Building Economics and Cost Control

Dr. Sarbesh MishraFinance Area, NICMARHyderabad – 500 084.

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About MyselfName : Dr Sarbesh Mishra

Qualifications 1. B.Com (Hons) 2. Post-graduate in Commerce 3. M.Phil in Commerce 4. Ph.D. (Commerce)

Experience : Joined University of Delhi, as a Lecturer in Commerce in 2001 and continued till 2005 and then joined Army Institute of Management, NOIDA as Senior Faculty, Finance prior to current appointment at NICMAR.

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Related to Cost (Thoughts) The most successful man in the life is the

man who has the best information.Benjamin Disraeli, 19th. Century PM of

England Even if you’re on right track, you’ll get run

over if you just sit there.Will Rogers, Certified Cost Analyst

He who controls the past controls future.George Orwell, Certified Public Accountant

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Contd…. You can’t get caught up in things that

you can’t control…….we can’t control our selling price. We can control our cost of manufacturing. We can control our efficiencies. We can control our waste.

Steven Appleton, CEO of Micro Technology If you don’t know where you’re going, it

doesn’t matter how you get there.Prof. Sarbesh Mishra, NICMAR, Hyderabad

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Capital Expenditure (CAPEX)Expenditure expended for the purpose of obtaining long term advantage for the business.

Examples Expenditure incurred in increasing the

quality fixed assets e.g. Purchase of additional furniture, Plant, Building for permanent use in Business.

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Revenue Expenditure“An expenditure that arises out of and in the course of regular business of a concern is termed as revenue expenditure”.

ExampleExpenditure incurred in the normal course of running the business e.g. expenses of administration, maintaining of facilities viz. Electricity, Telephone etc. cost incurred in manufacturing & selling the products, repairs, Depreciation, Interest on loan.

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Importance of Investment Decision Influence the firm’s growth in long-

term They affect the risk of the firm They involve commitment of large

volume of funds They are irreversible, or reversible at

substantial loss They are among most difficult

decisions to make.

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Investment Evaluation Criteria Estimation of Cash flows.

Estimation of required rate of return (Opportunity cost of capital)

Application of decision rule for making the choice

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Cash Flows Cash inflows or outflows occur at three

stages of capital investment project1. Project Initiation (For beginning operations,

Working Capital needs, Replacement of asset)2. Project Operation (Operating Expenditure,

Addl. Working capital need, inflow of cash generated by the investment)

3. Final Project Disposal (Cash inflows or outflows related to investment’s disposal, Cash inflows from the release of working capital no longer committed to the investment)

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Investment appraisal TechniquesTraditional Techniques Payback Period Method Accounting Rate of return MethodDiscounted Cash flow Technique1. Net Present Value method (NPV)2. Internal Rate of Return Method (IRR)3. Profitability Index Method (PI)

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Traditional TechniquesPayback Period Method Payback is the number of years required to

recover the original cash outlay invested in a project.

Payback = Initial Investment Annual Average Cash Flows

Project would be accepted if its payback period is less than the maximum or standard payback period set by management.

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Accounting Rate of Return (ARR) This measures the profitability of an

investment.

ARR = Average IncomeAverage Investment

Projects with higher ARR over the minimum rate established by the management will be accepted.

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DCF Techniques It explicitly recognizes the time value of

money.

Cash flows arising at different time periods differ in their value and are comparable when their present values are found out.

The compound interest rate is used for discounting cash flows is also called as the discount rate.

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Net Present Value Method (NPV) Cash flows of the invested projects should

be forecasted based on realistic assumptions.

Appropriate discount rate should identified to discount the forecasted cash flows.

Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

Net Present Value is found out by subtracting present value of cash inflows.

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NPV Formula

C1, C2 ….. Represent cash inflow in year 1,2 …., k is the opportunity cost of capital C0 is the initial cost of investment n is the expected life of the investment * k is assumed to be known and is constant

nƩt=1

Ct

(1+k)t

- C0 NPV =

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Acceptance Rule1. Accept the project when NPV is positive

2. Reject the project when NPV is negative

3. May accept the project when NPV is zero.

Higher the NPV, the better it is.

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Meaning of Budget A budget is a detailed plan of operations

for some specific future period. According to CIMA, London “a financial

statement, prepared prior to a defined period of time”.

Essentials budget includes:1. It is prepared in advance & is based on

future plan of actions.

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Contd….2. It relates to future period & is based on

objectives to be attained.3. It is a statement expressed in monetary

and/or physical units prepared for the implementation of policy formulated by management.

Different types of budgets are prepared for different types of purposes e.g. sales budget, Manufacturing Cost budget & at the end Master Budget is prepared.

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Classification & Types of BudgetClassification According to Time Long-term budgets. Short-term budgets. Current budgets.Classification on the Basis of

Flexibility Fixed budget. Flexible budget

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Budget, Budgeting & Budgetary Control Budget – Individual objectives of a

department etc. Budgeting – The process/act of

building budgets. Budgetary Control – “It embraces all

the above & includes the science of planning the budgets themselves & the utilization of such budgets to effect an overall management tool for the business planning & Control”

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Activity Based Budgeting Activities that incur costs in every

functional area of an organization are recorded and their relationships are defined and analyzed.

Activities are then tied to strategic goals, after which the costs of the activities needed are used to create the budget.

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Eliminate MudaJapanese Waste Management MUDA means waste, but the word carries a

deeper connotation. Any non-value activity or obstruction to smooth flow of an activity is Muda.

Muda exists in many forms and is to be eliminated.Less Muda = More happy clients (as it impacts quality, cost and delivery of products and services)

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Example Overproduction and Inventory, items

not immediately needed Defective products requesting repair

or scraping Motion; unnecessary movement and

energy used to perform tasks Process imposing inefficient and/or

unnecessary tasks, fail to synchronize systems

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Contd…. Idling; by excessive set-up or

equipment breakdowns Transport, poor timing; too

frequent or infrequent movement of goods and deliveries.

Turning loss into profit by muda elimination is one of the easiest ways for a company to improve its operations

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THANK YOU