Analytical Formulae

8/3/2019 Analytical Formulae

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CHAPTER 1SCOPE AND OBJECTIVES OF FINANCIALMANAGEMENTBASIC CONCEPTS1. Definition of Financial ManagementFinancial management comprises the forecasting, planning, organizing, directing, coordinating

and controlling of all activities relating to acquisition and application of thefinancial resources of an undertaking in keeping with its financial objective.2. Two Basic Aspects of Financial Management

Procurement of Funds:Obtaining funds from different sources like equity,

debentures, funding from banks, etc.

Effective Utilisation of Funds:Employment of funds properly and profitably.

3. Three Stages of Evolution of Financial Management

Traditional Phase:During this phase, financial management was considered

necessary only during occasional events such as takeovers, mergers, expansion,liquidation, etc.

Transitional Phase:During this phase, the day-to-day problems that financial

managers faced were given importance.

Modern Phase:Modern phase is still going on.

4. Two Main Objectives of Financial Management

Profit Maximisation:Profit Maximisation means that the primary objective of a

company is to earn profit.

Wealth / Value maximisation:Wealth / Value maximisation means that the

primary goal of a firm should be to maximize its market value and implies thatbusiness decisions should seek to increase the net present value of the economicprofits of the firm.

Conflict between Profit Maximisation and Wealth / Value maximisation:Out of

the two objectives, profit maximization and wealth maximization, in todays real

world situations which is uncertain and multi-period in nature, wealth maximizationis a better objective.5. Three Important Decisions for Achievement of Wealth Maximization

Investment Decisions: Investment decisions relate to the selection of assets in

which funds will be invested by a firm.

Financing Decisions: Financing decisions relate to acquiring the optimum finance

to meet financial objectives and seeing that fixed and working capitals areeffectively managed.

Dividend Decisions: Dividend decisions relate to the determination as to howmuch and how frequently cash can be paid out of the profits of an organisation asincome for its owners/shareholders.6. Calculation of Net Present Worth(i) W=V C(ii) V=E/K(iii) E=G-(M+T+I)(iv) W= A1/(1+K) + A2/(I+K) + ..+ An/(1+K) - C7. Role of Chief Financial Officer (CFO)


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Today the role of chief financial officer, or CFO, is no longer confined to accounting,financial reporting and risk management. Its about being a strategic business partnerof the chief executive officer.

CHAPTER 2TIME VALUE OF MONEY

1. Time Value of MoneyIt means money has time value. A rupee today is more valuable than a rupee a year hence.We use rate of interest to express the time value of money.2. Simple InterestSimple Interest may be defined as Interest that is calculated as a simple percentage ofthe original principal amount.

Formula for Simple Interest

SI = P0(i)(n)3. Compound InterestCompound interest is the interest calculated on total of previously earned interest andthe original principal.

Formula for Compound Interest

FVn = P0 (1+i)4. Present Value of a Sum of Moneyn

Present value of a sum of money to be received at a future date is determined bydiscounting the future value at the interest rate that the money could earn over theperiod.

Formula for Present Value of a Sum of Money

P0= n FV (1 + i) n

5. Future ValueFuture Value is the value at some future time of a present amount of money, or a series of

payments, evaluated at a given interest rate.

6. AnnuityAn annuity is a series of equal payments or receipts occurring over a specified numberof periods.

Present Value of an Ordinary Annuity: Cash flows occur at the end of each

period, and present value is calculated as of one period before the first cash flow.

Present Value of an Annuity Due: Cash flows occur at the beginning of each

period, and present value is calculated as of the first cash flow.

Formula for Present Value of An Annuity Due

PVAn= = R (PVIFi,n) Future Value of an Ordinary Annuity: Cash flows occur at the end of each

period, and future value is calculated as of the last cash flow.

Future Value of an Annuity Due: Cash flows occur at the beginning of each

period, and future value is calculated as of one period after the last cash flow.

Formula for Future Value of an Annuity Due

FVAn = R (FVIFAi,n)


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7. Sinking Fund

It is the fund created for a specified purpose by way of sequence of periodicpayments over a time period at a specified interest rate.

Formula for Sinking Fund

FVA=R [FVIFA(i,n)]

CHAPTER 3FINANCIAL ANALYSIS AND PLANNING

1. Financial Analysis and PlanningFinancial Analysis and Planning is carried out for the purpose of obtaining material andrelevant information necessary for ascertaining the financial strengths and weaknessesof an enterprise and is necessary to analyze the data depicted in the financial statements.The main tools are Ratio Analysis and Cash Flow and Funds Flow Analysis.2. Ratio AnalysisRatio analysis is based on the fact that a single accounting figure by itself may notcommunicate any meaningful information but when expressed as a relative to some otherfigure, it may definitely provide some significant information. Ratio analysis is comparisonof different numbers from the balance sheet, income statement, and cash flow statement

against the figures of previous years, other companies, the industry, or even the economy ingeneral for the purpose of financial analysis.3. Types of RatiosThe ratios can be classified into following four broad categories:a) Liquidity RatiosLiquidity or short-term solvency means ability of the business to pay its short-termliabilities.

Current Ratios: The Current Ratio is one of the best known measures of financial

strength.Current Assets / Current Liabilities

Quick Ratios: The Quick Ratio is sometimes called the "acid-test" ratio and is one

of the best measures of liquidity. It is a more conservative measure than currentratio.Quick Assets/ Current Liabilities

Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute

liquidity of the business. This ratio considers only the absolute liquidityavailable with the firm.

Cash + Marketable Securities / Current Liabilities = Cash Ratio

Basic Defense Interval: This ratio helps in determining the number of days

the company can cover its cash expenses without the aid of additionalfinancing.Basic Defense Interval = (Cash Receivables Marketable Securities) / ( Operating ExpensesInterest Income Taxes)/365

Net Working Capital Ratio: It helps to determine a company's ability to

weather financial crises over time.Net Working Capital Ratio = Current Assets - Current Liabilities


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(excluding short-term bank borrowing)b) Capital Structure/Leverage RatiosThe capital structure/leverage ratios may be defined as those financial ratioswhich measure the long term stability and structure of the firm.(i) Capital Structure Ratios: These ratios provide an insight into the financingtechniques used by a business and focus, as a consequence, on the longterm

solvency position.

Equity Ratio: This ratio indicates proportion of owners fund to total fund

invested in the business.

Equity Ratio = Shareholders' Equity / Total Capital Employed

Debt Ratio: This ratio is used to analyse the long-term solvency of a firm.

Debt Ratio = Total Debt / Capital Employed

Debt to Equity Ratio: Debt equity ratio is the indicator of leverage.

Debt to Equity Ratio = Debt Preferred Long Term / Shareholders' Equity

(ii) Coverage Ratios: The coverage ratios measure the firms ability toservice the fixed liabilities.

Debt Service Coverage Ratio: Lenders are interested in debt service coverage to

judge the firms ability to pay off current interest and instalments.

Debt Service Coverage Ratio = Earnings available for debt service / Interest Installments

Interest Coverage Ratio:Also known as times interest earned ratio indicates the

firms ability to meet interest (and other fixed-charges) obligations.

Interest Coverage Ratio = EBIT / Interest

Preference Dividend Coverage Ratio: This ratio measures the ability of a firm

to pay dividend on preference shares which carry a stated rate of return.

Pr eference Dividend Coverage Ratio = EAT / Preference dividend liability

Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing

ratio is also calculated to show the proportion of fixed interest (dividend) bearingcapital to funds belonging to equity shareholders.

Capital Gearing Ratio = (Preference Share Capital Debentures Long Term Loan) / (EquityShare Capital Reserves & Surplus Losses)

c) Activity RatiosThese ratios are employed to evaluate the efficiency with which the firm manages andutilises its assets.(i) Capital Turnover RatioThis ratio indicates the firms ability of generating sales per rupee of long term


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investment.

Capital Turnover Ratio = Sales / Capital Employed

(ii) Fixed Assets Turnover Ratio

A high fixed assets turnover ratio indicates efficient utilisation of fixed assets ingenerating sales.

Fixed Assets Turnover Ratio = Sales / Capital Assets

(iii) Working Capital Turnover

Working Capital Turnover = Sales / Working Capital

Working Capital Turnover is further segregated into Inventory Turnover, DebtorsTurnover, Creditors Turnover.

Inventory Turnover Ratio: This ratio also known as stock turnover ratio establishes

the relationship between the cost of goods sold during the year and average inventory heldduring the year.

Inventory Turnover Ratio = Sales / Average Inventory *

* Average Inventory Opening Stock Closing Stock / 2

Debtors Turnover Ratio: The debtors turnover ratio throws light on thecollection and credit policies of the firm

Sales / Average Accounts Receivable

Creditors Turnover Ratio: This ratio shows the velocity of debt payment by thefirm. It is calculated as follows:

Creditors Turnover Ratio = Annual Net Credit Purchases / Average Accounts Payable

d) Profitability RatiosThe profitability ratios measure the profitability or the operational efficiency of the firm.These ratios reflect the final results of business operations.

Return on Equity (ROE) : Return on Equity measures the profitability of equity funds

invested in the firm. This ratio reveals how profitability of the owners funds have been utilised by the firm.

ROE = Profit after taxes / Net worth

Earnings per Share: The profitability of a firm from the point of view of ordinaryshareholders can be measured in terms of number of equity shares. This isknown as Earnings per share.


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Earnings per share (EPS) = Net profit available to equity holders / Number of ordinary

shares outstanding

4. Importance of Ratio AnalysisThe importance of ratio analysis lies in the fact that it presents facts on a comparative basis

and enables drawing of inferences regarding the performance of a firm. It is relevant inassessing the performance of a firm in respect of following aspects:

Liquidity Position

Long-term Solvency

Operating Efficiency

Overall Profitability

Inter-firm Comparison

Financial Ratios for Supporting Budgeting.

5. Cash Flow Statement

Cash flow statement is a statement which discloses the changes in cash position betweenthe two periods. Along with changes in the cash position the cash flow statement also outlinesthe reasons for such inflows or outflows of cash which in turn helps to analyze thefunctioning of a business.6. Classification of Cash Flow ActivitiesThe cash flow statement should report cash flows during the period classified into followingcategories:

Operating Activities: These are the principal revenue-producing activities of the

enterprise and other activities that are not investing or financing activities.

Investing Activities: These activities relate to the acquisition and disposal of longterm

assets and other investments not included in cash equivalents. Cash equivalents

are short term highly liquid investments that are readily convertible into knownamounts of cash and which are subject to an insignificant risk of changes in value.

Financing Activities: These are activities that result in changes in the size and

composition of the owners capital (including preference share capital in the case of acompany) and borrowings of the enterprise.7. Procedure in Preparation of Cash Flow Statement

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 bycomparing these accounts given in the comparative balance sheets. The results willbe cash receipts and payments during the period responsible for the increase ordecrease in cash and cash equivalent items.

Calculation of the net cash provided or used by operating activities: It is by theanalysis of Profit and Loss Account, Comparative Balance Sheet and selectedadditional 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 intoaccount the additional information and effect on cash may be grouped under theinvesting and financing activities.


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Final 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. Thenet 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 financingactivities is equal to net increase or decrease in cash and cash equivalents.

8. Reporting of Cash Flow from Operating ActivitiesThere are two methods of converting net profit into net cash flows from operating activities-

Direct Method: actual cash receipts (for a period) from operating revenues and

actual cash payments (for a period) for operating expenses are arranged andpresented in the cash flow statement. The difference between cash receipts andcash payments is the net cash flow from operating activities.

Indirect Method: In this method the net profit (loss) is used as the base then

adjusted for items that affected net profit but did not affect cash.9. Funds Flow StatementIt ascertains the changes in financial position of a firm between two accounting periods. It

analyses the reasons for change in financial position between two balance sheets. It showsthe inflow and outflow of funds i.e., sources and application of funds during a particularperiod.

Sources of Funds

(a) Long term fund raised by issue of shares, debentures or sale of fixed assetsand(b) Fund generated from operations which may be taken as a gross beforepayment of dividend and taxes or net after payment of dividend and taxes.

Applications of Funds

(a) Investment in Fixed Assets(b) Repayment of Capital

CHAPTER 4FINANCING DECISIONS

1. Cost of CapitalCost of capital refers to the discount rate that is used in determining the present value ofthe estimated future cash proceeds of the business/new project and eventually decidingwhether the business/new project is worth undertaking or now. It is also the minimum rateof return that a firm must earn on its investment which will maintain the market value ofshare 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 levelas the investment that has been selected2. Components of Cost of CapitalThe cost of capital can be either explicit of implicit.

Explicit Cost: 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 itsincremental cash outflows.

Implicit Cost: It 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 underconsideration by the firm was accepted.3. Measurement of Specific Cost of Capital


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The first step in the measurement of the cost of the capital of the firm is the calculation ofthe cost of individual sources of raising funds.(a) Cost of DebtA debt may be in the form of Bond or Debenture.(i) Cost of Debentures:The cost of debentures and long term loans is the contractualinterest rate adjusted further for the tax liability of the company.

Cost of Irredeemable Debentures: Cost of debentures not redeemable during

the life time of the company.

Cost of Redeemable Debentures: If the debentures are redeemable after the

expiry of a fixed period

(ii) Amortisation of Bond: A bond may be amortised every year i.e. principal is repaidevery year rather than at maturity. In such a situation, the principal will go down withannual payments and interest will be computed on the outstanding amount

(b) Cost of Preference Share

The cost of preference share capital is the dividend expected by its holders. Cost of Irredeemable Preference Shares

Cost of irredeemable preference shares = PD / PO

Cost of Redeemable Preference Shares: If the preference shares are

redeemable after the expiry of a fixed period

5. Marginal Cost of CapitalIt may be defined as the cost of raising an additional rupee of capital. To calculate themarginal cost of capital, the intended financing proportion should be applied as weightsto marginal component costs. The marginal cost of capital should, therefore, becalculated in the composite sense. The marginal weights represent the proportion of

funds the firm intends to employ.6. Capital StructureCapital structure refers to the mix of a firms capitalisation (i.e. mix of long term sources offunds such as debentures, preference share capital, equity share capital and retainedearnings for meeting total capital requirment). While choosing a suitable financing pattern,certain factors like cost, risk, control, flexibility and other considerations like nature ofindustry, competition in the industry etc. should be considered.7. Optimal Capital Structure (EBIT-EPS Analysis)The basic objective of financial management is to design an appropriate capital structurewhich can provide the highest earnings per share (EPS) over the firms expected range ofearnings before interest and taxes (EBIT). EBIT-EPS analysis is a vital tool for designingthe 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

8. Capital Structure Theories

Net Income Approach: According to this approach, capital structure decision is

relevant to the value of the firm.

Net Operating Income Approach: NOI means earnings before interest and tax.

According to this approach, capital structure decisions of the firm are irrelevant.


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Modigliani-Miller Approach: Modigliani-Miller derived the following three propositions.

(i) Total market value of a firm is equal to its expected net operating incomedividend by the discount rate appropriate to its risk class decided by the market.(ii) The expected yield on equity is equal to the risk free rate plus a premiumdetermined as per the following equation: Kc = Ko + (Ko Kd) B/S

(iii) Average cost of capital is not affected by financial decision.

Traditional Approach: The principle implication of this approach is that

the cost of capital is dependent on the capital structure and there is anoptimal capital structure which minimises cost of capital.9. Over CapitalisationIt is a situation where a firm has more capital than it needs or in other words assets areworth less than its issued share capital, and earnings are insufficient to pay dividend andinterest.10. Under CapitalisationIt is just reverse of over-capitalisation. It is a state, when its actual capitalization is lowerthan its proper capitalization as warranted by its earning capacity.

11. LeveragesIn financial analysis, leverage represents the influence of one financial variable over someother related financial variable. These financial variables may be costs, output, salesrevenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc.12. Types of LeveragesOperating Leverage: It exists when a firm has a fixed cost that must be defrayedregardless of volume of business. It can be defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interestand taxes. Degree of operating leverage (DOL) is equal to the percentage increase in thenet operating income to the percentage increase in the output.

Degree of Operating Leverage = Contribution / EBIT

and equity in the capitalisation of a firm. Degree of financial leverage (DFL) is the ratio ofthe percentage increase in earning per share (EPS) to the percentage increase in earningsbefore interest and taxes (EBIT).

Degree of Financial Leverage = EBIT / EBT

Combined Leverage: It maybe defined as the potential use of fixed costs, both operatingand financial, which magnifies the effect of sales volume change on the earning per shareof the firm. Degree of combined leverage (DCL) is the ratio of percentage change inearning per share to the percentage change in sales. It indicates the effect the saleschanges will have on EPS.

Degree of Combined Leverage = DOL DFL

CHAPTER 5TYPES OF FINANCING

1. Sources of FundsThere are several sources of finance/funds available to any company. Some of theparameters that need to be considered while choosing a source of fund are:


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Cost of source of fund

Tenure

Leverage planned by the company

Financial conditions prevalent in the economy

Risk profile of both the company as well as the industry in which the company

operates.2. Categories of Sources of Funds(i) Long termRefer to those requirements of funds which are for a period exceeding 5 -10 years. Allinvestments in plant, machinery, land, buildings, etc., are considered as long termfinancial needs.

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

International financing like Euro-issues, Foreign currency loans

(ii) Medium termRefer to those funds which are required for a period exceeding one year but notexceeding 5 years.

Preference shares

Debentures/Bonds

Public deposits/fixed deposits for duration of three years

Commercial banks

Financial institutions

State financial corporations

Lease financing/Hire-Purchase financingExternal commercial borrowings

Euro-issues

Foreign Currency bonds

(iii) Short termInvestment in these current assets such as stock, debtors, cash, etc. assets is knownas meeting of working capital requirements of the concern. The main characteristic of


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short term financial needs is that they arise for a short period of time not exceedingthe accounting period. i.e., one year.

Trade credit

Accrued expenses and deferred income

Commercial banks

Fixed deposits for a period of 1 year or less

Advances received from customers

Various short-term provisions

3. Some Important Sources of Finance Defined

Venture Capital Financing: It refers to financing of new high risky venture promoted

by qualified entrepreneurs who lack experience and funds to give shape to their ideas.

Securitisation: It is a process in which illiquid assets are pooled into marketable

securities that can be sold to investors.

Leasing: It is a very popular source to finance equipments. It is a contract between

the owner and user of the asset over a specified period of time in which the asset ispurchased initially by the lessor (leasing company) and thereafter leased to the user(Lessee Company) who pays a specified rent at periodical intervals.

Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident

of sale.

Commercial Paper: A Commercial Paper is an unsecured money market instrument

issued in the form of a promissory note.

Export Finance: To support export, the commercial banks provide short term export

finance mainly by way of pre and post-shipment credit.

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 rateon such funds.

Seed Capital Assistance: The Seed capital assistance scheme is designed by IDBI

for professionally or technically qualified entrepreneurs and/or persons possessingrelevant experience, skills and entrepreneurial traits.

Deep Discount Bonds: Deep Discount Bonds is a form of zero-interest bonds. These

bonds are sold at a discounted value and on maturity face value is paid to theinvestors. In such bonds, there is no interest payout during lock in period.

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. Zero Coupon Bonds: A Zero Coupon Bonds does not carry any interest but it is sold

by the issuing company at a discount.

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 withminimum average maturity of 3 years.


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Euro Bonds: Euro bonds are debt instruments which are not denominated in the

currency of the country in which they are issued.

Foreign Bonds: These are debt instruments issued by foreign corporations or foreign

governments.

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 acertain number of a company's regular shares. ADRs allow US investors to buyshares of these companies without the costs of investing directly in a foreign stockexchange.

Global Depository Receipt (GDRs): These are negotiable certificate held in

the bank of one country representing a specific number of shares of a stocktraded on the exchange of another country. These financial instruments areused by companies to raise capital in either dollars or Euros.

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 toraise foreign capital.

CHAPTER 6INVESTMENT DECISIONS

1. Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments

that are in line with the goal of investors wealth maximization. The capital budgeting decisions are important, crucial and critical business decisions due to substantialexpenditure involved; long period for the recovery of benefits; irreversibility ofdecisions and the complexity involved in capital investment decisions.

One of the most important tasks in capital budgeting is estimating future cash flowsfor a project. The final decision we make at the end of the capital budgeting processis no better than the accuracy of our cash-flow estimates.

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.2. Calculating Cash FlowsIt is helpful to place project cash flows into three categories:a) Initial Cash OutflowThe initial cash out flow for a project is calculated as follows:-Cost of New Asset(s)+ Installation/Set-Up Costs

+ (-) Increase (Decrease) in Net Working Capital Level- Net Proceeds from sale of Old Asset (If it is a replacement situation)+(-) Taxes (tax saving) due to sale of Old Asset (If it is a replacement situation)= Initial Cash Outflow

b) Interim Incremental Cash FlowsAfter making the initial cash outflow that is necessary to begin implementing a project,the firm hopes to benefit from the future cash inflows generated by the project. It iscalculated as follows:-


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Net increase (decrease) in Operating Revenue- (+) Net increase (decrease) in Operating Expenses excluding depreciation= Net change in income before taxes- (+) Net increase (decrease) in taxes= Net change in income after taxes+(-) Net increase (decrease) in tax depreciation charges

= Incremental net cash flow for the periodc) Terminal-Year Incremental Net Cash FlowFor the purpose of Terminal Year we will first calculate the incremental net cash flowfor the period as calculated in point b) above and further to it we will makeadjustments in order to arrive at Terminal-Year Incremental Net Cash flow asfollows:-Incremental net cash flow for the period+(-) Final salvage value (disposal costs) of asset- (+) Taxes (tax saving) due to sale or disposal of asset+ (-) Decreased (increased) level of Net Working Capital= Terminal Year incremental net cash flow3. Techniques of Capital Budgeting

(a) Traditional (non-discounted)The most common traditional capital budgeting techniques are Payback Period andAccounting (Book) Rate of Return.(b) Time-adjusted (discounted)The most common time-adjusted capital budgeting techniques are Net Present ValueTechnique, Profitability Index, Internal Rate of Return Method, Modified Internal Rateof Return and Discounted Payback period.

4. Payback Period: The payback period of an investment is the length of time required forthe cumulative total net cash flows from the investment to equal the total initial cashoutlays

Payback period = Total initial capital investment / Annual expected after - tax net cash flow

Payback Reciprocal: It is the reciprocal of payback period.

Payback Reciprocal = Average annual cash in flow / Initial investment

5. Accounting (Book) Rate of Return: The accounting rate of return of an investmentmeasures the average annual net income of the project (incremental income) as apercentage of the investment

Accounting rate of return = Average annual net income / Investment

6. Net Present Value Technique: The net present value method uses a specified discount

rate to bring all subsequent net cash inflows after the initial investment to their presentvalues (the time of the initial investment or year 0).Net present value = Present value of net cash flow - Total net initial investment7. Desirability Factor/Profitability Index: In certain cases we have to compare a number ofproposals each involving different amounts of cash inflows, then we use Desirabilityfactor, or Profitability index.The desirability factor is calculated as below :


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Sum of discounted cash in flows / Initial cash outlay Or Total discounted cash outflow (as the

case may)

8. Internal Rate of Return Method: Internal rate of return for an investment proposal is thediscount rate that equates the present value of the expected net cash flows with the initialcash outflow.

9. Multiple Internal Rate of Return: In cases where project cash flows change signs orreverse during the life of a project e.g. an initial cash outflow is followed by cash inflowsand subsequently followed by a major cash outflow , there may be more than one IRR.10. Modified Internal Rate of Return (MIRR): Under this method , all cash flows , apartfrom the initial investment , are brought to the terminal value using an appropriate discountrate(usually the Cost of Capital). This results in a single stream of cash inflowin the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth yearand the terminal cash in flow as mentioned above. The discount rate which equates thepresent value of the terminal cash in flow to the zeroth year outflow is called the MIRR.11. Capital RationingIn capital rationing the firm attempts to select a combination of investment proposalsthat will be within the specific limits providing maximum profitability and ranks them in

descending order according to their rate of return.

CHAPTER 7MANAGEMENT OF WORKING CAPITAL

BASIC CONCEPTS AND FORMULAE

1. Working Capital Management

Working Capital Management involves managing the balance between firms shortterm

assets and its short-term liabilities.

From the value point of view, Working Capital can be defined as:

Gross Working Capital: It refers to the firms investment in current assets.

Net Working Capital: It refers to the difference between current assets and currentliabilities.

From the point of view of time, working capital can be divided into:

Permanent Working Capital: It is that minimum level of investment in the currentassets that is carried by the business at all times to carry out minimum level of itsactivities.Temporary Working Capital: It refers to that part of total working capital, which isrequired by a business over and above permanent working capital.2. Factors To Be Considered While Planning For Working Capital Requirement

Nature of business

Market conditions

Demand conditions

Operating efficiency

Credit policy

3. Finance manager has to pay particular attention to the levels of current assets and theirfinancing. To decide the levels and financing of current assets, the risk return trade offmust be taken into account. In determining the optimum level of current assets, the firmshould balance the profitability Solvency tangle by minimizing total costs.


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4. Working Capital CycleWorking Capital Cycle indicates the length of time between a companys paying formaterials, entering into stock and receiving the cash from sales of finished goods. It canbe determined by adding the number of days required for each stage in the cycle.5. Computation of Operating CycleOperating Cycle = R + W + F + D C

Where,R = Raw material storage periodW = Work-in-progress holding periodF = Finished goods storage periodD = Debtors collection period.C = Credit period availed.The various components of operating cycle may be calculated as shown below:

Raw material storage period = Average stock of raw material / Average cost of rawmaterial

consumptionper day

Work - in- progress holding period

Average work - in - progress inventory / Average cost of production per day

Finished goods storage period = Average stock of finished goods / Average cost of goods sold

per day

Debtors collection period = Average book debts / Average Credit Sales per day

Credit period availed = Average trade creditors / Average credit purchases per day

6. Treasury Management

Treasury management is defined as the corporate handling of all financial matters, thegeneration of external and internal funds for business, the management of currencies andcash flows and the complex, strategies, policies and procedures of corporate finance.

7. Management of CashIt involves efficient cash collection process and managing payment of cash both inside theorganisation and to third parties.The main objectives of cash management for a business are:-i. Provide adequate cash to each of its units;ii. No funds are blocked in idle cash; andiii. The surplus cash (if any) should be invested in order to maximize returns for thebusiness.

8. Cash BudgetCash Budget is the most significant device to plan for and control cash receipts andpayments. This represents cash requirements of business during the budget period. Thevarious purposes of cash budgets are:i. Coordinate the timings of cash needs. It identifies the period(s) when there mighteither be shortage of cash or an abnormally large cash requirement;ii. It also helps to pinpoint period(s) when there is likely to be excess cash;iii. It enables firm which has sufficient cash to take advantage like cash discounts on itsaccounts payable;


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iv. Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage ofcash) on favorable terms.9. Preparation of Cash BudgetThe Cash Budget can be prepared for short period or for long period.Cash budget for short period: Preparation of cash budget month by month wouldrequire the following estimates:

(a) As regards receipts:

Receipts from debtors;

Cash Sales; and

Any other source of receipts of cash (say, dividend from a subsidiary

company)

(b) As regards payments:

Payments to be made for purchases;

Payments to be made for expenses;

Payments that are made periodically but not every month;(i) Debenture interest;(ii) Income tax paid in advance;(iii) Sales tax etc.

Special payments to be made in a particular month, for example,

dividends to shareholders, redemption of debentures, repayments ofloan, payment of assets acquired, etc.Cash Budget for long period: Long-range cash forecast often resemble the projectedsources and application of funds statement. The following procedure may be adopted toprepare long-range cash forecasts:(i) Take the cash at bank and in the beginning of the year:(ii) 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 currentliabilities.(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.

10. Cash Management ModelsWilliam J. Baumols Economic Order Quantity Model, (1952): According to this model,optimum cash level is that level of cash where the carrying costs and transactions costsare the minimum.The formula for determining optimum cash balance is:Miller-Orr Cash Management Model (1966): According to this model the net cash flow iscompletely stochastic.When changes in cash balance occur randomly the application of control theory serves a


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useful purpose. The Miller-Orr model is one of such control limit models.11. MANAGEMENT OF MARKETABLE SECURITIESManagement of marketable securities is an integral part of investment of cash as this mayserve both the purposes of liquidity and cash, provided choice of investment is madecorrectly. As the working capital needs are fluctuating, it is possible to park excess fundsin 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 andare 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 withoutloss of time and price it is highly liquid or marketable.12. Inventory Management

Inventory management covers a large number of problems including fixation of minimumand maximum levels, determining the size of inventory to be carried, deciding about theissues, receipts and inspection procedures, determining the economic order quantity,proper storage facilities, keeping check over obsolescence and ensuring control overmovement of inventories.

13. Management of Receivables

The basic objective of management of sundry debtors is to optimise the return on

investment on these 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 debtorsis 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 properpolicies and their implementation.

There are basically three aspects of management of sundry debtors:

(i) Credit policy: The credit policy is to be determined. It involves a trade offbetween the profits on additional sales that arise due to credit being extended onthe one hand and the cost of carrying those debtors and bad debt losses on theother. This seeks to decide credit period, cash discount and other relevantmatters.(ii) Credit Analysis: This requires the finance manager to determine as to how riskyit is to advance credit to a particular party.(iii) Control of Receivables: This requires finance manager to follow up debtors and

decide about a suitable credit collection policy. It involves both laying down ofcredit policies and execution of such policies.

Important Sources of Financing of Receivables

(i) Pledging: This refers to the use of a firms receivable to secure a short termloan.(ii) Factoring: In factoring, accounts receivables are generally sold to a financialinstitution (a subsidiary of commercial bank-called Factor), who chargescommission and bears the credit risks associated with the accounts receivables


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purchased by it.14. Management of Payables

Management of Payables involves management of creditors and suppliers.

Trade creditor is a spontaneous source of finance in the sense that it arises from

ordinary business transaction. But it is also important to look after your creditors -

slow payment by you may create ill-feeling and your supplies could be disrupted andalso create a bad image for your company.

Creditors are a vital part of effective cash management and should be managed

carefully to enhance the cash position.15. Financing of Working Capital

It is advisable that the finance manager bifurcates the working capital requirements

between 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 thecontrary, temporary working capital may be financed by the short-term sources offinance.

Broadly speaking, the working capital finance may be classified between the two

categories:(i) Spontaneous Sources: Spontaneous sources of finance are those whichnaturally arise in the course of business operations. Trade credit, credit fromemployees, credit from suppliers of services, etc. are some of the exampleswhich may be quoted in this respect.(ii) Negotiable Sources: On the other hand the negotiated sources, as the nameimplies, are those which have to be specifically negotiated with lenders say,commercial banks, financial institutions, general public etc.

COSTING THEORY

CHAPTER 1BASIC CONCEPTS

Classification of Costs1. Nature of Element1.1 Material: Cost of Material used in production1.2 Labour: Cost of Workers1.3 Expenses: Costs other than Material and Labour2. Traceability to Object2.1 Direct Costs: Which can be allocated directly to the product2.2 Indirect Costs: Which cannot be directly allocated to the product

3. Functions3.1 Production Costs Cost of whole process of Production3.2 Selling Costs: Cost for creating demand of the product produced3.3 Distribution Costs: Costs starting from packing of the product tillreconditioning of empty products3.4 Administrative Costs: Cost of formulating policy, controlling theorganisation, costs not directly related to production3.5 Development Costs: Development Costs for trial Run3.6 Pre- Production Costs: Costs starting with implementation of decisions and


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ending with the commencement of the production process3.7 Conversion Costs: Cost of transforming direct material into FinishedProducts3.8 Product Costs: Costs necessary for production4. Variability4.1 Fixed Costs: Cost which remains constant in total

4.2 Variable Costs: Costs which changes with production

4.3 Semi- Variable Costs: Costs which are partly fixed and partly variable5. Controllability5.1 Controllable Costs: Costs which can be influenced by the action of aspecific member of an undertaking5.2 Uncontrollable Costs: Costs which can not be influenced by the action of aspecific member.6. Normality6.1 Normal Costs: Costs which are expected to be incurred in normal routine6.2 Abnormal Costs: Costs which are over and above normal costs7. Decision Making

7.1 Relevant Costs (Marginal Costs, Differential Costs, Opportunity Costs,Out of Pocket): Costs which are relevant and useful for decision making7.2 Irrelevant Costs (Sunk costs, Committed costs, Fixed costs): Costswhich are not relevant or useful to decision making8. Cash Outflow8.1 Explicit Costs: Costs involving immediate payment of cash8.2 Implicit Costs: Costs not involving immediate cash payment

Types of Costing1. Uniform Costing: Standardised principles and practices of costing are used by anumber of different industries.2. Marginal Costing: Only Variable Costs or costs directly linked are charged tothe product or process

3. Standard Costing:Standard Costs are compared with actual costs, to determinevariances4. Historical Costing:Where costs are recorded after they have incurred5. Direct Costing: Direct Costs are charged to the product or process, IndirectCosts are charged to the profit from the product or process.6. Absorption Costing: All costs (variable and Fixed) are charged to theproduct or process

Methods of Costing1. Job costing; Where all costs can be directly charged to a specific job2. Batch Costing: Where all costs can be directly charged to a group of products(batch)

3. Contract Costing: Similar to Job costing, but in this case the job is larger thanjob costing.4. Single or Output Costing: Cost ascertainment for a single product.5. Process Costing:The cost of production at each stage is ascertained separately6. Operating Costing : Ascertainment of Costs in cases where services arerendered7. Multiple Costing:Combination of two or more methods of costing, used wherethe nature of the product is complex and method cannot be ascertained


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CHAPTER 2MATERIALSBasic Concepts

1. Maximum Level: It indicates the maximum figure of inventory quantity held instock at any time.2. 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 tonon-availability of inventory.3. Re-order level: This level lies between minimum and the maximum levels in such away that before the material ordered is received into the stores, there is sufficientquantity on hand to cover both normal and abnormal consumption situations.4. Danger level: It is the level at which normal issues of the raw material inventory arestopped and emergency issues are only made.5. ABC Analysis: It is a system of inventory control. It exercises discriminating controlover different items of stores classified on the basis of the investment involved. Itemsare classified into the following categories:A Category: Quantity less than 10 % but value more than 70 %B Category; Quantiy less than 20 % but value about 20 %C Category: Quantity about 70 % but value less than 10%6. Two bin system: Under this system each bin is divided into two parts - one, smallerpart, should stock the quantity equal to the minimum stock or even the re-orderinglevel, and the other to keep the remaining quantity. Issues are made out of thelarger part; but as soon as it becomes necessary to use quantity out of the smallerpart of the bin, fresh order is placed.7. System of budgets: The exact quantity of various types of inventories and the timewhen they would be required can be known by studying carefully production plansand production schedules. Based on this, inventories requirement budget can beprepared. Such a budget will discourage the unnecessary investment in inventories.8. Perpetual inventory: Perpetual inventory represents a system of records maintainedby the stores department. It in fact comprises: ( i) Bin Cards, and (ii) Stores Ledger.

9. Continuous stock verification: Continuous stock taking means the physicalchecking of those records (which are maintained under perpetual inventory) withactual stock.10. Economic Order Quantity (EOQ): It is the calculation of optimum level quantity whichminimizes the total cost of Ordering and Delivery Cost and Carrying Cost.11. Review of slow and non-moving items: Disposing of as early as possible slow movingitems, in return with items needed for production to avoid unnecessary blockage ofresources.12. Input output ratio : Inventory control can also be exercised by the use of inputoutput ratio analysis. Input-output ratio is the ratio of the quantity of input ofmaterial to production and the standard material content of the actual output.13. Inventory turnover ratio: Computation of inventory turnover ratios for different

items of material and comparison of the turnover rates provides a useful guidancefor measuring inventory performance. High inventory turnover ratio indicates thatthe material in the question is a fast moving one. A low turnover ratio indicatesover-investment and locking up of the working capital in inventories14. Valuation of Material Issues: Several methods of pricing material issues have beenevolved which are as follows:a) First-in First-out method: The materials received first are to be issued first whenmaterial requisition is received. Materials left as closing stock will be at the price of


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latest purchases.b) Last-in First-out method:The materials purchased last are to be issued firstwhen material requisition is received. Closing stock is valued at the oldest stockprice.

c) Simple Average Method:

Material Issue Price= Total of unit price of each purchase / Total Nos of Purcahses

d) Weighted Average Price Method:This method gives due weightage to quantitiespurchased and the purchase price to determine the issue price.

Weighted Average Price =Total Cost of Materials received / Total Quantity purchased

15. Various Material Losses

a) Wastage: Portion of basic raw material lost in processing having no recoverablevalue

b) Scrap: The incidental material residue coming out of certain manufacturing

operations having low recoverable value.

c) Spoilage: Goods damaged beyond rectification to be sold without furtherprocessing.d) Defectives: Goods which can be rectified and turned out as good units by theapplication of additional labour or other services.

Basic Formulas1. Maximum Level = Reorder Level + Reordering Quantity Minimum Consumptionduring the period required to obtain delivery.OrRL + RQ MnCOr

Safety Stock + EOQ2. Minimum Level = Reorder Level (Normal usage per period Average deliverytime)3. Average Stock Level =

2

Maximum Level +Minimum Level

Minimum Level + Reorder Quantity4. Reorder Level = Maximum Reorder period Maximum Usage= Normal Usage (Minimum Stock Period + Average Delivery Time)= Safety Stock + Lead Time Consumption5. Danger Level = Minimum Consumption Emergency Delivery Time

6. EOQ =2 Annual Consumption Buying cost per order / Cost of carrying one unit of

inventory for one year

7. Ordering Cost = Annual usage Fixed Cost per Order / Quantity Ordered

8. Carrying Cost = Quantity ordered/2 Purchase Price for Inventory Carrying

Cost expressed as % of average inventory


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9. Inventory Turnover Ratio = Material Consumed / Average Inventory

10. Inventory Turnover Period = 365 Inventory Turnover Ratio

11. To decide whether discount on purchase of material should be availed or not, comparetotal inventory cost before discount and after discount. Total inventory cost will include

ordering cost, carrying cost and purchase cost.

12. Safety Stock = Annual Demand/365 (Max. lead time Normal / Average lead time)

13. Total Inventory Cost = Ordering Cost + Carrying Cost + Purchase CostNote: For calculation of total inventory carrying cost, average inventory should betaken ashalf of EOQ. Average inventory cost is normally given as a percentage of cost per unit

CHAPTER 3LABOURBasic Concepts

1. Labour Cost: Cost incurred for hiring of human resource of employees2. Direct Labour: 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.3 Idle Time: The time for which the employer pays but obtains no direct benefit or for noproductive purpose.4. Normal Idle Time: Time which can not be avoided or reduced in the normal course ofbusiness. The cost of normal idle time should be charged to the cost of production.5. Abnormal Idle Time: It arises on account of abnormal causes and should be charged toCosting Profit and Loss account.6. Time Keeping: It refers to correct recording of the employees attendance time7. Time Booking: It is basically recording the details of work done and the time spent byworkers on each job or process.8. Overtime: Payment to workers, when a worker works beyond the normal working hours.Usually overtime has to be paid at double the rate of normal hours.

9. Overtime Premium: Its the amount of extra payment paid to a worker under overtime.10. Labour Turnover: It is the rate of change in labour force during a specified period due toresignation, retirement and retrenchment. If the labour turnover is high, its a sign ofinstability and may affect the profitability of the firm.11. Incentives: It is the simulation for effort and effectiveness by offering monetary inducementor enhanced facilities.12. Time Rate System: The amount of wages due to a worker is arrived at by multiplying thetime worked by the appropriate time rate.13. Differential Time Rate: Different hourly rates are fixed for differtent levels of efficiency.Upto a certain level a fixed rate is paid and based on the efficiency level the hourly rateincreases gradually.

14. Straight Piece Work: Payment is made on the basis of a fixed amount per unit of output

irrespective of time taken. It is the number of units produced by the worker multiplied byrate per unit.15. Differential Piece Rate: For different level of output below and above the standard,different piece rates are applicable.16. Wage Abstract: A summary giving details of wages to be charged to individual jobs,workorders or processes for a specific period.CHAPTER 4OVERHEADSBASIC CONCEPTS AND FORMULAE


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Basic Concepts

1. Overheads: Overheads represent expenses that have been incurred in providing certainancillary facilities or services which facilitate or make possible the carrying out of theproduction process; by themselves these services are not of any use.2. Types of the Overheads on the basis of function:

Factory or Manufacturing Overheads

Office and Administration Overheads

Selling and Distribution Overheads

Research and Development Overheads

3. Types of the Overheads on the basis of nature:

Fixed Overhead-Expenses that are not affected by any variation in the volume of

activity.

Variable-Expenses that change in proportion to the change in the volume of

activity.

Semi variable- The expenses that do not change when there is a small change in

the level of activity but change whenever there is a slightly big change or change inthe same direction as change in the level of activity but not in the same proportion.4. Cost allocation-The term allocation refers to assignment or allotment of an entire item of cost to a particular cost center or cost unit.5. Cost apportionment- Apportionment implies the allotment of proportions of items of costto cost centres or departments.6. Re-apportionment- The process of assigning service department overheads toproduction departments is called reassignment or re-apportionment.7. Absorption- The process of recovering overheads of a department or any other costcenter from its output is called recovery or absorption.8. Methods used for re-apportionment of service department expenses over theproduction departments:

Direct re-distribution method- Under this method service department costs are

apportioned over the production departments only, ignoring the services renderedby one service department to the other.

Step Method or Non-reciprocal method-This method gives cognizance to the

service rendered by service department to another service department. Thesequence here begins with the department that renders service to the maximumnumber of other service departments.

Reciprocal Service Method-These methods are used when different service

departments render services to each other, in addition to rendering services toproduction departments. In such cases various service departments have to share

overheads of each other. The methods available for dealing with reciprocal servicesare(a) Simultaneous equation method;(b) Repeated distribution method;(c) Trial and error method.9. Methods for the Computation of the Overheads Rate :a) Percentage of direct materials method: Under this method, the cost of direct materialconsumed is the base for calculating the amount of overhead absorbed.b) Percentage of prime cost method This method is based on the fact that both


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materials as well as labour contribute in raising factory overheads. Hence, thetotal of the two i.e. Prime cost should be taken as base for absorbing thefactory overhead.c) Percentage of direct labour cost : This method also fails to give full recognition tothe element of the time which is of prime importance in the accounting for andtreatment 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.d) Labour hour rate Method: This method is an improvement on the percentage ofdirect wage basis, as it fully recognises the significance of the element of time inthe incurring and absorption of manufacturing overhead expenses.e) Machine hour rate method: By the machine hour rate method, manufacturingoverhead expenses are charged to production on the basis of number of hoursmachines are used on jobs or work orders.

10. Types of Overhead Ratesa) Normal rate: This rate is calculated by dividing the actual overheads byactual base. It is also known as actual rate.b) Pre-determined overhead rate: This rate is determined in advance by

estimating the amount of the overhead for the period in which it is to be used.c) Blanket overhead rates- Blanket overhead rate refers to the computation of onesingle overhead rate for the whole factory. It is to be distinguished from thedepartmental overhead rate which refers to a separaterd)Departmental overhead rate: Where the product lines are varied or machineryis used to a varying degree in the different departments, that is, where conditionsthroughout the factory are not uniform, the use of departmental rates is to bepreferred. ate for each individual cost centre or department.11. Methods of accounting of administrative overheads

Apportioning Administrative Overheads between Production and Sales

Departments.

Charging to Costing Profit and Loss Account.

Treating Administrative Overheads as a separate addition to Cost of

Production/Sales

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.

Basic Formulas1. Overhead Absorption Rate or Overhead Recovery Rate = Amount of overhead incurred /

Basis for absorption2. Predetermined Overhead Rate = Budgeted overhead for the period / Budgeted

basis for the period3. Blanket Overhead Rate = Overhead cos t for the entire factory for the period /

Base for the period (Total labour hours, total machine hours, etc


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4. Multiple Overhead Rate = Overhead allocated / apportioned to each Deptt. /Corresponding base

5. Variable portion in Semi-variable Overhead = Change in amount of expense /Change in activity or quantity

6. Direct cost of service departments should be apportioned to production departments, asit is also indirect cost for production departments.

CHAPTER 5NON-INTEGRATED ACCOUNTSBASIC CONCEPTS AND FORMULAEBasic Concepts

1. Cost Control Accounts: These are accounts maintained for the purpose of exercisingcontrol over the costing ledgers and also to complete the double entry in cost accounts.2. Integral System of Accounting: A system of accounting where both costing andfinancial transactions are recorded in the same set of books.3. Non- Integral System of Accounting: A system of accounting where two sets of booksare maintained- (i) for costing transactions; and (ii) for financial transactions4. Reconciliation: In the Non-Integral System of Accounting, since the cost and financialaccounts are kept separately, it is imperative that those should be reconciled, otherwisethe cost accounts would not be reliable. The reason for differences in the cost & financial

accounts can be of purely financial nature( Income and expenses) and notional nature

CHAPTER 6JOB COSTING & BATCH COSTINGBASIC CONCEPTS AND FORMULAEBasic Concepts1. Job Costing : According to this method costs are collected and accumulated accordingto jobs, contracts, products or work orders. Each job or unit of production is treated as aseparate entity for the purpose of costing. Job costing is carried out for the purpose ofascertaining cost of each job and takes into account the cost of materials, labour andoverhead etcMeaning of spoiled and decective work under job costing:-Spoiled :- Produced units can not be rectified.Defective:- Units can be rectified with some additional cost.2. Batch Costing: This is a form of job costing. Under job costing, executed job isused as a cost unit, whereas under batch costing, a lot of similar units whichcomprises the batch may be used as a cost unit for ascertaining cost. In the case ofbatch costing separate cost sheets are maintained for each batch of products byassigning a batch number.3. Economic Batch Quantity: There is one particular batch size for which both set up and

carrying costs are minimum. This size is known as economic or optimum batch quantity.

CHAPTER 7CONTRACT COSTING

BASIC CONCEPTS AND FORMULAEBasic Concepts

1. Contract costing:- Contract or terminal costing, as it is termed, is one form ofapplication of the principles of job costing. In fact a bigger job is referred to as a contract.Contract costing is usually adopted by building contractors engaged in the task ofexecuting Civil Contracts.2. Sub-Contract : Sub-contract costs are also debited to the Contract Account.3. Extra work : The extra work amount payable by the contractee should be added tothe contract price. If extra work is substantial, it is better to treat it as a separate


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contract. If it is not substantial, expenses incurred should be debited to the contractaccount as Cost of Extra work.4. Cost of work certified : All building contractors received payments periodicallyknown as running payment on the basis of the architects or surveyors certificates.But payments are not equal to the value of the work certified, a small percentage ofthe amount due is retained as security for any defective work which may be

discovered later within the guarantee period.5. Work uncertified : It represents the cost of the work which has been carried out bythe contractor but has not been certified by the contractees architect. It is always shown at cost price.6. Retention money : A contractor does not receive full payment of the work certifiedby the surveyor. Contractee retains some amount (say 10% to 20%) to be paid, aftersometime, when it is ensured that there is no fault in the work carried out by contractor.7. Work-in-progress: In Contract Accounts, the value of the work-in-progress consists of ( i)the cost of work completed, both certified and uncertified; ( ii) the cost of work not yetcompleted; and (iii) the amount of profit taken as credit. In the Balance Sheet, the workin-progress is usually shown under two heads, viz., certified and uncertified.8. Notional profit : It represents the difference between the value of work certified and cost

of work certified.

9. Estimated profit : It is the excess of the contract price over the estimated total costof the contract.10. Cost plus Contract : Under Cost plus Contract, the contract price is ascertained byadding a percentage of profit to the total cost of the work. Such type of contracts areentered into when it is not possible to estimate the Contract Cost with reasonableaccuracy due to unstable condition of material, labour services, etc.14. Operating Costing: It is a method of ascertaining costs of providing or operating aservice. This method of costing is applied by those undertakings which provideservices rather than production of commodities.15. Multiple Costing: It refers to the method of costing followed by a business wherein a

large variety of articles are produced, each differing from the other both in regard tomaterial required and process of manufacture. In such cases, cost of each article iscomputed separately by using, generally, two or more methods of costing.

5. Profits on incomplete contracts. The overriding principle being that there can be no attributable profit until the outcome ofa contract can reasonably be foreseen. Of the profit which in the light of all the circumstancescan be foreseen with a reasonable degree of certainty to arise on completion of the contractthere should be regarded as earned to date only that part which prudently reflects the amountof work performed to date. The method used for taking up such profits needs to beconsistently applied.6. The computation of escalation claim is based on wording of escalation clause. Normally it iscalculated on stipulated quantity of material and labour hours based on price and ratedifferential.7. Work certified and consequent payment:Work certified and consequent payment may be dealt with in the following manner:7.1 The amount of work certified can be debited to contractees account. On receipt of moneyfrom contractee, his personal account will be credited and cash or bank account, as thecause may be will be debited.

At the time of balance sheet preparation, Contractees Account will be shown on theAssets side as debtors.


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7.3 Under the second method (it is more common than the first, students are advised tofollow this method only) the amount of work certified is debited to work-in-progressaccount and credited to contract account. The work-in-progress should be shown on theassets side after deduction of cash received. Next year work-in-progress account will be

debited to contract account.

CHAPTER 8OPERATING COSTINGBASIC CONCEPTS AND FORMULAE

Basic Concepts1. Operating Costing: It is a method of ascertaining costs of providing or operating aservice. This method of costing is applied by those undertakings which provideservices rather than production of commodities.2. Cost units:

Transport service Passenger km., quintal km., or tonne km.

Supply service Kw hr., Cubic metre, per kg., per litre.

Hospital Patient per day, room per day or per bed, per operation etc.

Canteen Per item, per meal etc.

Cinema Per ticket.

Composite units i.e. tonnes kms., quintal kms. etc. may be computed in two ways.3.. Multiple Costing: It refers to the method of costing followed by a business wherein alarge variety of articles are produced, each differing from the other both in regard tomaterial required and process of manufacture. In such cases, cost of each article iscomputed separately by using, generally, two or more methods of costing.

Basic Formulas1. Absolute (weighted average) tonnes-kms:Absolute tonnes-kms., are the sum total of tonnes-kms., arrived at by multiplyingvarious distances by respective load quantities carried.

2. Commercial (simple average) tonnes-kms :Commercial tonnes-kms., are arrived at by multiplying total distance kms., by average

load quantity.

CHAPTER 9PROCESS & OPERATION COSTINGBASIC CONCEPTS AND FORMULAEBasic Concepts

1. Process Costing:- Used in industries where the material has to pass through two or moreprocesses for being converted into a final product.2. Operation Costing:- It is the refinement of process costing. It is concerned with thedetermination of the cost of each operation rather than the process.Treatment of Losses in process costing:-

(i) Normal process loss- The cost of normal process loss is absorbed by good unitsproduced under the process. The amount realised by the sale of normal process lossunits should be credited to the process account.(ii) Abnormal process loss- The total cost of abnormal process loss is credited to theprocess account from which it arise. the total cost of abnormal process loss is debitedto costing profit and loss account.(iii) Abnormal gain- The process account under which abnormal gain arises is debitedwith the abnormal gain and credited to Abnormal gain account which will be closed bytransferring to the Costing Profit and loss account.


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3. Equivalent production units:This concept use in the industries where manufacturing is a continuous activity. Convertingpartly finished units into equivalent finished units.4. Equivalent production means converting the incomplete production units into theirequivalent completed units.Equivalent completed units = {Actual number of units in the process of manufacture}

{Percentage of work completed}5. Valuation of work-in-progress : there are three methods for the valuation of work-inprogresswhich are as follows:(i) First-in-First Out (FIFO) method. Under this method the units completed andtransferred include completed units of opening work-in-progress and subsequently

introduced units. Proportionate cost to complete the opening work-in-progress and that toprocess the completely processed units during the period are derived

separately. The cost of opening work-in-progress is added to the proportionate costincurred on completing the same to get the complete cost of such units. In thismethod the closing stock of Work in progress is valued at current cost.

(ii) Last-in-First Out (LIFO) method. According to this method units lastly entering in theprocess are the first to be completed. This assumption has a different impact on the costsof the completed units and the closing inventory of work-in-progress. The completed unitswill be shown at their current cost and the closing inventory of work-in-progress willcontinue to appear at the cost of the opening inventory of work-in-progress.(iii) Average Cost method (or weighted average cost method). Under this method, thecost of opening work-in-progress and cost of the current period are aggregated andthe aggregate cost is divided by output in terms of completed units. The equivalentproduction in this case consists of work-load already contained in opening work-inprocessand work-load of current period.6. Inter-Process ProfitsThe output of one process is transferred to the next process not at cost but at market value

or cost plus a percentage of profit. The difference between cost and the transfer price isknown as inter-process profits.

CHAPTER 10JOINT PRODUCTS & BY PRODUCTSBASIC CONCEPTS AND FORMULAEBasic Concepts

1. Joint Products and By-Products(i) Joint Products - Two or more products of equal importance, produced,simultaneously from the same process, with each having a significant relative salevalue are known as joint products.(ii) Co-Products - Two or more products which are contemporary but do not emergenecessarily from the same material in the same process.

(iii) By-Products - products recovered from material discarded in a main process, orfrom the production of some major products2. Method of apportioning joint cost over joint products:The commonly used methods for apportioning total process costs upto the point ofseparation over the joint products are as follows :(i) Physical unit method(ii) Average unit cost method(iii) Survey method(iv) Contribution margin method


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(v) Market value method :(a) At the point of separation(b) After further processing(c) Net realisable value.3. Methods of apportioning joint cost over by-products :(a) Market value or value on realisation- The realisation on the disposal of the

by-product may be deducted from the total cost of production so as to arrive atthe cost of the main product.(b) Standard cost in technical estimates- The standard may be determined byaveraging costs recorded in the past and making technical estimates of thenumber of units of original raw material going into the main product and the

number forming the by-product or by adopting some other consistent basis. This methodmay be adopted where the by-product is not saleable in the condition in

which it emerges or comparative prices of similar products are not available.(c) Comparative price- Value of the by-product is ascertained with reference tothe price of a similar or an alternative material.(d) Re-use basis- The value put on the by-product should be same as that of the

materials introduced into the process.4. Treatment of By-Product Cost in Cost-Accounting(i) When they are of small total value:1. The sales value of the by-products may be credited to the Profit and LossAccount and no credit be given in the Cost Accounts. The credit to the Profitand Loss Account here is treated either as miscellaneous income or asadditional sales revenue.2. The sale proceeds of the by-product may be treated as deductions from thetotal costs. The sale proceeds in fact should be deducted either from theproduction cost or from the cost of sales.(ii) When the by-products are of considerable total value - The joint costs maybe divided over joint products and by-products by using relative market values ;

physical output method (at the point of split off) or ultimate selling prices (ifsold).(iii) Where they require further processing -The net realisable value of the byproductat the split-off point may be arrived at by subtracting the furtherprocessing cost from the realisable value of by-products.If total sales value of by-products at split-off point is small, it may be treated as per theprovisions discussed above under (i).In the contrary case, the amount realised from the sale of by-products will be

considerable and thus it may be treated as discussed under (ii).

CHAPTER 12MARGINAL COSTING

Basic Concepts

1. Absorption Costing: a method of costing by which all direct cost and applicable overheadsare charged to products or cost centers for finding out the total cost of production. Absorbedcost includes production cost as well as administrative and other cost.2. Break even chart: A mathematical or graphical representation, showing approximate profitor loss of an enterprise at different levels of activity within a limited range.3. Break Even Point: This is the level of activity there is neither a profit nor a loss.4. Cash Break Even Point: It is the level of activity where there is neither a cash profit nor acash loss.


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5. Cost Breakeven Point: It is the level of activity where the total cost under two alternativesare the same. It is also known as Cost indifference point.6. Differential Costing: It is a technique used in the preparation of adhoc information in whichonly cost and income differences in between alternative courses of action are taken intoconsideration.7. Direct Costing: This is a principle under which all costs which are directed related are

charged to products, processes, operations or services, of which they form an integral part.8. Marginal contribution: This is the difference between selling price and variable cost ofproduction.9. Marginal Cost: This is the variable cost of one unit of product or a service.10. Marginal Costing: It is a principle whereby variable cost are charged to cost units and fixedcost attributable to the relevant period is written off in full against contribution for that period.11. Profit Volume Chart: It is a diagram showing the expected relationship between costs,revenue at various volumes with profit being the residual.12. Profit Volume ratio: It is the ratio establishing the relationship between the contribution andthe sales value.13. Margin of Safety: This is the difference between the expected level of sales and the break

even sales

CHAPTER 13BUDGETS AND BUDGETARY CONTROL

BASIC CONCEPTS AND FORMULASBasic Concepts

1. Budget: It is statement of an estimated performance to be achieved in given time, expressedin currency value or quantity or both.2. Budget Centre: A section of an organization for which separate budget can be prepared andcontrol exercised.3. Budgetary Control: Guiding and regulating activities with a view to attaining predeterminedobjectives, effectively and efficiently.4. Budget Manual: The Budget manual is a schedule, document or booklet which shows, inwritten forms the budgeting organisation and procedures.

5. Budget Period: The period of time for which a budget is prepared and used. It may be ayear, quarter or a month.6. Components Of Budgetary Control System :1. Physical budgetsThose budgets which contain information in terms of physical units aboutsales, production etc. for example, quantity of sales, quantity of production,inventories, and manpower budgets are physical budgets.2. Cost budgetsBudgets which provide cost information in respect of manufacturing, selling,administration etc. for example, manufacturing costs, selling costs,administration cost, and research and development cost budgets are costbudgets.

3. Profit budgetsA budget which enables in the ascertainment of profit, for example, salesbudget, profit and loss budget, etc.4. Financial budgetsA budget which facilitates in ascertaining the financial position of a concern, for

example, cash budgets, capital expenditure budget, budgeted balance sheet etc.

7. Objectives of budgeting are Planning, Directing and Controlling8. Functional budgets - Budgets which relate to the individual functions in an organisation are


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known as Functional Budgets. For example, purchase budget; sales budget; productionbudget; plant-utilisation budget and cash budget.9. Master budget - It is a consolidated summary of the various functional budgets. It serves asthe basis upon which budgeted P & L A/c and forecasted Balance Sheet are built up.10. Long-term budgets - The budgets which are prepared for periods longer than a year arecalled long-term budgets. Such budgets are helpful in business forecasting and forward

planning. Capital expenditure budget and Research and Development budget are examplesof long-term budgets.11. Short-term budgets - Budgets which are prepared for periods less than a year areknown as short-term budgets. Cash budget is an example of short-term budget.Such types of budgets are prepared in cases where a specific action has to beimmediately taken to bring any variation under control, as in cash budgets.12. Basic budgets - A budget which remains unaltered over a long period of time iscalled basic budget.13. Current budgets - A budget which is established for use over a short period of timeand is related to the current conditions is called current budget.14. Fixed budgetAccording to Chartered Institute of Management Accountants of England, a fixed

budget, is a budget designed to remain unchanged irrespective of the level ofactivity actually attained.15. Flexible budget -According to Chartered Institute of Management Accountants of England, a flexible budgetis defined as a budget which, by recognizing the difference between fixed, semi-variable and

variable costs is designed to change in relation to the level of activity attained.

Analytical Formulae

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