per share that results from a percentage change in operating income. (a) Degree of combined leverage (b) Degree of financial leverage (c) Breakeven point (d) Degree of operating leverage.

9.

Combined leverage is the percentage change in relationship between sales and ____________. (a) Operating income (b) Operating leverage (c) Earnings per share (d) Breakeven point.

10. A highly leveraged firm is __________ risky than its peers. (a) Less (b) More (c) The same (d) None of the above.

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Financing Decisions

11. An advantage of debt financing is: (a) Interest payments are tax deductible (b) The use of debt, up to a point, lowers the firm's cost of capital (c) Does not dilute owner's earnings (d) All of the above. 12. The cost of equity capital is all of the following EXCEPT: (a) The minimum rate that a firm should earn on the equity-financed part of an investment (b) A return on the equity-financed portion of an investment that, at worst, leaves the market price of the tock unchanged (c) By far the most difficult component cost to estimate (d) Generally lower than the before-tax cost of debt. 13. In calculating the costs of the individual components of a firm’s financing, the corporate tax rate is important to which of the following component cost formulae? (a) Common stock (b) Debt (c) Preferred stock (d) None of the above. 14. Market values are often used in computing the weighted average cost of capital because (a) This is the simplest way to do the calculation (b) This is consistent with the goal of maximizing shareholder value (c) This is required in India by the SEBI (d) This is a very common mistake. 15. An EBIT-EPS indifference analysis chart is used for_______ (a) Evaluating the effects of business risk on EPS (b) Examining EPS results for alternative financing plans at varying EBIT levels (c) Determining the impact of a change in sales on EBIT (d) Showing the changes in EPS quality over time.Answers to Objective Type Questions 1. (d); 2. (a); 3. (b); 4. (c); 5. (a); 6. (c); 7. (a); 8. (b); 9. (c); 10. (b); 11. (d); 12. (d); 13. (b); 14. (b); 15. (b)4.63


B. Short Answer Type Questions

1.

Write short notes on: (a) Weighted average cost of capital (b) Marginal cost of capital (c) Indifference point.

2.

Differentiate between the following: (a) Business risk and Financial risk (b) Operating leverage and Financial leverage (c) Net Income approach and Net Operating Income approach of Capital Structure.

C. Long Answer Type Questions

1. 2. 3. 4. 5. 6. 7. 8. 9.

Explain briefly major considerations in capital structure planning. Explain briefly the four approaches for determining the cost of equity shares. Explain briefly, Modigliani and Miller approach on cost of capital. Explain briefly the traditional theory of capital structure. Define Operating Leverage and Financial Leverage. How the two leverages can be measured? Explain the impact of Financial Leverage on earning per share. What is Combined Leverage? Explain its significance in financial planning of a firm. Explain the advantages of equity financing. What are the advantages of debt financing from the point of company and investors?

D. Practical Problems

1.

(a) A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax bracket. You are required to calculate the cost of debt after tax. If debentures are issued at (i) Par, (ii) 10% discount and (iii) 10% premium. (b) If brokerage is paid at 2% what will be cost of debentures if issue is at par? A company's share is quoted in market at Rs. 40 currently. A company pays a dividend of Rs. 2 per share and investors expect a growth rate of 10% per year, compute: (a) The company’s cost of equity capital. (b) If anticipated growth rate is 11% p.a. calculate the indicated market price per share.

2.

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Financing Decisions

(c) If the company’s cost of capital is 16% and anticipated growth rate is 10% p.a., calculate the market price if dividend of Rs. 2 per share is to be maintained. 3. Three companies A, B & C are in the same type of business and hence have similar operating risks. However, the capital structure of each of them is different and the following are the details:A B C

Equity Share capital [Face value Rs. 10 per share] Market value per share Dividend per share Debentures [Face value per debenture Rs. 100] Market value per debenture Interest rate

Rs. Rs. Rs. Rs. Rs.

4,00,000 15 2.70 Nil — —

2,50,000 20 4 1,00,000 125 10%

5,00,000 12 2.88 2,50,000 80 8%

Assume that the current levels of dividends are generally expected to continue indefinitely and the income tax rate at 50%. You are required to compute the weighted average cost of capital of each company. 4. ZED Limited is presently financed entirely by equity shares. The current market value is Rs. 6,00,000. A dividend Rs. 1,20,000 has just been paid. This level of dividends is expected to be paid indefinitely. The company is thinking of investing in a new project involving a outlay of Rs. 5,00,000 now and is expected to generate net cash receipts of Rs. 1,05,000 per annum indefinitely. The project would be financed by issuing Rs. 5,00,000 debentures at the market interest rate of 18%. Ignoring tax consideration: (1) Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.6%. (2) Prove that weighted average cost of capital is not affected by gearing. 5. The following figures are made available to you: Net profits for the yearLess: Interest on secured debentures at 15% p.a.

18,00,000

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(Debentures were issued 3 months after the commencement of the year) Profit before taxLess: Income-tax at 35% and dividend distribution

1,12,500 16,87,500 8,43,750 8,43,750 1,00,000 Rs. 109.70

Tax Profit after tax Number of equity shares (Rs. 10 each) Market quotation of equity share

The company has accumulated revenue reserves of Rs. 12 lakhs. The company is examining a project calling for an investment obligation of Rs. 10 lakhs. This investment is expected to earn the same rate as funds already employed. You are informed that a debt equity ratio (Debt divided by debt plus equity) higher than 60% will cause the price earning ratio to come down by 25% and the interest rate on additional borrowals will cost company 300 basis points more than on their current borrowal in secured. You are required to advise the company on the probable price of the equity share, if (a) The additional investment were to be raised by way loans; or (b) The additional investment were to be raised by way of equity. 6. The Modern Chemicals Ltd. requires Rs. 25,00,000 for a new plant. This plant is expected to yield earnings before interest and taxes of Rs. 5,00,000. While deciding about the financial plan, the company considers the objective of 2aximising earnings per share. It has three alternatives to finance the project—by raising debt of Rs. 2,50,000 or Rs. 10,00,000 or Rs. 15,00,000 and the balance, in each case, by issuing equity shares. The company's share is currently selling at Rs. 150, but is expected to decline to Rs. 125 in case the funds are borrowed in excess of Rs. 10,00,000. The funds can be borrowed at the rate of 10% upto Rs. 2,50,000, at 15% over Rs. 2,50,000 and upto Rs. 10,00,000 and at 20% over Rs. 10,00,000. The tax rate applicable to the company is 50%. Which form of financing should the company choose ? A company provides the following figures:Rs.

7.

ProfitLess: Interest on debentures @ 12%

26,00,000 6,00,000 20,00,000

Profit before tax4.66

Financing Decisions

Less: Income-tax @ 50%

10,00,000 10,00,000 4,00,000 2.50 25 10

Profit after tax Number of equity shares (of Rs. 10 each) Earning per share (EPS) Ruling price in market P/E (Price/Earning) Ratio The company has undistributed reserves of Rs. 60,00,000.

The company needs Rs. 20,00,000 for expansion; this amount will earn the same rate as funds already employed. You are informed that a debt equity ratio higher than 35% pulls the PE ratio down to 8 and raises the interest rate on additional amount borrowed at 14%. You are required to ascertain the probable price of the share if(i) (ii) 8. The additional funds are raised as a loans; or The amount is raised by issuing equity shares.

EXE Limited is considering three financing plans. The key information is as follows: (a) Total investment to be raised is Rs. 2,00,000 (b) Plans of Financing ProportionPlan Equity Debt Preference Shares —

A B C

100% 50% 50%

— 50 -

— 50%

(c) Cost of debt 8%; Cost of preference 8% (d) Tax rate 50% (Assume no dividend tax) (e) Equity shares of face value of Rs. 10 each will be issued at a premium of Rs. 10 per share. (g) (i) Expected EBIT is Rs. 80,000 Earning per share4.67

You are required to determine for each plan:


(ii) (iii) 9.

The Financial break-even point. Compute the EBIT range among the plans of indifference. Sales Debt/Equity Interest rate Operating profit Rs. 50,000 3:1 12% Rs. 20,00,000

Calculate the Operating Leverage from the following data:

10. Calculate the Degree of Operating Leverage, Degree of Financial Leverage and the Degree of Combined Leverage for the following firms and interpret the results: Output (unit) Fixed Costs (Rs.) Unit Variable costs (Rs) Interest expenses (Rs.) Unit Selling price (Rs.)P 3,00,000 Q 75,000 R 5,00,000

3,50,000 1.00 25,000 3.00

7,00,000 7.50 40,000 25.00

5,00,000 0.10 – 0.50

11. XYZ Ltd. sells 2000 units @ Rs. 10 per unit. The variable cost of production is Rs. 7 and Fixed cost is Rs. 1,000. The company raised the required funds by issue of 100, 10% debentures @ Rs. 100 each and 2000 equity shares @ Rs. 10 per share. The sales of XYZ Ltd. are expected to increase by 20%. Assume tax rate of company is 50%. You are required to calculate the impact of increase in sales on earning per share. 12. The following figures relate to two companies:P Ltd. 500 200 300 150 150 50 100 (Rs. in lakhs) Q Ltd. 1,000 300 700 400 300 100 200

Sales Less : Variable costs Contribution Less : Fixed costs EBIT Less : Interest Profit before tax (PBT)

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Financing Decisions

You are required to : (i) (ii) Calculate the operating, financial and combined leverages for the two companies; and Comment on the relative risk position of them.

13. The capital structure of ABC Ltd. consist of an ordinary share capital of Rs. 5,00,000 (equity shares of Rs. 100 each at par value) and Rs. 5,00,000 (10% debenture of Rs. 100 each). Sales increased from 50,000 units to 60,000 units, the selling price is Rs. 12 per unit, variable cost amounts to Rs. 8 per unit and fixed expenses amount to Rs. 1,00,000. The income tax rate is assumed to be 50%. You are required to calculate the following: (a) The percentage increase in earning per share; (b) The degree of financial leverage at 50,000 units and 60,000 units; (c) The degree of operating leverage at 50,000 units and 60,000 units; (d) Comment on the behaviour E.P.S., operating and financial leverage in relation to increases in sales from 50,000 units to 60,000 units. 14. A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs. 55,00,000. (i) (ii) What is the firm’s R.O.I.? Does it have favourable financial leverage?

(iii) What are the operating, financial and combined leverage of the firm ? (iv) If the sales drop to Rs. 50,00,000, what will be the new E.B.I.T. ? 15. Calculate the operating leverage, financial leverage and combined leverage from the following data under Situations I and II and Financial Plan A and B : Installed Capacity Actual Production and Sales Selling Price Variable Cost Fixed Cost: Under Situation I Under Situation II Rs. 15,000 Rs. 20,000 4,000 units 75% of the Capacity Rs. 30 Per Unit Rs. 15 Per Unit

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Financial Plan A Rs. B Rs.

Equity Debt (Rate of Interest at 20%)

10,000 10,000 20,000

15,000 5,000 20,000

16. From the following prepare Income statement of Company A, B and C. Company Financial Leverage Interest Operating Leverage Variable cost as a percentage to sales sales Income tax rate A 3:1 Rs. 200 4:1 66 2/3% 45% B 4:1 Rs. 300 5:1 75% 45% C 2:1 Rs. 1,000 3:1 50% 45%

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CHAPTER

5

TYPES OF FINANCINGLearning Objectives After studying this chapter, you will be able to Understand♦ the different sources of finance available to a business; Differentiate between♦ the various long term, medium term and short term sources of finance; Understand♦ the meaning and purpose of Venture Capital financing; Understand the meaning and♦ purpose of securitisation and debt securitization; Understand the concept of♦ lease financing; Understand the financing of export trade by banks; and ♦ ♦ Understand the various financial instruments dealt with in the International market. 1. INTRODUCTION

One of the most important consideration for an entrepreneur–company in implementing a new project or undertaking expansion, diversification, modernisation and rehabilitation scheme is ascertaining the cost of project and the means of finance. There are several sources of finance/funds available to any company. An effective appraisal mechanism of various sources of funds available to a company must be instituted in the company to achieve its main objectives. Such a mechanism is required to evaluate risk, tenure and cost of each and every source of fund. The selection of the fund source is dependent on the financial strategy pursued by the company, the leverage planned by the company, the financial conditions prevalent in the economy and the risk profile of both the company as well as the industry in which the company operates. Each and every source of fund has some advantages as well as disadvantages. 2. FINANCIAL NEEDS AND SOURCES OF FINANCE OF A BUSINESS

2.1 Financial Needs of a Business: Business enterprises need funds to meet their different

Financial Management types of requirements. All the financial needs of a business may be grouped into the following three categories: (i) Long term financial needs: Such needs generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long term financial needs. Funds required to finance permanent or hard core working capital should also be procured from long term sources. (ii) Medium term financial needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for them are classified in the category of medium term financial needs. Sometimes long term requirements, for which long term funds cannot be arranged immediately may be met from medium term sources and thus the demand of medium term financial needs, are generated. As and when the desired long term funds are made available, medium term loans taken earlier may be paid off. (iii) Short term financial needs: Such type of financial needs arise to finance in current assets such as stock, debtors, cash, etc. Investment in these assets is known as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully. The requirement of working capital depends upon a number of factors which may differ from industry to industry and from company to company in the same industry. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period. i.e., one year. The basic principle for meeting the short term financial needs of a concern is that such needs should be met from short term sources, and for medium term financial needs from medium term sources and long term financial needs from long term sources. Accordingly, the method of raising funds is to be decided with reference to the period for which funds are required. Basically, there are two sources of raising funds for any business enterprise. viz., owner’s capital and borrowed capital. The owner’s capital is used for meeting long term financial needs and it primarily comes from share capital and retained earnings. Borrowed capital for all the other types of requirement can be raised from different sources such as debentures, public deposits, loans from financial institutions and commercial banks, etc. The following section shows at a glance the different sources from where the three aforesaid types of finance can be raised in India.

5.2

Types of Financing

2.2 Sources of Finance of a Business (i) 1. 2. 3. 4. 5. 6. 7. 8. 9. (ii) 1. 2. 3. 4. 5. 6. 7. 8. 9. Long-term Share capital or Equity share Preference shares Retained earnings Debentures/Bonds of different types Loans from financial institutions Loans from State Financial Corporation Loans from commercial banks Venture capital funding Asset securitisation Medium-term Preference shares Debentures/Bonds Public deposits/fixed deposits for duration of three years Commercial banks Financial institutions State financial corporations Lease financing/Hire-Purchase financing External commercial borrowings Euro-issues

10. International financing like Euro-issues, Foreign currency loans

10. Foreign Currency bonds (iii) Short-term 1. 2. Trade credit Accrued expenses and deferred income5.3

Financial Management 3. 4. 5. 6. Commercial banks Fixed deposits for a period of 1 year or less Advances received from customers Various short-term provisions

It is evident from the above section that funds can be raised from the same source for meeting different types of financial requirements. 2.3 Financial sources of a business can also be classified as follows by using different basis : 1. (i) (ii) 2. (i) 3. (i) (ii) According to period: Long term sources Medium term sources According to ownership: Owners capital or equity capital, retained earnings etc. According to source of generation: Internal sources e.g. retained earnings and depreciation funds etc. External sources e.g. debentures, loans etc.

(iii) Short term sources

(ii) Borrowed capital such as debentures, public deposits, loans etc.

However for the sake of convenience, the different sources of funds can also be classified into following categories. (i) (ii) Security financing - financing through shares and debentures. Internal financing - financing through retained earning, depreciation.

(iii) Loans financing - this includes both short term and long term loans. (iv) International financing. (v) Other sources. 3. LONG TERM SOURCES OF FINANCE There are different sources of funds available to meet long term financial needs of the5.4

Types of Financing

business. These sources may be broadly classified into share capital (both equity and preference) and debt (including debentures, long term borrowings or other debt instruments). In recent times in India, many companies have raised long term finance by offering various instruments to public like deep discount bonds, fully convertible debentures etc. These new instruments have characteristics of both equity and debt and it is difficult to categorised these either as debt or equity. The different sources of long term finance can now be discussed: 3.1 Owners Capital or Equity Capital : A public limited company may raise funds from promoters or from the investing public by way of owners capital or equity capital by issuing ordinary equity shares. Ordinary equity shares are a source of permanent capital. Ordinary shareholders are owners of the company and they undertake the risks of business. They are entitled to dividends after the income claims of other stakeholders are satisfied. Similarly, in the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met. They elect the directors to run the company and have the optimum control over the management of the company. Since equity shares can be paid off only in the event of liquidation, this source has the least risk involved. This is more so due to the fact that equity shareholders can be paid dividends only when there are distributable profits. However, the cost of ordinary shares is usually the highest. This is due to the fact that such shareholders expect a higher rate of return on their investment as compared to other suppliers of long-term funds. Such behaviour is directly related to the risk undertaken by ordinary shareholders when compared to the providers of other forms of capital e.g. debt. Whereas, an ordinary shareholder shall take responsibility of losses incurred by the company by foregoing dividend or accepting a lesser amount, a debt holder shall be statutorily entitled to get regular payments as per the contract. Hence, when compared to those who have provided loan capital to the company, ordinary shareholders carry a higher amount of risk and so expect a higher return. Further, the dividend payable on shares is an appropriation of profits and not a charge against profits. This means that unlike debt, ordinary equity shares do not provide any tax shield to the company, thereby resulting in a higher cost. Ordinary share capital also provides a security to other suppliers of funds. Thus, a company having substantial ordinary share capital may find it easier to raise further funds, in view of the fact that share capital provides a security to other suppliers of funds. The Companies Act, 1956 and SEBI Guidelines for disclosure and investors' protections and the clarifications thereto lay down a number of provisions regarding the issue and management of equity shares capital.

5.5

Financial Management Advantages and disadvantages of raising funds by issue of equity shares are : (i) (ii) It is a permanent source of finance. Since such shares are not redeemable, the company has no liability for cash outflows associated with its redemption. Equity capital increases the company’s financial base and thus helps further the borrowing powers of the company.

(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 issue. Apart from the above mentioned advantages, equity capital has some disadvantages to the company when compared with other sources of finance. These are as follows: (i) (ii) The cost of ordinary shares is higher because dividends are not tax deductible and also the floatation costs of such issues are higher. Investors find ordinary shares riskier because of uncertain dividend payments and capital gains.

(iii) The issue of new equity shares reduces the earning per share of the existing shareholders until and unless the profits are proportionately increased. (iv) The issue of new equity shares can also reduce the ownership and control of the existing shareholders. 3.2 Preference Share Capital: These are a special kind of shares; the holders of such shares enjoy priority, both as regards to the payment of a fixed amount of dividend and repayment of capital on winding up of the company. Long-term funds from preference shares can be raised through a public issue of shares. Such shares are normally cumulative, i.e., the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends. The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans etc. Most of preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period. Preference share capital is a hybrid form of financing which imbibes within itself some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax deductible payment. It

5.6

Types of Financing

resembles debt capital because the rate of preference dividend is fixed. Typically, when preference dividend is skipped it is payable in future because of the cumulative feature associated with most of preference shares. Cumulative Convertible Preference Shares (CCPs) may also be offered, under which the shares would carry a cumulative dividend of specified limit for a period of say three years after which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period. Preference share capital may be redeemed at a pre decided future date or at an earlier stage inter alia out of the profits of the company. This enables the promoters to withdraw their capital from the company which is now self-sufficient, and the withdrawn capital may be reinvested in other profitable ventures. It may be mentioned that irredeemable preference shares cannot be issued by any company. Preference shares have gained importance after the Finance bill 1997 as dividends became tax exempted in the hands of the individual investor and are taxable in the hands of the company as tax is imposed on distributed profits at a flat rate. At present, a domestic company paying dividend will have to pay dividend distribution tax @ 12.5% plus surcharge of 10% plus an education cess equalling 2% (total 14.025%). Advantages and disadvantages of raising funds by issue of preference shares are: (i) (ii) No dilution in EPS on enlarged capital base - If equity is issued it reduces EPS, thus affecting the market perception about the company. There is leveraging advantage as it bears a fixed charge. Non payment of preference dividends does not force company into liquidity.

(iii) There is no risk of takeover as the preference shareholders do not have voting rights except in case where dividend arrears exist. (iv) The preference dividends are fixed and pre decided. Hence Preference shareholders do not participate in surplus profits as the ordinary shareholders. (v) Preference capital can be redeemed after a specified period. The following are the disadvantages of the preference shares: (i) One of the major disadvantages of preference shares is that preference dividend is not tax deductible and so does not provide a tax shield to the company. Hence a preference share is costlier to the company than debt e.g. debenture.

5.7

Financial Management (ii) Preference dividends are cumulative in nature. This means that although these dividends may be omitted, they shall need to be paid later. Also, if these dividends are not paid, no dividend can be paid to ordinary shareholders. The non payment of dividend to ordinary shareholders could seriously impair the reputation of the company concerned. 3.3 Retained Earnings: Long-term funds may also be provided by accumulating the profits of the company and by 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 profit every 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. 3.4 Debentures or Bonds: Loans can be raised from public by issuing debentures or bonds by public limited companies. Debentures are normally issued in different denominations ranging from Rs. 100 to Rs. 1,000 and carry different rates of interest. By issuing debentures, a company can raise long term loans from public. Normally, debentures are issued on the basis of a debenture trust deed which lists the terms and conditions on which the debentures are floated. Debentures are either secured or unsecured. As compared with preference shares, debentures provide a more convenient mode of longterm funds. The cost of capital raised through debentures is quite low since the interest payable on debentures can be charged as an expense before tax. From the investors' point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits. Debentures are thus instruments for raising long-term debt capital. Secured debentures are protected by a charge on the assets of the company. While the secured debentures of a wellestablished company may be attractive to investors, secured debentures of a new company do not normally evoke same interest in the investing public. Debentures can be straight debentures or convertible debentures. A convertible debenture is the type which can be converted, either fully or partly, into shares after a specified period of time. Debentures can be divided into the following three categories: (i) (ii) Non convertible debentures – These types of debentures do not have any feature of conversion and are repayable on maturity. Fully convertible debentures – Such debentures are converted into equity shares as per the terms of issue in relation to price and the time of conversion. Interest rates on such debentures are generally less than the non convertible debentures because of their carrying the attractive feature of getting themselves converted into shares.

5.8

Types of Financing

(iii) Partly convertible debentures – Those debentures which carry features of a convertible and a non convertible debenture belong to this category. The investor has the advantage of having both the features in one debenture. Advantages of raising finance by issue of debentures are: (i) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax-deductible. Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment. Debenture financing does not result in dilution of control.

(ii)

(iii) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases. The disadvantages of debenture financing are: (i) (ii) Debenture interest and capital repayment are obligatory payments. The protective covenants associated with a debenture issue may be restrictive.

(iii) Debenture financing enhances the financial risk associated with the firm. (iv) Since debentures need to be paid during maturity, a large amount of cash outflow is needed at that time. These days many companies are issuing convertible debentures or bonds with a number of schemes/incentives like warrants/options etc. These bonds or debentures are exchangeable at the option of the holder for ordinary shares under specified terms and conditions. Thus for the first few years these securities remain as debentures and later they can be converted into equity shares at a pre-determined conversion price. The issue of convertible debentures has distinct advantages from the point of view of the issuing company. Firstly, such an issue enables the management to raise equity capital indirectly without diluting the equity holding, until the capital raised has started earning an added return to support the additional shares. Secondly, such securities can be issued even when the equity market is not very good. Thirdly, convertible bonds are normally unsecured and, therefore, their issuance may ordinarily not impair the borrowing capacity. These debentures/bonds are issued subject to the SEBI guidelines notified from time to time. Public issue of debentures and private placement to mutual funds now require that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.). The credit rating is given after evaluating factors like track record of the company, profitability, debt servicing capacity, credit worthiness and the perceived risk of lending.5.9

Financial Management 3.5 Loans from Financial Institutions: In India specialised institutions provide long- term financial assistance to industry. Thus, the Industrial Finance Corporation of India, the State Financial Corporations, the Life Insurance Corporation of India, the National Small Industries Corporation Limited, the Industrial Credit and Investment Corporation, the Industrial Development Bank of India, and the Industrial Reconstruction Corporation of India provide term loans to companies. Before a term loan is sanctioned, a company has to satisfy the concerned financial institution regarding the technical, commercial, economic, financial and managerial viability of the project for which the loan is required. Such loans are available at different rates of interest under different schemes of financial institutions and are to be repaid according to a stipulated repayment schedule. The loans in many cases stipulate a number of conditions regarding the management and certain other financial policies of the company. Term loans represent secured borrowings and at present it is the most important source of finance for new projects. They generally carry a rate of interest inclusive of interest tax, depending on the credit rating of the borrower, the perceived risk of lending and the cost of funds. These loans are generally repayable over a period of 6 to 10 years in annual, semiannual or quarterly instalments. Term loans are also provided by banks, State financial/development institutions and all- India term lending financial institutions. Banks and State Financial Corporations normally provide term loans to projects in the small scale sector while for the medium and large industries term loans are provided by State developmental institutions alone or in consortium with banks and State financial corporations. For large scale projects All India financial institutions provide the bulk of term finance either singly or in consortium with other All India financial institutions, State level institutions and/or banks. After Independence, the institutional set up in India for the provision of medium and long term credit for industry has been broadened. The assistance sanctioned and disbursed by these specialised institutions has increased impressively during the years.. A number of such specialised institutions have been established all over the country. 3.6 Loans from Commercial Banks: The primary role of the commercial banks is to cater to the short term requirements of industry. Of late, however, banks have started taking an interest in term financing of industries in several ways, though the formal term lending is, so far, small and is confined to major banks only. Term lending by banks has become a controversial issue these days. It has been argued that term loans do not satisfy the canon of liquidity which is a major consideration in all bank

5.10

Types of Financing

operations. According to the traditional values, banks should provide loans only for short periods and for operations which result in the automatic liquidation of such credits over short periods. On the other hand, it is contended that the traditional concept of liquidity requires to be modified. The proceeds of the term loan are generally used for what are broadly known as fixed assets or for expansion in plant capacity. Their repayment is usually scheduled over a long period of time. The liquidity of such loans is said to depend on the anticipated income of the borrowers. As a matter of fact, a working capital loan is more permanent and long term than a term loan. The reason for making this statement is that a term loan is always repayable on a fixed date and ultimately, a day will come when the account will be totally adjusted. However, in the case of working capital finance, though it is payable on demand, yet in actual practice it is noticed that the account is never adjusted as such; and, if at all the payment is asked back, it is with a clear purpose and intention of refinance being provided at the beginning of the next year or half year. To illustrate this point let us presume that two loans are granted on January 1, 2006 (a) to A; term loan of Rs. 60,000/- for 3 years to be paid back in equal half yearly instalments, and (b) to B : cash-credit limit against hypothecation, etc. of Rs. 60,000. If we make two separate graphs for the two loans, they may appear to be like the figure shown below.

06

07

08

09

06

07

08

09

Note : It has been presumed that both the concerns are good. Payment of interest has been ignored. It has been presumed that cash credit limit is being enhanced gradually. The above graphs clearly indicate that at the end of 2009 the term loan would be fully settled whereas the cash credit limit may have been enhanced to over a lakh of rupees. It really amounts to providing finances for long term. This technique of providing long term finance can be technically called as “rolled over for periods exceeding more than one year”. Therefore, instead of indulging in term financing by the rolled over method, banks can and should extend credit term after a proper appraisal of5.11

Financial Management applications for terms loans. In fact, as stated above, the degree of liquidity in the provision for regular amortisation of term loans is more than in some of these so called demand loans which are renewed from year to year. Actually, term financing disciplines both the banker and the borrower as long term planning is required to ensure that cash inflows would be adequate to meet the instruments of repayments and allow an active turnover of bank loans. The adoption of the formal term loan lending by commercial banks will not in any way hamper the criteria of liquidity and as a matter of fact, it will introduce flexibility in the operations of the banking system. The real limitation to the scope of bank activities in this field is that all banks are not well equipped to make appraisal of such loan proposals. Term loan proposals involve an element of risk because of changes in the conditions affecting the borrower. The bank making such a loan, therefore, has to assess the situation to make a proper appraisal. The decision in such cases would depend on various factors affecting the conditions of the industry concerned and the earning potential of the borrower. 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 compared with that on term loans. 4. VENTURE CAPITAL FINANCING

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. 4.1 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 known5.12

Types of Financing

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 IDBI. 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 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 India. Some common methods of venture capital financing are as follows: (i) 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. (ii) 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 becomes5.13

Financial Management commercially sounds. (iii) 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. (iv) 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. 5. DEBT SECURITISATION

Securitisation is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. The following example illustrates the process in a conceptual manner: A finance company has issued a large number of car loans. It desires to raise further cash so as to be in a position to issue more loans. One way to achieve this goal is by selling all the existing loans, however, in the absence of a liquid secondary market for individual car loans, this may not be feasible. Instead, the company pools a large number of these loans and sells interest in the pool to investors. This process helps the company to raise finances and get the loans off its Balance Sheet. .These finances shall help the company disburse further loans. Similarly, the process is beneficial to the investors as it creates a liquid investment in a diversified pool of auto loans, which may be an attractive option to other fixed income instruments. The whole process is carried out in such a way, that the ultimate debtors- the car owners – may not be aware of the transaction. They shall continue making payments the way they were doing before, however, these payments shall reach the new investors instead of the company they (the car owners) had financed their car from. The example provided above illustrates the general concept of securitisation as understood in common spoken English. Securitisation can take the form of ‘debt securitisation’ in which the underlying pool of assets (debt) is sold to a company or a trust for an immediate cash payment. The company which buys these pool of assets issues securities and utilises the regular cash flows arising out of the underlying pool of assets for servicing such issued securities. Thus securitisation follows a two way process, (1) the sale of an asset or a pool of assets to a company for immediate cash payment and (2) the repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable securities.

5.14

Types of Financing

The company to which the underlying pool of assets or asset is sold is known as a ‘Special Purpose Vehicle’ (SPV) and the company which sells the underlying pool of assets or asset is known as the originator. The process of securitisation is generally without recourse i.e. the investor bears the credit risk or risk of default and the issuer is under an obligation to pay to investors only if the cash flows are received by him from the collateral. The issuer however, has a right to legal recourse in the event of default. The risk run by the investor can be further reduced through credit enhancement facilities like insurance, letters of credit and guarantees. In a simple pass through structure, the investor owns a proportionate share of the asset pool and cash flows when generated are passed on directly to the investor. This is done by issuing pass through certificates. In mortgage or asset backed bonds, the investor has a lien on the underlying asset pool. The SPV accumulates payments from the original borrowers from time to time and makes payments to investors at regular predetermined intervals. The SPV can invest the funds received in short term instruments and improve yield when there is time lag between receipt and payment. In India, the Reserve Bank of India had issued draft guidelines on securitisation of standard assets in April 2005. These guidelines were applicable to banks, financial institutions and non banking financial companies. The guidelines were suitably modified and brought into effect from February 2006. 5.1 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 assets. 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.

5.15

Financial Management 6. LEASE FINANCING

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. 7. SHORT TERM SOURCES OF FINANCE

There are various sources available to meet short term needs of finance. The different sources are discussed below: 7.1 Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to almost all business operations. It can be in the form of an 'open account' or 'bills payable'. Trade credit is preferred as a source of finance because it is without any explicit cost and till a business is a going concern it keeps on rotating. Another very important characteristic of trade credit is that it enhances automatically with the increase in the volume of business. 7.2. Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a company has to pay for the services which it has already received. Such expenses arise out of the day to day activities of the company and hence represent a spontaneous source of finance. Deferred income, on the other hand, reflects the amount of funds received by a company in lieu of goods and services to be provided in the future. Since these receipts increase a company’s liquidity, they are also considered to be an important source of spontaneous finance.

5.16

Types of Financing

7.3 Advances from Customers: Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing or construction time usually demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful. 7.4. Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources of short term borrowings and to provide an additional instrument to investors. Subsequently, in addition to the Corporate, Primary Dealers and All India Financial Institutions have also been allowed to issue Commercial Papers. Commercial Papers can be issued for maturities between 15 days and a maximum up to one year from the date of issue. These can be issued in denominations of Rs 5 lakh or multiples thereof. All eligible issuers are required to get the credit rating from Credit Rating Information Services of India Ltd,(CRISIL), or the Investment Information and Credit Rating Agency of India Ltd (ICRA) or the Credit Analysis and Research Ltd (CARE) or the FITCH Ratings India Pvt Ltd or any such other credit rating agency as is specified by the Reserve Bank of India .Individuals, banking companies, corporate bodies incorporated in India, Non Resident Indians, Foreign Institutional Investors etc are allowed to invest in Commercial Paper, the minimum amount of such investment being Rs 5 lakhs. 7.5 Bank Advances: Banks receive deposits from public for different periods at varying rates of interest. These funds are invested and lent in such a manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met and a reasonable profit is made. A bank's lending policy is not merely profit motivated but has to also keep in mind the socio- economic development of the country. Bank advances are in the form of loan, overdraft, cash credit and bills purchased/discounted etc. Banks do not sanction advances on a long term basis beyond a small proportion of their demand and time liabilities. Advances are granted against tangible securities such as goods, shares, government promissory notes, Bills etc. In very rare cases, clean advances may also be allowed. (i) 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. Except by way of interest and other charges no further adjustments are made in this account. Loan accounts are not running accounts like overdraft and cash credit accounts, repayment under the loan5.17

Financial Management account may be the full amounts or by way of schedule of repayments agreed upon as in case of term loans. The securities may be shares, government securities, life insurance policies and fixed deposit receipts, etc. (ii) Overdraft: Under this facility, customers are allowed to withdraw in excess of credit balance standing in their Current Deposit Account. 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. 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 balances. 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. (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. Therefore, while entertaining proposals for clean advances; banks exercise a good deal of restraint since they have no backing of any tangible security. If the parties are already enjoying secured advance facilities, this may be a point in favour and may be taken into account while screening such proposals. The turnover in the account, satisfactory dealings for considerable period and reputation in the market are some of the factors which the bank will normally see. As a safeguard, banks take guarantees from other persons who are credit worthy before granting this facility. A clean advance is generally granted for a short period and must not be continued for long. (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. 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. 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. 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

5.18

Types of Financing

the creditor as security for repayment of debt. 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 realisation of his advance under proper notice to the borrower. (v) Advances against goods : Advances against goods occupy an important place in total bank credit. Goods are security have certain distinct advantages. They provide a reliable source of repayment. Advances against them are safe and liquid. Also, there is a quick turnover in goods, as they are in constant demand. So a banker accepts them as security. Generally goods are charged to the bank either by way of pledge or by way of hypothecation. The term 'goods' includes all forms of movables which are offered to the bank as security. They may be agricultural commodities or industrial raw materials or partly finished goods. For the purpose of calculation of the drawing limits, valuation of the goods is made from time to time. In case of hypothecation advance, an undertaking is obtained from the borrower that the goods are not charged to some other bank. The bank also takes periodical statements of stocks regarding quantity valuation etc. The Reserve Bank of India issues directives from time to time imposing restrictions on advances against certain commodities. It is obligatory on banks to follow these directives in letter and spirit. The directives also sometimes stipulate changes in the margin. (vi) Bills Purchased/Discounted : These advances are allowed against the security of bills which may be clean or documentary. Bills are sometimes purchased from approved customers in whose favour limits are sanctioned. Before granting a limit the banker satisfies himself as to the credit worthiness of the drawer. Although the term 'bills purchased' gives the impression that the bank becomes the owner or purchaser of such bills, in actual practice the bank holds the bills only as security for the advance. The bank, in addition to the rights against the parties liable on the bills, can also exercise a pledge’s rights over the goods covered by the documents. Usance bills maturing at a future date or sight are discounted by the banks for approved parties. When a bill is discounted, the borrower is paid the present worth. The bankers, however, collect the full amounts on maturity. The difference between these two amounts represents earnings of the bankers for the period. This item of income is called 'discount'. Sometimes, overdraft or cash credit limits are allowed against the security of bills. A suitable margin is usually maintained. Here the bill is not a primary security but only a collateral security. The banker in the case, does not become a party to the bill, but merely collects it as an agent for its customer.

5.19

Financial Management When a banker purchases or discounts a bill, he advances against the bill; he has therefore to be very cautious and grant such facilities only to those customers who are creditworthy and have established a steady relationship with the bank. Credit reports are also compiled on the drawees. (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. These documents include a bill of lading, dock warehouse keeper's certificate, railway receipt, etc. A person in possession of a document to goods can by endorsement or delivery (or both) of document, enable another person to take delivery of the goods in his right. An advance against the pledge of such documents is equivalent to an advance against the pledge of goods themselves. (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. The other type of bills which also come under this category are bills from contractors for work executed either wholly or partially under firm contracts entered into with the above mentioned Government agencies. These bills are clean bills without being accompanied by any document of title of goods. But they evidence supply of goods directly to Governmental agencies. Sometimes these bills may be accompanied by inspection notes from representatives of government agencies for having inspected the goods before they are despatched. If bills are without the inspection report, banks like to examine them with the accepted tender or contract for verifying that the goods supplied under the bills strictly conform to the terms and conditions in the acceptance tender. These supply bills represent debt in favour of suppliers/contractors, for the goods supplied to the government bodies or work executed under contract from the Government bodies. 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. The power of attorney has got to be registered with the Government department concerned. The banks also take separate letter from the suppliers / contractors instructing the Government body to pay the amount of bills direct to the bank. Supply bills do not enjoy the legal status of negotiable instruments because they are not bills of exchange. The security available to a banker is by way of assignment of debts represented by the supply bills.

5.20

Types of Financing

(ix) Term Loans by banks: Term loans are an instalment credit repayable over a period of time in monthly/quarterly/half-yearly or yearly instalment. Banks grant term loans for small projects falling under priority sector, small scale sector and big units. Banks have now been permitted to sanction term loan for projects as well without association of financial institutions. The banks grant loans for periods which normally range from 3 to 7 years and sometimes even more. These loans are granted on the security of fixed assets. 7.6 Financing of Export Trade by Banks: Exports play an important role in accelerating the economic growth of developing countries like India. Of the several factors influencing export growth, credit is a very important factor which enables exporters in efficiently executing their export orders. The commercial banks provide short term export finance mainly by way of pre and post-shipment credit. Export finance is granted in Rupees as well as in foreign currency. In view of the importance of export credit in maintaining the pace of export growth, RBI has initiated several measures in the recent years to ensure timely and hassle free flow of credit to the export sector. These measures, inter alia, include rationalization and liberalization of export credit interest rates, flexibility in repayment/prepayment of pre-shipment credit, special financial package for large value exporters, export finance for agricultural exports, Gold Card Scheme for exporters etc. Further, banks have been granted freedom by RBI to source funds from abroad without any limit for exclusively for the purpose of granting export credit in foreign currency, which has enabled banks to increase their lending’s under export credit in foreign currency substantially during the last few years. The advances by commercial banks for export financing are in the form of: (i) (ii) Pre-shipment finance i.e., before shipment of goods. Post-shipment finance i.e., after shipment of goods.

7.6.1 Pre-Shipment Finance: This generally takes the form of packing credit facility; packing credit is an advance extended by banks to an exporter for the purpose of buying, manufacturing, processing, packing, shipping goods to overseas buyers. Any exporter, having at hand a firm export order placed with him by his foreign buyer or 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 advance. Normally, banks insist upon their customers to lodge with them irrevocable letters of credit opened in favour of the customers by the overseas buyers. The letter of credit and firm sale contracts not only serve as evidence of a definite arrangement for realisation of the export5.21

Financial Management 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. 7.6.1.1 Types of Packing Credit (a) 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 clean type of export advance. Each proposal is weighed according to particular requirements of the trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (ECGC) cover should be obtained by the bank. (b) Packing credit against hypothecation of goods: Export finance is made available on certain terms and conditions where the exporter has pledge able 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, along with the firm export order or letter of credit relative stock statements and thereafter continue submitting them every fortnight and/or whenever there is any movement in stocks. (c) 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. (d) E.C.G.C. guarantee: Any loan given to an exporter for the manufacture, processing, purchasing, or packing of goods meant for export against a firm order qualifies for the packing. credit guarantee issued by Export Credit Guarantee Corporation (ECGC). (e) Forward exchange contract: Another requirement of packing credit facility is that if the export bill is to be drawn in a foreign currency, the exporter should enter into a forward exchange contact with the bank, thereby avoiding risk involved in a possible change in the rate of exchange. Documents required : In case of partnership firms, banks usually require the following documents: (i) Joint and several demand promote signed on behalf of the firm as well as by the partners individually. (ii) Letter of continuity (signed on behalf of the firm and partners individually).

5.22

Types of Financing

(iii) Letter of Pledge to secure demand cash credit against goods (in case of pledge) OR Agreement of Hypothecation to secure demand cash credit (in case of hypothecation). (iv) Letter of Authority to operate the account. (v) Declaration of Partnership. (In case of sole traders, sole proprietorship declaration). (vi) Agreement to utilise the monies drawn in terms of contract. (vii) Letter of Hypothecation (for bills). In case of limited companies banks usually require the following documents : (i) (ii) Demand Pro-note Letter of continuity.

(iii) Agreement of hypothecation or Letter of pledge signed on behalf of the company. (iv) General guarantee of the directors of the company in their joint and several personal capacities. (v) Certified copy of the board of directors' resolution. (vi) Agreement to utilise the monies drawn in terms of contract should bear the seal of the company. (vii) Letter of Hypothecation (for bills). 7.6.2 Post-shipment Finance: It takes the following forms: (a) Purchase/discounting of documentary export bills : Finance is provided to exporters by purchasing export bills drawn payable at sight or by discounting usance export bills covering confirmed sales and backed by documents including documents of the title of goods such as bill of lading, post parcel receipts, or air consignment notes. Documents to be obtained: (i) (ii) Letter of hypothecation covering the goods; and General guarantee of directors or partners of the firm as the case may be.

(b) E.C.G.C. Guarantee: Post-shipment finance, given to an exporter by a bank through purchase, negotiation or discount of an export bill against an order, qualifies for post-shipment export credit guarantee. It is necessary, however, that exporters should obtain a shipment or

5.23

Financial Management contracts risk policy of E.C.G.C. Banks insist on the exporters to take a contracts shipments (comprehensive risks) policy covering both political and commercial risks. The Corporation, on acceptance of the policy, will fix credit limits for individual exporters and the Corporation’s liability will be limited to the extent of the limit so fixed for the exporter concerned irrespective of the amount of the policy. (c) Advance against export bills sent for collection : Finance is provided by banks to exporters by way of advance against export bills forwarded through them for collection, taking into account the creditworthiness of the party, nature of goods exported, usance, standing of drawee, etc. appropriate margin is kept. Documents to be obtained : (i) (ii) Demand promissory note. Letter of continuity.

(iii) Letter of hypothecation covering bills. (iv) General Guarantee of directors or partners of the firm (as the case may be). (d) Advance against duty draw backs, cash subsidy, etc.: To finance export losses sustained by exporters, bank advance against duty draw-back, cash subsidy, etc., receivable by them against export performance. Such advances are of clean nature; hence necessary precaution should be exercised. Conditions : Bank providing finance in this manner see that the relative export bills are either negotiated or forwarded for collection through it so that it is in a position to verify the exporter's claims for duty draw-backs, cash subsidy, etc. 'An advance so availed of by an exporter is required to be liquidated within 180 days from the date of shipment of relative goods. Documents to be obtained: (i) (ii) Demand promissory note. Letter of continuity.

(iii) General Guarantee of directors of partners of the firm as the case may be. (iv) Undertaking from the borrowers that they will deposit the cheques/payments received from the appropriate authorities immediately with the bank and will not utilise such amounts in any other way.

5.24

Types of Financing

Other facilities extended to exporters: (i) (ii) On behalf of approved exporters, banks establish letters of credit on their overseas or up country suppliers. Guarantees for waiver of excise duty, etc. due performance of contracts, bond in lieu of cash security deposit, guarantees for advance payments etc., are also issued by banks to approved clients.

(iii) To approved clients undertaking exports on deferred payment terms, banks also provide finance. (iv) Banks also endeavour to secure for their exporter-customers status reports of their buyers and trade information on various commodities through their correspondents. (v) Economic intelligence on various countries is also provided by banks to their exporter clients. 7.7 Inter Corporate Deposits: 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 period. 7.8 Certificate of Deposit (CD): 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 such funds. 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. 7.9 Public Deposits: Public deposits are very important source of short-term and medium term finances particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid up capital and reserves, from the public and shareholders. These deposits may be accepted for a period of six months to three years. Public deposits are unsecured loans; they should not be used for acquiring fixed assets since they are to be repaid within a period of 3 years. These are mainly used to finance working capital requirements. 8. OTHER SOURCES OF FINANCING

8.1 Seed Capital Assistance: The Seed capital assistance scheme is designed by IDBI for

5.25

Financial Management professionally or technically qualified entrepreneurs and/or persons possessing relevant experience, skills and entrepreneurial traits. 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. 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. 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. 8.2 Risk Capital Foundation Scheme: The Risk Capital Foundation Scheme is an autonomous foundation set up and funded by IFCI. It assists promoters of projects costing between Rs 2 crores and Rs 15 crore. The ceiling on the assistance varies between Rs 15 lakhs and Rs 40 lakhs depending on the number of applicant promoters. 8.3 Internal Cash Accruals: Existing profit making companies which undertake an expansion/ diversification programme may be permitted to invest a part of their accumulated reserves or cash profits for creation of capital assets. In such cases, past performance of the company permits the capital expenditure from within the company by way of disinvestment of working/invested funds. In other words, the surplus generated from operations, after meeting all the contractual, statutory and working requirement of funds, is available for further capital expenditure. 8.4 Unsecured Loans: Unsecured loans are typically provided by promoters to meet the promoters' contribution norm. These loans are subordinate to institutional loans. The rate of interest chargeable on these loans should be less than or equal to the rate of interest on institutional loans and interest can be paid only after payment of institutional dues. These loans cannot be repaid without the prior approval of financial institutions. Unsecured loans are considered as part of the equity for the purpose of calculating of debt equity ratio. 8.5 Deferred Payment Guarantee: Many a time suppliers of machinery provide deferred credit facility under which payment for the purchase of machinery can be made over a period of time. The entire cost of the machinery is financed and the company is not required5.26

Types of Financing

to contribute any amount initially towards acquisition of the machinery. Normally, the supplier of machinery insists that bank guarantee should be furnished by the buyer. Such a facility does not have a moratorium period for repayment. Hence, it is advisable only for an existing profit making company. 8.6 Capital Incentives: The backward area development incentives available often determine the location of a new industrial unit. These incentives usually consist of a lump sum subsidy and exemption from or deferment of sales tax and octroi duty. The quantum of incentives is determined by the degree of backwardness of the location. The special capital incentive in the form of a lump sum subsidy is a quantum sanctioned by the implementing agency as a percentage of the fixed capital investment subject to an overall ceiling. This amount forms a part of the long-term means of finance for the project. However, it may be mentioned that the viability of the project must not be dependent on the quantum and availability of incentives. Institutions, while appraising the project, assess the viability of the project per se, without considering the impact of incentives on the cash flows and profitability of the project. Special capital incentives are sanctioned and released to the units only after they have complied with the requirements of the relevant scheme. The requirements may be classified into initial effective steps and final effective steps. The initial effective steps include formation of the firm/company, acquisition of land in the backward area and registration for manufacture of the products. The final effective steps include obtaining clearances under FEMA, capital goods clearance/import licence, conversion of Letter of Intent to Industrial License, tie up of the means of finance, all clearances required for the setting up of the unit, aggregate expenditure incurred for the project should exceed 25% of the project cost and at least 10% of the fixed assets should have been created/acquired site. The release of special capital incentives by the concerned State Government generally takes one to two years. The promoters therefore find it convenient to avail bridge finance against the capital incentives. Provision for the same should be made in the pre-operative expenses considered in the project cost. Further, as the bridge finance may be available to the extent of 85%, the balance 15% may have to be brought in by the promoters from their own resources. 9. NEW INSTRUMENTS

The new instruments that have been introduced since early 90’s as a source of finance is staggering in their nature and diversity. These new instruments are as follows: 9.1 Deep Discount Bonds: Deep Discount Bonds is a form of zero-interest bonds. These5.27

Financial Management bonds are sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is no interest payout during lock in period. IDBI was the first to issue a deep discount bond in India in January, 1992. The bond of a face value of Rs. 1 lakh was sold for Rs. 2,700 with a maturity period of 25 years. The investor could hold the bond for 25 years or seek redemption at the end of every five years with a specified maturity value as shown below. Holding Period (years) Maturity value (Rs.) Annual rate of interest (%) 5 5,700 16.12 10 12,000 16.09 15 25,000 15.99 20 25 50,000 1,00,000 15.71 15.54

The investor can sell the bonds in stock market and realise the difference between face value (Rs. 2,700) and market price as capital gain. 9.2 Secured Premium Notes: Secured Premium Notes is issued along with a detachable warrant and is redeemable after a notified period of say 4 to 7 years. The conversion of detachable warrant into equity shares will have to be done within time period notified by the company. 9.3 Zero interest fully convertible debentures: These are fully convertible debentures which do not carry any interest. The debentures are compulsorily and automatically converted after a specified period of time and holders thereof are entitled to new equity shares of the company at predetermined price. From the point of view of company this kind of instrument is beneficial in the sense that no interest is to be paid on it, if the share price of the company in the market is very high than the investors tends to get equity shares of the company at the lower rate. 9.4 Zero Coupon Bonds: 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. 9.5 Double Option Bonds: These have also been recently issued by the IDBI. The face value of each bond is Rs. 5,000. The bond carries interest at 15% per annum compounded half yearly from the date of allotment. The bond has maturity period of 10 years. Each bond has two parts in the form of two separate certificates, one for principal of Rs. 5,000 and other for interest (including redemption premium) of Rs. 16,500. Both these certificates are listed on all major stock exchanges. The investor has the facility of selling either one or both parts anytime he likes.5.28

Types of Financing

9.6 Option Bonds: These are cumulative and non-cumulative bonds where interest is payable on maturity or periodically. Redemption premium is also offered to attract investors. These were recently issued by IDBI, ICICI etc. 9.7 Inflation Bonds: Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus, the investor gets interest which is free from the effects of inflation. For example, if the interest rate is 11 per cent and the inflation is 5 per cent, the investor will earn 16 per cent meaning thereby that the investor is protected against inflation. 9.8 Floating Rate Bonds: This as the name suggests is bond where the interest rate is not fixed and is allowed to float depending upon the market conditions. This is an ideal instrument which can be resorted to by the issuer to hedge themselves against the volatility in the interest rates. This has become more popular as a money market instrument and has been successfully issued by financial institutions like IDBI, ICICI etc. 10. INTERNATIONAL FINANCING

The essence of financial management is to raise and utilise the funds raised effectively. There are various avenues for organisations to raise funds either through internal or external sources. The sources of external sources include: 10.1 Commercial Banks: Like domestic loans, commercial banks all over the world extend Foreign Currency (FC) loans also for international operations. These banks also provide to overdraw over and above the loan amount. 10.2 Development Banks: Development banks offer long & medium term loans including FC loans. Many agencies at the national level offer a number of concessions to foreign companies to invest within their country and to finance exports from their countries. E.g. EXIM Bank of USA. 10.3 Discounting of Trade Bills: This is used as a short term financing method. It is used widely in Europe and Asian countries to finance both domestic and international business. 10.4 International Agencies: A number of international agencies have emerged over the years to finance international trade & business. The more notable among them include The Inter- national Finance Corporation (IFC), The International Bank for Reconstruction and Development (IBRD), The Asian Development Bank (ADB), The International Monetary Fund (IMF), etc. 10.5 International Capital Markets: Today, modern organisations including MNC's depend upon sizeable borrowings in Rupees as well as Foreign Currency. In order to cater to the5.29

Financial Management needs of such organisations, international capital markets have sprung all over the globe such as in London. In international capital market, the availability of FC is assured under the four main systems viz: * * * * Euro-currency market Export credit facilities Bonds issues Financial Institutions.

The origin of the Euro-currency market was with the dollar denominated bank deposits & loans in Europe particularly in London. Euro-dollar deposits are dollar denominated time deposits available at foreign branches of US banks & at some foreign banks. Banks based in Europe accept dollar denominated deposits & make dollar denominated deposits to the clients. This forms the backbone of the Euro-currency market all over the globe. In this market, funds are made available as loans through syndicated Euro-credit of instruments such as FRN's. FR certificates of deposits. 10.6 Financial Instruments: Some of the various financial instruments dealt with in the international market are briefly described below: (a) External Commercial Borrowings(ECB) : 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. 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 Approval Route.

5.30

Types of Financing

(b) 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. (c) Foreign Bonds: These are debt instruments issued by foreign corporations or foreign governments. Such bonds are exposed to default risk, especially the corporate bonds. These bonds are denominated in the currency of the country where they are issued, however, in case these bonds are issued in a currency other than the investors home currency, they are exposed to exchange rate risks. An example of a foreign bond ‘A British firm placing Dollar denominated bonds in USA’. (d) Fully Hedged Bonds: As mentioned above, in foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate the risk by selling in forward markets the entire stream of principal and interest payments. (e) Medium Term Notes: 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. The entire documentation and various regulatory approvals can be taken at one point of time (f) Floating Rate Notes: These are issued up to seven years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans. (g) Euro Commercial Papers (ECP): ECPs are short term money market instruments. They are for maturities less than one year. They are usually designated in US Dollars. (h) Foreign Currency Option: A FC Option is the right to buy or sell, spot, future or forward, a specified foreign currency. It provides a hedge against financial and economic risks. (i) Foreign Currency Futures: FC Futures are obligations to buy or sell a specified currency in the present for settlement at a future date. 10.7 Euro Issues by Indian Companies : Indian companies are permitted to raise foreign currency resources through issue of ordinary equity shares through Global Depository Receipts(GDRs)/ American Depository Receipts (ADRs) and / or issue of Foreign Currency

5.31

Financial Management Convertible Bonds (FCCB) to foreign investors i.e. institutional investors or individuals (including NRIs) residing abroad . Such investment is treated as Foreign Direct Investment. The government guidelines on these issues are covered under the Foreign Currency Convertible Bonds and Ordinary Shares (Through depositary receipt mechanism) Scheme, 1993 and notifications issued after the implementation of the said scheme. (a) American Depository Deposits (ADR) : 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. ADRs allow US investors to buy shares of these companies without the costs of investing directly in a foreign stock exchange. 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 very stringent. 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. 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. 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 Exchanges. 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. (b) Global Depository Receipt (GDRs): 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. 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 industries5.32

Types of Financing

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. (c) Indian Depository Receipts (IDRs): 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. The IDRs are listed and traded in India in the same way as other Indian securities are traded. 10.8 Other Types of International Issues (a) Foreign Euro Bonds: In domestic capital markets of various countries the Bonds issues referred to above are known by different names such as Yankee Bonds in the US, Swiss Frances in Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK. (b) Euro Convertible Bonds: A convertible bond is a debt instrument which gives the holders of the bond an option to convert the bonds into a pre-determined number of equity shares of the company. Usually the price of the equity shares at the time of conversion will have a premium element. These bonds carry a fixed rate of interest and if the issuer company so desires may also include a Call Option (where the issuer company has the option of calling/ buying the bonds for redemption prior to the maturity date) or a Put Option (which gives the holder the option to put/sell his bonds to the issuer company at a pre-determined date and price). (c) Euro Bonds: Plain Euro Bonds are nothing but debt Instruments. These are not very atattractive for an investor who desires to have valuable additions to his investments. (d) Euro Convertible Zero Bonds: These bonds are structured as a convertible bond. No interest is payable on the bonds. But conversion of bonds takes place on maturity at a predetermined price. Usually there is a five years maturity period and they are treated as a deferred equity issue. (e) Euro Bonds with Equity Warrants: These bonds carry a coupon rate determined by market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed Income Funds Management may like to invest for the purposes of regular income.

5.33

Financial Management Self Examination Questions A. Objective Type Questions 1. The largest provider of short-term credit for a business is: (a) Banks (b) Suppliers to the firm (c) Commercial paper (d) None of the above. 2. The number of days until the firm is past due to a supplier is called the: (a) Discount period (b) Term to credit (c) 3. Payment period (d) None of the above. The principal value of a bond is called the: (a) The coupon rate (b) The par value (c) The maturity value (d) None of the above. 4. An advantage of debt financing is: (a) Interest payments are tax deductible (b) The use of debt, up to a point, lowers the firm's cost of capital (c) Does not dilute owner's earnings (d) All of the above. 5. Zero coupon bonds: (a) Are sold at par (b) Pay no interest payment (c) Are sold at a deep discount (d) b and c above.5.34

Types of Financing

6.

Commercial paper can be issued by: (a) Corporate (b) Primary Dealers (c) All India Financial Institutions (d) All of the above.

7.

Commercial paper can be issued in the following denominations: (a) Rs 5 Lakhs (b) Rs 10 Lakhs (c) Rs 5 Lakhs and multiples there of (d) Rs 1 Lakh and multiples there of.

8.

Commercial paper is a: (a) Short term source of Finance (b) Medium term source of Finance (c) Long term source of Finance (d) None of the above.

9.

Which amongst the following are short term sources of finance? (a) Accrued expenses (b) Deferred income (c) Equity shares (d) Debentures.

10. In a tax environment, the cost of debenture to the issuing company: (a) Lower than the cost of equity shares (b) Higher than the cost of equity shares (c) Higher than the cost of preference shares (d) None of the above.

5.35

Financial Management Answers to Objective Type Questions 1. (b); 2. (c); 3. (b); 4. (d); 5. (d); 6. (d); 7. (c); 8. (a); 9. (a) & (b); 10. (a) B. Short Answer Type Questions 1. 2. Briefly discuss the different sources of long term finance. Write short notes on: (a) Zero interest fully convertible debentures (b) Deep discount bonds (c) Inflation bonds (d) Debt securitization. 3. 4. 5. C. 1. 2. 3. 4. 5. Why are debentures considered cheaper than equity as a source of finance? Discuss briefly. What do you understand by the term ‘ploughing back of profits’? Discuss briefly the concept of ‘Seed Capital Assistance’. Long Answer Type Questions Explain the advantages of equity financing. What are the advantages of debt financing from the point of company and investors? What do you mean by venture capital financing and what are the methods of this type of financing? What are the advantages of lease financing? Discuss the various ways in which Indian companies can raise foreign currency.

5.36

CHAPTER

6

INVESTMENT DECISIONSLearning objectives After studying this chapter, you will be able to ♦ ♦ ♦ ♦ Describe capital budgeting decisions; Understand the purpose and process of Capital Budgeting; Appreciate the importance of cash flows and understand the basic principles for measuring the same; Evaluate projects using various capital budgeting techniques like PB (Pay Back ), NPV (Net Present Value), PI (Profitability Index) , IRR (Internal Rate of Return), MIRR (Modified Internal Rate of Return) and ARR (Accounting Rate of Return); and Understand the advantages and disadvantages of the above mentioned techniques. INTRODUCTION

1.♦

Financing and investment of funds are two crucial financial functions. The investment of funds also termed as capital budgeting requires a number of decisions to be taken in a situation in which funds are invested and benefits are expected over a long period. The term capital budgeting means planning for capital assets. It involves proper project planning and commercial evaluation of projects to know in advance technical feasibility and financial viability of the project. 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 alternatives. In any business the commitment of funds in land, buildings, equipment, stock and other types of assets must be carefully made. Once the decision to acquire a fixed asset is taken, it becomes very difficult to reverse that decision. The expenditure on plant and machinery and other long term assets affects operations over a period of years. It becomes a commitment that influences long term prospects and the future earning capacity of the firm.


However, Capital Budgeting excludes certain investment decisions, wherein, the benefits of investment proposals cannot be directly quantified. For example, management may be considering a proposal to build a recreation room for employees. The decision in this case will be based on qualitative factors, such as management − employee relations, with less consideration on direct financial returns. However, most investment proposals considered by management will require quantitative estimates of the benefits to be derived from accepting the project. A bad decision can be detrimental to the value of the organisation over a long period of time. 2. PURPOSE OF CAPITAL BUDGETING

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. 3. CAPITAL BUDGETING PROCESS

The extent to which the capital budgeting process needs to be formalised and systematic procedures established depends on the size of the organisation; number of projects to be considered; direct financial benefit of each project considered by itself; the composition of the firm's existing assets and management's desire to change that composition; timing of expenditures associated with the projects that are finally accepted. (i) Planning: The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm's fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and

6.2

Investment Decisions

promising opportunities are advanced in the form of a proposal to enter the evaluation phase. (ii) Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances. (iii) Selection: Considering the returns and risks associated with the individual projects as well as the cost of capital to the organisation, the organisation will choose among projects so as to maximise shareholders’ wealth. (iv) Implementation: When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project. (v) Control: The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits. (vi) Review: When a project terminates, or even before, the organisation should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in the future. 4. TYPES OF CAPITAL INVESTMENT DECISIONS

There are many ways to classify the capital budgeting decision. Generally capital investment decisions are classified in two ways. One way is to classify them on the basis of firm’s existence. Another way is to classify them on the basis of decision situation. 4.1 On the basis of firm’s existence: The capital budgeting decisions are taken by both newly incorporated firms as well as by existing firms. The new firms may be required to take decision in respect of selection of a plant to be installed. The existing firm may be required to take decisions to meet the requirement of new environment or to face the challenges of competition. These decisions may be classified as follows: (i) Replacement and Modernisation decisions: The replacement and modernisation decisions aim at to improve operating efficiency and to reduce cost. Generally all types of plant and machinery require replacement either because of the economic life of the plant or machinery is over or because it has become technologically outdated. The former decision is known as replacement decisions and later one is known as modernisation decisions. Both replacement and modernisation decisions are called cost reduction decisions. (ii) Expansion decisions: Existing successful firms may experience growth in demand of their product line. If such firms experience shortage or delay in the delivery of their products

6.3


due to inadequate production facilities, they may consider proposal to add capacity to existing product line. (iii) Diversification decisions: These decisions require evaluation of proposals to diversify into new product lines, new markets etc. for reducing the risk of failure by dealing in different products or by operating in several markets. Both expansion and diversification decisions are called revenue expansion decisions. 4.2 On the basis of decision situation: The capital budgeting decisions on the basis of decision situation are classified as follows: (i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more alternative proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. For instance, a firm may be considering proposal to install a semi-automatic or highly automatic machine. If the firm install a semiautomatic machine it exclude the acceptance of proposal to install highly automatic machine. (ii) Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which give a higher return than certain desired rate of return are accepted and the rest are rejected. (iii) Contingent decisions: The contingent decisions are dependable proposals. The investment in one proposal requires investment in one or more other proposals. For example if a company accepts a proposal to set up a factory in remote area it may have to invest in infrastructure also e.g. building of roads, houses for employees etc. 5. PROJECT CASH FLOWS

Project cash flows are defined as the financial costs and benefits associated with a project. The estimation of costs and benefits are made with the help of inputs provided by marketing, production, engineering, costing, purchase, taxation, and other departments. The project cash flow stream consists of cash outflows and cash inflows. The costs are denoted as cash outflows whereas the benefits are denoted as cash inflows. The future costs and benefits associated with each project are as follows: (i) (ii) Capital costs Operating costs

(iii) Revenue (iv) Depreciation (v) Residual value An investment decision implies the choice of an objective, an appraisal technique and the

6.4


project’s life. The objective and technique must be related to definite period of time. The life of the project may be determined by taking into consideration the following factors: (i) (ii) Technological obsolescence Physical deterioration

(iii) A decline in demand for the output of the project. No matter how good a company's maintenance policy, its technological forecasting ability or its demand forecasting ability, uncertainty will always be present because of the difficulty in predicting the duration of a project life. To allow realistic appraisal, the value of cash payment or receipt must be related to the time when the transfer takes place. In particular, it must be recognised that Re. 1 received today is worth more than Re. 1 received at some future date because Re. 1 received today could be earning interest in the intervening period. This is the concept of 'Time Value of Money' (for a detailed understanding of the Time Value of Money please refer to Chapter 2). The process of converting future sums into their present equivalent is known as discounting, which is used to determine the present value of future cash flows. 6. BASIC PRINCIPLES FOR MEASURING PROJECT CASH FLOWS

For developing the project cash flows the following principles must be kept in mind: 1. Incremental Principle: The cash flows of a project must be measured in incremental terms. To ascertain a project’s incremental cash flows, one has to look at what happens to the cash flows of the firm 'with the project and without the project', and not before the project and after the project as is sometimes done. The difference between the two reflects the incremental cash flows attributable to the project. Project cash flows for year t = Cash flow for the firm with the project for year t − Cash flow for the firm without the project for year t. 2. Long Term Funds Principle: A project may be evaluated from various points of view: total funds point of view, long-term funds point of view, and equity point of view. The measurement of cash flows as well as the determination of the discount rate for evaluating the cash flows depends on the point of view adopted. It is generally recommended that a project may be evaluated from the point of view of long-term funds (which are provided by equity stockholders, preference stock holders, debenture holders, and term lending institutions) because the principal focus of such evaluation is normally on the profitability of long-term funds. 3. Exclusion of Financing Costs Principle: When cash flows relating to long-term funds are being defined, financing costs of long-term funds (interest on long-term debt and equity

6.5


dividend) should be excluded from the analysis. The question arises why? The weighted average cost of capital used for evaluating the cash flows takes into account the cost of longterm funds. Put differently, the interest and dividend payments are reflected in the weighted average cost of capital. Hence, if interest on long-term debt and dividend on equity capital are deducted in defining the cash flows, the cost of long-term funds will be counted twice. The exclusion of financing costs principle means that: (i) (ii) The interest on long-term debt (or interest) is ignored while computing profits and taxes and; The expected dividends are deemed irrelevant in cash flow analysis.

While dividends pose no difficulty as they come only from profit after taxes, interest needs to be handled properly. Since interest is usually deducted in the process of arriving at profit after tax, an amount equal to interest (1 − tax rate) should be added back to the figure of profit after tax. That is, Profit before interest and tax (1 − tax rate) = (Profit before tax + interest) (1 − tax rate) = (Profit before tax) (1 − tax rate) + (interest) (1 − tax rate) = Profit after tax + interest (1 − tax rate) Thus, whether the tax rate is applied directly to the profit before interest and tax figure or whether the tax − adjusted interest, which is simply interest (1 − tax rate), is added to profit after tax, we get the same result. 4. Post−tax Principle: Tax payments like other payments must be properly deducted in deriving the cash flows. That is, cash flows must be defined in post-tax terms. Illustration 1 ABC Ltd is evaluating the purchase of a new project with a depreciable base of Rs. 1,00,000; expected economic life of 4 years and change in earnings before taxes and depreciation of Rs. 45,000 in year 1, Rs. 30,000 in year 2, Rs. 25,000 in year 3 and Rs. 35,000 in year 4. Assume straight-line depreciation and a 20% tax rate. You are required to compute relevant cash flows.

6.6


Solution Rs. Years 1 Earnings before depreciation Less: Depreciation Earnings before tax Less: Tax [@20%] Add: Depreciation Net Cash flow Working Note: Depreciation = Rs. 1, 00,000÷4 = Rs. 25,000 Illustration 2 XYZ Ltd is considering a new investment project about which the following information is available. (i) The total outlay on the project will be Rs. 100 lacks. This consists of Rs.60 lacks on plant and equipment and Rs.40 lacks on gross working capital. The entire outlay will be incurred at the beginning of the project. The project will be financed with Rs.40 lacks of equity capital; Rs.30 lacks of long term debt (in the form of debentures); Rs. 20 lacks of short-term bank borrowings, and Rs. 10 lacks of trade credit. This means that Rs.70 lacks of long term finds (equity + long term debt) will be applied towards plant and equipment (Rs. 60 lacks) and working capital margin (Rs.10 lacks) – working capital margin is defined as the contribution of long term funds towards working capital. The interest rate on debentures will be 15 percent and the interest rate on short-term borrowings will be 18 percent. tax and 45,000 25,000 20,000 4,000 16,000 25,000 41,000 2 30,000 25,000 5,000 1,000 4,000 25,000 29,000 3 25,000 25,000 0 0 0 25,000 25,000 4 35,000 25,000 10,000 2,000 8,000 25,000 33,000

(ii)

(iii) The life of the project is expected to be 5 years and the plant and equipment would fetch a salvage value of Rs. 20 lacks. The liquidation value of working capital will be equal to Rs.10 lacks. (iv) The project will increase the revenues of the firm by Rs. 80 lacks per year. The increase in operating expenses on account of the project will be Rs.35.0 lacks per year. (This

6.7


includes all items of expenses other than depreciation, interest, and taxes). The effective tax rate will be 50 percent. (v) Plant and equipment will be depreciated at the rate of 331/3 percent per year as per the written down value method. So, the depreciation charges will be : Rs. (in lacs) First year 20.0 Second year 13.3 Third year 8.9 Fourth year 5.9 Fifth year 4.0 Given the above details, you are required to work out the post-tax, incremental cash flows relating to long-term funds. Solution Cash Flows for the New ProjectRs. (in lacs) Years 0 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) Plant and equipment Working capital margin Revenues Operating Costs Depreciation Interest on short-term bank borrowings Interest on debentures Profit before tax Tax Profit after tax Net salvage value of plant and equipment Net recovery working capital margin Initial Investment [(a) + (b)] (70.0) (60.0) (10.0) 80.0 35.0 20.0 3.6 4.5 16.90 8.45 8.45 80.0 35.0 13.33 3.6 4.5 23.57 11.79 11.78 80.0 35.0 8.89 3.6 4.5 28.01 14.01 14.00 80.0 35.0 5.93 3.6 4.5 30.97 15.49 15.48 80.0 35.0 3.95 3.6 4.5 32.95 16.48 16.47 20.0 10.0 1 2 3 4 5

6.8

Investment Decisions(n) Operating cash inflows [(j) +(e) + (g) (1–T)] (o) Terminal cash flow [(k) + (l) ] (p) Net cash flow. [(m) + (n) + (o) ] (70.0) 30.70 27.36 25.14 23.66 52.67 30.00 30.70 27.36 25.14 23.66 22.67

Working Notes (with explanations): (i) The initial investment, occurring at the end of year 0, is Rs. 70 lacs. This represents the commitment of long-term funds to the project. The operating cash inflow, relating to longterm funds, at the end of year 1 is Rs. 30.7 lacs. That is, Profit after tax + Depreciation + Interest on debentures (1 – tax ) Rs. 8.45 lacs + Rs.20 lacs + Rs. 4.5 lacs (1 – 0.50) The operating cash inflows for the subsequent years have been calculated similarly. (ii) The terminal cash flow relating to long-term funds is equal to : Net Salvage value of plant and equipment + Net recovery of working capital margin When the project is terminated, its liquidation value will be equal to: Net Salvage value of plant and equipment + Net recovery of working capital The first component belongs to the suppliers of long-term funds. The second component is applied to repay the current liabilities and recover the working capital margin. 7. CAPITAL BUDGETING TECHNIQUES

In order to maximise the return to the shareholders of a company, it is important that the best or most profitable investment projects are selected. Because the results for making a bad long-term investment decision can be both financially and strategically devastating, particular care needs to be taken with investment project selection and evaluation. There are a number of techniques available for appraisal of investment proposals and can be classified as presented below:

6.9


CAPITAL BUDGETING TECHNIQUES

Traditional or Non-Discounting

Time-adjusted or Discounted Cash Flows Net Present Value Profitability Index

Payback Period

Accounting Rate of Return

Internal Rate of Return Modified Internal Rate of Return

Discounted Payback

Organizations may use any or more of capital investment evaluation techniques; some organizations use different methods for different types of projects while others may use multiple methods for evaluating each project. These techniques have been discussed below – net present value, profitability index, internal rate of return, modified internal rate of return, payback period, and accounting (book) rate of return. Payback Period: 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 project. As with other methods discussed, the first steps 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

6.10


equation:Payback period = Total initial capital investment Annual expected after - tax net cash flow

When the annual expected after-tax net cash flows are not uniform, the cumulative cash inflow from operations must be calculated for each year by subtracting cash outlays for operations and taxes from cash inflows and summing the results until the total is equal to the initial capital investment. Advantages: 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 cash invested. 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. Limitations: 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 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. Illustration 3 Suppose a project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12½% (straight line method) but before tax 50%. The first step would be to calculate the cash inflow from this project. The cash inflow is Rs. 4,00,000 calculated as follows : Rs. Profit before tax 3,00,000 Less : Tax @ 50% 1,50,000 Profit after tax 1,50,000 Add : Depreciation written off 2,50,000 Total cash inflow 4,00,000 While calculating cash inflow, depreciation is added back to profit after tax since it does not6.11


result in cash outflow. The cash generated from a project therefore is equal to profit after tax plus depreciation. Payback period =Rs. 20,00,000 = 5 Years 4,00,000

Some Accountants calculate payback period after discounting the cash flows by a predetermined rate and the payback period so calculated is called, ‘Discounted payback period’. Payback Reciprocal : As the name indicates it is the reciprocal of payback period. A major drawback of the payback period method of capital budgeting is that it does not indicate any cut off period for the purpose of investment decision. It is, however, argued that the reciprocal of the payback would be a close approximation of the internal rate of return if the life of the project is at least twice the payback period and the project generates equal amount of the annual cash inflows. In practice, the payback reciprocal is a helpful tool for quickly estimating the rate of return of a project provided its life is at least twice the payback period. The payback reciprocal can be calculated as follows:

Average annual cash in flow Initial investmentIllustration 4 Suppose a project requires an initial investment of Rs. 20,000 and it would give annual cash inflow of Rs. 4,000. The useful life of the project is estimated to be 5 years. In this example payback reciprocal will be :Rs 4,000 × 100 = 20% Rs20,000

The above payback reciprocal provides a reasonable approximation of the internal rate of return, i.e. 19% discussed later in this chapter. Accounting (Book) Rate of Return: 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 Investment

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

6.12


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. Advantages: 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 consistency. 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. Limitations: 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 working capital and other outlays that are not included in the book value of the project. Illustration 5 Suppose a project requiring an investment of Rs. 10,00,000 yields profit after tax and depreciation as follows: Profit after tax and depreciation Rs. 1. 50,000 2. 75,000 3. 1,25,000 4. 1,30,000 5. 80,000 Total 4,60,000 Suppose further that at the end of 5 years, the plant and machinery of the project can be sold for Rs. 80,000. In this case the rate of return can be calculated as follows. Years

Total Profit × 100 Net investment in the project × No. of years of profit

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Rs 4,60,000 × 100 Rs 9,20,000 × 5 years

= 10%

This rate is compared with the rate expected on other projects, had the same funds been invested alternatively in those projects. Sometimes, the management compares this rate with the minimum rate (called-cut off rate) they may have in mind. For example, management may decide that they will not undertake any project which has an average annual yield after tax less than 15%. Any capital expenditure proposal which has an average annual yield of less than 15% will be automatically rejected. Net Present Value Technique: 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 (the time of the initial investment or year 0). 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. The overall cost of capital of a firm is a proportionate average of the costs of the various components of the firm’s financing. A firm obtains funds by issuing preferred or common stock; borrowing money using various forms of debt such a notes, loans, or bonds; or retaining earnings. The costs to the firm are the returns demanded by debt and equity investors through which the firm raises the funds. The net present value of a project is the amount, in current rupees, the investment earns after yielding the desired rate of return in each period. Net present value = Present value of net cash flow - Total net initial investment The steps to calculating net present value are (1) determine the net cash inflow in each year of the investment, (2) select the desired rate of return, (3) find the discount factor for each year based on the desired rate of return selected, (4) determine the present values of the net

6.14


cash flows by multiplying the cash flows by the discount factors, (5) total the amounts for all years in the life of the project, and (6) subtract the total net initial investment. Illustration 6 Compute the net present value for a project with a net investment of Rs. 1, 00,000 and the following cash flows if the company’s cost of capital is 10%? Net cash flows for year one is Rs. 55,000; for year two is Rs. 80,000 and for year three is Rs. 15,000. [PVIF @ 10% for three years are 0.909, 0.826 and 0.751] Solution Year 1 2 3 Total Discounted Cash Flows Less: Net Investment Net Present Value Net Cash Flows 55,000 80,000 15,000 1,27,340 1,00,000 27,340 PVIF @ 10% 0.909 0.826 0.751 Discounted Cash Flows 49,995 66,080 11,265 1,27,340

Recommendation: Since the net present value of the project is positive, the company should accept the project. Illustration 7 ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the purchase of equipment; the company uses the net present value technique to evaluate projects. The capital budget is limited to 500,000 which ABC Ltd believes is the maximum capital it can raise. The initial investment and projected net cash flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You are required to compute the NPV of the different projects. Initial Investment Project Cash Inflows Year 1 2 3 4 5 Project A 200,000 50,000 50,000 50,000 50,000 50,000 Project B 190,000 40,000 50,000 70,000 75,000 75,000 Project C 250,000 75,000 75,000 60,000 80,000 100,000 Project D 210,000 75,000 75,000 60,000 40,000 20,000

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Solution Calculation of net present value: Present Period value factor 1 0.893 2 0.797 3 0.712 4 0.636 5 0.567 Present value of cash inflows Less: Initial investment Net present value Advantages (i) (ii) NPV method takes into account the time value of money. The whole stream of cash flows is considered. Project A 44,650 39,850 35,600 31,800 28,350 180,250 200,000 (19,750) Project B 35,720 39,850 49,840 47,700 42,525 215,635 190,000 25,635 Project C 66,975 59,775 42,720 50,880 56,700 277,050 250,000 27,050 Project D 66,975 59,775 42,720 25,440 11,340 206,250 210,000 (3,750)

(iii) The net present value can be seen as the addition to the wealth of share holders. The criterion of NPV is thus in conformity with basic financial objectives. (iv) The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees. The NPVs of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merit. Limitations (i) (ii) It involves difficult calculations. The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice.

(iii) The ranking of projects depends on the discount rate. Let us consider two projects involving an initial outlay of Rs. 25 lakhs each with following inflow : (Rs in lakhs) Project A Project B 1st year 50.0 12.5 2nd year 12.5 50.0

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At discounted rate of 5% and 10% the NPV of Projects and their rankings at 5% and 10% are as follows: NPV @ 5% Project A Project B 33.94 32.25 Rank I II NPV @ 10% 30.78 27.66 Rank I II

The project ranking is same when the discount rate is changed from 5% to 10%. However, the impact of the discounting becomes more severe for the later cash flows. Naturally, higher the discount rate, higher would be the impact. In the case of project B the larger cash flows come later in the project life, thus decreasing the present value to a larger extent. (iv) The decision under NPV method is based on absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive projects. Desirability Factor/Profitability Index: In above Illustration the students may have seen how 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. Mathematically : The desirability factor is calculated as below :

Sum of discounted cash in flows Initial cash outlay/Total discounted cash outflow (as the case may)Illustration 8 Suppose we have three projects involving discounted cash outflow of Rs.5,50,000, Rs75,000 and Rs.1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for these projects are Rs. 6,50,000, Rs. 95,000 and Rs 1,00,30,000 respectively. Calculate the desirability factors for the three projects. Solution The desirability factors for the three projects would be as follows: 1.Rs. 6,50,000 = 1.18 Rs. 5,50,000

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2. 3.

Rs. 95,000 = Rs. 75,000

1.27 1.001

Rs.1,00,30,000 = Rs.1,00,20,000

It would be seen that in absolute terms project 3 gives the highest cash inflows yet its desirability factor is low. This is because the outflow is also very high. The Desirability/ Profitability Index factor helps us in ranking various projects. Advantages The method also uses the concept of time value of money and is a better project evaluation technique than NPV. Limitations 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. 8. 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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There are various ways of resorting to capital rationing. For instance, a firm may effect capital rationing through budgets. It may also put up a ceiling when it has been financing investment proposals only by way of retained earnings (ploughing back of profits). Since the amount of capital expenditure in that situation cannot exceed the amount of retained earnings, it is said to be an example of capital rationing. 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) (ii) To identify the projects which can be accepted by using the technique of evaluation discussed above. 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 results. The following illustration shows how a firm may resort to capital rationing under situation of resource constraints. Illustration 9 Alpha Limited is considering five capital projects for the years 2000,2001,2002 and 2003. The company is financed by equity entirely and its cost of capital is 12%. The expected cash flows of the projects are as follows : Year and Cash flows (Rs. ‘000) Project A B C D E 2000 (70) (40) (50) — (60) 2001 35 (30) (60) (90) 20 2002 35 45 70 55 40 2003 20 55 80 65 50

Note : Figures in brackets represent cash outflows.6.19


All projects are divisible i.e. size of investment can be reduced, if necessary in relation to availability of funds. None of the projects can be delayed or undertaken more than once. Calculate which project Alpha Limited should undertake if the capital available for investment is limited to Rs. 1,10,000 in year 2000 and with no limitation in subsequent years. For your analysis, use the following present value factors: Year Discounting factor Solution Computation of Net Present Value (NPV) & Profitability Index (PI) (Rs. ‘000) Project Discounted 2000 A B C D E (70) (40) (50) — (60) Cash Flows 2001 31.15 (26.70) (53.40) (80.10) 17.80 2002 28 36 56 44 32 (Refer to working note) 2003 14.20 39.05 56.80 46.15 35.50 NPV 3.35 8.35 9.40 10.05 25.30 PI 1.048 1.125 1.091 1.125 1.422 2000 1.00 2001 0.89 2002 0.80 2003 0.71

Ranking of Projects in descending order of profitability index Rank Projects 1 E 2 D 3 B 4 C 5 A

Selection and Analysis: For Project ‘D’ there is no capital rationing but it satisfies the criterion of required rate of return. Hence Project D may be undertaken. For other projects the requirement is Rs. 2,20,000 in year 2000 whereas the capital available for investment is only Rs. 1,10,000. Based on the ranking, the final selection from other projects which will yield maximum NPV will be:

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Project and Rank E(1) B(2) C(3) Ranking of Projects capital availability : Projects Rank Working Note :

Amount of Initial Investment Rs. 60,000 40,000 10,000 (Restriction) excluding ‘D’ which is to start in 2001 when there is no limitation on E 1 B 2 C 3 A 4

Computation of Discounted Cash flows Year Present value factor Project A Cash flows Discounted cash flows B Cash flows Discounted cash flows C Cash flows Discounted cash flows D Cash flows Discounted cash flows E Cash flows Discounted cash flows Illustration 10 2000 1.00 (70) (70) (40) (40) (50) (50) — — (60) (60) 2001 0.89 35 31.15 (30) (26.70) (60) (53.40) (90) (80.10) 20 17.80

(Rs. ‘000) 2002 0.80 35 28 45 36 70 56 55 44 40 32 2003 0.71 20 14.20 55 39.05 80 56.80 65 46.15 50 35.50

Note : Figures in brackets represent cash outflows. Venture Ltd. has Rs. 30 lakhs available for investment in capital projects. It has the option of making investment in projects 1,2,3 and 4. Each project is entirely independent and has a useful life of 5 years. The expected present value of cash flows from the projects is as follows:

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Projects

Initial outlay Rs.

Present value of cash flowsf Rs. 10,00,000 19,00,000 11,40,000 20,00,000

1 2 3 4

8,00,000 15,00,000 7,00,000 13,00,000

Which of the above investment should be undertaken? Assume that the cost of capital is 12% and risk free interest rate is 10% per annum. Given compounded sum of Re. 1 at 10% in 5 years is Rs. 1.611 and discount factor of Re. 1 at 12% rate for 5 years is 0.567. Solution This is a problem on capital rationing. The fund available with the company is Rs. 30 lakhs. The company will adopt those projects which will maximise the NPV. Statement showing NPV of projects Project Initial outlay Present value of future cash flow Rs (i) 1 2 3 4 8,00,000 15,00,000 7,00,000 13,00,000 (ii) 10,00,000 19,00,000 11,40,000 20,00,000 NPV

Rs (iii)=(ii) – (i) 2,00,000 4,00,000 4,40,000 7,00,000

The NPV of the projects 1,2,3 is Rs. 10,40,000 (with full available amount utilised). The NPV of the projects 1, 3 and 4 is Rs. 40,000 (with Rs. 28 lakhs utilised, leaving Rs. 2,00,000 to be invested elsewhere). Now, Rs. 2,00,000 can be invested for a period of 5 years @ 10%. It is given in the question that the compounded value of Re. 1 @ 10% per annum for 5 years is Rs. 1.611. Therefore for Rs. 2,00,000 invested now for 5 years @ 10% the amount to be received after 5 years will be Rs. 3,22,200 (Rs. 2,00,000 × 1.611).

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The amount to be received at the end of 5th years would be Rs. 1,82,687.40 (Rs. 3,22,200 × 0.567). Since, the amount to be received 15,22,687 after 5 years by making investment in projects 1, 3 and 4 & investing balance amount available @ 10% is greater than the amount to be received of Rs. 10,40,000 by investing in projects 1, 2 and 3. It is advisable that the venture Ltd. should make investment in projects 1, 3 and 4. Internal Rate of Return Method: 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 useful life If A is the annuity discount factor, then A=

Total initial cash disbursements and commitment s for the investment Annual (equal) net cash flows from the investment

Once A has been calculated, the discount rate is the interest rate that has the same discount factor as A in the annuity table along the row for the number of periods of the useful life of the investment. This computed discount rate or the internal rate of return will be compared to the criterion rate the organization has selected to assess the investment’s desirability. 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 budgeting process.

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Illustration 11 Calculate the internal rate of return of an investment of Rs. 1, 36,000 which yields the following cash inflows: Year 1 2 3 4 5 Solution Calculation of IRR Since the cash inflow is not uniform, the internal rate of return will have to be calculated by the trial and error method. In order to have an approximate idea about such rate, the ‘Factor’ must be found out. ‘The factor reflects the same relationship of investment and cash inflows as in case of payback calculations’: Cash Inflows (in Rs.) 30,000 40,000 60,000 30,000 20,000

F=Where, F I C

I C= = = Factor to be located Original Investment Average Cash inflow per year

For the project,

Factor =

1,36,000 36,000

= 3.78 The factor thus calculated will be located in the present value of Re.1 received annually for N year’s table corresponding to the estimated useful life of the asset. This would give the expected rate of return to be applied for discounting the cash inflows. In case of the project, the rate comes to 10%.

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Year 1 2 3 4 5

Cash Inflows (Rs.) 30,000 40,000 60,000 30,000 20,000

Discounting factor at 10% 0.909 0.826 0.751 0.683

Present Value (Rs.) 27,270 33,040 45,060 20,490 12,420 1,38,280

0.621 Total present value

The present value at 10% comes to Rs. 1,38,280, which is more than the initial investment. Therefore, a higher discount rate is suggested, say, 12%. Year 1 2 3 4 5 Cash Inflows (Rs.) 30,000 40,000 60,000 30,000 20,000 Discounting factor at 10% 0.893 0.797 0.712 0.636 0.567 Total present value Present Value (Rs.) 26,790 31,880 42,720 19,080 11,340 1,31,810

The internal rate of return is, thus, more than 10% but less than 12%. The exact rate can be obtained by interpolation:

IRR =

Rs.1,38,280 − Rs.1,36,000 10 + Rs.1,38,280 − Rs.1,31,810 x 2 ⎡ ⎛ ⎞⎤ ⎟⎥ ⎢ ⎜ ⎝ ⎠⎦ ⎣ ⎛ 2280 x2 6470 10 +⎞ ⎟ ⎜ ⎝ ⎠10 + 0.7

= =

IRR = 10.7% Acceptance Rule The use of IRR, as a criterion to accept capital investment decision involves a comparison of

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IRR with the required rate of return known as cut off rate . The project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut off rate the firm is indifferent. If IRR less than cut off rate the project is rejected. Internal rate of return and mutually exclusive projects Projects are called mutually exclusive, when the selection of one precludes the selection of others e.g. in case a company owns a piece of land which can be put to use for either of the two different projects S or L, then such projects are mutually exclusive to each other i.e. the selection of one project necessarily means the rejection of the other. Refer to the figure below:Net Present Value (Rs.) 400 Project L’s Net Present Value Profile 300

200 Cross overrabe = 7% Project S5 Net Present value profile 100 IRR = 14% 0

5

7

10 IRR = 12%

15

Cost of Capital %

As long as the cost of capital is greater than the crossover rate of 7 % , then (1) NPV

S

is

larger than NPV L and (2) IRR S exceeds IRR L . Hence , if the cut off rate or the cost of capital is greater than 7% , both the methods shall lead to selection of project S. However, if the cost of capital is less than 7% , the NPV method ranks Project L higher , but the IRR method indicates that the Project S is better. As can be seen from the above discussion, mutually exclusive projects can create problems with the IRR technique because IRR is expressed as a percentage and does not take into account the scale of investment or the quantum of money earned. Let us consider another example of two mutually exclusive projects A and B with the following details,

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Cash flows Year 0 Project A Project B (Rs 1,00,000) (Rs 5,00,000) Year 1 Rs 1,50,000 Rs 6,25,000 IRR 50% 25% NPV(10%) Rs 36,360 Rs 68,180

Project A earns a return of 50% which is more than what Project B earns; however the NPV of Project B is greater than that of Project A . Acceptance of Project A means that Project B must be rejected since the two Projects are mutually exclusive. Acceptance of Project A also implies that the total investment will be Rs 4,00,000 less than if Project B had been accepted, Rs 4,00,000 being the difference between the initial investment of the two projects. Assuming that the funds are freely available at 10% , the total capital expenditure of the company should be ideally equal to the sum total of all outflows provided they earn more than 10% along with the chosen project from amongst the mutually exclusive. Hence, in case the smaller of the two Projects i.e. Project A is selected, the implication will be of rejecting the investment of additional funds required by the larger investment. This shall lead to a reduction in the shareholders wealth and thus, such an action shall be against the very basic tenets of Financial Management. In the above mentioned example the larger of the two projects had the lower IRR , but never the less provided for the wealth maximising choice. However, it is not safe to assume that a choice can be made between mutually exclusive projects using IRR in cases where the larger project also happens to have the higher IRR . Consider the following two Projects A and B with their relevant cash flows; Year 0 1 2 3 4 A Rs (9,00,000) 7,00,000 6,00,000 4,00,000 50,000 B Rs (8,00,000) 62,500 6,00,000 6,00,000 6,00,000

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In this case Project A is the larger investment and also has t a higher IRR as shown below, Year 0 1 2 3 4 IRR A = 46% IRR B = 35% However, in case the relevant discounting factor is taken as 5% , the NPV of the two projects provides a different picture as follows; Project A Year 0 1 2 3 4 (Rs) (9,00,000) 7,00,000 6,00,000 4,00,000 50,000 r= 5% 1.0 0.9524 0.9070 0.8638 0.8227 NPV PV(Rs) (9,00,000) 6,66,680 5,44,200 3,45,520 41,135 6,97,535 (Rs) (8,00,000) 62,500 6,00,000 6,00,000 6,00,000 Project B r= 5% 1.0 0.9524 0.9070 0.8638 0.8227 PV(Rs) (8,00,000) 59,525 5,44,200 5,18,280 4,93,630 8,15,635 (Rs) (9,00,000) 7,00,000 6,00,000 4,00,000 50,000 r=46% 1.0 0.6849 0.4691 0.3213 0.2201 PV(Rs) (9,00,000) 4,79, 430 2,81,460 1,28,520 11,005 (415) (Rs) (8,00,000) 62,500 6,00,000 6,00,000 6,00,000 R=35% 1.0 0.7407 0.5487 0.4064 0.3011 PV(Rs) (8,00,000) 46,294 3,29,220 2,43,840 1,80,660 14

As may be seen from the above, Project B should be the one to be selected even though its IRR is lower than that of Project A. This decision shall need to be taken in spite of the fact that Project A has a larger investment coupled with a higher IRR as compared with Project B. This type of an anomalous situation arises because of the reinvestment assumptions implicit in the two evaluation methods of NPV and IRR. The Reinvestment assumption The Net Present Value technique assumes that all cash flows can be reinvested at the discount rate used for calculating the NPV. This is a logical assumption since the use of the NPV technique implies that all projects which provide a higher return than the discounting factor are accepted. In contrast, IRR technique assumes that all cash flows are reinvested at the projects IRR. This assumption means that projects with heavy cash flows in the early

6.28


years will be favoured by this method vis-à-vis projects which have got heavy cash flows in the later years. This implicit reinvestment assumption means that Projects like A , with cash flows concentrated in the earlier years of life will be preferred by the method relative to Projects such as B. Projects with unequal lives Let us consider two mutually exclusive projects ‘A’ and ‘B’ with the following cash flows, Year Project A Project B 0 Rs (30,000) (30,000) 1 Rs 20,000 37,500 2 Rs 20,000

The calculation of NPV and IRR could help us evaluate the two projects; however, it is also possible to equate the life span of the two for decision making purposes. The two projects can be equated in terms of time span by assuming that the company can reinvest in Project ‘B’ at the end of year 1. In such a case the cash flows of Project B will appear to be as follows; Year Project ‘B’ Project B reinvested Total cash flows (30,000) 0 Rs (30,000) 1 Rs 37,500 (30,000) 7,500 37,500 37,500 2 Rs

The NPVs and IRRs of both these projects under both the alternatives are shown below NPV (r=10%) Rs Cash flows (Project A 2Years) Cash flows (Project B 1 Year) Adjusted cash flows (Project A 2 Years) Adjusted cash flow (Project B 2 years) NPV A = 4,711 22% 25% 22% 25% IRR

NPV B = 4,090 NPV A = 4,711

NPV B = 7,810

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As may be seen from the above analysis, the ranking as per IRR makes Project B superior to Project A, irrespective of the period over which the assumption is made. However, when we consider NPV, the decision shall be favouring Project B; in case the re investment assumption is taken into account. This is diametrically opposite to the decision on the basis of NPV when re investment is not assumed. In that case the NPV of Project A makes it the preferred project. Hence, in case it is possible to re invest as shown in the example above, it is advisable to compare and analyse alternative projects by considering equal lives, however, this process cannot be generalised to be the best practice, as every case shall need to be judged on its own distinctive merits. Comparisons over differing lives are perfectly fine if there is no presumption that the company will be required or shall decide to re invest in similar assets. Multiple Internal 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. The following graph of discount rate versus NPV may be used as an illustration;NPV

IRR

IRR 2

Discount Role

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 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. Advantages

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(i) (ii)

This method makes use of the concept of time value of money. All the cash flows in the project are considered.

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(iii) IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital (iv) IRR technique helps in achieving the objective of minimisation of shareholders wealth. Limitations (i) 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.

(ii)

(iii) 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. (iv) 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. Modified Internal Rate of Return (MIRR): As mentioned earlier, there are several limitations attached with the concept of the conventional Internal Rate of Return. The MIRR addresses some of these deficiencies e.g, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results which are consistent with the Net Present Value method. Under this method , all cash flows , apart from the initial investment , are brought to the terminal value using an appropriate discount rate(usually the Cost of Capital). This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash in flow as mentioned above. The discount rate which equates the present value of the terminal cash in flow to the zeroth year outflow is called the MIRR. Illustration 12 Using details given in illustration 11, calculate MIRR considering a 8% Cost of Capital .

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Solution Year Cash flow Rs 0 1,36,000 The net cash flows from the investment shall be compounded to the terminal year at 8% as follows, Year 1 2 3 4 5 Cash flow @8% reinvestment rate factor 30,000 1.3605 40,000 60,000 30,000 20,000 1.2597 1.1664 1.0800 1.0000 Rs. 40,815 50,388 69,984 32,400 20,000

MIRR of the investment based on a single cash in flow of Rs 2,13,587 and a zeroth year cash out flow of Rs 1,36,000 is 9.4% (approximately) Comparison of Net Present Value and Internal Rate of Return Methods Both the net present value and the internal rate of return methods are discounted cash flow methods which mean that they consider the time value of money. The time value of money takes into account that cash received today is worth more than cash received at any future time because cash received today can be invested at a specified interest rate. The time value of money is the opportunity cost (forgone interest) from not having the cash today. Additionally, both these techniques consider all cash flows over the expected useful life of the investment. Because of these two characteristics, discounted cash flow techniques are considered to be the most theoretically sound methods for evaluating capital investments. There are circumstances under which the net present value method and the internal rate of return methods will reach different conclusions. Results may vary significantly when capital investment projects differ in (1) amount of initial investments, (2) net cash flow patterns, or (3) length of useful lives. In addition, these two methods can yield different conclusions in situations with (4) varying costs of capital over the life of a project and (5) multiple investments. To use capital budgeting techniques properly, these situations must be understood. (1) The net present value method will favour a project with a large initial investment because the project is more likely to generate large net cash inflows. Because the internal rate of return method uses percentages to evaluate the relative profitability of an investment, the

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amount of the initial investment has no effect on the outcome. Therefore, the internal rate of return method is more appropriate for assessing investments requiring significantly different initial investments. (2) Differences in the timing and amount of net cash inflows affect a project’s internal rate of return. This results from the fact that the internal rate of return method assumes that all net cash inflows from a project earn the same rate of return as the project’s internal rate of return. In contrast, the net present value method assumes that all net cash inflows from an investment earn the desired rate of return used in the calculation. The desired rate of return used by the net present value method is usually the organization’s weighted-average cost of capital, a more conservative and more realistic expectation in most cases. (3) Both methods favour projects with long useful lives as long as a project earns positive net cash inflow during the extended years. As long as the net cash inflow in a year is positive, no matter how small, the net present value increases, and the projects desirability improves. Likewise, the internal rate of return method considers each additional useful year of a project another year that its cumulative net cash inflow will earn a return equal to the project’s internal rate of return. A problem arises when an organization is forgoing more beneficial opportunities to continue a project. For example, there might be uses of space or talent where the organization would earn a higher return than the return from the continuation of the project. (4) As an organization’s financial condition or operating environment changes, its cost of capital could also change. A proper capital budgeting procedure should incorporate changes in the organization’s cost of capital or desired rate of return in evaluating capital investments. The net present value method can accommodate different rates of return over the years by using the appropriate discount rates for the net cash inflow of different periods. The internal rate of return method calculates a single rate that reflects the return of the project under consideration and cannot easily handle situations with varying desired rates of return. (5) The net present value method evaluates investment projects in cash amounts while the internal rate of return method evaluates investment projects in percentages or rates. The net present values from multiple projects can be added to arrive at a single total net present value for all investments while the percentages or rates of return on multiple projects cannot be added to determine an overall rate of return. A combination of projects requires a recalculation of the internal rate of return. Illustration 13 CXC Company is preparing the capital budget for the next fiscal year and has identified the following capital investment projects: Project A: Redesign and modification of an existing product that is current scheduled to be terminated. The enhanced model would be sold for six more years.

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Project B: Expansion of a product that has been produced on an experimental basis for the past year. The expected life of the product line is eight years. Project C: Reorganization of the plant’s distribution centre, including the installation of computerized equipment for tracking inventory. Project D: Addition of a new product. In addition to new manufacturing equipment, a significant amount of introductory advertising would be required. If this project is implemented, Project A would not be feasible due to limited capacity. Project E: Automation of the Packaging Department that would result in cost savings over the next six years. Project F: Construction of a building wing to accommodate offices presently located in an area that could be used for manufacturing. This change would not add capacity for new lines but would alleviate crowded conditions that currently exist, making it possible to improve the productivity of two existing product lines that have been unable to meet market demand. The cost of capital for CXC Company is 12%, and it is assumed that any funds not invested in capital projects and any funds released at the end of a project can be invested at this rate. As a benchmark for the accounting (book) rate of return, CXC has traditionally used 10%. Further information about the projects is shown below.Project A Capital Investment Net Present Value @12% Internal Rate of Return Payback Period Accounting Rate of Return 106,000 69,683 35% 2.2 years 18% Project B 200,000 23,773 15% 4.5 years 9% Project C 140,000 (10,228) 9% 3.9 years 6% Project D 160,000 74,374 27% 4.3 years 21% Project E 144,000 6,027 14% 2.9 years 12% Project F 130,000 69,513 26% 3.3 years 18%

If CXC Company has no budget restrictions for capital expenditures and wishes to maximize stakeholder value, the company would choose, based on the given information, to proceed with Projects A or D (mutually exclusive projects), B, E, and F. All of these projects have a positive net present value and an internal rate of return that is greater that the hurdle rate or cost of capital. Consequently, any one of these projects will enhance stakeholder value. Project C is omitted because it has a negative net present value and the internal rate of return is below the 12% cost of capital. With regard to the mutually exclusive projects, the selection of Project A or Project D is dependent on the valuation technique used for selection. If net present value is the only technique used, CXC Company would select Projects B, D, E, and F with a combined net present value of 173,687, the maximum total available. If either the payback method or the

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internal rate of return is used for selection, Projects A, B, E, and F would be chosen as Project A has a considerably shorter payback period than Project D, and Project A also has a higher internal rate of return that Project D. The accounting rate of return for these two projects is quite similar and does not provide much additional information to inform the company’s decision. The deciding factor for CXC Company between Projects A and D could very well be the payback period and the size of the initial investment; with Project A, the company would be putting fewer funds at risk for a shorter period of time. If CXC Company were to use the accounting rate of return as the sole measurement criteria for selecting projects, Project B would not be selected. It is clear from the other measures that Project B will increase stakeholder value and should be implemented if CXC has no budget restrictions; this clearly illustrates the necessity that multiple measures be used when selecting capital investment projects. Rather than an unrestricted budget, let us assume that the CXC capital budget is limited to 4,50,000. In cases where there are budget limitations (referred to as capital rationing), the use of the net present value technique is generally recommended as the highest total net present value of the group of projects that fits within the budget limitation will provide the greatest increase in stakeholder value. The combination of Projects A, B, and F will yield the highest net present value to CXC Company for an investment of 436,000. Self Examination Questions A. 1. Objective Type Questions A capital budgeting technique which does not require the computation of cost of capital for decision making purposes is, (a) Net Present Value method (b) Internal Rate of Return method (c) Modified Internal Rate of Return method (d) Pay back 2. If two alternative proposals are such that the acceptance of one shall exclude the possibility of the acceptance of another then such decision making will lead to, (a) Mutually exclusive decisions (b) Accept reject decisions (c) Contingent decisions (d) None of the above

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3.

In case a company considers a discounting factor higher than the cost of capital for arriving at present values, the present values of cash inflows will be (a) Less than those computed on the basis of cost of capital (b) More than those computed on the basis of cost of capital (c) Equal to those computed on the basis of the cost of capital (d) None of the above

4.

The pay back technique is specially useful during times (a) When the value of money is turbulent (b) When there is no inflation (c) When the economy is growing at a steady rate coupled with minimal inflation. (d) None of the above

5.

While evaluating capital investment proposals, time value of money is used in which of the following techniques, (a) Payback method (b) Accounting rate of return (c) Net present value (d) None of the above

6.

IRR would favour project proposals which have, (a) Heavy cash inflows in the early stages of the project. (b) Evenly distributed cash inflows throughout the project. (c) Heavy cash inflows at the later stages of the project (d) None of the above.

7.

The re investment assumption in the case of the IRR technique assumes that, (a) Cash flows can be re invested at the projects IRR (b) Cash flows can be re invested at the weighted cost of capital (c) Cash flows can be re invested at the marginal cost of capital (d) None of the above

8.

Multiple IRRs are obtained when, (a) Cash flows in the early stages of the project exceed cash flows during the later stages.

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(b) Cash flows reverse their signs during the project (c) Cash flows are un even (d) None of the above. 9. Depreciation is included as a cost in which of the following techniques, (a) Accounting rate of return (b) Net present value (c) Internal rate of return (d) None of the above 10. Management is considering a Rs 1,00,000 investment in a project with a 5 year life and no residual value . If the total income from the project is expected to be Rs 60,000 and recognition is given to the effect of straight line depreciation on the investment, the average rate of return is : (a) 12% (b) 24% (c) 60% (d) 75% 11. Assume cash outflow equals Rs 1,20,000 followed by cash inflows of Rs 25,000 per year for 8 years and a cost of capital of 11%. What is the Net present value? (a) (Rs 38,214) (b) Rs 9,653 (c) Rs 8,653 (d) Rs 38,214 12. What is the Internal rate of return for a project having cash flows of Rs 40,000 per year for 10 years and a cost of Rs 2,26,009? (a) 8% (b) 9% (c) 10% (c) 12%

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13. While evaluating investments, the release of working capital at the end of the projects life should be considered as, (a) Cash in flow (b) Cash out flow (c) Having no effect upon the capital budgeting decision (d) None of the above. 14. Capital rationing refers to a situation where, (a) Funds are restricted and the management has to choose from amongst available alternative investments. (b) Funds are unlimited and the management has to decide how to allocate them to suitable projects. (c) Very few feasible investment proposals are available with the management. (d) None of the above 15. Capital budgeting is done for (a) Evaluating short term investment decisions. (b) Evaluating medium term investment decisions. (c) Evaluating long term investment decisions. (d) None of the above Answers to Objective Type Questions 1. (d); 2. (a); 3. (a) ; 4. (a); 5. (c) ; 6. (a); 7. 10. (b); 11. (c); 12. (d); 13. (a); 14. (a); 15. (c). B. 1. Short Answer Type Questions Define the following terms: (a) Capital Budgeting (b) Regular payback period and discounted payback period (c) Independent projects and mutually exclusive projects. (d) Internal rate of return method and modified rate of return method. (e) Net Present Value method. (f) Capital rationing. (a); 8. (b); 9. (a);

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2. 3. 4. 5. 6. 7. 8. C. 1.

Why is discounted cash flow a superior method for capital budgeting? “The higher the cut off rate, the more will be the company willing to pay for cost saving equipment”. Discuss. Does the IRR model make significantly different decisions than the NPV method? Discuss. Two projects have an identical Net Present Value of Rs 50,000. Are both projects equal in desirability. What are the basic objections to the use of Average Rate of Return concept for evaluating projects? Discuss the principal limitations of the cash payback period for evaluating capital investment proposals. Your boss has suggested that a one year payback means 100 % average returns. Do you agree? Long Answer Type Questions Explain why, if two mutually exclusive projects are being compared, the short term project might have the higher ranking under NPV criteria if the cost of capital is high, but the long term project will be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects? In what sense is a reinvestment rate assumption embodied in the NPV , IRR and MIRR methods? What is the assumed reinvestment rate of each method? Discuss in detail the ‘Capital Budgeting Process’ What are the various types of Capital Investment decisions known to you? Discuss the basic principles for measuring project cash flows. Practical Problems (a) You are required to calculate the total present value of inflow at rate of discount of 12% of following data. Year end Cash inflows Rs. 1 2 3 2,30,000 2,28,000 2,78,000

2. 3. 4. 5. D. 1.

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4 5 6

2,83,000 2,73,000 80,000 (Scrap Value)

(b) Considering the data given in the above. Calculate the total present value of inflows and outflows if the rate of discount is 10% assuming that Rs. 10,00,000 of outflows would be spent as follows: Beginning of year 1 Beginning of year 2 Beginning of year 3 Beginning of year 4 2. Consider the following example of cash flows from two projects. No. of years 1 2 3 4 5 6 7 8 Total Project A Nil Nil 5,000 20,000 50,000 1,50,000 50,000 40,000 3,15,000 Project B 40,000 50,000 1,20,000 10,000 10,000 Nil Nil Nil 2,30,000 Rs. 2,50,000 Rs. 2,50,000 Rs. 2,50,000 Rs. 2,50,000

Both projects cost Rs. 1,50,000 each . You are required to compute the payback period for both projects. Which project will you prefer? 3. A company wants to replace its old machine with a new automatic machine. Two models A and B are available at the same cost of Rs. 5 lakhs each. Salvage value of the old machine is Rs. 1 lakh. The utilities of the existing machine can be used if the company purchases model A. Additional cost of utilities to be purchased in that case are Rs. 1 lakh. If the company purchases model B then all the existing utilities will have to be replaced with new utilities costing Rs. 2 lakhs. The salvage value of the old utilities will

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be Rs. 0.20 lakhs. The earnings after taxation are expected to be as follows : (Cash inflows) Year/Model 1. 2. 3. 4. 5. Salvage value at the end of Year 5 A Rs. 1,00,000 1,50,000 1,80,000 2,00,000 1,70,000 50,000 B Rs. 2,00,000 2,10,000 1,80,000 1,70,000 40,000 60,000 P.V. Factor @ 15% 0.87 0.76 0.66 0.57 0.50

The targeted return on capital is 15% you are required to : (i) (ii) 4. Compute, for the two machines separately, net present value, discounted payback period and desirability factor and Advice which of the machines is to be selected ?

Suppose the management of a concern is considering two projects both involving Rs. 10,00,000 each and having profits after tax and depreciation as follows: Year 1 2 3 4 5 Total A Rs. 50,000 75,000 1,25,000 1,30,000 80,000 4,60,000 B Rs. Nil Nil Nil 2,30,000 2,30,000 4,60,000

Suppose further that both projects can be sold for Rs. 80,000 each after 5 years. You are required to compute the annual rate of return of both the projects. Will you consider both projects to be equal?

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5.

A product is currently manufactured on a plant which is not fully depreciated for tax purposes and has a book value of Rs., 60,000 (it was bought for Rs. 1,20,000 six years ago). The cost of the product is as under: Unit cost Rs. 24.00 8.00 16.00 16.00 Rs. 64.00

Direct costs Indirect labour Other variable overheads Fixed overheads

10,000 units are normally produced. It is expected that the old machine can be used, indefinitely into the future, after suitable repairs, estimated to cost Rs. 40,000 annually, are carried out. A manufacturer of machinery is offering a new machine with the latest technology at Rs.3,00,000 after trading off the old plant for Rs. 30,000. The projected cost of the product will then be : Per unit Rs. Direct costs 14.00 Indirect labour 12.00 Other variable overheads 12.00 20.00 Fixed overheads 58.00 The fixed overheads are allocations from other departments pls the depreciation of plant and machinery. The old machine can be sold for Rs. 40,000 in the open market. The new machine is expected to last for 10 years at the end of which, its salvage value will be Rs. 20,000. Rate of corporate taxation is 50%. For tax purposes, the cost of the new machine and that of the old one may be depreciated in 10 years. The minimum rate of return expected is 10%. It is also anticipated that in future the demand for the products will stay to 10,000 units. Advise whether the new machine can be purchased ignore capital gains taxes. Present value of Re. 1 at 10% for years 1-10 are : .909, .826, .751, .683, .621, .564, .513, .467, .424 and .383 respectively.

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6.

Modern Enterprises Ltd. is considering the purchase of a new computer system for its Research and Development Division, which would cost Rs. 35 lakhs. The operation and maintenance costs (excluding depreciation) are expected to be Rs. 7 lakhs per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value is expected to be Rs. 1 lakh. The tangible benefits expected from the system in the form of reduction in design and drafts-menship costs would be Rs. 12 lakhs per annum. Besides, the disposal of used drawing, office equipment and furniture, initially, is anticipated to net Rs. 9 lakhs. Capital expenditure in research and development would attract 100% write-off for tax purpose. The gains arising from disposal of used assets may be considered tax-free. The company’s effective tax rate is 50%. The average cost of capital to the company is 12%. The present value factors at 12% discount rate are : Year 1 2 3 4 5 6 PVF 0.892 0.797 0.711 0.635 0.567 0.506

After appropriate analysis of cash flows, please advise the company of the financial viability of the proposal. 7. A sole trader installs plant and machinery in rented premises for the production of luxury article, the demand for which is expected to last only 5 years. The total capital put in by the sole trader is as under: Plant and Machinery Working Capital Rs. 2,70,500 Rs. 40,000 Rs. 3,10,500

The working capital will be fully realised at the end of the 5th year. The scrap value of the plant expected to be realised at the end of the 5th year is only Rs. 5,500. The trader’s earnings are expected to be as under :

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Years

Cash profits after depreciation and tax Rs.

Tax payable Rs. 20,000 30,000 40,000 26,000 5,000

1 2 3 4 5

90,000 1,30,000 1,70,000 1,16,000 19,500

Present value factors of various rates of interest are given below : Years 11% 0.9009 2 3 4 5 0.8116 0.7312 0.6587 0.5935 12% 0.8929 0.7972 0.7118 0.6355 0.5674 13% 0.8850 0.7831 0.6931 0.6133 0.5428 14% 0.8770 0.7695 0.6750 0.5921 0.5194 15% 0.8696 0.7561 0.6575 0.5718 0.4972

You are required to compute the present value of cash flows discounted at the various rates of interests given above and state the return from the project. (3,34,172; 3,25,996; 3,18,128; 3,10,543; 3,03,251 : Yield 14%) 8. The Alpha Co. Ltd, is considering the purchase of a new machine. Two alternative machines (A & B) have been suggested, each costing Rs. 4,00,000. Earnings after taxation but before depreciation are expected to be as follows :

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Year Machine A Rs. 1 2 3 4 5 Total 40,000 1,20,000 1,60,000 2,40,000 1,60,000 7,20,000

Cash Flows Machine B Rs. 1,20,000 1,60,000 2,00,000 1,20,000 80,000 6,80,000

The company has a target rate return on capital @ 10 percent and on this basis, you are required : (a) Compare profitability of the machines and state which alternative you consider financially preferable, (b) Compute the pay back period for each project and, (c) Compute annual rate of return for each project. (Present value of machine B is higher than that of machine A; Payback period machine A – 3 years 4 months, machine B 2 years 7.2 months ; Annual return machine A – 16%, machine B – 14%) 9. Company X is forced to choose between two machines A and B. The two machines are designed differently, but have identical capacity and do exactly the same job. Machine A costs Rs. 1,50,000 and will last for 3 years. It costs Rs. 40,000 per year to run. Machine B is an ‘economy’ model costing only Rs. 1,00,000, but will last only for 2 years, and costs Rs. 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore tax. Opportunity cost of capital is 10 percent. Which machine company X should buy ?

10. S Engineering Company is considering replacing or repairing a particular machine, which has just broken down. Last year this machine costed Rs. 20,000 to run and maintain. These costs have been increasing in real terms in recent years with the age of the machine. A further useful life of 5 years is expected, if immediate repairs of Rs. 19,000 are carried out. If the machine is not repaired it can be sold immediately to realise about Rs. 5,000 (Ignore loss/gain on such disposal)

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Alternatively, the company can buy a new machine for Rs. 49,000 with an expected life of 10 years with no salvage value after providing depreciation on straight line basis. In this case, running and maintenance costs will reduce to Rs. 14,000 each year and are not expected to increase much in real terms for a few years at least. S Engineering Company regard a normal return of 10% p.a. after tax as a minimum requirement on any new investment. Considering capital budgeting techniques, which alternative will you choose? Take corporate tax rate of 50% and assume that depreciation on straight line basis will be accepted for tax purposes also. Given cumulative present value of Re. 1 p.a. at 10% for 5 years Rs. 3.791 and for 10 years Rs. 6.145.

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CHAPTER

7

MANAGEMENT OF WORKING CAPITALUNIT – I : MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL Learning Objectives After studying this chapter, you will be able to understand The meaning and the♦ significance of working capital management; The concept of operating cycle and♦ the estimation of working capital needs; The need for investing in current♦ assets; The need for managing current assets and current liabilities; and ♦ ♦ Financing of working capital. 1.1 INTRODUCTION

Decisions relating to working capital and short term financing are referred to as Working Capital Management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. 1.2 MEANING AND CONCEPT OF WORKING CAPITAL

There are two concepts of working capital - gross and net. Gross working capital refers to the firm’s investment in current assets. Current assets are those assets which can be converted into cash within an accounting year. Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year. Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash balances etc. Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends payable, short term loans.


Working capital is also known as operating capital. A most important value, it represents the amount of day-to-day operating liquidity available to a business. A company can be endowed with assets and profitability, but short of liquidity if these assets cannot readily be converted into cash. A positive working capital means that the company is able to payoff its short-term liabilities. A negative working capital means that the company currently is unable to meet its short-term liabilities. From the point of view of time, the term working capital can be divided into two categories viz., Permanent and temporary. Permanent working capital refers to the hard core working capital. It is that minimum level of investment in the current assets that is carried by the business at all times to carry out minimum level of its activities. Temporary working capital refers to that part of total working capital, which is required by a business over and above permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on fluctuating from time to time according to the business activities it may be financed from short-term sources. The following diagrams shows Permanent and Temporary or Fluctuating or variable working capital

7.2

Management of Working Capital

Both kinds of working capital i.e. permanent and fluctuating (temporary) are necessary to facilitate production and sales through the operating cycle. 1.2.1 Importance of Adequate 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 called overtrading. Early warning signs of over trading include: Pressure on existing cash. ♦ ♦ Exceptional cash generating activities e.g., offering high discounts for early cash payment. Bank overdraft exceeds authorized limit. Seeking greater♦ ♦ overdrafts or lines of credit. Part-paying suppliers or other creditors. ♦ ♦ Paying bills in cash to secure additional supplies. Management pre-occupation♦ with surviving rather than managing. Frequent short-term emergency requests to♦ the bank (to help pay wages, pending receipt of a cheque).

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Every business needs adequate liquid resources in order to maintain day-to-day cash flow. It needs enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its workforce engaged and ensure its supplies. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. Even a profitable business may fail if it does not have adequate cash flow to meet its liabilities as they fall due. Therefore, when business make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. Increased production leads to hold additional stocks of raw materials and work in progress. Increased sales usually means that the level of debtors will increase. A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital. A question then arises what is an optimum amount of working capital for a firm? We can say that a firm should neither have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of working capital carefully and determine the optimum level of investment in working capital. 1.2.2 Optimum Working Capital: If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly. The working capital ratio, which measures this ability to pay back can be calculated as current assets divided by current liabilities. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at, ‘two’ and the acid test ratio at, ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. An optimum working capital ratio is dependent upon the business situation as such and the nature and composition of various current assets. A company having short conversion cycle (from cash to cash) my have a lower current ratio.

7.4


In nutshell, a firm needs to maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous. Excessive working capital means holding costs and idle funds which earn no profits for the firm. Paucity of working capital not only impairs the firm’s profitability but also results in production interruptions, inefficiencies and sales disruptions. The management should therefore maintain the right amount of working capital continuously. 1.3 MANAGEMENT OF WORKING CAPITAL Working capital management is the functional area of finance that covers all the current accounts of its firm. It is concerned with management of the level of individual current assets and the current liabilities or in other words the management of total working capital. Managing Working Capital is a matter of balance. A firm must have sufficient cash on hand to meet its immediate needs while ensuring that idle cash is invested to the organizations best possible advantage. To avoid the difficulties, it is necessary to have clear and accurate reports on each of the components of working capital and an awareness of the potential impact of likely influences. Sound financial and statistical techniques, supported by judgement should be used to predict the quantum of working capital required at different times. Adequate provisions of working capital mitigates risk. Working capital management entails short-term decisions generally, relating to its next one year period which are “reversible”. Management will use a combination of policies and techniques for the management of working capital. These require managing the current assets – generally cash and cash equivalents, inventories and debtors. There are also a variety of short term financing options which are considered. The various steps in the management of working capital involve: Cash management – Identify the cash♦ balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management – Identify the level of inventory which♦ allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow; The techniques like Just In Time (JIT) and Economic order quantity (EOQ) are used for this. Debtors management – Identify the♦ appropriate credit policy, i.e., credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). The tools like Discounts and allowances are used for this. Short term financing – Inventory is♦ ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring” in order to finance7.5


working capital requirements. There are, however, certain constraints in the management of working capital such as: (i) (ii) Non-realisation of the importance of working capital. Continuous inflation in the economy.

(iii) The existence of seller’s market or monopoly conditions; and (iv) High profitability. 1.3.1 Determinants of Working Capital: The following factors will generally influence the working capital requirements of the firm: (i) (ii) Nature of Business. Market and demand conditions.

(iii) Technology and manufacturing Policies. (iv) Credit Policy of the firm. (v) Availability of credit from suppliers. (vi) Operating efficiency. (vii) Price Level Changes. 1.4 ISSUES IN THE WORKING CAPITAL MANAGEMENT Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable securities, debtors (receivables) and stocks (inventories) and creditors (payables). The finance manager has to determine the levels and composition of current assets. He has to ensure a right mix of different current assets and that current liabilities are paid in time. There are many aspects of working capital management which makes it important function of financial management. Time: Working capital management requires much of the finance♦ manager’s time. Investment: Working capital represents a large portion of the♦ total investment in assets. Credibility: Working capital management has great♦ significance for all firms but it is very critical for small firms. Growth: The♦ need for working capital is directly related to the firm’s growth. It is advisable that the finance manager should take precautionary measures for effective and efficient management of working capital. He has to pay particular attention to the levels of

7.6


current assets and their financing. To decide the levels and financing of current assets, the risk return trade off must be taken into account. 1.4.1 Current Assets to Fixed Assets Ratio: The finance manager is required to determine the optimum level of current assets so that the shareholders value is maximized. A firm needs fixed and current assets to support a particular level of output. However, to support the same level of output, the firm can have different levels of current assets. As the firm’s output and sales increases, the need for current assets also increases. Generally, current assets do not increase in direct proportion to output, current assets may increase at a decreasing rate with output. This relationship is based upon the notion that it takes a greater proportional investment in current assets when only a few units of output are produced than it does later on when the firm can use its current assets more efficiently. The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed assets ratio. Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant. A conservative policy implies greater liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of the firms may fall between these two extreme policies. The following diagram shows alternative current assets policies:

7.7


1.4.2 Liquidity versus Profitability: Risk return trade off − A firm may follow a conservative, aggressive or moderate policy as discussed above. However, these policies involve risk, return trade off. A conservative policy means lower return and risk. While an aggressive policy produces higher return and risk. The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity position. However, to have higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets. This will improve firm’s profitability as fewer funds will be tied up in idle current assets, but its solvency would be threatened and exposed to greater risk of cash shortage and stock outs. The following illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive and moderate etc. Illustration 1 A firm has the following data for the year ending 31st March, 2006: Rs. Sales (1,00,000 @ Rs.20/-) Earning before Interest and Taxes 20,00,000 2,00,000

Fixed Assets 5,00,000 The three possible current assets holdings of the firm are Rs.5,00,000/-, Rs.4,00,000/- and Rs. 3,00,000. It is assumed that fixed assets level is constant and profits do not vary with current assets levels. The effect of the three alternative current assets policies is as follows: Effect of alternative Working Capital Policies (Amount in Rs.) Working Capital Policy Sales Earnings before Interest and Taxes (EBIT) Current Assets Fixed Assets Total Assets Return on Total Assets (EBIT/Total Assets) Current Assets/Fixed Assets7.8

Conservative 20,00,000 2,00,000 5,00,000 5,00,000 10,00,000 20% 1.00

Moderate 20,00,000 2,00,000 4,00,000 5,00,000 9,00,000 22.22% 0.80

Aggressive 20,00,000 2,00,000 3,00,000 5,00,000 8,00,000 25% 0.60


The aforesaid calculations shows that the conservative policy provides greater liquidity (solvency) to the firm, but lower return on total assets. On the other hand, the aggressive policy gives higher return, but low liquidity and thus is very risky. The moderate policy generates return higher than Conservative policy but lower than aggressive policy. This is less risky than Aggressive policy but more risky than conservative policy. In determining the optimum level of current assets, the firm should balance the profitability – Solvency tangle by minimizing total costs. Cost of liquidity and cost of illiquidity. 1.5 ESTIMATING WORKING CAPITAL NEEDS Operating cycle is one of the most reliable method of Computation of Working Capital. However, other methods like ratio of sales and ratio of fixed investment may also be used to determine the Working Capital requirements. These methods are briefly explained as follows: (i) Current assets holding period: To estimate working capital needs based on the average holding period of current assets and relating them to costs based on the company’s experience in the previous year. This method is essentially based on the Operating Cycle Concept.

(ii) Ratio of sales: To estimate working capital needs as a ratio of sales on the assumption that current assets change with changes in sales. (iii) Ratio of fixed investments: To estimate Working Capital requirements as a percentage of fixed investments. A number of factors will, however, be impacting the choice of method of estimating Working Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and variability in sales price would generally be considered. The production cycle and credit and collection policies of the firm will have an impact on Working Capital requirements. Therefore, they should be given due weightage in projecting Working Capital requirements. 1.6 OPERATING OR WORKING CAPITAL CYCLE 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 days it takes to pay a supplier invoice. Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two.7.9


Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory build-up. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable build-up. Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard, you might miss out on the one big order. Cash flows in a cycle into, around and out of a business. It is the business’s life blood and every manager’s primary task is to help keep it flowing and to use the cashflow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn’t generate surplus, the business will eventually run out of cash. The faster a business expands, the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash which will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm’s total profits. There are two elements in the business cycle that absorb cash – Inventory (stocks and workin-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans. Working Capital Cycle CASH DEBTORS STOCK WIP RAW MATERIAL LABOUR OVERHEAD

Each component of working capital (namely inventory, receivables and payables) has two dimensions ……TIME ………and MONEY, when it comes to managing working capital then time is money. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory

7.10


levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you will have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you are effectively creating free finance to help fund future sales. If you……………… Collect receivables (debtors) faster Collect receivables (debtors) slower Get better credit (in terms of duration or amount) from suppliers. Shift inventory (stocks) faster Move inventory (stocks) slower. Then …………………. You release cash from the cycle Your receivables soak up cash. You increase your cash resources. You free up cash. You consume more cash.

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 capital cycle. 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 as follows: Operating Cycle Where, R= W= F= D= C= Raw material storage period Work-in-progress holding period Finished goods storage period Debtors collection period. Credit period availed.7.11

=

R+W+F+D–C


The various components of operating cycle may be calculated as shown below: (1) (2)(3) (4) (5)Raw material storage period = Average stock of raw material Average cost of raw material consumption per day

Work - in - progress holding period =Finished goods storage period = Debtors collection period = Credit period availed =

Average work - in - progress inventory Average cost of production per day

Average stock of finished goods Average cost of goods sold per day

Average book debts Average Credit Sales per day

Average trade creditors Average credit purchases per day

1.6.1 Working Capital Based on Operating Cycle: One of the method for forecasting working capital requirement is based on the concept of operating cycle. The calculation of operating cycle and the formula for estimating working capital on its basis has been demonstrated with the help of following illustration: Illustration 2 From the following information of XYZ Ltd., you are required to calculate : (a) Net operating cycle period. (b) Number of operating cycles in a year. (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) Raw material inventory consumed during the year Average stock of raw material Work-in-progress inventory Average work-in-progress inventory Finished goods inventory Average finished goods stock held Average collection period from debtors Average credit period availed No. of days in a year Rs. 6,00,000 50,000 5,00,000 30,000 8,00,000 40,000 45 days 30 days 360 days

7.12


The various components of operating cycle may be calculated as shown below: (1) (2)

Raw material storage period =

Average stock of raw material Average cost of raw material consumption per day

Work - in - progress holding period =

Average work - in - progress inventory Average cost of production per day

(3) (4) (5)

Finished goods storage period = Debtors collection period = Credit period availed =

Average stock of finished goods Average cost of goods sold per day

Average book debts Average Credit Sales per day

Average trade creditors Average credit purchases per day

1.6.1 Working Capital Based on Operating Cycle: One of the method for forecasting working capital requirement is based on the concept of operating cycle. The calculation of operating cycle and the formula for estimating working capital on its basis has been demonstrated with the help of following illustration: Illustration 2

From the following information of XYZ Ltd., you are required to calculate : (a) Net operating cycle period. (b) Number of operating cycles in a year. (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) Raw material inventory consumed during the year Average stock of raw material Work-in-progress inventory Average work-in-progress inventory Finished goods inventory Average finished goods stock held Average collection period from debtors Average credit period availed No. of days in a yearRs. 6,00,000 50,000 5,00,000 30,000 8,00,000 40,000 45 days 30 days 360 days

7.13


Solution Calculation of Net Operating Cycle period of XYZ Ltd. Raw material storage period: (a) Days 30

Average stock of raw material Average cost of raw material consumption per⎛ ⎞ ⎜ ⎜ day ⎟ ⎟ ⎝ ⎠(Rs. 50,000 / 1667*) *(Rs. 6,00,000 / 360 days) W.I.P. holding period : (b) 22

Average work − in − progress inventory Average cost of production per day⎛ ⎞ ⎜ ⎜ ⎟ ⎟ ⎝ ⎠Rs. 30,000 / 1,388)** **(Rs. 5,00,000 / 360 days) Finished goods storage period : (c) 18

Average stock of finished goods Average cost of goods sold per day ⎛ ⎜ ⎜ ⎝(Rs.40,000 / 2,222)******(Rs. 8,00,000 / 360 days) Debtors collection period: (d) Total operating cycle period: [(a) + (b) + (c) + (d)] Less: Average credit period availed

⎞ ⎟ ⎟ ⎠

45 115 30 85 4.2 (360 days / 85 days)

(i) (ii)

Net operating cycle period Number of operating cycles in a year

The net operating cycle represents the net time gap between investment of cash and its recovery of sales revenue. If depreciation is excluded from expenses in the computation of operating cycle, the net operating cycle also represents the cash conversion cycle. It is the

7.14


net time interval between cash collections from sales of product and cash payments for the resources acquired by the firm. The Finance Manager is required to manage the operating cycle effectively and efficiently. The length of operating cycle is the indicator of performance of management. The net operating cycle represents the time interval for which the firm has to negotiate for Working Capital from its Bankers. It enables to determine accurately the amount of working capital needed for the continuous operation of business activities. The operating cycle calls for proper monitoring of external environment of the business, changes in government policies like taxation, import policies, credit policy of Reserve Bank of India, price trend, technological advancement etc. They have since their own impact on the length of operating cycle.1.6.2 Estimate of amount of Working Capital based on Current Assets and Current Liabilities

The estimate of working capital can be projected if the amount of current assets and current liabilities can be estimated as follows: The various constituents of current assets and current liabilities have a direct bearing on the computation of working capital and the operating cycle. The holding period of various constituents of operating cycle may either contract or expand the net operating cycle period. Shorter the operating cycle period, lower will be the requirement of working capital and viceversa.Estimation of Current Assets

The estimates of various components of working capital may be made as follows:(i) Raw materials inventory: The funds to be invested in raw materials inventory may be estimated on the basis of production budget, the estimated cost per unit and average holding period of raw material inventory by using the following formula:

Estimated production × Estimated cost of raw material (in units) Average⎧ ⎫ ⎪ ⎪ raw material holding period per unit × (in months / in days) 12 months /⎪ ⎪ ⎨ ⎬ 360 days ⎪ ⎪ ⎪ ⎪ ⎩ ⎭Note: 360 days in a year are generally assumed to facilitate calculation. (ii) Work-in-progress inventory: The funds to be invested in work-in-progress can be estimated by the following formula:

7.15


Estimated production × Estimated work − in − process (in units) cost per unit⎧ ⎪ 12 months / 360 days ⎪ ⎨ ⎪ ⎪ ⎩

Average holding period of × W.I.P. (months / days) ) ⎫ ⎪ ⎪ ⎬ ⎪ ⎪ ⎭

(iii) Finished Goods: The funds to be invested in finished goods inventory can be estimated with the help of following formula:

Estimated production × Cost of production (Per unit (in units) excluding⎧ ⎫ ⎪ depreciation Average holding period of finished × 12 months / 360 days ⎪ ⎪ ⎪ ⎨ ⎬ ⎪ goods inventory (months / days) ⎪ ⎪ ⎪ ⎩ ⎭(iv) Debtors: Funds to be invested in trade debtors may be estimated with the help of following formula:

Estimated credit sales × Cost of sales (Per unit ( in units) excluding⎧ ⎫ ⎪ depreciation Average debtors collection × period (months/days) 12⎪ ⎪ ⎪ ⎨ ⎬ months/360 days (v) Minimum desired Cash and Bank balances to be⎪ ⎪ ⎪ ⎪ ⎩ ⎭ maintained by the firm has to be added in the current assets for the computation of working capital.Estimation of Current Liabilities

Current liabilities generally affect computation of working capital. Hence, the amount of working capital is lowered to the extent of current liabilities (other than bank credit) arising in the normal course of business. The important current liabilities like trade creditors, wages and overheads can be estimated as follows: (i)Trade creditors:

× Raw material requirements Estimated yearly production (in units) Credit⎫ ⎧ ⎪ ⎪ period granted by per unit × 12 months/360 days suppliers (months/days)⎪ ⎪ ⎨ ⎬ ⎪ ⎪ ⎪ ⎪ ⎩ ⎭

7.16


(ii)

Direct Wages:

Estimated production × Direct labour cost (in units) per unit Average time⎧ ⎫ ⎪ ⎪ lag in payment x of wages (months/days) 12 months/360 days ⎪ ⎪ ⎨ ⎬ ⎪ ⎪ ⎪ ⎪ ⎩ ⎭ (iii) Overheads (other than depreciation and amortization): × Overhead cost ⎫ ⎧ Estimatd yearly production (in units) Average time lag in payment per unit ⎪ ⎪ ⎪ ⎪ × 12 months / 360 days of overheads (months / days) ⎨ ⎬ ⎪ ⎪ ⎪ ⎪ ⎩ ⎭Note:The amount of overheads may be separately calculated for different types of overheads. In the case of selling overheads, the relevant item would be sales volume instead of production volume.

The following illustration shows the process of working capital estimation:Illustration 3

On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working capital that will be required during the year. From the following information prepare the working capital requirements forecast. Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during the present year. The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and Overheads 20%. Raw materials are expected to remain in store for an average of 2 months before issue to production. Each unit is expected to be in process for one month, the raw materials being fed into the pipeline immediately and the labour and overhead costs accruing evenly during the month. Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3 months. Credit allowed by creditors is 2 months from the date of delivery of raw material. Credit allowed to debtors is 3 months from the date of dispatch. Selling price is Rs.5 per unit. There is a regular production and sales cycle. Wages and overheads are paid on the 1st of each month for the previous month. The company normally keeps cash in hand to the extent of Rs.20,000.Solution Working Notes: 1. Raw material inventory: The cost of materials for the whole year is 60% of the Sales value.

7.17


Hence it is 60,000 units x Rs.5 x

60 = Rs.1,80,000 . The monthly consumption of raw 100 material would be Rs.15,000. Raw material requirements would be for two months; hence raw materials in stock would be Rs.30,000.

2. 3.

Debtors: The average sales would be Rs.25,000 p.m. Therefore, a sum of Rs.75,000/would be the amount of sundry debtors. Work in process: (Students may give special attention to this point). It is stated that each unit of production is expected to be in process for one month). Rs.

(a) (b)

Raw materials in work-in-process (being one month’s raw material requirements) Labour costs in work-in-process (It is stated that it accrues evenly during the month. Thus, on the first day of each month it would be zero and on the last day of month the work-in-process would include one month’s labour costs. On an average therefore, it would be equivalent to ½ of the month’s labour costs) Overheads (For ½ month as explained above) Total work-inprocessFinished goods inventory:

15,000 1,250

(c)

_2,500 18,750

4.

5. 6.

45,000 (3 month’s costs of production) 7,500 Raw materials Labour 15,000 Overheads 67,500 Creditors: Suppliers allow a two months’ credit period. Hence, the average amount of creditors would be Rs.30,000 being two months’ purchase of raw materials.Direct Wages payable: The direct wages for the whole year is 60,000 units × Rs.5 x 10% = Rs.30,000. The monthly direct wages would be Rs.2,500 (Rs. 30,000 ÷12). Hence, wages payable would be Rs.2,500. Overheads Payable: The overheads for the whole year is 60,000 units × Rs.5 x 20% = Rs.60,000. The monthly overheads will be Rs.5,000 (Rs.60,000 ÷ 12). Hence overheads payable would be Rs.5,000 p.m.

7.

7.18


Statement of Working Capital required: Current Assets: Rs. Rs.

Raw materials inventory (Refer to working note 1) Debtors (Refer to working note 2) Working–in-process (Refer to working note 3) Finished goods inventory (Refer to working note 4) CashCurrent Liabilities

30,000 75,000 18,750 67,500 20,000 30,000 2,500 5,000 37,500 1,73,750 2,11,250

Creditors (Refer to working note 5) Direct wages payable (Refer to working note 6) Overheads payable (Refer to working note 7) Estimated working capital requirements

1.6.3 Working capital requirement estimation based on cash cost: We have already seen that working capital is the difference between current assets and current liabilities. To estimate requirements of working capital, we have to forecast the amount required for each item of current assets and current liabilities. However, in practice another approach may also be useful in estimating working capital requirements. This approach is based on the fact that in the case of current assets, like sundry debtors and finished goods, etc., the exact amount of funds blocked is less than the amount of such current assets. Thus, if we have sundry debtors worth Rs.1 lakh and our cost of production is Rs.75,000, the actual amount of funds blocked in sundry debtors is Rs.75,000 the cost of sundry debtors, the rest (Rs.25,000) is profit. Again some of the cost items also are non-cash costs; depreciation is a non-cash cost item. Suppose out of Rs.75,000, Rs.5,000 is depreciation; then it is obvious that the actual funds blocked in terms of sundry debtors totaling Rs.1 lakh is only Rs.70,000. In other words, Rs.70,000 is the amount of funds required to finance sundry debtors worth Rs.1 lakh. Similarly, in the case of finished goods which are valued at cost, non-cash costs may be excluded to work out the amount of funds blocked. Many experts, therefore, calculate the working capital requirements by working out the cash costs of finished goods and sundry debtors. Under this approach, the debtors are calculated not as a percentage of sales value but as a percentage of cash costs. Similarly, finished goods are valued according to cash costs.

7.19


Illustration 4

The following annual figures relate to XYZ Co.,Rs.

Sales (at two months’ credit) Materials consumed (suppliers extend two months’ credit) Wages paid (monthly in arrear) Manufacturing expenses outstanding at the end of the year (Cash expenses are paid one month in arrear) Total administrative expenses, paid as above

36,00,000 9,00,000 7,20,000 80,000 2,40,000

Sales promotion expenses, paid quarterly in advance 1,20,000 The company sells its products on gross profit of 25% counting depreciation as part of the cost of production. It keeps one months’ stock each of raw materials and finished goods, and a cash balance of Rs.1,00,000. Assuming a 20% safety margin, work out the working capital requirements of the company on cash cost basis. Ignore work-in-process.Solution Statement of Working Capital requirements (cash cost basis)

A. Current Asset Materials Finished Goods Debtors Cash Prepaid expenses (Sales promotion) B. Current Liabilities: Creditors for materials Wages outstanding Manufacturing expenses Administrative expenses Net working capital (A-B)

Rs

Rs

.

(Rs. 9,00,000 ÷12) (Rs. 25,80,000 ÷12) (Rs.29,40,000÷6) (Rs. 1,20,000÷4) (Rs.9,00,000÷6) (Rs.7,20,000÷ 12) (Rs.2,40,000÷12)

75,000 2,15,000 4,90,000 1,00,000 30,000 1,50,000 60,000 80,000 20,000 3,10,000 6,00,000 9,10,000

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Add safety margin 20% Total working capital requirements Working Notes: (i) Computation of Annual Cash cost of Production Material consumed Wages Manufacturing expenses (Rs.80,000 x 12) Total cash cost of production Computation of Annual Cash cost of sales: Cash cost of production as in (i) above Administrative Expenses Sales promotion expenses Total cash cost of sales

1,20,000 7,20,000Rs. 9,00,000 7,20,000 _9,60,000 25,80,000 Rs. 25,80,000 2,40,000 _1,20,000 29,40,000

(ii)

Illustration 5

PQ Ltd., a company newly commencing business in 2005 has the undermentioned projected Profit and Loss Account:Rs.

Sales Cost of goods sold Gross Profit Administrative Expenses Selling Expenses Profit before tax Provision for taxation Profit after tax The cost of goods sold has been arrived at as under: Materials used Wages and manufacturing Expenses DepreciationLess: Stock of Finished goods (10% of goods produced not yet sold)

Rs. 2,10,000 1,53,000 57,000

14,000 13,000

27,000 30,000 10,000 20,000

84,000 62,500 _23,500 1,70,000 __17,000 1,53,000

7.21


The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the year’s production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses. The company believes in keeping materials equal to two months’ consumption in stock. All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of the Income tax will be paid in advance in quarterly instalments. The company wishes to keep Rs.8,000 in cash. Prepare an estimate of (i) working capital, and (ii) cash cost of working capital.Note: All workings should form part of the answer. Solution (i) Estimate of Working Capital requirements Rs. Current Assets Finished stock: Rs. Current Liabilities Sundry Creditors:

Purchases Provision for taxation

14,088 3,000 --------17,088

Raw materials Wages Depreciation Work-in-progress

8,400 6,250 2,350 17,000

Balance being working capital required, (say Rs.77,500)

77,543

Materials Wages Depreciation Raw Material Sundry Debtors: Materials Wages Depreciation Adm. & expenses Profit Selling

12,600 3,750 _1,410

17,760 16,100

10,080 7,500 2,820 3,600 4,000 28,000

7.22


Prepaid Expenses: Wages Admn. & expenses Cash in hand 94,631(ii) Estimate of Cash Cost of Working Capital

Selling

5,521 2,250

7,771 _8,000 94,631Rs.

Working capital as per statement given aboveLess:

77,543 10,580 66,963Rs.

Profit and Depreciation for which funds are not needed (see working note (vii)

Cash Cost of working capital required, say Rs.67,000 Working Notes: (i) Work-in-progress 15% of material consumed for finished goods 15% of 40% of wages and expenses 15% of 40% of Depreciation (ii)

12,600 3,750

_1,410 17,760 th of total materials consumed i.e., Rs.84,000 for finished goods Raw materials will be 1/6 plus Rs.12,600 for work-in-progress, i.e. Rs.16,100.

(iii) Sundry Debtors: 80% of two months’ Sales, i.e., Rs.2,10,000 ×

80 2 × = Rs.28,000 100 12

Individual items have been computed on that basis. (iv) Creditors for raw materials on the basis of total purchases during the year (Rs.84,000 + Rs.12,600+Rs.16,100) × 1½ /12) = Rs.14,088. (v) Wages paid in advance: (Rs.62,500 + Rs.3,750) × 1/12 = Rs.5,521. (vi) Administrative & Selling expenses paid in advance Rs.27,000 ×1/12 = Rs.2,250/-

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(vii) Depreciation and profit included in the cost of current assets:Rs.

Depreciation: Finished goods Work-in-progress Debtors Profit included in Debtors (including income-tax, i.e., Rs.1,333) 2,350 1,410 2,820 6,580 4,000 10,580Illustration 6

M.A. Limited is commencing a new project for manufacture of a plastic component. The following cost information has been ascertained for annual production of 12,000 units which is the full capacity:Costs per unit (Rs.)

Materials Direct labour and variable expenses Fixed manufacturing expenses Depreciation Fixed administration expenses

40 20 6 10 _4 80

The selling price per unit is expected to be Rs.96 and the selling expenses Rs.5 per unit. 80% of which is variable. In the first two years of operations, production and sales are expected to be as follows:Year Production (No. of units) Sales (No.of units)

1 2.

6,000 9,000

5,000 8,500

To assess the working capital requirements, the following additional information is available:7.24


(a) (b) (c) (d) (e) (f)

Stock of materials Work-in-process Debtors Cash balance Creditors for supply of materials Creditors for expenses

2.25 months’ average consumption Nil 1 month’s average sales. Rs.10,000 1 month’s average purchase during the year. 1 month’s average of all expenses during the year.

Prepare, for the two years: (i) (ii) (i)M.A. Limited Projected Statement of Profit / Loss (Ignoring Taxation) Year 1 Year 2

A projected statement of Profit/Loss (Ignoring taxation); and A projected statement of working capital requirements.

Solution

Production (Units) Sales (Units) Sales revenue @ Rs. 96 per unit: (A)Cost of production:

6,000 5,000Rs.

9,000 8,500Rs.

4,80,000 2,40,000 1,20,000 72,000 1,20,000 48,000

8,16,000 3,60,000 1,80,000 72,000 1,20,000 48,000

Materials @ Rs. 40 per unit Direct labour and variable expenses @ Rs.20 per unit Fixed manufacturing expenses (Production Capacity: 12,000 units @ Rs.6) Depreciation (Production Capacity : 12,000 units @ Rs.10) Fixed administration expenses (Production Capacity : 12,000 units @ Rs.4)

7.25


Total costs of productionAdd: Opening stock of finished goods

_6,00,000

7,80,000 1,00,000

(Year 1 : Nil; Year 2 : 1,000 units) Cost of goods available (Year 1: 6,000 units; Year 2: 10,000 units)Less: Closing stock of finished goods at average cost (year 1: 1000 units, year 2 : 1500 units)

6,00,000 1,00,000 5,00,000 20,000 12,000 5,32,000 (-) 52,000

8,80,000 1,32,000 7,48,000 34,000 12,000 7,94,000 (+) 22,000

Cost of goods soldAdd: Selling expenses – Variable @ 4 per unit Fixed (12,000 × Re.1)

Cost of Sales : (B) Profit (+) / Loss (-): (A-B)Working Notes:

1.

Calculation of creditors for supply of materials:Year 1 Rs. Year 2 Rs.

Materials consumed during the yearAdd: Closing stock (2.25 month’s average consumption) Less: Opening Stock

2,40,000 45,000 2,85,000

3,60,000 67,500 4,27,500 45,000 3,82,500 31,875Year 2 Rs.

Purchases during the year Average purchases per month (Creditors)

2,85,000 23,750Year 1 Rs.

2.

Creditors for expenses: Total direct labour, manufacturing, administration and selling expenses for the year Average per month 2,72,000 22,667 3,46,000 28,833

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(ii) Projected statement of working capital requirements Year 1 Rs. Current Assets: Year 2 Rs.

Stock of materials (2.25 month’s average consumption) Finished goods Debtors (1 month’s average sales) Cash Total Current Assets (A)Current Liabilities:

45,000 1,00,000 40,000 _10,000 1,95,000 23,750 22,667 46,417 1,48,583

67,500 1,32,000 68,000 _10,000 2,77,500 31,875 28,833 60,708 2,16,792

Creditors for supply of materialsRefer to working note 1)

Creditors for expenses(Refer to working note 2)

Total Current Liabilities: (B) Estimated Working Capital Requirements: (A-B)

1.6.4 Effect of Double Shift Working on Working Capital requirements: Increase in the number of hours of production has an effect on the working capital requirements. The greatest economy in introducing double shift is the greater use of fixed assets-little or marginal funds may be required for additional assets.

It is obvious that in double shift working, an increase in stocks will be required as the production rises. However, it is quite possible that the increase may not be proportionate to the rise in production since the minimum level of stocks may not be very much higher. Thus, it is quite likely that the level of stocks may not be required to be doubled as the production goes up two-fold. The amount of materials in process will not change due to double shift working since work started in the first shift will be completed in the second; hence, capital tied up in materials in process will be the same as with single shift working. As such the cost of work-in-process, will not change unless the second shift’s workers are paid at a higher rate. Fixed overheads will remain fixed whereas variable overheads will increase in proportion to the increased production. Semi-variable overheads will increase according to the variable element in them.

7.27


However, in examinations the students may increase the amount of stocks of raw materials proportionately unless instructions are to the contrary.Illustration 7

Samreen Enterprises has been operating its manufacturing facilities till 31.3.2006 on a single shift working with the following cost structure:Per Unit Rs.

Cost of Materials Wages (out of which 40% fixed) Overheads (out of which 80% fixed) Profit Selling Price Sales during 2005-06 – Rs.4,32,000. As at 31.3.2006 the company held:

6.00 5.00 5.00 2.00 18.00Rs.

Stock of raw materials (at cost) Work-in-progress (valued at prime cost) Finished goods (valued at total cost) Sundry debtors

36,000 22,000 72,000 1,08,000

In view of increased market demand, it is proposed to double production by working an extra shift. It is expected that a 10% discount will be available from suppliers of raw materials in view of increased volume of business. Selling price will remain the same. The credit period allowed to customers will remain unaltered. Credit availed of from suppliers will continue to remain at the present level i.e., 2 months. Lag in payment of wages and expenses will continue to remain half a month. You are required to assess the additional working capital requirements, if the policy to increase output is implemented.

7.28


Solution Statement of cost at single shift and double shift working 24,000 units Per Unit Rs. Total Rs. 48,000 Units Per unit Rs. Total Rs.

Raw materials Wages Fixed Overheads - Variable Fixed Total cost Profit Variable

6 3 2 1 4 16 2 18

1,44,000 72,000 48,000 24,000 96,000 3,84,000 48,000 4,32,000

5.40 3.00 1.00 1.00 2.00 12.40 5.60 18.00

2,59,200 1,44,000 48,000 48,000 96,000 5,95,200 2,68,800 8,64,000

Sales in units 2005-06

=

Sales Rs.4,32,000 = = 24,000 units Unit selling price Rs.18

Stock of Raw Materials in units on 31.3.2006 =Value of stock Rs.36,000 = 6,000 units = Cost per unit 6

Stock of work-in-progress in units on 31.3.2006 =

Value of work − in − progress Rs.22,000 = = 2,000 units Cost per unit (Rs.6 + Rs.5)Value of stock Rs.72,000 = = 4,500 units. Cost per unit Rs.16

Stock of finished goods in units 2005-06=

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Comparative Statement of Working Capital Requirement Single Shift Unit Rate Rs. Amount Rs. Double Shift Unit Rate Rs. Amount Rs.

Current Assets Inventories Raw Materials Work-in-Progress Finished Goods Sundry Debtors Total Current Assets: (A) Current Liabilities Creditors for Materials Creditors for Wages Creditors for Expenses Total Current Liabilities: (B) Working Capital: (A) – (B) Less: Profit included in Debtors 6000 2 4000 1000 1000 6 5 5 24,000 5,000 5,000 34,000 2,04,000 8000 2000 2000 5.40 4.00 3.00 43,200 8,000 _6,000 57,200 3,54,000 6000 2000 4500 6000 6 11 16 18 36,00 22,000 72,000 1,08,000 2,38,000 12000 2000 9000 12000 5.40 9.40 12.40 18.00 64,800 18,800 1,11,600 2,16,000 4,11,200

_12,000 12,000 5.60 _67,200 1,92,000 2,86,800 Increase in Working Capital requirement is (Rs.2,86,800 – Rs.1,92,000) or Rs.94,800Notes:

(i) (ii)

The quantity of material in process will not change due to double shift working since work started in the first shift will be completed in the second shift. The valuation of work-in-progress based on prime cost as per the policy of the company is as under.Single shift Rs. Double shift Rs.

Materials Wages – Variable Fixed

6.00 3.00 _2.00 11.00

5.40 3.00 1.00 9.40

7.30


UNIT – II : TREASURY AND CASH MANAGEMENT 2.1 TREASURY MANAGEMENT: MEANING

Tight money, escalating interest rates and economic volatility have called for a specialised skills called Treasury Management. Until recently, no major efforts were made to manage cash. In the wake of the competitive business environment resulting from the liberalization of the economy, there is a pressure to manage cash. The demand for funds for expansions coupled with high interest rates, foreign exchange volatility and the growing volume of financial transactions have necessitated efficient management of money. Treasury management is defined as ‘the corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows and the complex, strategies, policies and procedures of corporate finance.’ The treasury management mainly deals with working capital management and financial risk management. The former constitutes cash management and decides the asset liability mix. Financial risk management includes forex and interest rate management. The key goal of treasury management is planning, organizing and controlling cash assets to satisfy the financial objectives of the organization. The goal may be to maximize the return on the available cash, or minimize interest cost or mobilise as much cash as possible for corporate ventures. Dealing in forex, money and commodity markets involves complex risks of fluctuating exchange rates, interest rates and prices which can affect the profitability of the organization. Treasury managers try to minimize lapses by adopting risk transfer and hedging techniques that suit the internal policies of the organisation. Options, futures and swaps are a few of the major derivative instruments, the Treasury Managers use for hedging their risk.2.2 FUNCTIONS OF TREASURY DEPARTMENT

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 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.

7.31


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 sales.

The treasury will manage any net exchange exposures in accordance with company policy. If risks are to be minimized then forward contracts can be used either to buy or sell currency forward.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 currency rates. 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. 2.3 MANAGEMENT OF CASH

Management of cash is an important function of the finance manager. The Finance Manager has to provide adequate cash to each of the units. For the survival of the business it is absolutely essential that there should be adequate cash. It is the duty of finance manger to have liquidity at all parts of the organization while managing cash. On the other hand, he has also to ensure that there are no funds blocked in idle cash. Idle cash resources entail a great deal of cost in terms of interest charges and in terms of opportunities costs. Hence, the question of costs of idle cash must also be kept in mind by the finance manager. A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and costs.2.3.1 The Need for Cash: The following are three basic considerations in determining the amount of cash or liquidity as have been outlined by Lord Keynes:

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. In such cases, it is only the7.32


reserve cash balance that can enable the firm to make its payments in time. ♦ 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. 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.Facets of Cash Management: Cash management is concerned with the managing of (i) Cash flows into and out of the firm; (ii) Cash flows within the firm; and (iii) Cash balances held by the firm at a point of time by financing deficit or investing surplus cash. It is generally represented by a cash management cycle. Sales generates cash which has to be disbursed out.

In recent years, a number of innovations have been made in cash management techniques. An obvious aim of the firm these days is to mange its cash affairs in such a way as to maintain a minimum balance of cash and to invest the surplus immediately in profitable investment opportunities. In order to synchronise the cash receipt and payments. A firm need to develop appropriate strategies for cash management viz:(i) Cash Planning: The pattern of cash inflows and outflows should be properly predicted in advance. Cash budget is a tool to achieve this objective.

(ii) Managing the cash flows: The cash inflows should be accelerated, while as far as possible, the outflows should be decelerated. (iii) Optimum cash level: In deciding about the appropriate level of cash balances, the cost of idle cash and danger of shortage should be taken into consideration. (iv) Investing surplus cash: The surplus cash should be properly invested to earn profits. The firm should decide about the division of such cash balance between various alternative short term investment opportunities such as, bank deposits, marketable securities, inter-corporate lending.

The ideal cash management system will depend upon various factors viz., product, organization structure, competition, culture and options available. The task is really complex. The exact nature of a cash management system would depend upon the organizational structure of an enterprise. In a highly centralized organization the system would be such that the central or head office controls the inflows and outflows of cash on a routine and daily basis. In a decentralized form of organisation, where the divisions have compelete

7.33


responsibility of conducting their affairs, it may not be possible and advisable for the central office to exercise a detailed control over cash inflows and outflows.2.3.2 Cash Planning: Cash Planning is a technique to plan and control the use of cash. This protects the financial conditions of the firm by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given period. This may be done periodically either on daily, weekly or monthly basis. The period and frequency of cash planning generally depends upon the size of the firm and philosophy of management. As firms grows and business operations become complex, cash planning becomes inevitable for continuing success.

The very first step in this direction is to estimate the requirement of cash. For this purpose cash flow statements and cash budget are required to be prepared. The technique of preparing cash flow and funds flow statements have been discussed in this book. The preparation of cash budget has however, been demonstrated here.2.3.3 Cash Budget: Cash Budget is the most significant device to plan for and control cash receipts and payments. This represents cash requirements of business during the budget period.

One of the significant advantage of cash budget is to determine the net cash inflow or outflow so that the firm is enabled to arrange finances. However, the firm’s decision for appropriate sources of financing should depend upon factors such as cost and risk. Cash Budget helps a firm to manage its cash position. It also helps to utilise funds in better ways. On the basis of cash budget, the firm can decide to invest surplus cash in marketable securities and earn profits. The cash budget is prepared on the basis of receipts and payments method and offers following benefits: (i) (ii) (i) (ii) It provides a complete picture of all items of expected cash flows. It is a sound tool of managing daily cash operations. Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be delayed, or unanticipated demands may cause large disbursements. It fails to highlight the significant movements in the Working Capital items.

This method, however, suffers from the following limitations:

In order to maintain an optimum cash balance, what is required is (i) a complete and accurate forecast of net cash flows over the planning horizon and (ii) perfect synchronization of cash receipts and disbursements. Thus, implementation of an efficient cash management system starts with the preparation of a plan of firm’s operations for a period in future. This plan will help in preparation of a statement of receipts and disbursements expected at different point of

7.34


time of that period. It will enable the management to pin point the time of excessive cash or shortage of cash. This will also help to find out whether there is any expected surplus cash still unutilized or shortage of cash which is yet to be arranged for. In order to take care of all these considerations, the firm should prepare a cash budget. The following figure highlights the cash surplus and cash shortage position over the period of cash budget for preplanning to take corrective and necessary steps.

2.4

METHODS OF CASH FLOW BUDGETING

Cash flow budget is a detailed budget of income and cash expenditures incorporating both revenue and capital items. The cash flow budget should be prepared in the same format in which the actual position is to be presented. The year’s budget is usually phased into shorter periods for control e.g., monthly or quarterly. Cash budget is concerned with liquidity must reflect changes between opening and closing debtor balances and between opening and closing creditor balances as well as focusing attention on other inflows and outflows of cash. The cash budget shows the cash flows arising from the operational budgets and the profit and assets structure. A cash budget can be prepared in the following ways:7.35


1. Receipts and Payments Method: In this method all the expected receipts and payments for budget period are considered. All the cash inflow and outflow of all functional budgets including capital expenditure budgets are considered. Accruals and adjustments in accounts will not affect the cash flow budget. Anticipated cash inflow is added to the opening balance of cash and all cash payments are deducted from this to arrive at the closing balance of cash. This method is commonly used in business organizations. 2. Adjusted Income Method: In this method the annual cash flows are calculated by adjusting the sales revenues and cost figures for delays in receipts and payments (change in debtors and creditors) and eliminating non-cash items such as depreciation. 3. Adjusted Balance Sheet Method: In this method, the budgeted balance sheet is predicted by expressing each type of asset and short-term liabilities as percentage of the expected sales. The profit is also calculated as a percentage of sales, so that the increase in owners equity can be forecasted. Known adjustments, may be made to long-term liabilities and the balance sheet will then show if additional finance is needed.

It is important to note that the capital budget will also be considered in the preparation of cash flow budget because the annual budget may disclose a need for new capital investments and also, the costs and revenues of any new projects coming on stream will need to be incorporated in the short-term budgets. A number of additional financial statements, such as sources and application of funds statement or schedules or loan service payments or capital raising schedules may be produced. The Cash Budget can be prepared for short period or for long period.Cash budget for short period: Preparation of cash budget month by month would require the following estimates:

(a) As regards receipts: 1. 2. 3. 1. 2. 3. Receipts from debtors; Cash Sales; and Any other source of receipts of cash (say, dividend from a subsidiary company) Payments to be made for purchases; Payments to be made for expenses; Payments that are made periodically but not every month; (i) (ii) debenture interest; income tax paid in advance;

(b) As regards payments:

7.36


(iii) sales tax etc. 4. Special payments to be made in a particular month, for example, dividends to shareholders, redemption of debentures, repayments of loan, payment of assets acquired, etc.Co. Ltd. Cash Budget Period……………… Month 1 Receipts: Month 2 Month 3 Month 12

2.4.1 Format of Cash Budget

1. Opening balance 2. Collection from debtors 3. Cash sales 4. Loans from banks 5. Share capital 6. Miscellaneous receipts 7. Other itemsTotal Payments:

1. Payments to creditors 2. Wages 3. Overheads (a) (b) (c) 4. Interest 5. Dividend 6. Corporate tax7.37


7. Capital expenditure 8. Other itemsTotal

Closing balance [Surplus (+)/Shortfall (-)] Students are required to do good practice in preparing the cash budgets. The following illustration will show how short term cash budgets can be prepared.Illustration 1

Prepare monthly cash budget for six months beginning from April 2006 on the basis of the following information:(i) Estimated monthly sales are as follows:Rs. Rs.

January February March April May (ii)

1,00,000 June 1,20,000 July 1,40,000 August 80,000 September 60,000 October

80,000 1,00,000 80,000 60,000 1,00,000

Wages and salaries are estimated to be payable as follows:Rs. Rs.

April May June

9,000 July 8,000 August 10,000 September

10,000 9,000 9,000

(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month and the balance in two months. There are no bad debt losses. (iv) Purchases amount to 80% of sales and are made and paid for in the month preceding the sales. (v) The firm has 10% debentures of Rs.1,20,000. Interest on these has to be paid quarterly in January, April and so on. (vi) The firm is to make an advance payment of tax of Rs.5,000 in July, 2006.7.38


(vii) The firm had a cash balance of Rs.20,000 on April 1, 2006, which is the minimum desired level of cash balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation of temporary investments or temporary borrowings at the end of each month (interest on these to be ignored).Solution

Workings: Collection from debtors:(Amount in Rs.)February Total sales Credit sales (80% of total sales) Collections: One month Two months Total collections 72,000 84,000 24,000 1,08,000 48,000 28,000 76,000 36,000 16,000 52,000 48,000 12,000 60,000 60,000 16,000 76,000 48,000 20,000 68,000 1,20,000 March 1,40,000 April 80,000 May 60,000 June 80,000 July 1,00,000 August 80,000 September 60,000

96,000

1,12,000

64,000

48,000

64,000

80,000

64,000

48,000

Monthly Cash Budget for Six months, April to September, 2006(Amount in Rs.)Receipts: April Opening balance Cash sales Collection from debtors Total cash available (A) 20,000 16,000 1,08,000 1,44,000 May 20,000 12,000 76,000 1,08,000 June 20,000 16,000 52,000 88,000 July 20,000 20,000 60,000 1,00,000 August 20,000 16,000 76,000 1,12,000 September 20,000 12,000 68,000 1,00,000

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Financial ManagementPayments: Purchases Wages & salaries Interest on debentures Tax payment Total payments (B) Minimum desired cash balance 20,000 80,000 64,000 (64,000) 20,000 92,000 16,000 (16,000) 20,000 1,10,000 (22,000) ---20,000 1,02,000 (2,000) 20,000 77,000 35,000 (35,000) 20,000 1,09,000 (9,000) ----48,000 9,000 3,000 --60,000 64,000 8,000 ----72,000 80,000 10,000 ------90,000 64,000 10,000 3,000 5,000 82,000 48,000 9,000 -----57,000 80,000 9,000 ------89,000

Total cash needed (C) Surplus deficit (A-C) Investment/financing Temporary Investments Liquidation of investments or borrowings temporary temporary

---of (64,000) 20,000

---(16,000) 20,000

22,000 22,000 20,000

2,000 2,000 20,000

---(35,000) 20,000

9,000 9,000 20,000

Total effect investment/financing (D)

Closing cash balance (A+DB)

Illustration 2

From the following information relating to a departmental store, you are required to prepare for the three months ending 31st March, 2006:(a) Monthwise cash budget on receipts and payments basis; and (b) Statement of Sources and uses of funds for the three months period. It is anticipated that the working capital at 1st January, 2006 will be as follows:Rs. in ‘000’s

Cash in hand and at bank Short term investments Debtors

545 300 2,570

7.40


Stock Trade creditors Other creditors Dividends payable Tax due Plant Budgeted Profit Statement: January Sales Cost of sales Gross Profit Administrative, Selling and Distribution Expenses 315 Net Profit before tax Budgeted balances at the end of each months: 31st Short term investments Debtors Stock Trade creditors Other creditors Dividends payable Tax due Plant (depreciation ignored) Jan. 700 2,600 1,200 2,000 200 485 320 800 150 270 125Rs. in ‘000’s

1,300 2,110 200 485 320 800Rs.in ‘000’s

February 1,800 1,405 395

March 1,700 1,330 370 255 115 31st March 200 2,350 1,000 1,900 200 -320 1,550

2,100 1,635 465

29th Feb. --2,500 1,100 1,950 200 -320 1,600

Depreciation amount to Rs.60,000 is included in the budgeted expenditure for each month.

7.41


Solution

Workings: (1) Payments to creditors: Cost of Sales Add Closing Stocks Less: Opening Stocks Purchases Add: Trade Creditors, Opening balance Less: Trade Creditors, closing balance Payment (2) Receipts from debtors: Debtors, Opening balances Add Sales Less Debtors, closing balance ReceiptCASH BUDGET

Rs. in ‘000’

Jan. 2006 1,635 1,200 2,835 1,300 1,535 2,110 3,645 2,000 1,645 2,570 2,100 4,670 2,600 2,070

Feb.2006

March, 2006

1,405 1,100 2,505 1,200 1,305 2,000 3,305 1,950 1,355 2,600 1,800 4,400 2,500 1,900

1,330 1,000 2,330 1,100 1,230 1,950 3,180 1,900 1,280 2,500 1,700 4,200 2,350 1,850

(a) 3 months ending 31st March, 2006(Rs, in 000’s) January, 2006 Feb. 2006 March, 2006

Opening cash balances Add Receipts: From Debtors Sale of Investments Sale of Plant Total (A)

545 2,070 ----2,615

315 1,900 700 --2,915

65 1,850 ---50 1,965

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Deduct Payments Creditors Expenses Capital Expenditure Payment of dividend Purchase of investments Total payments (B) Closing cash balance (A - B) (b)Sources:

1,645 255 ----400 2,300 315

1,355 210 800 485 --2,850 65

1,280 195 ----200 1,675 290

Statement of Sources and uses of Funds for the Three Month Period Ending 31st March, 2006 Rs.’000 Rs.’000

Funds from operation: Net profit Add Depreciation Sale of plant Decrease in Working Capital TotalUses:

390 180 570 50 620 665 1,285 800 485 1,285Statement of Changes in Working Capital January,06 Rs.000 March, 06 Rs.000 Increase Rs.000 Decrease Rs.000

Purchase of plant Payment by dividends Total

Current Assets

Cash in hand and at Bank Short term Investments

545 300

290 200

255 100

7.43


Debtors StockCurrent Liabilities

2,570 1,300 4,715

2,350 1,000 3,840 1,900 200 320 2,420 1,420 665 665 210 -----

220 300

Trade Creditors Other Creditors Tax Due Working Capital Decrease

2,110 200 320 2,630 2,085

-------

2,085 2,085 875 875 2.4.2 Cash Budget for long period: Long-range cash forecast often resemble the projected sources and application of funds statement. The following procedure may be adopted to prepare long-range cash forecasts: (i) (ii) Take the cash at bank and in the beginning of the year:Add:

(a) Trading profit (before tax) expected to be earned; (b) Depreciation and other development expenses incurred to be written off; (c) Sale proceeds of assets’; (d) Proceeds of fresh issue of shares or debentures; and (e) Reduction in working capital that is current assets (except cash) less current liabilities. (iii) Deduct: (a) Dividends to be paid. (b) Cost of assets to be purchased. (c) Taxes to be paid. (d) Debentures or shares to be redeemed. (e) Increase in working capital.

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Illustration 3

You are given below the Profit & Loss Accounts for two years for a company:Profit and Loss AccountYear 1 Rs. To Opening stock To Raw materials To Stores To Manufacturing Expenses To Other Expenses To Depreciation To Net Profit 80,00,000 3,00,00,000 1,00,00,000 1,00,00,000 1,00,00,000 1,00,00,000 1,30,00,000 9,10,00,000 Year 2 Rs. 1,00,00,000 4,00,00,000 1,20,00,000 1,60,00,000 1,00,00,000 1,00,00,000 1,80,00,000 11,60,00,000 9,10,00,000 11,60,00,000 By Sales By Closing stock By Misc. Income Year 1 Rs. 8,00,00,000 1,00,00,000 10,00,000 Year 2 Rs. 10,00,00,000 1,50,00,000 10,00,000

Sales are expected to be Rs.12,00,00,000 in year 3. As a result, other expenses will increase by Rs.50,00,000 besides other charges. Only raw materials are in stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same amount as between year 1 and 2. You may assume that no dividend is being paid. The Company can use 75% of the cash generated to service a loan. How much cash from operations will be available in year 3 for the purpose? Ignore income tax.Solution Projected Profit and Loss Account for the year 3 Year 2 Year 3 Actual Projected (Rs. in (Rs. in lakhs) lakhs) Year 2 Actual (Rs. in lakhs) Year 3 Projected (Rs. in lakhs)

To Materials consumed To Stores

350 120

420 By Sales 144 By Misc. Income

1,000 10

1,200 10

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To Mfg. Expenses To Other expenses To Depreciation To Net profitCash Flow:

160 100 100 180 1,010

192 150 100 204 1,210 1,010 1,210

(Rs. in lakhs)

ProfitAdd: Depreciation Less: Cash required for increase in stock

204 100 304 50 254

Net cash inflow Available for servicing the loan: 75% of Rs.2,54,00,000 or Rs.1,90,50,000Working Notes:

(i)

Material consumed in year 2: 35% of sales. Likely consumption in year 3 : Rs.1200 ×

35 or Rs. 420 (lakhs) 100

(ii)

Stores are 12% of sales, as in year 2.

(iii) Manufacturing expenses are 16% of sales.Note: The above also shows how a projected profit and loss account is prepared. 2.4.3 Managing Cash Collection and Disbursements: The finance manager must control the levels of cash balance at various points in the organization. This task assumes special importance on account of the fact that there is generally a tendency amongst divisional managers to keep cash balance in excess of their needs. Hence, the finance manager must devise a system whereby each division of an organization retains enough cash to meet its day-to-day requirements without having surplus balance on hand. For this, methods have to be employed to:

(a) Speed up the mailing time of payments from customers; (b) Reduce the time during which payments received by the firm remain uncollected and speed up the movement of funds to disbursement banks.

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Having prepared the cash budget, the finance manager should ensure that there does not exists a significant deviation between projected cash flows and actual cash flows. To achieve this cash management efficiency will have to be improved through a proper control of cash collection and disbursement. The twin objectives in managing the cash flows should be to accelerate cash collections as much as possible and to decelerate or delay cash disbursements.2.4.4 Accelerating Cash Collections: A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash collections by issuing invoices quickly and taking other necessary steps for cash collection. It can be accelerated by reducing the time lag between a customer pays bill and the cheque is collected and funds become available for the firm’s use. A firm can decentralized collection system known as concentration banking and lock box system to speed up cash collection and reduce float time. (i) Concentration Banking: In concentration banking the company establishes a number of strategic collection centres in different regions instead of a single collection centre at the head office. This system reduces the period between the time a customer mails in his remittances and the time when they become spendable funds with the company. Payments received by the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds to the concentration bank of head office. The concentration bank with which the company has its major bank account is generally located at the headquarters. Concentration banking is one important and popular way of reducing the size of the float. (ii) Lock Box System: Another means to accelerate the flow of funds is a lock box system. While concentration banking, remittances are received by a collection centre and deposited in the bank after processing. The purpose of lock box system is to eliminate the time between the receipt of remittances by the company and deposited in the bank. A lock box arrangement usually is on regional basis which a company chooses according to its billing patterns.

Under this arrangement, the company rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers are billed with instructions to mail their remittances to the lock boxes. The bank picks up the mail several times a day and deposits the cheques in the company’s account. The cheques may be microfilmed for record purposes and cleared for collection. The company receives a deposit slip and lists all payments together with any other material in the envelope. This procedure frees the company from handling and depositing the cheques. The main advantage of lock box system is that cheques are deposited with the banks sooner and become collected funds sooner than if they were processed by the company prior to deposit. In other words lag between the time cheques are received by the company and the time they are actually deposited in the bank is eliminated. The main drawback of lock box system is the cost of its operation. The bank provides a number of services in addition to usual clearing of cheques

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and requires compensation for them. Since the cost is almost directly proportional to the number of cheques deposited. Lock box arrangements are usually not profitable if the average remittance is small. The appropriate rule for deciding whether or not to use a lock box system or for that matter, concentration banking, is simply to compare the added cost of the most efficient system with the marginal income that can be generated from the released funds. If costs are less than income, the system is profitable, if the system is not profitable, it is not worth undertaking.(iii) Playing the float: Besides accelerating collections, an effective control over payments can also cause faster turnover of cash. This is possible only by making payments on the due date, making excessive use of draft (bill of exchange) instead of cheques. Availability of cash can be maximized by playing the float. In this, a firm estimates accurately the time when the cheques issued will be presented for encashment and thus utilizes the float period to its advantage by issuing more cheques but having in the bank account only so much cash balance as will be sufficient to honour those cheques which are actually expected to be presented on a particular date. 2.4.5 Different Kinds of Float with reference to Management of Cash: 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 with reference to management of cash are:

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. ♦ Mail float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery. 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 company. Banking processing float: This is the time♦ from the deposit of the cheque to the crediting of funds in the sellers account.2.4.6 Delaying Payments: A firm can increase its net float by speeding up collections. It can also increase the net float by delayed disbursement of funds from the bank by increasing the mail time. A company may make payment to its outstation suppliers by a cheque and send it through mail. The delay in transit and collection of the cheque, will be used to increase the float. 2.4.7 Controlling Disbursements: The effective control of disbursement can also help the firm in conserving cash and reducing the financial requirements. Disbursement arise due to trade credit, which is a spontaneous, source of funds. The firm should make payments using credit terms to the fullest extent.

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2.4.8 Determining The Optimum Cash Balance: A firm should maintain optimum cash balance to cater to the day-to-day operations. It may also carry additional cash as a buffer or safety stock. The amount of cash balance will depend on the risk-return trade off. The firm should maintain optimum - just enough, neither too much nor too little cash balance. This, however, poses a question. How to determine the optimum cash balance if cash flows are predictable and if they are not predictable? 2.5 CASH MANAGEMENT MODELS

In recent years several types of mathematical models have been developed which helps to determine the optimum cash balance to be carried by a business organization. The purpose of all these models is to ensure that cash does not remain idle unnecessarily and at the same time the firm is not confronted with a situation of cash shortage. All these models can be put in two categories-inventory type models and stochastic models. Inventory type models have been constructed to aid the finance manager to determine optimum cash balance of his firm. William J. Baumol’s economic order quantity model applies equally to cash management problems under conditions of certainty or where the cash flows are predictable. However, in a situation where the EOQ Model is not applicable, stochastic model of cash management helps in determining the optimum level of cash balance. It happens when the demand for cash is stochastic and not known in advance.2.5.1 William J. Baumol’s Economic Order Quantity Model, (1952): 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= Where, 2U × P S C= U= P= S= Optimum cash balance Annual (or monthly) cash disbursement Fixed cost per transaction. Opportunity cost of one rupee p.a. (or p.m.)

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Illustration 4

A firm maintains a separate account for cash disbursement. Total disbursement are Rs.1,05,000 per month or Rs.12,60,000 per year. Administrative and transaction cost of transferring cash to disbursement account is Rs.20 per transfer. Marketable securities yield is 8% per annum. Determine the optimum cash balance according to William J. Baumol model.Solution

The optimum cash balance C =

2 × Rs.12,60,000 × Rs. 20 = Rs.25,100 0.08

The limitation of the Baumol’s model is that it does not allow the cash flows to fluctuate. Firms in practice do not use their cash balance uniformly nor they are able to predict daily cash inflows and outflows. The Miller-Orr (MO) model overcomes this shortcoming and allows for daily cash flow variation.2.5.2 Miller-Orr Cash Management Model (1966): 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 marketable7.50


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. The following diagram illustrates the Miller-Orr model.

h Upper control limit

Z

Cash Balance (Rs.)

Return point

0 Time Lower control limit

The MO Model is more realistic since it allows variations in cash balance within lower and upper limits. The finance manager can set the limits according to the firm’s liquidity requirements i.e., maintaining minimum and maximum cash balance.2.6 RECENT DEVELOPMENTS IN CASH MANAGEMENT

Now-a-days, electronic delivery and payment system are becoming increasingly important because of increased competition and the demand for more efficient and convenient capabilities. A considerable number of transactions and amounts of funds can be moved electronically from one place to another almost instantaneously. Consequently, the opportunities presented are not only beneficial but can create a risk to a business firm. Such threats include internal and external fraud, theft and unauthorized manipulation of financial data. Therefore, we can easily observe the rapid transition from the most basic and traditional principles to now complex strategies dominated by the technology and globalisation, but the

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basic goal is same i.e., the efficient utilisation of cash in a way which is consistent with the overall strategic objectives of a business unit.2.6.1 Electronic Fund Transfer: With the developments which took place in the Information technology, 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 following ways:

Instant updation of accounts. The quick transfer of funds. Instant♦ ♦ ♦ information about foreign exchange rates.2.6.2 Zero Balance Account: 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. 2.6.3 Money Market Operations: One of the tasks of ‘treasury function’ of larger companies is the investment of surplus funds in the money market. The chief characteristic of money market banking is one of size. Banks obtain funds by competing in the money market for the deposits by the companies, public authorities, High Networth Investors (HNI), and other banks. Deposits are made for specific periods ranging from overnight to one year, a highly competitive rates which reflect supply and demand on a daily, even hourly basis are quoted. Consequently, the rates can fluctuate quite dramatically, especially for the shorter-term deposits. Surplus funds can thus be invested in money market easily. 2.6.4 Petty Cash Imprest System: 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 predetermined balance. This will reduce the strain of the management in managing petty cash expenses and help in the managing cash efficiently. 2.6.5 Management of Temporary Cash Surplus

Temporary cash surpluses can be profitably invested in the following: Short-term♦ deposits in Banks and financial institutions. Short-term debt market♦ instruments. Long-term debt instruments.♦

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Shares of Blue chip listed companies.♦2.6.6 Electronic Cash Management System: Most of the cash management systems nowa-days are electronically based, since ‘speed’ is the essense of any cash management system. Electronically, transfer of data as well as funds play a key role in any cash management system. Various elements in the process of cash management are linked through a satellite. Various places that are interlinked may be the place where the instrument is collected, the place where cash is to be transferred in company’s account, the place where the payment is to be transferred etc.

Certain networked cash management system may also provide a very limited access to third parties like parties having very regular dealings of receipts and payments with the company etc. A finance company accepting deposits from public through sub-brokers may give a limited access to sub-brokers to verify the collections made through him for determination of his commission among other things.Benefits: Good cash management is a conscious process of knowing:

When, where and how a company’s cash needs will arise. Knowing what are the♦ ♦ best sources of meeting at a short notice additional cash requirement. ♦ Maintaining good and cordial relations with bankers and other creditors.Scientific cash management results in:

Significant saving in time. Decrease in interest costs. Less paper work. ♦ ♦ ♦ ♦ Greater accounting accuracy. More control over time and funds. Supports♦ ♦ electronic payments. Faster transfer of funds from one location to another,♦ where required. Speedy conversion of various instruments into cash. Making♦ ♦ available funds wherever required, whenever required. Reduction in the amount of♦ ‘idle float’ to the maximum possible extent. Ensures no idle funds are placed at♦ any place in the organization. It makes inter-bank balancing of funds much♦ easier.

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It is a true form of centralised ‘Cash Management’. Produces faster electronic♦ ♦ reconciliation. Allows for detection of book-keeping errors. Reduces the♦ ♦ number of cheques issued. Earns interest income or reduce interest expense. Even♦ a multinational organization having subsidiaries worldwide, can pool everything internationally so that the company offset the debts with the surplus monies from various subsidiaries. It will result in transformation of treasury function into a profit-centre by optimizing cash and putting it on profitable use. Creative and pro-active cash management solutions can contribute dramatically to a company’s profitability and to its competitive edge. The ultimate purpose of scientific cash management is to ensure solvency, liquidity and profitability of the organization as a whole.2.6.7 Virtual Banking: The practice of banking has undergone a significant change in the nineties. While banks are striving to strengthen customer base and relationship and move towards relationship banking, customers are increasingly moving away from the confines of traditional branch banking and are seeking the convenience of remote electronic banking services. And even within the broad spectrum of electronic banking the virtual banking has gained prominence

Broadly virtual banking denotes the provision of banking and related services through extensive use of information technology without direct recourse to the bank by the customer. The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machines (ATMs). Subsequently, driven by the competitive market environment as well as various technological and customer pressures, other types of virtual banking services have grown in prominence throughout the world. The Reserve Bank of India has been taking a number of initiatives, which will facilitate the active involvement of commercial banks in the sophisticated cash management system. One of the pre-requisites to ensure faster and reliable mobility of funds in a country is to have an efficient payment system. Considering the importance of speed in payment system to the economy, the RBI has taken numerous measures since mid Eighties to strengthen the payments mechanism in the country. Introduction of computerized settlement of clearing transactions, use of Magnetic Ink Character Recognition (MICR) technology, provision of inter-city clearing facilities and high value clearing facilities, Electronic Clearing Service Scheme (ECSS), Electronic Funds Transfer (EFT) scheme, Delivery vs. Payment (DVP) for Government securities transactions, setting up of Indian Financial Network (INFINET) are some of the significant developments.

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Introduction of Centralised Funds Management System (CFMS), Securities Services System (SSS), Real Time Gross Settlement System (RTGS) and Structured Financial Messaging System (SFMS) are the other top priority items on the agenda to transform the existing system into a state of the art payment infrastructure in India. The current vision envisaged for the payment systems reforms is one, which contemplates linking up of at least all important bank branches with the domestic payment systems network thereby facilitating cross border connectivity. With the help of the systems already put in place in India and which are coming into being, both banks and corporates can exercise effective control over the cash management.Advantages

The advantages of virtual banking services are as follows: Lower cost of♦ handling a transaction. The increased speed of response to customer♦ requirements. The lower cost of operating branch network along with reduced♦ staff costs leads to cost efficiency. Virtual banking allows the possibility of♦ improved and a range of services being made available to the customer rapidly, accurately and at his convenience. The popularity which virtual banking services have won among customers, is due to the speed, convenience and round the clock access they offer.2.7 CASH MANAGEMENT SERVICES – THE ICICI BANK WAY

ICICI Bank offers receivables and payable management solutions to companies under its Cash Management Services. Local cheque collection is offered from more than 630 centres and up country cheques payable at more than 4,500 centres. The cheques can be collected and credited to the centralized account. Companies can plan their expenditure/investments as the credit is provided on a guaranteed day arrangement basis. The vast reach is offered in combination with advanced technology, which enables the companies to receive customized MIS through e-mail and web to take care of reconciliation. Companies can also avail of ICICI Bank’s payment products viz, issue of bulk demand drafts/pay orders, cheque writing, RTGS, ECS and dividend/interest warrants. These products help the companies to reduce administrative cost and improve efficiency. Companies can avoid transit delays and courier costs by using the remote printing (pay orders) facility.(Source: The Economic Times, New Delhi May 2, 2006)

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2.8

MANAGEMENT OF MARKETABLE SECURITIES

Management of marketable securities is an integral part of investment of cash as this may serve both the purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to park excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles. Safety: Return and risks go hand in hand. As the♦ objective in this investment is ensuring liquidity, minimum risk is the criterion of selection. 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, more risky. 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 or marketable. The choice of marketable securities is mainly limited to Government treasury bills, Deposits with banks and Intercorporate deposits. Units of Unit Trust of India and commercial papers of corporates are other attractive means of parking surplus funds for companies along with deposits with sister concerns or associate companies. Besides this Money Market Mutual Funds (MMMFs) have also emerged as one of the avenues of short-term investment. They focus on short-term marketable securities such as Treasury bills, commercial papers certificate of deposits or call money market. There is a lock in period of 30 days after which the investment may be converted into cash. They offer attractive yields, and are popular with institutional investors and some big companies.

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UNIT – III : MANAGEMENT OF INVENTORY

3.1

INVENTORY MANAGEMENT

Inventories constitute a major element of working capital. It is, therefore, important that investment in inventory is property controlled. The objectives of inventory management are, to a great extent, similar to the objectives of cash management. Inventory management covers a large number of problems including fixation of minimum and maximum levels, determining the size of inventory to be carried, deciding about the issues, receipts and inspection procedures, determining the economic order quantity, proper storage facilities, keeping check over obsolescence and ensuring control over movement of inventories. The aspects concerning control over inventories have been discussed in Chapters 1 and 2 of Cost Accounting under Section A of this book.

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UNIT – IV : MANAGEMENT OF RECEIVABLES

4.1

INTRODUCTION

A firm needs to offer its goods and services on credit to customers as a Business strategy to boost the sales. This represents a considerable investment of funds so the management of this asset can have significant effect on the profit performance of the company. The basic objective of management of sundry debtors is to optimise the return on investment on this assets known as receivables. Large amounts are tied up in sundry debtors, there are chances of bad debts and there will be cost of collection of debts. On the contrary, if the investment in sundry debtors is low, the sales may be restricted, since the competitors may offer more liberal terms. Therefore, management of sundry debtors is an important issue and requires proper policies and their implementation. While studying management of accounts receivable, we focus on its importance, what determines the investment in it, what are the decision variables involved and how do we determine them. Investment in accounts receivables constitute a substantial portion of a firms assets. Moreover, since cash flows from a sale cannot be invested until the accounts receivable are collected their control warrants added importance, efficient collection will lead to both profitability and liquidity of the firm.4.2 ROLE TO BE PLAYED BY THE FINANCE MANAGER:

It is possible that the finance manager can affect the volume of credit sales and collection period and consequently, the investment in receivables. That is through the changes in credit policy. The term credit policy is used to refer to the combination of three decisions variables: (i) credit standards; (ii) Credit terms; and (iii) Collection efforts. Credit standards refer to the criteria’s to decide the types of customers to whom goods could be sold on credit. Whereas credit terms specify the duration of credit and terms of payments by customers. Collection efforts determine the actual collection period. The lower the collection period, the lower the investment in accounts receivables.4.3 ASPECTS OF MANAGEMENT OF DEBTORS

There are basically three aspects of management of sundry debtors.

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1. Credit policy: The credit policy is to be determined. It involves a trade off between the profits on additional sales that arise due to credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. This seeks to decide credit period, cash discount and other relevant matters. The credit period is generally stated in terms of net days. For example if the firm’s credit terms are “net 50”. It is expected that customers will repay credit obligations not later than 50 days.

Further, the cash discount policy of the firm specifies: (a) The rate of cash discount. (b) The cash discount period; and (c) The net credit period. For example, the credit terms may be expressed as “3/15 net 60”. This means that a 3% discount will be granted if the customer pays within 15 days; if he does not avail the offer he must make payment within 60 days.2. Credit Analysis: This require the finance manager to determine as to how risky it is to advance credit to a particular party. 3. Control of receivable: This requires finance manager to follow up debtors and decide about a suitable credit collection policy. It involves both laying down of credit policies and execution of such policies.

There is always cost of maintaining receivables which comprises of following costs: (i) (ii) The company requires additional funds as resources are blocked in receivables which involves a cost in the form of interest (loan funds) or opportunity cost (own funds) Administrative costs which include record keeping, investigation of credit worthiness etc.

(iii) Collection costs. (iv) Defaulting costs.4.4 FACTORS DETERMINING CREDIT POLICY

The credit policy is an important factor determining both the quantity and the quality of accounts receivables. Various factors determine the size of the investment a company makes in accounts receivables. They are, for instance: (i) (ii) The effect of credit on the volume of sales; Credit terms;

(iii) Cash discount; (iv) Policies and practices of the firm for selecting credit customers.

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(v) Paying practices and habits of the customers. (vi) The firm’s policy and practice of collection. (vii) The degree of operating efficiency in the billing, record keeping and adjustment function, other costs such as interest, collection costs and bad debts etc., would also have an impact on the size of the investment in receivables. The rising trend in these costs would depress the size of investment in receivables. The firm may follow a lenient or a stringent credit policy. The firm which follows a lenient credit policy sells on credit to customers on very liberal terms and standards. On the contrary a firm following a stringent credit policy sells on credit on a highly selective basis only to those customers who have proper credit worthiness and who are financially sound. Any increase in accounts receivables that is, additional extension of trade credit not only results in higher sales but also requires additional financing to support the increased investment in accounts receivables. The costs of credit investigations and collection efforts and the chances of bad debts are also increased.4.5 FACTORS UNDER THE CONTROL OF THE FINANCE MANAGER

The finance manager has operating responsibility for the management of the investment in receivables. In addition to his role of supervising the administration of credit, the finance manager is in a particularly strategic position to contribute to top management decisions relating to the best credit policies of the firm. In the beginning, the finance manager plays a very important role in the determination of credit period and deciding the criteria for selection of credit applications. Once it has been done and the management has determined the role of credit in the package of goods and services offered, the finance manager has relatively little impact upon the level of receivables. He may, however, limit the amount of receivables by rejecting occasionally credit applications or he may speed up the conversion of receivables into cash by aggressive collection policy. But these activities have smaller effect upon the level of receivables than the initial and fundamental decision regarding the terms of credit and the overall credit standards laid down by the firm. The basic objective of receivables management should be to maximize return on total investment. The policies which stress short credit terms, stringent credit standards, and aggressive collection policies would, no doubt, reduce the size of investment in receivables and also minimize bad debt losses, but such policies would also restrict sales and profit margins. As a consequence, despite the low investment in receivables, the rate of return on total investment of the firm would be lower than that attainable with higher levels of sales, profits and receivables. The finance manager has to strike a balance between the cost of increased investment in receivables and profits from the higher levels of sales.7.60


Illustration 1

A trader whose current sales are in the region of Rs.6 lakhs per annum and an average collection period of 30 days wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following information:Credit Policy Increase in collection period Increase in sales Present default anticipated

A B C D

10 days 20 days 30 days 45 days

Rs.30,000 Rs.48,000 Rs.75,000 Rs.90,000

1.5% 2% 3% 4%

The selling price per unit is Rs.3. Average cost per unit is Rs.2.25 and variable costs per unit are Rs.2. The current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year. Which of the above policies would you recommend for adoption?Solution Evaluation of Credit Policies Part I Credit Policy Exiting A B C D

Credit Period (Days) Expected (Rs.) additional sales

30

40 30,000 10,000

50 48,000 16,000

60 75,000 25,000

75 90,000 30,000

Contribution of additional sales (one-third of selling price) Bad debs (Expected Sales × Default percentage) Additional bad debts 6,000 --

9,450 3,450

12,960 6,960

20,250 14,250

27,600 21,600

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Contribution of additional sales less additional bad debts (A)Part II

__

6,550

9,040

10,750

8,400

Expected sales (Rs.) Receivables turnover ratio Average receivables Investment in receivables (Receivables × Variable cost i.e, two-thirds of sales price i.e. Rs.50,000 × 2/3 = Rs.33,333 and so on) Additional investment receivables in

6,00,000 12 50,000

6,30,000 9 70,000

6,48,000 7.2 90,000

6,75,000 6 1,12,500

6,90,000 4.8 1,43,750

33,333 __ __

46,667 13,334 2,667

60,000 26,667 5,333

75,000 41,667 8,333

95,833 62,500 12,500

Required return on additional investment at 20% (B) Excess of additional contribution over required return on additional investment in receivables (A)-(B)

__

3,883

3,707

2,417

(4,100)

The additional contribution over required return on additional investment in receivables is the maximum under Credit Policy A. Hence, Policy A is recommended for adoption followed by B and C. Policy D cannot be adopted because it would result in the reduction of the existing profits.Illustration 2

XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two proposed policies. Currently, the firm has annual credit sales of Rs.50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs.1,50,000. The firm is required to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the selling price. Given the following information, which is the better option?

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(Amount in Rs.) Present Policy Policy Option I Policy Option I

Annual credit sales Accounts receivable turnover ratio Bad debt lossesSolution

50,00,000 4 times 1,50,000

60,00,000 3 times 3,00,000

67,50,000 2.4 times 4,50,000

XYZ CORPORATION Evaluation of Credit Policies (Amount in Rs.) Present Policy Policy Option I Policy Option II

Annual credit sales Accounts receivable turnover Average collection period Average level of accounts receivable Marginal increase in investment in receivable less profit margin Marginal increase in sales Profit on marginal increase in sales (30%) Marginal increase in bad debt losses Profit on marginal increase in sales less marginal bad debts loss Required return on marginal investment @ 25% Surplus (loss) after required rate of return

50,00,000 4 times 3 months 12,50,000 ___ ___ ___ ___ ___ ___ ___ ___

60,00,000 3 times 4 months 20,00,000 5,25,000 10,00,000 3,00,000 1,50,000 1,50,000 1,31,250 18,750

67,50,000 2.4 times 5 months 28,12,500 5,68,750 7,50,000 2,25,000 1,50,000 75,000 1,42,188 (67,188)

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It is clear from the above that the policy option I has a surplus of Rs.18,750/- whereas option II shows a deficit of Rs.67,188/- on the basis of 25% return. Hence policy option I is better.Illustration 3

As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods to a group of new customers with 10% risk of non-payment. This group would require one and a half months credit and is likely to increase sales by Rs.1,00,000 p.a. Production and Selling expenses amount to 80% of sales and the income-tax rate is 50%. The company’s minimum required rate of return (after tax) is 25%. Should the sales manager’s proposal be accepted? Also find the degree of risk of non-payment that the company should be willing to assume if the required rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.Solution Extension of credit to a group of new customers:

Profitability of additional sales: Increase in sales per annum Less Bad debt losses (10%) of sales Net sales revenue Less Production and selling expenses (80% of sales) Profit before tax Less Income tax (50%) Profit after taxAverage investment in additional receivables.

Rs.

1,00,000 10,000 90,000 80,000 10,000 5,000 5,000

Period of credit: 1 1 2 months Receivables turnover: Average amount of receivables: Average investment in receivables:

12 =8 1 12 Rs.1,00,000 = Rs.12,500 8Rs.12,500 × 80% = Rs.10,000

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The available rate of return:

Rs. 5,000 × 100 = 50% Rs.10,000

Since the available rate of return is 50%, which is higher than the required rate of return of 25%, the Sales Manager’s proposal should be accepted. (i) Acceptable degree of risk of non-payment if the required rate of return (after tax is 30%) Required amount of profit after tax on investment: Rs.10,000 × 30% = Rs.3,000 Required amount of profit before tax at this level:

Rs.3,000×100 = Rs.6,000 50Net sales revenue required: Rs.80,000 + Rs.6,000 = Rs.86,000 Acceptable amount of bad debt losses: Rs.1,00,000 – Rs.86,000 = Rs.14,000 Acceptable degree of risk of non-payment:Rs.14,000 x 100 = 14% Rs.1,00,000

(ii)

Acceptable degree of risk of non-payment if the required rate of return (after tax) is 40%: Required amount of profit after tax on investment: Rs.10,000 × 40% = Rs.4,000 Required amount of profit before tax

Rs. 4,000 x 100 = Rs.8,000 50Net sales revenue required: Rs.80,000 + Rs.8,000 = Rs.88,000 Acceptable amount of bad debt losses: Rs.1,00,000 – Rs.88,000 = Rs.12,000 Acceptable degree of risk of non-payment:

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Rs.12,000 ×100 = 12% 1,00,000

(iii) Acceptable degree of risk of non-payment of the required rate of return (after tax) is 60%: Required amount of profit after tax on investment: Rs.10,000 × 60% = Rs.6,000 Required amount of profit before tax:

Rs. 6,000×100 = Rs.12,000 50Net sales revenue required: Rs.80,000 + Rs.12,000 = Rs.92,000 Acceptable amount of bad debt losses: Rs.1,00,000 – Rs.92,000 = Rs.8,000 Acceptable degree of risk of non-payment:Rs.8,000 ×100 = 8% Rs.1,00,000

Illustration 4

Slow Payers are regular customers of Goods Dealers Ltd., Calcutta and have approached the sellers for extension of a credit facility for enabling them to purchase goods from Goods Dealers Ltd. On an analysis of past performance and on the basis of information supplied, the following pattern of payment schedule emerges in regard to Slow Payers: Schedule At the end of 30 days At the end of 60 days At the end of 90 days At the end of 100 days Pattern 15% of the bill 34% of the bill. 30% of the bill. 20% of the bill.

Non-recovery 1% of the bill. Slow Payers want to enter into a firm commitment for purchase of goods of Rs.15 lakhs in 2005, deliveries to be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of commodity is Rs.150 on which a profit of Rs.5 per unit is expected to be made. It is anticipated by Goods Dealers Ltd., that taking up of this contract would mean7.66


an extra recurring expenditure of Rs.5,000 per annum. If the opportunity cost of funds in the hands of Goods Dealers is 24% per annum, would you as the finance manager of the seller recommend the grant of credit to Slow Payers? Workings should form part of your answer. Assume year of 360 days.Solution Evaluation of Extension of Credit Facility to Slow Payers:

(i) (ii)

Anticipated Return on the Contract

Rs.

Rs.15,00,000 ×5 Margin return: 150 ⎛ ⎞ ⎟ ⎜ ⎝ ⎠Less: Recurring annual costs

50,000 5,000 ______ 45,000 1st January, 3,75,000Period (Days) Products for each quarter

Net anticipated return (ii) Quarterly sales value of the goods to be delivered on Rs.15,00,000 1st April, 1st July nd 1st October: 4 ⎛ ⎞ ⎜ ⎟ ⎝ ⎠Amount due for each quarter

(iii)

Opportunity Cost (Interest Cost) of Funds to be Locked up:

Rs.56,250 (15% of Rs.3,75,000) Rs.1,27,500 (34% of Rs.3,75,000). Rs.1,12,500 (30% of Rs.3,75,000) Rs.75,000 (20% of Rs.3,75,000) Rs.3,750 (1% of Rs.3,75,000)

30 days 60 days 90 days 100 days Non recovery (See Note 1) Total Products

16,87,500 76,50,000 1,01,25,000 75,00,000

2,69,62,500

Amount of interest cost for the year @ 24% p.a.: 2,69,62,500 24 × ×4 360⎛ ⎞ ⎟ ⎜ 100 ⎠ ⎝

71,900

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(iv) (v)

Total Non-recovery of Bad Debts for the year: (Rs.3,750 × 4) Profitability of Proposed Grant of Credit Facility: Net anticipated return from sales

15,000

45,000

Less: Interest cost on funds :Locked up 71,900 86,900 …….. Bad debts 15,000 (41,900) Profits (Loss) In the light of the above the finance manager will not recommend the grant of credit facility to Slow Payers as it is not profitable. Note:(i) Interest cost could be calculated on the amount of bad debts also.

(ii) Interest cost could be calculated on the amount of cost of sales instead of sales value.4.6 FINANCING RECEIVABLES

Pledging of accounts receivables and Factoring have emerged as the important sources of financing of accounts receivables now a days.(i) Pledging: This refers to the use of a firm’s receivable to secure a short term loan. A firm’s receivables can be termed as its most liquid assets and this serve as prime collateral for a secured loan. The lender scrutinizes the quality of the accounts receivables, selects acceptable accounts, creates a lien on the collateral and fixes the percentage of financing receivables which ranges around 50 to 90%. The major advantage of pledging accounts receivables is the ease and flexibility it provides to the borrower. Moreover, financing is done regularly. This, however, suffers on account of high cost of financing. (ii) Factoring: Factoring is a new concept in financing of accounts receivables. This refers to out right sale of accounts receivables to a factor or a financial agency. A factor is a firm that acquires the receivables of other firms. The factoring lays down the conditions of the sale in a factoring agreement. The factoring agency bears the right of collection and services the accounts for a fee.

Normally, factoring is the arrangement on a non-recourse basis where in the event of default the loss is borne by this factor. However, in a factoring arrangement with recourse, in such situation, the accounts receivables will be turned back to the firm by the factor for resolution. There are a number of financial distributors providing factoring services in India. Some

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commercial banks and other financial agencies provide this service. The biggest advantages of factoring are the immediate conversion of receivables into cash and predicted pattern of cash flows. Financing receivables with the help of factoring can help a company having liquidity without creating a net liability on its financial condition. Besides, factoring is a flexible financial tool providing timely funds, efficient record keepings and effective management of the collection process. This is not considered to be as a loan. There is no debt repayment, no compromise to balance sheet, no long term agreements or delays associated with other methods of raising capital. Factoring allows the firm to use cash for the growth needs of business.Illustration 5

A Factoring firm has credit sales of Rs.360 lakhs and its average collection period is 30 days. The financial controller estimates, bad debt losses are around 2% of credit sales. The firm spends Rs.1,40,000 annually on debtors administration. This cost comprises of telephonic and fax bills along with salaries of staff members. These are the avoidable costs. A Factoring firm has offered to buy the firm’s receivables. The factor will charge 1% commission and will pay an advance against receivables on an interest @15% p.a. after withholding 10% as reserve. What should the firm do? Assume 360 days in a year.Solution

Average level of receivables = Rs.360 lakhs ×

30 = 30 lakhs 360Rs.30,000 Rs.3,00,000 Rs.3,30,000 Rs.30,00,000 Rs. 3,30,000 Rs.26,70,000 Rs. 33,375 Rs.26,36,625 = =

Factoring Commission = 1% of Rs.30,00,000 = Reserve = 10% of Rs.30,00,000 Total (i) Thus, the amount available for advance is Average level of receivablesLess: Total (i) from above

(ii)Less: Interest @ 15% p.a. for 30 days

Net Amount of Advance available.

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Evaluation of Factoring Proposal

Cost to the Firm Factoring Commission = Rs.30,00,000 × Interest charges = Rs. 33,375 × Savings to the firmRs.

360 = Rs. 3,60,000 30

360 Rs.4,00,500 = 30 Rs.7,60,500

Cost of credit administration Cost of bad-debt losses, 0.02 × 360 lakhs The Net benefit to the firm∴

1,40,000 7,20,000 8,60,000Rs.

Savings to the firm - Cost to the firm Net Savings

8,60,000 7,60,500 99,500

Conclusion: Since the savings to the firm exceeds the cost to the firm on account of factoring, The proposal is acceptable. 4.7 INNOVATIONS IN RECEIVABLE∴ MANAGEMENT

During the recent years, a number of tools, techniques, practices and measures have been invented to increase effectiveness in accounts receivable management. Following are the major determinants for significant innovations in accounts receivable management and process efficiency.1. Re-engineering Receivable Process: In some of the organizations real cost reductions and performance improvements have been achieved by re-engineering in accounts receivable process. Re-engineering is a fundamental re-think and re-design of business processes by incorporating modern business approaches. The nature of accounts receivables is such that decisions made elsewhere in the organization are likely to affect the level of resources that are expended on the management of accounts receivables.

The following aspects provides an opportunity to improve the management of accounts receivables.7.70


(a) Centralisation: Centralisation of high nature transactions of accounts receivables and payable is one of the practice for better efficiency. This focuses attention on specialized groups for speedy recovery. (b) Alternative Payment Strategies: Alternative payment strategies in addition to traditional practices, result into efficiencies in the management of accounts receivables. It is observed that payment of accounts outstanding is likely to be quicker where a number of payment alternatives are made available to customers. Besides, this convenient payment methods is a marketing tool that is of benefit in attracting and retaining customers. The following alternative modes of payment may also be used alongwith traditional methods like Cheque Book etc., for making timely payment, added customer service, reducing remittance processing costs and improved cash flows and better debtor turnover.

(i) (ii)

Direct debit: I.e., authorization for the transfer of funds from the purchasers bank account. Integrated Voice Response: This system uses human operators and a computer based system to allow customers to make payment over phone, generally by credit card. This system has proved to be beneficial in the orgnisations processing a large number of payments regularly.

(iii) Collection by a third party: The payment can be collected by an authorized external firm. The payments can be made by cash, cheque, credit card or Electronic fund transfer. Banks may also be acting as collecting agents of their customers and directly depositing the collections in customers bank accounts. (iv) Lock Box Processing: Under this system an outsourced partner captures cheques and invoice data and transmits the file to the client firm for processing in that firm’s systems. (v) Payments via Internet.(c) Customer Orientation: Where individual customers or a group of customers have some strategic importance to the firm a case study approach may be followed to develop good customer relations. A critical study of this group may lead to formation of a strategy for prompt settlement of debt. 2. Evaluation of Risk: Risk evaluation is a major component in the establishment of an effective control mechanism. Once risks have been properly assessed controls can be introduced to either contain the risk to an acceptable level or to eliminate them entirely. This also provides an opportunity for removing inefficient practices. This involves a rethink of processes and questioning the way that tasks are performed. This also opens

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the way for efficiency and effectiveness benefits in the management of accounts receivables.3. Use of Latest Technology: Technological developments now-a-days provides an opportunity for improvement in accounts receivables process. The major innovations available are the integration of systems used in the management of accounts receivables, the automation and the use of e-commerce. (a) E-commerce refer to the use of computer and electronic telecommunication technologies, particularly on an inter-organisational level, to support trading in goods and services. It uses technologies such as Electronic Data Inter-change (EDI), Electronic Mail, Electronic Funds Transfer (EFT) and Electronic Catalogue Systems to allow the buyer and seller to transact business by exchange of information between computer application systems. (b) Accounts Receivable Systems: Now-a-days all the big companies develop and maintain automated receivable management systems. Manual systems of recording the transactions and managing receivables is not only cumbersome but ultimately costly also. These integrated systems automatically update all the accounting records affected by a transaction. For example, if a transaction of credit sale is to be recorded, the system increases the amount the customer owes to the firm, reduces the inventory for the item purchased, and records the sale. This system of a company allows the application and tracking of receivables and collections, using the automated receivables system allows the company to store important information for an unlimited number of customers and transactions, and accommodate efficient processing of customer payments and adjustments. 4. Receivable Collection Practices: The aim of debtors collection should be to reduce, monitor and control the accounts receivable at the same time maintain customer goodwill. The fundamental rule of sound receivable management should be to reduce the time lag between the sale and collection. Any delays that lengthen this span causes receivables to unnecessary build up and increase the risk of bad debts. This is equally true for the delays caused by billing and collection procedures as it is for delays caused by the customer.

The following are major receivable collection procedures and practices: (i) (ii) Issue of Invoice. Open account or open-end credit.

(iii) Credit terms or time limits. (iv) Periodic statements. (v) Use of payment incentives and penalties.7.72


(vi) Record keeping and Continuous Audit. (vii) Export Factoring: Factors provide comprehensive credit management, loss protection collection services and provision of working capital to the firms exporting internationally. (viii) Business Process Outsourcing: This refers to a strategic business tool whereby an outside agency takes over the entire responsibility for managing a business process.5. Use of Financial tools/techniques: The finance manager while managing accounts receivables uses a number of financial tools and techniques. Some of them have been described hereby as follows: (i) Credit analysis: While determining the credit terms, the firm has to evaluate individual customers in respect of their credit worthiness and the possibility of bad debts. For this purpose, the firm has to ascertain credit rating of prospective customers. Credit rating: An important task for the finance manager is to rate the various debtors who seek credit facility. This involves decisions regarding individual parties so as to ascertain how much credit can be extended and for how long. In foreign countries specialized agencies are engaged in the task of providing rating information regarding individual parties. Dun and Broadstreet is one such source.

The finance manager has to look into the credit-worthiness of a party and sanction credit limit only after he is convinced that the party is sound. This would involve an analysis of the financial status of the party, its reputation and previous record of meeting commitments. The credit manager here has to employ a number of sources to obtain credit information. The following are the important sources: Trade references; Bank references; Credit bureau reports; Past experience; Published financial statements; and Salesman’s interview and reports. Once the credit-worthiness of a client is ascertained, the next question is to set a limit of the credit. In all such enquiries, the credit manager must be discreet and should always have the interest of high sales in view.(ii) Decision tree analysis of granting credit: The decision whether to grant credit or not is a decision involving costs and benefits. When a customer pays, the seller makes profit but when he fails to pay the amount of cost going into the product is also gone. If the relative chances of recovering the dues can be decided it can form a probability distribution of payment or non-payment. If the chances of recovery are 9 out of 10 then probability of recovery is 0.9 and that of default is 0.1.

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Credit evaluation of a customer shows that the probability of recovery is 0.9 and that of default is 0.1. the revenue from the order is Rs.5 lakhs and cost is Rs.4 lakhs. The decision is whether credit should be granted or not. The analysis is presented in the following diagram.Rs.1,00,000.00 Grant

Rs.4,00,000.00

Do not grant

The weighted net benefit is Rs.[1,00,000 × 0.9 i.e. 90,000 – 0.1 × 4,00,000 i.e. 40,000] = 50,000. So credit should be granted.(iii) Control of receivables: Another aspect of management of debtors is the control of receivables. Merely setting of standards and framing a credit policy is not sufficient; it is, equally important to control receivables. (iv) Collection policy: Efficient and timely collection of debtors ensure that the bad debt losses are reduced to the minimum and the average collection period is shorter. If a firm spends more resources on collection of debts, it is likely to have smaller bad debts. Thus, a firm must work out the optimum amount that it should spend on collection of debtors. This involves a trade off between the level of expenditure on the one hand and decrease in bad debt losses and investment in debtors on the other.

The collection cell of a firm has to work in a manner that it does not create too much resentment amongst the customers. On the other hand, it has to keep the amount of the outstandings in check. Hence, it has to work in a very smoothen manner and diplomatically. It is important that clear-cut procedures regarding credit collection are set up. procedures must answer questions like the following: Such

(a) How long should a debtor balance be allowed to exist before collection process is started. (b) What should be the procedure of follow up with defaulting customer? How reminders are to be sent and how should each successive reminder be drafted? (c) Should there be a collection machinery whereby personal calls by company’s representatives are made?

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(d) What should be the procedure for dealing with doubtful accounts? Is legal action to be instituted? How should account be handled?4.8 (i) MONITORING OF RECEIVABLES Computation of average age of receivables: It involves computation of average collection period.

(ii) 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 periodically. 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 recognise 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 firms. The following is an illustration of the ageing schedule of receivables:Ageing Schedule Age Classes (Days) As on 30th June, 2005 Month of Sale Balance of Percentage Receivables to total (Rs.) 41,500 11.9 74,200 21.4 1,85,600 53.4 35,300 10.2 10,800 3.1 As on 30th September, 2005 Month Sale of Balance of Percentage Receivables to total (Rs.) 1,00,000 22.7 2,50,000 56.8 48,000 10.9 40,000 9.1 2,000 0.5

1-30 31-60 61-90 91-120 121 and more

June May April March Earlier

September August July June Earlier

_______ 3,47,400

___ 100

_______ 4,40,000

___ 100

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The above ageing schedule shows a substantial improvement in the liquidity of receivables for the quarter ending September, 2005 as compared with the liquidity of receivables for the quarter ending June, 2005. It could be possible due to greater collection efforts of the firm.(iii) Collection Programme:

(a) Monitoring the state of receivables. (b) Intimation to customers when due date approaches. (c) Telegraphic and telephonic advice to customers on the due date. (d) Threat of legal action on overdue A/cs. (e) Legal action on overdue A/cs. The following diagram shows the relationship between collection expenses and bad debt losses which has to be established as initial increase in collection expenses may have only a small impact on bad debt losses.

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UNIT – V : FINANCING OF WORKING CAPITAL

5.1

INTRODUCTION

After determining the amount of working capital required, the next step to be taken by the finance Manager is to arrange the funds. As discussed earlier, it is advisable that the finance manager bifurcates the working capital requirements between the permanent working capital and temporary working capital. The permanent working capital is always needed irrespective of sales fluctuations, hence should be financed by the long-term sources such as debt and equity. On the contrary the temporary working capital may be financed by the short-term sources of finance. The short-term sources of finance, which are generally expected to be matured within the same operating cycle or say within the same accounting year or at the most in next year, finance a major portion of total current assets. This requires a number of decisions to be taken by the finance manager with regard to the Cash Balance and the timing of cash to be maintained, investment in short-term securities, when the payment to creditors is to be made, when and how much funds are to be raised by borrowings. Most of these sources are not often close substitute for one another because each source has unique characteristics, advantages and disadvantages. The present unit, focuses on (i) the different sources of financing working capital requirements as well as recent developments. Broadly speaking, the working capital finance may be classified between the two categories: (i) (ii) Spontaneous sources. Negotiable sources.

The finance manager has to be very careful while selecting a particular source, or a combination thereof for financing of working capital. Generally, the following parameters will guide his decisions in this respect: (i) (ii) Cost factor Impact on credit rating

(iii) Feasibility (iv) Reliability (v) Restrictions (vi) Hedging approach or matching approach i.e., Financing of assets with the same maturity as of assets.7.77


The spontaneous sources of finance are those which naturally arise in the course of business operations. Trade credit, credit from employees, credit from suppliers of services, etc. Are some of the examples which may be quoted in this respect. On the other hand the negotiated sources, as the name implies, are those which have to be specifically negotiated with lenders say, commercial banks, financial institutions, general public etc.5.2 SOURCES OF FINANCE

5.2.1 As outlined above trade credit is a spontaneous source of finance which is normally extended to the purchaser organization by the sellers or services providers. This source of financing working capital is more important since it contributes to about one-third of the total short-term requirements. The dependence on this source is higher due to lesser cost of finance as compared with other sources. Trade credit is guaranteed when a company acquires supplies, merchandise or materials and does not pay immediately. If a buyer is able to get the credit with out completing much formalities, it is termed as ‘open account trade credit.’

On the other hand in the case of “Bills Payable” the purchaser will have to give a written promise to pay the amount of the bill/invoice either on demand or at a fixed future date to the seller or the bearer of the note. Due to its simplicity, easy availability and lesser explicit cost, the dependence on this source is much more in all small or big organizations. Especially, for small enterprises this form of credit is more helpful to small and medium enterprises. The amount of such financing depends on the volume of purchases and the payment timing. Another spontaneous source of short-term financing is the accrued expenses or the outstanding expenses liabilities. The accrued expenses refer to the services availed by the firm, but the payment for which has yet to be made. It is a built in and an automatic source of finance as most of the services like wages, salaries, taxes, duties etc., are paid at the end of the period. The accrued expenses represent an interest free source of finance. There is no explicit or implicit cost associated with the accrued expenses and the firm can ensure liquidity by accruing these expenses.5.2.2 Inter-corporate Loans and Deposits: Sometime, organizations having surplus funds invest for shot-term period with other organizations. The rate of interest will be higher than the bank rate of interest and depending on the financial soundness of the borrower company. This source of finance reduces dependence on bank financing. 5.2.3 Commercial Papers: Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period. This is an instrument that enables highly rated corporate borrowers for short-term borrowings and provides an additional financial instrument

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to investors with a freely negotiable interest rate. The maturity period ranges from minimum 7 days to less than 1 year.5.2.4 Commercial Papers in India: 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) (ii)

Enabling the highly rated corporate borrowers to diversify their sources of short term borrowings, and To provide an additional instrument to the short term investors.

These guidelines have stipulated certain conditions meant primarily to ensure that only financially strong companies come forward to issue the CP. Subsequently, these guidelines have been modified. The main features of the guidelines relating to issue of CP in India may be summarized as follows: (i) CP should be in the form of usance promissory note negotiable by endorsement and delivery. It can be issued at such discount to the face value as may be decided by the issuing company. CP is subject to payment of stamp duty. The aggregate amount that can be raised by commercial papers is not restricted any longer to the company’s cash credit component of the Maximum Permissible Bank Finance.

(ii)

(iii) CP is issued in the denomination of Rs.5,00,000, but the maximum lot or investment is Rs.25,00,000 per investor. The secondary market transactions can be of Rs.5,00,000 or multiples thereof. The total amount proposed to be issued should be raised within two weeks from the date on which the proposal is taken on record by the bank. (iv) CP should be issued for a minimum period of 7 days and a maximum of less than 1 year. No grace period is allowed for repayment and if the maturity date falls on a holiday, then it should be paid on the previous working day. Each issue of CP is treated as a fresh issue. (v) Commercial papers can be issued by a company whose (i) tangible net worth is not less than Rs.5 crores, (ii) funds based working capital limit is not less than 4 crores, (iii) shares are listed on a stock exchange, (iv) specified credit rating of P2 is obtained from CRISIL or A2 from ICRA, and (v) the current ratio is 1.33:1. (vi) The issue expenses consisting of dealers fees, credit rating agency fees and other relevant expenses should be borne by the issuing company. (vii) CP may be issued to any person, banks, companies. The issue of CP to NRIs can only be on a non-repatriable basis and is not transferable.

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(viii) CP can be issued up to 100% of the fund based working capital loan limit. The working capital limit is reduced accordingly on issuance of CP. (ix) Deposits by the issue of CP have been exempted from the provisions of section 58A of the Companies Act, 1956. Any company proposing to issue CP has to submit an application to the bank which provide working capital limit to it, along with the credit rating of the firm. The issue has to be privately placed within two weeks by the company or through a merchant banker. The initial investor pays the discounted value of the CP to the firm. Thus, CP is issued only through the bank who has sanctioned the working capital limit to the company. It is counted as a part of the total working capital limit and it does not increase the working capital resources of the firm. Annual Financing Cost = Where FV SP MP = = =

FV − SP 360 x MP SPFace value of CP Issue price of CP Maturity period of CP.

For example, a CP of the face value of Rs.6,00,000 is issued at Rs.5,80,000 for a maturity period of 120 days. The annual financing cost of the CP is: Annual Financing Cost =

Rs. 6,00,000 − Rs. 5,80,000 360 x Rs. 5,80,000 120

= 10.34% In the same case, if the maturity period is 180 days, then the annual financing cost is: Annual Financing Cost =

Rs. 6,00,000 − Rs. 5,80,000 360 x Rs. 5,80,000 180

= 6.90% For the same maturity periods of 120 days and 180 days, if the issue price is taken at Rs.5,60,000, then the annual financing cost comes to 21.42% and 14.28% respectively. So, it can be seen that the cost of CP varies inversely to the issue price as well as the maturity period.5.2.5 CP as a Source of Financing: From the point of the issuing company, CP provides the following benefits:

(a) CP is sold on an unsecured basis and does not contain any restrictive conditions.

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(b) Maturing CP can be repaid by selling new CP and thus can provide a continuous source of funds. (c) Maturity of CP can be tailored to suit the requirement of the issuing firm. (d) CP can be issued as a source of fund even when money market is tight. (e) Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans. However, CP as a source of financing has its own limitations: (i) (ii) Only highly credit rating firms can use it. New and moderately rated firm generally are not in a position to issue CP. CP can neither be redeemed before maturity nor can be extended beyond maturity.

5.2.6 Funds Generated from Operations: Funds generated from operations, during an accounting period, increase working capital by an equivalent amount. The two main components of funds generated from operations are profit and depreciation. Working capital will increase by the extent of funds generated from operations. Students may refer to funds flow statement given earlier in this chapter. 5.2.7 Public Deposits: Deposits from the public is one of the important source of finance particularly for well established big companies with huge capital base for short and mediumterm. 5.2.8 Bills Discounting: Bill discounting is recognized as an important short term Financial Instrument and it is widely used method of short term financing. In a process of bill discounting, the supplier of goods draws a bill of exchange with direction to the buyer to pay a certain amount of money after a certain period, and gets its acceptance from the buyer or drawee of the bill. 5.2.9 Bill Rediscounting Scheme: The bill rediscounting Scheme was introduced by Reserve Bank of India with effect from 1st November, 1970 in order to extend the use of the bill of exchange as an instrument for providing credit and the creation of a bill market in India with a facility for the rediscounting of eligible bills by banks. Under the bills rediscounting scheme, all licensed scheduled banks are eligible to offer bills of exchange to the Reserve Bank for rediscount. 5.2.10 Factoring: Students may refer to the unit on Receivable Management wherein the concept of factoring has been discussed. Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial institution. In other words, factoring is a continuous arrangement between a financial institution, (namely the factor) and a firm (namely the client) which sells goods and services to trade customers on credit. As per this arrangement, the factor purchases the client’s trade debts including accounts receivables

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either with or without recourse to the client, and thus, exercises control over the credit extended to the customers and administers the sales ledger of his client. To put it in a layman’s language, a factor is an agent who collects the dues of his client for a certain fee. The differences between Factoring and Bills discounting are as follows: (i) (ii) Factoring is called as ‘Invoice factoring’ whereas bills discounting is known as “Invoice discounting”. In factoring the parties are known as client, factor and debtor whereas in bills discounting they are known as Drawer, Drawee and Payee.

(iii) Factoring is a sort of management of book debts whereas bills discounting is a sort of borrowing from commercial banks. (iv) For factoring there is no specific Act; whereas in the case of bills discounting, the Negotiable Instrument Act is applicable.5.3 WORKING CAPITAL FINANCE FROM BANKS

Banks in India today constitute the major suppliers of working capital credit to any business activity. Recently, some term lending financial institutions have also announced schemes for working capital financing. The two committees viz., Tandon Committee and Chore Committee have evolved definite guidelines and parameters in working capital financing, which have laid the foundations for development and innovation in the area.5.3.1 Instructions on Working Capital Finance by Banks Assessment of Working Capital

•

Reserve Bank of India has withdrawn the prescription, in regard to assessment of working capital needs, based on the concept of Maximum Permissible Bank Finance, in April 1997. Banks are now free to evolve, with the approval of their Boards, methods for assessing the working capital requirements of borrowers, within the prudential guidelines and exposure norms prescribed. Banks, however, have to take into account Reserve Bank’s instructions relating to directed credit (such as priority sector, export, etc.), and prohibition of credit (such as bridge finance, rediscounting of bills earlier discounted by NBFCs) while formulating their lending policies. With the above liberalizations, all the instructions relating to MPBF issued by RBI from time to time stand withdrawn. Further, various instructions/guidelines issued to banks with objective of ensuring lending discipline in appraisal, sanction, monitoring and utilization of bank finance cease to be mandatory. However, banks have the option of incorporating such of the instructions/guidelines as are considered necessary in their lending policies/procedures.

•

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5.4

FACTORS DETERMINING CREDIT POLICY Cash Credit: This facility will be given by the banker to the customers by giving certain amount of credit facility on continuous basis. The borrower will not be allowed to exceed the limits sanctioned by the bank. Bank Overdraft: It is a short-term borrowing facility made available to the companies in case of urgent need of funds. The banks will impose limits on the amount they can lend. When the borrowed funds are no longer required they can quickly and easily be repaid. The banks issue overdrafts with a right to call them in at short notice. Bills Discounting: The company which sells goods on credit, will normally draw a bill on the buyer who will accept it and sends it to the seller of goods. The seller, in turn discounts the bill with his banker. The banker will generally earmarks the discounting bill limit. Bills Acceptance: To obtain finance under this type of arrangement a company draws a bill of exchange on bank. The bank accepts the bill thereby promising to pay out the amount of the bill at some specified future date. Line of Credit: Line of Credit is a commitment by a bank to lend a certain amount of funds on demand specifying the maximum amount. Letter of Credit: It is an arrangement by which the issuing bank on the instructions of a customer or on its own behalf undertakes to pay or accept or negotiate or authorizes another bank to do so against stipulated documents subject to compliance with specified terms and conditions. Bank Guarantees: Bank guarantee is one of the facilities that the commercial banks extend on behalf of their clients in favour of third parties who will be the beneficiaries of the guarantees.

The bank credit will generally be in the following forms: •

•

•

•

• •

•

Self Examination Questions A. Objective Type Questions

1.

The credit terms may be expressed as “3/15 net 60”. This means that a 3% discount will be granted if the customer pays within 15 days, if he does not avail the offer he must make payment within 60 days. (a) I agree with the statement (b) I do not agree with the statement (c) I cannot say.

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2.

The term ‘net 50’ implies that the customer will make payment. (a) Exactly on 50th day (b) Before 50th day (c) Not later than 50th day (iv) None of the above.

3.

Trade credit is a source of : (a) Long-term finance (b) Medium term finance (c) Spontaneous source of finance (d) None of the above.

4.

The term float is used in (a) Inventory Management (b) Receivable Management (c) Cash Management (d) Marketable securities.

5.

William J Baumol’s model of Cash Management determines optimum cash level where the carrying cost and transaction cost are: (a) Maximum (b) Minimum (c) Medium (d) None of the above.

6.

In Miller – ORR Model of Cash Management: (a) The lower, upper limit, and return point of Cash Balances are set out (b) Only upper limit and return point are decided (c) Only lower limit and return point are decided (d) None of the above are decided.

7.

Working Capital is defined as (a) Excess of current assets over current liabilities (b) Excess of current liabilities over current assets

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(c) Excess of Fixed Assets over long-term liabilities (d) None of the above. 8. Working Capital is also known as “Circulating Capital, fluctuating Capital and revolving capital”. The aforesaid statement is; (a) Correct (b) Incorrect (c) Cannot say. 9. The basic objectives of Working Capital Management are: (a) Optimum utilization of resources for profitability (b) To meet day-to-day current obligations (c) Ensuring marginal return on current assets is always more than cost of capital (d) Select any one of the above statement. 10. The term Gross Working Capital is known as: (a) The investment in current liabilities (b) The investment in long-term liability (c) The investment in current assets (d) None of the above. 11. The term net working capital refers to the difference between the current assets minus current liabilities. (a) The statement is correct (b) The statement is incorrect (c) I cannot say. 12. The term “Core current assets’ was coined by (a) Chore Committee (b) Tandon Committee (c) Jilani Committee (d) None of the above. 13. The concept operating cycle refers to the average time which elapses between the acquisition of raw materials and the final cash realization. This statement is

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(a) Correct (b) Incorrect (c) Partially True (d) I cannot say. 14. As a matter of self-imposed financial discipline can there be a situation of zero working capital now-a-days in some of the professionally managed organizations. (a) Yes (b) No (c) Impossible (d) Cannot say. 15. Over trading arises when a business expands beyond the level of funds available. The statement is (a) Incorrect (b) Correct (c) Partially correct (d) I cannot say. 16. A Conservative Working Capital strategy calls for high levels of current assets in relation to sales. (a) I agree (b) Do not agree (c) I cannot say. 17. The term Working Capital leverage refer to the impact of level of working capital on company’s profitability. This measures the responsiveness of ROCE for changes in current assets. (a) I agree (b) Do not agree (c) The statement is partially true. 18. The term spontaneous source of finance refers to the finance which naturally arise in the course of business operations. The statement is (a) Correct

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(b) Incorrect (c) Partially Correct (d) I cannot say. 19. Under hedging approach to financing of working capital requirements of a firm, each asset in the balance sheet assets side would be offset with a financing instrument of the same approximate maturity. This statement is (a) Incorrect (b) Correct (c) Partially correct (d) I cannot say. 20. Trade credit is a (a) Negotiated source of finance (b) Hybrid source of finance (c) Spontaneous source of finance (d) None of the above. 21. Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial institution. The statement is (a) Correct (b) Incorrect (c) Partially correct (d) I cannot say. 22. A factoring arrangement can be both with recourse as well as without recourse: (a) True (b) False (c) Partially correct (d) Cannot say. 23. The Bank financing of working capital will generally be in the following form. Cash Credit, Overdraft, bills discounting, bills acceptance, line of credit; Letter of credit and bank guarantee. (a) I agree

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(b) I do not agree (c) I cannot say. 24. When the items of inventory are classified according to value of usage, the technique is known as: (a) XYZ Analysis (b) ABC Analysis (c) DEF Analysis (d) None of the above. 25. When a firm advises its customers to mail their payments to special Post Office collection centers, the system is known as. (a) Concentration banking (b) Lock Box system (c) Playing the float (d) None of the above.Answer to Objective Type Questions 1. (a); 2.(c); 3. (c); 4. (c); 5. (b); 6. (a); 7. (a); 8. (a); 9. (b); 10. (c); 11. (a); 12. (b); 13. (a); 14. (a); 15. (b); 16. (a); 17. (a); 18. (a); 19. (b); 20. (c); 21. (a); 22. (a); 23. (a); 24. (b); 25. (b). B. Practical Problems

1.

Foods Ltd. is presently operating at 60% level producing 36,000 packets of snack foods and proposes to increase capacity utilization in the coming year by 33 % over the existing level of production. The following data has been supplied: (i) Unit cost structure of the product at current level: Raw Material Wages (Variable) Overheads (Variable) Fixed Overheads Profit Selling PriceRs.

4 2 2 1 3 12

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(ii)

Raw materials will remain in stores for 1 month before being issued for production. Material will remain in process for further 1 month. Suppliers grant 3 months credit to the company.

(iii) Finished goods remain in godown for 1 month. (iv) Debtors are allowed credit for 2 months. (v) Lag in wages and overhead payments is 1 month and these expenses accrue evenly throughout the production cycle. (vi) No increase either in cost of inputs or selling price is envisaged. Prepare a projected profitability statement and the working capital requirement at the new level, assuming that a minimum cash balance of Rs.19,500 has to be maintained. 2. A newly formed company has applied to the commercial bank for the first time for financing its working capital requirements. The following information is available about the projections for the current year: Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-progress. Based on the above activity estimated cost per unit is:(Rs. per unit)

Raw material Direct wages Overheads (exclusive of depreciation) Total cost

80 30 60 170

Selling price 200 Raw materials in stock: average 4 weeks consumption, work-in-progress (assume 50% completion stage in respect of conversion cost) (materials issued at the start of the processing). Finished goods in stock Credit allowed by suppliers Credit allowed to debtors/receivables Lag in payment of wages 8,000 units Average 4 weeks Average 8 weeks Average 1½ weeks

Cash at banks (for smooth operation) is expected to be Rs.25,000 Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly. All sales are on credit basis only. Find out: the net working capital required.

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3.

The following is the projected Balance Sheet of Excel Limited as on 31-3-2004. The company wants to increase the fund-based limits from the Zonal Bank from Rs.100 lakhs to Rs.300 lakhs:Balance Sheet as on 31-3-2004 (Rs. lakhs) Liabilities Rs. Assets Rs.

Share Capital Reserves & Surplus Secured Loans Unsecured Loans Current Liabilities

100 Fixed Assets 150 Current Assets 450 Miscellaneous Expenditure 1,050 200

800 1,000 150

1,950 The following are the other information points to be considered:

1,950

(1) Secured loans include instalments payable to financial institutions before 31-3-2004 Rs.100 lakhs. (2) Secured loans include working capital facilities expected from Zonal Bank Rs.300 lakhs. (3) Unsecured loans include fixed deposits from public amounting to Rs.400 lakhs out of which Rs.100 lakhs are due for repayment before 31-3-2004. (4) Unsecured loans include Rs.600 lakhs of zero interest fully convertible debentures due for conversion on 30-9-2003. (5) Current assets include deferred receivables due for payment after 31-3-2004 Rs.40 lakhs. (6) The company has introduced a voluntary retirement scheme for workers costing Rs.40 lakhs payable on 31-3-2008 and this amount is included in current liabilities: (i) You are required to calculate from the above information the maximum permissible bank finance by all the three methods for working capital as per Tandon Committee norms. For your exercise, assume that core current assets constitute 25% of the current assets. Also compute the Current Ratio for all the three methods.

(ii) 4.

A company newly commencing business in 2003 has the under mentioned Projected Profit and Loss Account:

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Sales Cost of goods soldGross Profit

42,00,000 30,60,000 11,40,000 2,80,000 2,60,000 5,40,000 6,00,000 2,00,000 4,00,000 (Rs) 16,80,000 12,50,000 4,70,000 34,00,000 3,40,000

Administrative expenses Selling expenses Profit before tax Provision for taxationProfit after tax The cost of goods sold has been arrived at as under

Material used Wages and manufacturing expenses DepreciationLess: Stock of finished goods (10% of goods produced not yet sold)

30,60,000 The figures given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the year’s production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses. The company believes in keeping material equal to two months consumption in stock. All expenses will be paid one month in arrear. Suppliers of material will extend 1½ month’s credit; Sales will be 20% for cash and the rest at two months’ credit; 90% of the Income-tax will be paid in advance in quarterly instalments. The company wishes to keep Rs.1,00,000 in cash. Prepare an estimate of the requirement of (i) Working Capital; and (ii) Cash Cost of Working Capital. 5. A company is considering its working capital investment and financial policies for the next year. Estimated fixed assets and current liabilities for the next year are Rs.2.60 crore and Rs.2.34 crore respectively. Estimated Sales and EBIT depend on current assets investment, particularly inventories and book-debts. The Financial Controller of the company is examining the following alternative Working Capital Policies:(Rs. Crores) Working Capital Policy Investment in Estimated EBIT7.91


Current Assets

Sales

Conservative Moderate

4.50 3.90

12.30 11.50

1.23 1.15

Aggressive 2.60 10.00 1.00 After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working capital policy. The company is now examining the use of long-term and short-term borrowings for financing its assets. The company will use Rs.2.50 crore of the equity funds. The corporate tax rate is 35%. The company is considering the following debt alternatives:Financing Policy Short-term Debt Long-term Debt

Conservative Moderate Aggressive

0.54 1.00 1.50

1.12 0.66 0.16 16%

Interest rate- Average 12% You are required to calculate the following:

(a) Working Capital Investment for each Policy: (a) Net Working Capital position; (b) Rate of Return; (c) Current ratio. (b) Financing for each policy; (a) Net Working Capital; (b) Rate of Return of Shareholders equity; (c) Current ratio. 6. The turnover of R Ltd. is Rs.60 lakhs of which 80% is on credit. Debtors are allowed one month to clear off the dues. A factor is willing to advance 90% of the bills raised on credit for a fee of 2% a month plus a commission of 4% on the total amount of debts. R Ltd. as a result of this arrangement is likely to save Rs.21,600 annually in management costs and avoid bad debts at 1% on the credit sales. A scheduled bank has come forward to make an advance equal to 90% of the debts at an interest rate of 18% p.a. However, its processing fee will be at 2% on the debts. Would you accept factoring or the offer from the bank? 7. A Bank is analyzing the receivables of Jackson Company in order to identify acceptable collateral for a short-term loan. The company’s credit policy is 2/10 net 30. the bank lends 80 per cent on accounts where customers are not currently overdue and where the average payment period does not exceed 10 days past the net period. A schedule of Jackson’s receivables has been prepared. How much will the bank lend on a pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?Account Amount Days Outstanding Average Payment

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Rs.

In days

Period historically

74 91 107 108 114 116 8.

25,000 9,000 11,500 2,300 18,000 29,000

15 45 22 9 50 16

20 60 24 10 45 10

123 14,000 27 48 A Ltd. has a total sales of Rs.3.2 crores and its average collection period is 90 days. The past experience indicates that bad debt losses are 1.5% on Sales. The expenditure incurred by the firm in administering its receivable collection efforts are Rs.5,00,000. A factor is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as reserve. Calculate the effective cost of factoring to the Firm. Explain briefly some of the techniques of inventory control used in manufacturing organization.

9.

10. Ten items kept in inventory by the School of Management Studies at State University are listed below. Which items should be classified as ‘A’ items, ‘B’ items and ‘C’ items? What percentage of items is in each class? What percentage of total annual value is in each class?Item Annual Usage Value per unit (Rs.) 1 200 40.00 2 100 360.00 3 2,000 0.20 4 400 20.00 5 6,000 0.04 6 1,200 0.80 7 120 100.00 8 2,000 0.70 9 1,000 1.00 10 80 400.00 Economic Enterprises require 90,000 units of a certain item annually. The cost per unit is Rs.3, the cost per purchase order is Rs.300 and the Inventory carrying cost Rs.6 per unit per year.

11

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(i) (ii)

What is the Economic Order Quantity. What should the firm do if the supplier offers discounts as below, viz.,Discounts%

Order quantity

4,500 – 5,999 6,000 and above

2 3

12. The annual demand for an item of raw material is 4,000 units and the purchase price is expected to be Rs.90 per unit. The incremental cost processing an order is Rs.135 and the cost of storage is estimated to be Rs.12 per unit. What is the optimal order quantity and total relevant cost of this order quantity? Suppose that Rs.135 as estimated to be the incremental cost of processing an order is incorrect and should have been Rs.80. All other estimates are correct. What is the difference in cost on account of this error? Assume at the commencement of the period that a supplier offers 4,000 units at a price of Rs.86. The materials will be delivered immediately and placed in the stores. Assume that the incremental cost of placing the order is zero and original estimate of Rs.135 for placing an order for the economic batch is correct. Should the order be accepted? 13. (a) The following details are available in respect of a firm: (i) (ii) (iii) Annual requirement of inventory Cost per unit (other than carrying and ordering cost) Carrying costs are likely to be 40,000 units Rs.16 15% per year Rs.480 per order

(iv) Cost of placing order Determine the economic ordering quantity. (b) The experience of the firm being out of stock is summarized below: (1)Stock out (No. of units)

No. of times

500 400 250 100 50 0

1 (1) 2 (2) 3 (3) 4 (4) 10 (10) 80 (80)

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Figures in brackets indicate percentage of time the firm has been out of stock. (2) Stock out costs are Rs.40 per unit. (3) Carrying cost of inventory per unit is Rs.20. Determine the optimal level of stock out inventory. (c) A firm has 5 different levels in its inventory. The relevant details are given. Suggest a breakdown of the items into A, B and C classifications:Item No. Avg. No. of units inventory Avg. Cost per unit (Rs.)

1 2 3 4 5

20,000 10,000 32,000 28,000 60,000

60 100 11 10 3.40

14. A firm is engaged in the manufacture of two products A and B. Product A uses one unit of Component P and two units of Components Q. Products B uses two units of Component P, one unit of Component Q and two units of Component R. Component R which is assembled in the factory uses one unit of Component Q. Components P and Q are purchased from the market. The firm has prepared the following forecast for sales and inventory for the next year:Products

A Sales Inventories: At the end of the year At the beginning of the year Units Units 1,000 3,000 Units 8,000

B 15,000 2,000 5,000

The production of both the products and the assembling of the component R will be spread out uniformly throughout the year. The firm at present orders its inventory of components P and Q in quantities equivalent to 3 months consumption. The firm has been advised that savings in the provisioning of components can arise by changing over to the ordering system based on economic7.95


ordering quantities. Components:Particulars

The firm has compiled the following data relating to the two (Rs.)P Q

Component usage per annum Price per unit Order placing costs per order Carrying costs per annum Required:

30,000 2.00 15.00 20%

48,000 0.80 15.00 20%

(a) Prepare a budget of production and requirements of components for the next year. (b) Find the economic order quantity. (c) Based on the economic order quantity calculated in (b) above, calculate the savings arising from switching over to the new ordering system both in terms of cost and reduction in working capital. 15. Radiance Garments Ltd. manufactures readymade garments and sells them on credit basis through a network of dealers. Its present sale is Rs.60 lakh per annum with 20 days credit period. The company is contemplating an increase in the credit period with a view to increasing sales. Present variable costs are 70% of sales and the total fixed costs Rs.8 lakh per annum. The company expects pre-tax return on investment @ 25%. Some other details are given as under:Proposed Credit Policy Average Collection Period (days) Expected Annual Sales (Rs.lakh)

I II III IV

30 40 50 60

65 70 74 75

Required: When credit policy should the company adopt? Present your answer in a tabular form. Assume 360 days a year. Calculation should be made upto two digits after decimal. 16. H. Ltd. has a present annual sales level of 10,000 units at Rs.300 per unit. The variable cost is Rs.200 per unit and the fixed costs amount to Rs.3,00,000 per annum. The7.96


present credit period allowed by the company is 1 month. The company is considering a proposal to increase the credit periods to 2 months and 3 months and has made the following estimates:Existing Proposal

Credit Policy Increase in Sales % of Bad Debts

1 month 1%

2 months 15% 3%

3 months 30% 5%

There will be increase in fixed cost by Rs.50,000 on account of increase of sales beyond 25% of present level. The company plans on a pretax return of 20% on investment in receivables. You are required to calculate the most paying credit policy for the company. 17. Star Limited manufacturers of Colour T.V. sets, are considering the liberalization of existing credit terms to three of their large Customers A,B and C. The credit period and likely quantity of TV sets that will be lifted by the customers are as follows:Quantity Lifted (No. of TV Sets) Credit Period (Days) A B C

0 30 60 90

1,000 1,000 1,000 1,000

1,000 1,500 2,000 2,500

− − 1,000 1,500

The selling price per TV set is Rs.9,000. The expected contribution is 20% of the selling price. The cost of carrying debtors averages 20% per annum. You are required: (a) Determine the credit period to be allowed to each customer. (Assume 360 day in a year for calculation purposes). (b) What other problems the company might face in allowing the credit period as determined in (a) above?

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18. The present credit terms of P Company are 1/10 net 30. Its annual sales are Rs.80 lakhs, its average collection period is 20 days. Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost of capital is 10 per cent. The proportion of sales on which customers currently take discount is 0.5. P Company is considering relaxing its discount terms to 2/10 net 30. Such relaxation is expected to increase sales by Rs.5 lakhs, reduce the average collection period to 14 days and increase the proportion of discount to sales to 0.8. What will be the effect of relaxing the discount policy on company’s profit? Take year as 360 days. 19. The credit manager of XYZ Ltd. is reappraising the company’s policy. The company sells its products on terms of net 30. Cost of goods sold is 85% of sales and fixed costs are further 5% of sales. XYZ classifies its customers on a scale of 1 to 4. During the past five years, the experience was as under:Classification Default as a percentage of sales Average collection period-indays for non-defaulting accounts 45 42 40 80

1 2 3 4

0 2 10 20

The average rate of interest is 15%. What conclusions do you draw about the Company’s Credit Policy? What other factors should be taken into account before changing the present policy? Discuss. 20. Easy Limited specializes in the manufacture of a computer component. The component is currently sold for Rs.1,000 and its variable cost is Rs.800. For the year ended 31-32006 the company sold on an average 400 components per month. At present the company grants one month credit to its customers. The company is thinking of extending the same to two months on account of which the following is expected: Increase in Sales Increase in Stock Increase in Creditors You are required: To advise the company on whether or not to extend the credit terms if: (a) all customers avail the extended credit period of two months; and 25% Rs.2,00,000 Rs.1,00,000

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(b) existing customers do not avail the credit terms but only the new customers avail the same. Assume in this case the entire increase in sales is attributable to the new customers. 21 Star Limited is manufacturer of various electronic gadgets. The annual turnover for the year 2006 was Rs.730 lakhs. The company has a wide network of sales outlets all over the country. The turnover is spread evenly for each of the 50 weeks of the working year. All sales are for credit and sales within the week are also spread evenly over each of the five working days. All invoicing of credit sales is carried out at the Head Office in Bombay. Sales documentation is sent by post daily from each location to the Head Office for the past two years. Delays in preparing and dispatching invoices were noticed. As a result, only some of the invoices were dispatched in the same week and the remainder the following week. An analysis of the delay in invoicing (being the interval between the date of sale and the date of despatch of the invoice indicated the following pattern: No. of days of delay in invoicing % of weeks sales 3 20 4 10 5 40 6 30

A further analysis indicated that the debtors take on an average 36 days of credit before paying. This period is measured from the day of despatch of the invoice rather than the date of sale. It is proposed to hire an agency for undertaking the invoicing work at various locations. The agency has assured that the maximum delay would be reduced to three days under the following pattern: No. of days of delay in invoicing % of weeks sales 0 40 1 40 2 20

The agency has also offered additionally to monitor the collections which will reduce the credit period to 30 days. Star Limited expects to save Rs.4,000 per month in postage costs. All working funds are borrowed from a local bank at simple interest rate of 20% p.a. The agency has quoted a fee of Rs.2,00,000 p.a. for the invoicing work and Rs.2,50,000 p.a. for monitoring collections and is willing to offer a discount of Rs.50,000 provided both the works are given. You are required to advise Star Limited about the acceptance of agency’s proposal. Working should form part of the answer.7.99


22. Pollock Co. Pvt. Ltd., which is operating for the last 5 years, has approached Sudershan Industries for grant of credit limit on account of goods bought from the latter, annexing Balance Sheet and Income Statement for the last 2 years as below:Pullock Co. Pvt. Ltd. – Balance Sheet (Rs. ‘000) Liabilities Current year Last year Assets Current year Last year

Share Capital Equity (Rs.10) Share Premium Retained Earnings Total Equity First Mortgage Second Mortgage Bonds Long-term Liabilities Account Payable Notes Payable Secured Liabilities Total Liabilities Current

600 400 900 1,900 200 -300 500 300 600 100 1,000 3,400

Plant & Equipment 600 (Less Depreciation) 400 Land 700 1,700 Total Fixed Assets 300 Inventories 200 Account Receivable 300 Marketable Securities 800 Cash 60 Total Current Assets 220 70 350 2,850

1,500 750 2,250 580 350 120 100 1,150

1,400 750 2,150 300 200 120 80 700

3,400

2,850

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Pollock Co. Pvt. Ltd. – Income Statement (Rs.’000) Particulars Current Year Last Year

Sales Income from investments Opening inventory Total Manufacturing Costs Ending Inventory General and Admn. Expenses Operating Income Interest Expenses Earnings before Taxes Income-tax Net Income after Taxes Dividend declared and paid

5,980 20 300 4,200 (580) 3,920 2,080 950 1,130 60 1,070 480 590 6,000

5,780 20 400 3,200 (300) 3,300 2,500 750 1,750 62 1,688 674 1,014 250 5,800

Sudershan Industries has established the following broad guidelines for granting credit limits to its customers: (i) (ii) Limit credit limit to 10% of net worth and 20% of the net working capital. Not to give credit in excess of Rs.1,00,000 to any single customer.

You are required to detail the steps required for establishing credit limits to Pollock Co. Pvt. Ltd. In this case what you consider to be reasonable credit limit. 23 The annual cash requirement of A Ltd. is Rs.10 lakhs. The company has marketable securities in lot sizes of Rs.50,000, Rs.1,00,000, Rs.2,00,000, Rs.2,50,000 and Rs.5,00,000. Cost of conversion of marketable securities per lot is Rs.1,000. The company can earn 5% annual yield on its securities. You are required to prepare a table indicating which lot size will have to be sold by the company. Also show that the economic lot size can be obtained by the Baumol Model. 24. JPL has two dates when it receives its cash inflows, i.e., Feb. 15 and Aug. 15. On each of these dates, it expects to receive Rs.15 crore. Cash expenditure are expected to be steady throughout the subsequent 6 month period. Presently, the ROI in marketable

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securities is 8% per annum, and the cost of transfer from securities to cash is Rs.125 each time a transfer occurs. (i) (ii) What is the optimal transfer size using the EOQ model? What is the average cash balance? What would be your answer to part (i), if the ROI were 12% per annum and the transfer costs were Rs.75/-? Why do they differ from those in part (i)?

25. Beta Limited has an annual turnover of Rs.84 crores and the same is spread over evenly each of the 50 weeks of the working year. However, the pattern within each week is that the daily rate of receipts on Mondays and Tuesdays is twice that experienced on the other three days of the week. The cost of banking per day is estimated at Rs.2,500. It is suggested that banking should be done daily or twice a week. Tuesdays and Fridays as compared to the current practice of banking only on Fridays. Beta Limited always operates on bank overdraft and the current rate of interest is 15% per annum. This interest charge is applied by the bank on a simple daily basis. Ignoring taxation, advise Beta Limited the best course of banking. For your exercise, use 360 days a year for computational purposes. 26. The following is the Balance Sheet of Amar Industries Ltd. as at 31st March, 2006:(Rs. lakhs) Liabilities

Capital and Reserves 12% Debentures Creditors for purchases Creditors for expenses Provision for bonus Provision for tax Proposed dividendsAssets

1,650 900 600 70 30 100 50 3,400

Fixed Assets at costLess: Depreciation

1,300 400 900 700 1,200

Sundry debtors Stocks and stores7.102


Loans and advances Cash and bank balances

500 100 3,400

The projected Profit and Loss Account for the first four months in 2006-2007 shows the following:(Rs.lakhs)

Particulars Sales Excise duty recoveries (a) Materials: Opening StockAdd: Purchases Less: Closing Stock

April 800 80 880 1200 600 1200 600 180 80 (b) 860 20 (a)-(b)

May 800 80 880 1200 660 1260 600 180 84 864 16

June 900 90 990 1260 720 1320 660 200 88 948 42

July 900 90 990 1320 720 1320 720 200 92 1012 (22)

Net Expenses Excise duty Profi/(Loss)t

The following are relevant additional information: (i) (ii) 10% of sales are for cash and the balance on 30 days’ credit. Creditors for purchases are paid in 30 days. (a) interest payable at the end of each quarter. (b) depreciation of Rs.10 lakhs per month; (c) provision for bonus to workmen of Rs.5 lakhs per month, payable only in October, 2006. (d) one-half of rest of the expenses payable in the month following.

(iii) Expenses include:

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(iv) Rs.250 lakhs of debentures are redeemable by 30th June. (v) Provision for taxation includes Rs.70 lakhs of surplus provision carried forward from earlier years besides the balance for the year 2005-2006 payable before 30th June, 2006. (vi) Annual General Meeting is to be held on 31st May, 2006. (vii) Over-draft is permissible interest on which may be ignored. You are required to prepare the cash budgets for the months of April to July, 2006 on a monthly basis. 27. The following information is available in respect of ABC Ltd: (1) Materials are purchased and received one month before being used and payment is made to suppliers two months after receipt of materials. (2) Cash is received from customers three months after finished goods are sold and delivered to them. (3) No time lag applies to payment of wages and expenses. (4) The following figures apply to recent and future months:Month Materials received Sales Wages and Expenses

January Febuary March April May June July August

20,000 22,000 24,000 26,000 28,000 30,000 32,000 34,000

30,000 33,000 36,000 39,000 42,000 45,000 48,000 51,000

9,500 10,000 10,500 11,000 11,500 12,000 12,500 13,000

(5) Cash balance at the beginning of April is Rs.10,000. (6) all products are sold immediately they have been made and that materials used and sums spent on wages and expenses during any particular month relate strictly to the sales made during that month. Prepare cash flow forecast month by month from April to July, profit and loss forecast for four months (April-July) and a movement of funds statement for the four-month period (April-July).

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28. Fixed overheads excluding bank interest amount to Rs.6,00,000 per annum spread out evenly throughout the year. Sales forecast is as under:Product July August Sept. Oct. Nov. 2005

L B

4,200 2,100

4,600 2,300

3,600 1,800

4,000 2,000

4,500 1,900

Production: 75% of each months’ sales will be produced in the month of sale and 25% in the previous months. Sales Pattern: L: -One-third of sales will be on cash basis on which cash discount of 2% is allowed. -One third will be on documents against payment basis. The documents will be discounted by the bank in the month of sales itself. -Balance of one-third will be on documents against acceptance basis. The payment under this scheme will be received in the third month. For e.g. for sales made in September, payment will be received in November. B: 80% of the sales will be against cash to be received in the month of sales and the balance 20% will be received next following month.

Direct Materials: 50% of the direct materials required for each month’s production will be purchased in the previous month and the balance in the month of production itself. The payment will be made in the month next following the purchase. Direct Wages: 80% of the direct wages will be paid in the month of use of direct labour for production and the balance in the next following month. Variable Overheads: 50% to be paid in the month of incurrence and the balance in the next following month. Fixed Overheads: 40% will be paid in the month of incurrence and the other 40% in the next following month. The balance of 20% represents depreciation.

The bill discounting charges payable to the bank in the month in which the bills are discounted amount to 50 paise per Rs.100 of bills discounted. A cash balance of Rs.1,00,000 will be maintained on 1st July, 2006. Prepare a cash budget monthwise for July, August and September, 2006.7.105


29. A new manufacturing company is to be incorporated from January 1, 2003. Its authorised capital will be Rs.2 crore divided into 20 lakh equity shares of Rs.10 each. It intends to raise capital by issuing equity shares of Rs.1 crore (fully paid) on 1st January. Besides, a loan of Rs.13 lakh @12% per annum will be obtained from a financial institution on 1st January and further borrowings will be made at the same rate of interest on the first day of the month in which borrowing is required. All borrowings will be repaid alongwith interest on the expiry of one year. The company will make payment for the following assets in January:(Rs. lakhs)

Plant and Machinery Land and Building Furniture Motor Vehicles Stock of Raw Materials The following further details are available: (i) Projected Sales (January-June):(Rs. lakhs)

20 40 10 10 10

(Rs. lakhs)

January February March (ii) Gross Profit will be 25% on sales.

30 35 35

April May June

40 40 45

(iii) The company will make credit sales only and these will be collected in the second month following sales. (iv) Creditors will be paid in the first month following credit purchases. There will be credit purchases only. (v) The company will keep minimum stock of raw materials of Rs.10 lakhs. (vi) Depreciation will be charged @10% per annum on cost on all fixed assets. (vii) Payment of preliminary expenses of Rs.1 lakh will be made in January.

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(viii) Wages and salaries will be Rs.2 lakhs each month and will be paid on the first day of the next month. (ix) Administrative expenses of Rs.1 lakh per month will be paid in the month of their incurrence. Assume no minimum required cash balance. You are required to prepare the monthly cash budget (January-June), the projected Income Statement for the 6 month period and the projected Balance Sheet as on 30th June, 2003. 30. Dyer Ltd. manufactures a variety of products using a standardized process, which takes one month to complete. Each production batch is started at the beginning of a month and is transferred to finished goods at the beginning of the next month. The cost structure, based on current selling price is: % Sale Price Variable Costs Raw Materials Other Variable Costs Total Variable Cost – used for Stock Valuation Contribution 30 40 70 30 100

Activity levels are constant throughout the year and annual sales, all of which are made on credit are Rs.24,00,000. Dyer Ltd. is now planning to increase sales volume by 50% and unit sales price by 10%, such expansion would not alter the fixed costs of Rs.50,000 per month, which includes monthly depreciation of plant of Rs.10,000. Similarly raw material and other variable costs per unit will not alter as a result of the price rise. In order to facilitate the envisaged increases several changes would be required in the long run. The relevant changes are:(i) (ii) The average credit period allowed to customers will increase to 70 days; Suppliers will continue to be paid on strictly monthly terms;

(iii) Raw material stocks held will continue to be sufficient for one month’s production; (iv) Stocks of finished goods held will increase to one month’s output;

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(v) There will be no change in the production period and other variable costs will continue to be paid for in the month of production; (vi) The current end-of-month working capital position is:(Rs.’000)

Raw Materials WIP Finished Goods Debtors Creditors Net Working Capital – Excluding Cash

60 140 70 270 200 470 60 410

Compliance with the long-term changes required by the expansion will be spread over several months. The relevant points concerning the transitional arrangements are: (i) (ii) The cash balance anticipated at the end of the May is Rs.80,000. Upto and including June all sales will be made on one month’s credit. From July all sales will be on the transitional credit terms which will mean: 60% of sales will take 2 months’ credit. 40% of sales will take 3 months’ credit. (iii) Sale price increase will occur with effect from sales in the month of August. (iv) Production will increase by 50% with effect from the month of July. Raw material purchases made in June will reflect this. (v) Sales volume will increase by 50% from sales made in October. Required: (a) Show the long-term increase in annual profit and long-term working capital requirements as a result of the plans for expansion and a price increase. (Costs of financing the extra working capital requirements may be ignored). (b) Produce a monthly cash forecast for the period from June to December, the first seven months of the transitional period. Prepare also a working capital position at the end of December.

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(c) Using your findings for (a) and (b) above, make brief comments to the management of Dyer Ltd. on the major factors concerning the financial aspects of the expansion which should be brought to their attention. Assume that there are 360 days in a year and each month contains 30 days.

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19107552 13823737 Cost Accounting and Financial Management[1]

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