NATURE & CHARACTERISTICS OF MANAGEMENT

55A. ANANDA KUMAR / INDUSTRIAL MANAGEMENT / UNIT-2

INDUSTRIAL MANAGEMENTUNIT 2FINANCIAL MANAGEMENTAll business decisions have financial implications. A single decision may financially affect different departments of an oganisation. Financial management may be described as making decisions on financial matters, implementing the decisions and review of the implementation. It is the process of managing the finance function.According to Archer ad Ambrosio, Financial management is the application of the planning and control functions to the finance function.In the words of Guthman and Dougall, Business finance may be defined as the activity concerned with planning, raising, controlling and administering of the funds. It includesFinance planningRaising of financial resourcesManagement of financial resources and Control of financial resources

OBJECTIVES OF FINANCIAL MANAGEMENTFinancial management is concerned with the raising of funds and their effective utilization. The firm has to procure the funds at the minimum possible cost and use them efficiently. For this purpose, the following decisions are to be made.Investment decisionsFinancial decisionsDividend decisions

1. Investment Decisions: Investment decision is the most important financial decision. It is concerned with deciding the total amount of assets to be held in the firm and their composition. The investment decisions are of two types:a. Long term Investment Decision: Long term investment decision refers to the capital expenditure decision. It is also known as capital budgeting. It involves the evaluation of various capital expenditure proposals in terms of their cost, revenue, profit and risks. Pay-back period, Accounting Rate of Return, Net Present Value, Net Present Value Index and Internal Rate of Return are widely used for evaluation of investment proposals.b. Short-term Investment Decision: Short-term investment decision is concerned with the management of working capital. It is also known as liquidity decision. It involves decisions regarding investment in current assets, allocation of funds among cash, receivables inventories etc.2. Financing Decision: Once the investment decision is made, the finance manager has to decide the sources of finance for financing the investment. Debt and equity are two major sources of long-term finance. Use of debt helps to enhance the earnings of the shareholder. But excessive debt increases the risk. Therefore, the choice must be made in such a way that the capital structure is optimum and the value of the firm is maximized. In practice, factors such as control, management, flexibility, legal aspects, and long covenants are also considered in deciding the capital structure.3. Dividend Decision: Dividend decision is concerned with deciding the quantum of profits to be distributed to share holders (payout). The finance manager has to decide whether the firm should distribute all the profits, retain all the profits or distribute a portion and retain the balance. The finance manager should generally aim at an optimum dividend payout, which maximizes the value of the firm. However, he should also consider factors like dividend stability, issue of bonus shares, aspirations of shareholders, industry practices and taxation in making dividend decisions.PURPOSE OF INVESTMENTIn a business enterprise, money is invested for the following purposes:To procure land, buildings or for making expansion of the existing plant.For getting raw material, machinery, instruments, tools etc.For purchasing material transporting vehicles.On water, power, gas and other supplies for running the enterprise.For administrative and selling services.On development projects and diversification of products.For increasing companys manufacturing capability.Research work, e.g., on cost reduction, etc.For paying salaries for direct and indirect workers.To organize the business.

CAPITALThe termCapitalhas several meanings and it is used in many business contexts. In general, capital is accumulated assets or ownership. It is the life-blood of a business enterprise. Capital is a universal lubricant which keeps enterprise dynamic. Capital designates physical sources when applied to production and (it means) money when applied to finance. It covers all the elements (e.g., money, land, building, machinery, materials, etc.) a businessman needs to start an enterprise. It is to measure of the amount of resources of an enterprise. Capital develops products, keeps workers and machines at work, encourages management to make progress and create value.TYPES OF CAPITALCapital may be of the following two types:Fixed or Block capitalWorking or Current capital

1. Fixed or Block Capital: Fixed capital is a compulsory initial investment made by the entrepreneur to start up the activities of his business. Fixed assets or capital investments that are needed to start up and conduct business, even at a minimal stage. These capital are considered fixed in that they are not used up in the actual production of a good or service, but have a reusable value. Fixed-capital investments are typically depreciated on the company's accounting statements over a long period of time, up to 20 years or more. Examples include factories, land, office buildings, equipment & machinery, tools, furniture, insurance policies, legal contracts and manufacturing equipment etc. anything that is not continually purchased in the course of production of a good or service.2. Working or Current capital: Working Capital refers to a firms investment in short term assets cash, short term securities, accounts receivable and inventories. Net working capital is defined as current assets minus current liabilities. It refers to all aspects of the administration of both current assets and current liabilities. It is needed in any business because of the time lag between paying for materials and operating costs, and getting the money back again (together with added profit) from the customer.Once fixed assets, e.g., building, equipment, machinery, etc., have been purchased, the enterprise needs funds to meet its day-to-day needs and expenditures such asPurchase of raw material and supplies.Payment of employee wages.Storage costs.Advertisement and selling expenses.Equipment and plant maintenance costsTransportation and shipping expensesExpenditures during the time lag between the sale of the products and payment for them.

Working Capital = Current Assets Current Liabilities

USES OF WORKING CAPITALLoss from business operations would decrease the working capital.The purchase of non-current assets generally causes a decrease in current assets or increase in current liabilities. Therefore, it should appear as the use of funds.The retirement of long-term liabilities such as payment to preferences shareholders and debenture holders involves the use of cash.Dividend to shareholders.Interest to lenders.

SOURCES OF FINANCEIn order to start an industrial concern, i.e., to produce and to sell, there must be adequate finance for purchasing fixed assets (building, machinery, etc.), raw materials and other supplies. There should also be sufficient finance to meet day-to-day expenditures of the enterprise. The sources of finance may be categorized as follows:Internal SourcesExternal Sources

1. Internal Sources:a. Retained Equity Earnings: This implies retaining the earnings of the shareholders for internal reinvestment. Every rupee retained is a rupee with-held from distribution to existing shareholders. While doing so, management must do something to maintain the interest of shareholders.b. Depreciation Provisions: Depreciation provisions represent the maintenance of a capital stock to replace the existing machinery when it becomes uneconomical to use. Depreciation provision is a major source of internally generated funds.c. Deferred Taxation: Due to the time-lag between the earning of profit and payment of the appropriate taxation, the funds, represented by the tax liability, are available for use.d. Personal Funds Saved or Inherited: In order to win confidence or external financiers, it is very necessary that the would-be owner must have assets of his own to invest in the firm.2. External Sources:a. Savings: People save a percentage of their salary for a rainy day. With the money thus saved, people purchase life insurance, but stocks and bonds, buy shares or deposit in a bank. Thus saved money is made available to business enterprises for further use and investment. It may be said that almost all capital for investment in business and industry comes from savings of people.b. Loans: Money can be borrowed from the following sources for starting or expanding the business, Friends and relationsMoney lending institutionsCommercial and other banks, etc.When money is borrowed, it becomes obligatory that the interest should be paid in time and the loan be paid back on the mutually agreed date.

c. Shares: Funds are collected by issuing shares to public. The number of authorized shares that can be issued and the value of each share is specified. This is decided on the basis of the capital to be collected by issuing shares. Shares are issued for raising funds either when starting a new concern or when it is decided to expand and improve upon the existing one. Preference sharesOrdinary shares Deferred sharesd. Debentures: Business corporations having good record of earnings and favourable prospects of expansion, in search for outside (external) funds to support operations and growth, may raise capital by borrowing it on a formal document known as a Debenture. Debenture is a certificate of indebtedness issued by the corporation. A Fixed rate interest is paid on debentures and the amount is repayable after the stated number of years. The essential relationship between the company and the (bond) debenture holder is that of debtor-creditor.

e. Corporate bonds: Corporate bonds are of two types: (1) Unsecured bonds or Debentures as discussed above, and (2) Secured bonds, in which case some form of claim on the assets of the corporation is tied if the corporation fails to pay interest to the investor or does not return his money back after the stated number of years. Mortgage bonds are example of secured bonds.f. Public Deposits: Public may be asked to deposit their money directly with the company for a fixed long/short period ranging from half a year to seven years.g. Taking in partners: Capital may be raised by adding partners in the business who are ready to invest in the firm.h. Bank loans: Short term loans are easily available from commercial and other banks on reasonable interest rates.i. Hire purchase: The hirer makes a deposit, he gets the machinery (goods), etc., he needs and then he pays a number of periodical money installments. At the end of a period when all the installments have been paid, the possession of the goods passes to the hirer.EVALUATION OF INVESTMENT1. Payback Period: Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.Formula: The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is: Initial InvestmentPayback period = Cash Inflow per periodWhen cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: B Payback period = A + CIn the above formula,A is the last period with a negative cumulative cash flow;B is the absolute value of cumulative cash flow at the end of the period A;C is the total cash flow during the period after ABoth of the above situations are applied in the following examples.Decision RuleAccept the project only if its payback period is LESS than the target payback period.Example 1: Even Cash FlowsCompany C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.SolutionPayback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 yearsExample 2: Uneven Cash FlowsCompany C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.Solution(cash flows in millions)CumulativeCash FlowYearCash Flow

0(50)(50)110(40)213(27)316(11)419852230Payback Period= 3 + (|-$11M| $19M)= 3 + ($11M $19M) 3 + 0.58 3.58 yearsAdvantages and Disadvantages of Payback PeriodAdvantages of payback period are:Payback period is very simple to calculate.It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are.For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

Disadvantages of payback period are:Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method.It does not take into account, the cash flows that occur after the payback period.

2. Accounting Rate of Return (ARR): Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.Formula: Accounting Rate of Return is calculated using the following formula:

Average Accounting Profit ARR = Average InvestmentAverage accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.Decision Rule: Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.Solution Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years Annual Depreciation = ($130,000 $10,500) 6 $19,917 Average Accounting Income = $32,000 $19,917 = $12,083 Accounting Rate of Return = $12,083 $130,000 9.3%Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in thousands of dollars. Use the straight line depreciation method.Project A:Year 0 1 2 3Cash Outflow -220Cash Inflow 91 130 105Salvage Value 10Project B:Year 0 1 2 3Cash Outflow -198Cash Inflow 87 110 84Salvage Value 18SolutionProject A:Step 1: Annual Depreciation = (220 10 ) / 3 = 70Step 2: Year 1 2 3 Cash Inflow 91 130 105 Salvage Value 10 Depreciation* -70 -70 -70 Accounting Income 21 60 45Step 3: Average Accounting Income = (21 + 60 + 45 ) / 3 = 42Step 4: Accounting Rate of Return = 42 / 220 = 19.1%Project B:Step 1: Annual Depreciation = (198 18) / 3 = 60Step 2: Year 1 2 3 Cash Inflow 87 110 84 Salvage Value 18 Depreciation* -60 -60 -60 Accounting Income 27 50 42Step 3: Average Accounting Income = (27 + 50 + 42) / 3 = 39.666Step 4: Accounting Rate of Return = 39.666 / 198 20.0%Since the ARR of the project B is higher, it is more favorable than the project A.Advantages and Disadvantages Accounting Rate of Return:AdvantagesLike payback period, this method of investment appraisal is easy to calculate.It recognizes the profitability factor of investment.

DisadvantagesIt ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher.It can be calculated in different ways. Thus there is problem of consistency.It uses accounting income rather than cash flow information. Thus it is not suitable for projects which having high maintenance costs because their viability also depends upon timely cash inflows.

3. Net Present Value (NPV): Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money by using discounted cash inflows.Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.Calculation Methods and FormulasThe first step involved in the calculation of NPV is the determination of the present value of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). When they are even, present value can be easily calculated by using the present value formula of annuity. However, if they are uneven, we need to calculate the present value of each individual net cash inflow separately.In the second step we subtract the initial investment on the project from the total present value of inflows to arrive at net present value.Thus we have the following two formulas for the calculation of NPV:When cash inflows are even: 1 (1 + i)-nNPV= R Initial Investment i

In the above formula,R is the net cash inflow expected to be received each period;i is the required rate of return per period;n are the number of periods during which the project is expected to operate and generate cash inflows.When cash inflows are uneven: R1 R2 R3 NPV= + + + Initial Investment (1 + i)1 (1 + i)2 (1 + i)3

Where, i is the target rate of return per period; R1 is the net cash inflow during the first period; R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third period, and so on ...Decision RuleAccept the project only if its NPV is positive or zero. Reject the project having negative NPV. While comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV.Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month for 12 months. Assume that the salvage value of the project is zero. The target rate of return is 12% per annum.SolutionWe have, Initial Investment = $243,000 Net Cash Inflow per Period = $50,000 Number of Periods = 12Discount Rate per Period = 12% 12 = 1%Net Present Value = $50,000 (1 (1 + 1%)^-12) 1% $243,000 = $50,000 (1 1.01^-12) 0.01 $243,000 $50,000 (1 0.887449) 0.01 $243,000 $50,000 0.112551 0.01 $243,000 $50,000 11.2551 $243,000 $562,754 $243,000 $319,754Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320 thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present value of the investment if the discount rate is 18%. Round your answer to nearest thousand dollars.SolutionPV Factors:Year 1 = 1 (1 + 18%)^1 0.8475 Year 2 = 1 (1 + 18%)^2 0.7182Year 3 = 1 (1 + 18%)^3 0.6086 Year 4 = 1 (1 + 18%)^4 0.5158The rest of the problem can be solved more efficiently in table format as show below:Year1234Net Cash Inflow $3,411 $4,070 $5,824 $2,065 Salvage Value 900 Total Cash Inflow $3,411 $4,070 $5,824 $2,965 Present Value Factor 0.8475 0.7182 0.6086 0.5158 Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31 Total PV of Cash Inflows $10,888 Initial Investment 8,320 Net Present Value $2,568 thousand Advantage and Disadvantage of NPVAdvantage: Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal techniques which do not discount future cash flows such payback period and accounting rate of return.Disadvantage: It is based on estimated future cash flows of the project and estimates may be far from actual results.4. Internal Rate of Return (IRR): Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal.Decision RuleA project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted.IRR CalculationThe calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus:NPV = 0; orPV of future cash flows Initial Investment = 0; or CF1 CF2 CF3 + + + Initial Investment= 0 (1 + r)1 (1 + r)2 (1 + r)3

Where,r is the internal rate of return;CF1 is the period one net cash inflow;CF2 is the period two net cash inflow,CF3 is the period three net cash inflow, and so on ...But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However, there are alternative procedures which can be followed to find IRR. The simplest of them is described below:Guess the value of r and calculate the NPV of the project at that value.If NPV is close to zero then IRR is equal to r.If NPV is greater than 0 then increase r and jump to step 5.If NPV is smaller than 0 then decrease r and jump to step 5.Recalculate NPV using the new value of r and go back to step 2.

ExampleFind the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first, second, third and fourth years are expected to be $65,200, $98,000, $73,100 and $55,400 respectively.Solution Assume that r is 10%. NPV at 10% discount rate = $18,372 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $204 NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14%Parts of Final AccountsThe final account of business concern generally includes two parts. The first part is Trading and Profit and Loss Account. This is prepared to find out the net result of the business. The second part is Balance Sheet which is prepared to know the financial position of the business. However manufacturing concerns, will prepare a Manufacturing Account prior to the preparation of trading account, to find out cost of production.1. Trading AccountTrading means buying and selling. The trading account shows the result of buying and selling of goods.NeedAt the end of each year, it is necessary to ascertain the net profit or net loss. For this purpose, it is first necessary to know the gross profit or gross loss. The trading account is prepared to ascertain this.The difference between the selling price and the cost price of the goods is the gross earning of the business concern. Such gross earning is called as gross profit. However, when the selling price is less than the cost of goods purchased, the result is gross loss.

Format of a Trading Account

2. Profit and Loss AccountAfter calculating the gross profit or gross loss the next step is to prepare the profit and loss account. To earn net profit a trader has to incur many expenses apart from those spent for purchases and manufacturing of goods. If such expenses are less than gross profit, the result will be net profit. When total of all these expenses are more than gross profit the result will be net loss.Need:The aim of profit and loss account is to ascertain the net profit earned or net loss suffered during a particular period.

3. Balance Sheet:This forms the second part of the final accounts. It is a statement showing the financial position of a business. Balance sheet is prepared by taking up all personal accounts and real accounts (assets and properties) together with the net result obtained from profit and loss account. On the left hand side of the statement, the liabilities and capital are shown. On the right hand side, all the assets are shown. Balance sheet is not an account but it is a statement prepared from the ledger balances. So we should not prefix the accounts with the words To and By.Balance sheet is defined as a statement which sets out the assets and liabilities of a business firm and which serves to ascertain the financial position of the same on any particular date.Need:The need for preparing a Balance sheet is as follows:i. To know the nature and value of assets of the businessii. To ascertain the total liabilities of the business.iii. To know the position of owners equity.FormatThe Balance sheet of a business concern can be presented in the following two formsi. Horizontal form or the Account formii. Vertical form or Report formi) Horizontal form of Balance Sheet:The right hand side of the balance sheet is asset side and the left hand side is liabilities side. All accounts having debit balance will appear in the asset side and all those having credit balance will appear in the liability side.

ii) Vertical form of Balance Sheet:In this, Balance Sheet is presented in a statement form.

Financial AccountingAccounting can be defined as an information system that provides information about the results of a business' performance and its economic position.The main objective of a business is to maximize profit. The goal of maximization of profit cannot be materialized unless there is constant monitoring by those charges with management and governance. Accounting asks as a language through which the business speaks for itself.Financial Accounting generates financial statements which provide information most relevant to users which are outside the company such as investors, lenders, government authorities, rating agencies, etc.Financial AccountsManagement Accounts Financial accounts describe the performance of a business over a specific period and the state of affairs at the end of that period. The specific period is often referred to as the "Trading Period" and is usually one year long. The period-end date as the "Balance Sheet Date" Management accounts are used to help management record, plan and control the activities of a business and to assist in the decision-making process. They can be prepared for any period (for example, many retailers prepare daily management information on sales, margins and stock levels). Companies that are incorporated under the Companies Act 1989 are required by law to prepare and publish financial accounts. The level of detail required in these accounts reflects the size of the business with smaller companies being required to prepare only brief accounts. There is no legal requirement to prepare management accounts, although few (if any) well-run businesses can survive without them. The format of published financial accounts is determined by several different regulatory elements:Company LawAccounting StandardsStock Exchange

There is no pre-determined format for management accounts. They can be as detailed or brief as management wish. Financial accounts concentrate on the business as a whole rather than analysing the component parts of the business. For example, sales are aggregated to provide a figure for total sales rather than publish a detailed analysis of sales by product, market etc. Management accounts can focus on specific areas of a business' activities. For example, they can provide insights into performance of:ProductsSeparate business locations (e.g. shops)Departments / divisions

Most financial accounting information is of a monetary nature Management accounts usually include a wide variety of non-financial information. For example, management accounts often include analysis of:Employees (number, costs, productivity etc.)Sales volumes (units sold etc.)Customer transactions (e.g. number of calls received into a call centre)

By definition, financial accounts present a historic perspective on the financial performance of the business Management accounts largely focus on analysing historical performance. However, they also usually include some forward-looking elements - e.g. a sales budget; cash-flow forecast.

Managerial AccountingManagement accounting or managerial accounting is the process of identifying, analyzing, recording and presenting financial information that is used for internally by the management for planning, decision making and control.In contrast to financial accounting, managerial accounting is concerned with providing helpful information and reports to internal users such as managers and entrepreneurs etc. so that they can control and plan the business activities. Few of the main areas, in which managerial accounting is used are:Planning and Budgeting: Managers use managerial accounting techniques to plan what to sell, how much to sell, what price is to be charged to reimburse the costs of production and also earn an optimal profit. Also they have to plan how to finance the operations and how to manage cash etc. This is very important to keep the business operations working smoothly. The capital budgeting and master budget are the two important topics in this area.Decision Making: When managers have to decide whether or not to start a particular project, they need managerial accounting information to estimate the benefits of various opportunities and decide which one to choose. Mangers often use relevant costing techniques.Measurement of Performance: Managers have to compare the actual results of operations to budgeted figures to evaluate the performance of the business. They use managerial accounting techniques such as standard costing to evaluate the performance of specific departments. They then make necessary adjustments in those departments which are not performing well.

AdvantagesSince it is focused on making future decisions with the help of past financial data, it is forward looking and therefore progressive in nature.It is meant for internal users like top management and therefore it is not necessary that it is made by following strict guidelines which is the case with financial accounting.It is flexible in nature and therefore it can be prepared anytime and they are not required to be made yearly they can be made monthly or on weekly basis.It takes all the data and then present it in such a way that a proper analysis about the feasibility and profitability of any business decision can be made.

DisadvantagesIt is dependent on cost accounting and financial accounts and therefore the accuracy of it is also dependent on how accurate that data is, hence it is one of the limitations as far as its usability is concerned.It is affected by the bias of top management and therefore it is likely that they may tweak it in such a way so as to benefit themselves rather than shareholders.Since it does not follow accounting principles, it cannot be compared with other companys and hence proper evaluation about the management may not be possible on the basis of management accountancy.

Cost accountingCost accounting is a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant for a particular environment. Cost accounting information is commonly used in financial accounting information, but first we are concentrating on its use by managers to make decisions.Unlike the accounting systems that help in the preparation of financial reports periodically, the cost accounting systems and reports are not subject to rules and standards like the Generally Accepted Accounting Principles. As a result, there is wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.Cost Accounting vs Financial AccountingFinancial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/service in a scientific manner and facilitate cost control and cost reduction.Financial accounting reports the results and position of business to government, creditors, investors, and external parties owners etc. Cost Accounting is an internal reporting system for an organizations own management for decision making.

In financial accounting, cost classification based on type of transactions, e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is basically on the basis of functions, activities, products, process and on internal planning and control and information needs of the organization.Financial accounting aims at presenting true and fair view of transactions, profit and loss for a period and Statement of financial position (Balance Sheet) on a given date. It aims at computing true and fair view of the cost of production/services offered by the firm.

Classification of costsClassification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:By Element: There are three elements of costing i.e. material, labor and expenses.By Nature or Traceability: Direct Costs and Indirect Costs. Direct Costs are Directly attributable/traceable to Cost Object. Direct costs are assigned to Cost Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect costs are allocated or apportioned to cost objects.By Functions: production, administration, selling and distribution, R&D.By Behavior: fixed, variable, semi-variable. Costs are classified according to their behavior in relation to change in relation to production volume within given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. Variable costs change according to volume of production. Semi-variable Costs are partly fixed and partly variable.By control ability: controllable, uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious management action. Uncontrollable costs cannot be controlled or influenced by a conscious management action.By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-day business operations. Abnormal costs arise because of any abnormal activity or event not part of routine business operations. E.g. costs arising of floods, riots, accidents etc.By Time: Historical Costs and Predetermined costs. Historical costs re costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. Example: Standard Costs.By Decision making Costs: These costs are used for managerial decision making.

Marginal Costs: Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.Differential Costs: This cost is the difference in total cost that will arise from the selection of one alternative to the other.Opportunity Costs: It is the value of benefit sacrificed in favor of an alternative course of action.Relevant Cost: The relevant cost is a cost which is relevant in various decisions of management.Replacement Cost: This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date.Shutdown Cost: These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued.Capacity Cost: These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions.Other Costs

AdvantagesIt is objective.It is easily understood by users.It is easy to apply.It provides useful information to users.It is prudent. Where there is uncertainty, measuring non-current assets at historical cost is a cautious approach.It has stood the test of time. Systems of current cost accounting and fair value accounting are based on academic theories and have never really been proved to work in practice.If (for example) the current market prices of property or investments are very different from their historical cost, this information can be disclosed in the notes to the financial statements. There is no need to adjust the amounts in the statement of financial position or the other primary statements.Use of fair values and current values can encourage management to manipulate the amounts in the financial statements, because current value can only be an estimate.Current value accounting anticipates profits that may never be realised.Because market values can fluctuate, using fair value can cause volatility in the financial statements.

DisadvantagesNon-current asset values are unrealistic. The most striking example is property.Depreciation is inadequate to finance the replacement of non-current assets. Depreciation is not provided for in order to enforce retention of profits and therefore ensure that funds are available for asset replacement. It is intended as a measure of the contribution of non-current assets to an entitys activities in the period.Holding gains on inventories are included in profit. During a period of high inflation the monetary value of inventories held may increase significantly while they are being processed. The conventions of historical cost accounting lead to the unrealised part of this holding gain (known as inventory appreciation) being included in profit for the year.Profits (or losses) on holdings of net monetary items are not shown.The true effect of inflation on capital maintenance is not shown.Comparisons over time are unrealistic.Historical cost no longer reflects economic reality.

Types of costs1. Fixed Costs: Fixed costs are expenses that do not change in proportion to the activity of a business, within the relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales. 2. Variable Costs: Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable. 3. Average Cost: Average cost is equal to total cost divided by the number of goods produced.4. Total Cost/Output: It is also equal to the sum of average variable costs (total variable costs divided by Output) 5. Marginal Cost: Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. So, the marginal costs involved in making one more wooden table are the additional materials and labour cost incurred.6. Direct Costs: Direct costs can be defined as costs which can be accurately traced to a cost object with little effort. Cost object may be a product, a department, a project, etc. Direct costs typically benefit a single cost object therefore the classification of any cost either as direct or indirect is done by taking the cost object into perspective. A particular cost may be direct cost for one cost object but indirect cost for another cost object.Most direct costs are variable but this may not always be the case. For example, the salary of a supervisor for a month who has only supervised the construction of a single building is a direct fixed cost incurred on the building.Examples: Cost of gravel, sand, cement and wages incurred on production of concrete.7. Indirect Costs: Costs which cannot be accurately attributed to specific cost objects are called indirect costs. These typically benefit multiple cost objects and it is impracticable to accurately trace them to individual products, activities or departments etc.Examples: Cost of depreciation, insurance, power, salaries of supervisors incurred in a concrete plant.BREAK-EVEN ANALYSISIntroductionBreak-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").The Break-Even ChartIn its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.Fixed CostsFixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.Examples of fixed costs: - Rent and rates - Depreciation - Research and development - Marketing costs (non- revenue related) - Administration costsVariable CostsVariable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.A distinction is often made between "Direct" variable costs and "Indirect" variable costs.Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.Semi-Variable CostsWhilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

WORKING CAPITAL MANAGEMENTWorking capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.CalculationCurrent assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:accounts receivable (current asset)inventory (current assets), andaccounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilitiesfor example has paid off some short-term creditors, or a combination of both.Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:Current Assets Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances.Cash balance items often attract a one-for-one, purchase-price adjustment.

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.Decision criteriaBy definition, working capital management entails short-term decisionsgenerally, relating to the next one-year periodwhich are "reversible". These decisions are therefore not taken on the same basis as capital-investment decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.One measure of cash flow is provided by the cash conversion cyclethe net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See economic value added (EVA).

Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.

Management of working capital - GuideGuided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.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 minimizes reordering costs - and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantityDebtors 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); see Discounts and allowances.Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

CONCEPTS OF WORKING CAPITALThe two concepts of working capital are1. Gross working capital: It refers to the investment made by the company in current assets. Current assets are the assets which can be converted into cash with an accounting year or operating cycle. It also includes cash, short-term securities, debtors, bills receivable and stock.2. Net working capital: The difference between current assets and current is called the net working capital. Current liabilities are the one which is claimed from the outsiders and are expected to be returned within an accounting year. It includes creditors, bills payable, and out siding expenses.Net working capital may be positive or negative. A net working capital becomes positive only when the current assets exceed current liabilities. A negative net working capital occurs when current liabilities exceed current assets.TWO DANGEROUS POINTS OF CURRENT ASSETSDanger of inadequate working capitalInadequate working capital will lead to a condition, in which one cannot pay its short-term liabilities in time. So there arises a situation where there is a loss of reputation and tight credit terms. The organizations requirements cannot be fulfilled in bulk; hence it cannot take the advantage of cash discounts.Difficulties will arise in meeting the day-to-day expenses. This will lead to inefficiency and increase in costs with the minimum profits.Lack of working capital will lead to less favorable marketing conditions and less profitable projects.Due to scarcity of working capital, fixed assets are not properly utilized. Thus this results in the fall of investments return.

Danger of Excessive Working CapitalExcessive working capital will lead to low investments in fixed assets. Hence there will be no profits for the business and there can be no proper rate of return on its investments.The low rate of return on investment will lead to the fall in the value of shares.Excessive working capital will lead to unnecessary purchasing and excessive amount of inventories. As a result, there are chances of theft and loses. Excessive debtors and defective credit policy are the indication of excessive working capital. There may be delay in collection and increased incidence of bad debts.Excessive working capital will make the management complacent. This will lead to overall inefficiency in the organization.

NEED FOR WORKING CAPITAL MANAGEMENTBeyond the limit, both the current assets i.e., inadequate working capital and excessive working capital are dangerous. Beyond the limitations of both the level, the common goal of the organization cannot be achieved. Working capital Management provides effective and efficient decision to allocate the current assets.TYPES OF WORKING CAPITALThe two types of working capital are, 1. Permanent working capital.2. Temporary working capital.1. Permanent Working Capital: As the operating cycle is a continuous process, the need for current assets is felt constantly. The Magnitude of the current assets need not to be the same. It may increase or decrease over the time.However, there is a minimum level of current assets which are continuously required by the firm to continue its business operations. This minimum level of the current assets is known as permanent or fixed working capital. However the permanent working capital line needs not to be horizontal.2. Temporary working capital: On the other hand, when there is a slack period in the market, the investment made on the inventories and account receivable will be low. The change of the extra working capital used to support the production and sales, is known as fluctuating or variable or temporary working capitals. When the company has a peak period of sales, it will have large amount of inventories, when compared to their normal sales. This makes the costumers to invest money for credit sales.