Analytical Formulae

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BASIC CONCEPTS 1. Definition of Financial Management “Financial management comprises the forecasting, planning, organizing, directing, coordinating and controlling of all activities relating to acquisition and application of the financial 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 that business decisions should seek to increase the net present value of the economic profits of the firm. • Conflict between Profit Maximisation and Wealth / Value maximisation: Out of the two objectives, profit maximization and wealth maximization, in today‟s real world situations which is uncertain and multi-period in nature, wealth maximization is 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 are effectively managed. • Dividend Decisions: Dividend decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income 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) - C 7. Role of Chief Financial Officer (CFO)

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

1. Time Value of Money It 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 Interest Simple Interest may be defined as Interest that is calculated as a simple percentage of the original principal amount. • Formula for Simple Interest

SI = P0 (i)(n)
3. Compound Interest Compound interest is the interest calculated on total of previously earned interest and the original principal. • Formula for Compound Interest

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

Present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. • Formula for Present Value of a Sum of Money

P0 = n FV (1 + i) –n
5. Future Value Future 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. Annuity An annuity is a series of equal payments or receipts occurring over a specified number of 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)

7. Sinking Fund

It is the fund created for a specified purpose by way of sequence of periodic payments over a time period at a specified interest rate. Formula for Sinking Fund
FVA=R [FVIFA(i,n)]

1. Financial Analysis and Planning Financial Analysis and Planning is carried out for the purpose of obtaining material and relevant information necessary for ascertaining the financial strengths and weaknesses of 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 Analysis Ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed as a relative to some other figure, it may definitely provide some significant information. Ratio analysis is comparison of 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 in general for the purpose of financial analysis. 3. Types of Ratios The ratios can be classified into following four broad categories: a) Liquidity Ratios Liquidity or short-term solvency means ability of the business to pay its short-term liabilities. • 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 current ratio. 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 liquidity available 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 additional financing. Basic Defense Interval = (Cash Receivables Marketable Securities) / ( Operating Expenses Interest 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

(excluding short-term bank borrowing) b) Capital Structure/Leverage Ratios The capital structure/leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. (i) Capital Structure Ratios: These ratios provide an insight into the financing techniques 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 firm‟s ability to service the fixed liabilities. • Debt Service Coverage Ratio: Lenders are interested in debt service coverage to judge the firm‟s 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 firm‟s 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) bearing capital to funds belonging to equity shareholders.

Capital Gearing Ratio = (Preference Share Capital Debentures Long Term Loan) / (Equity Share Capital Reserves & Surplus Losses) c) Activity Ratios These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. (i) Capital Turnover Ratio This ratio indicates the firm‟s ability of generating sales per rupee of long term

investment. Capital Turnover Ratio = Sales / Capital Employed (ii) Fixed Assets Turnover Ratio A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating 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, Debtors Turnover, 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 held during the year. Inventory Turnover Ratio = Sales / Average Inventory * * Average Inventory Opening Stock Closing Stock / 2 Debtors’ Turnover Ratio: The debtor‟s turnover ratio throws light on the collection and credit policies of the firm Sales / Average Accounts Receivable Creditors’ Turnover Ratio: This ratio shows the velocity of debt payment by the firm. It is calculated as follows: Creditors Turnover Ratio = Annual Net Credit Purchases / Average Accounts Payable d) Profitability Ratios The 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 ordinary shareholders can be measured in terms of number of equity shares. This is known as Earnings per share.

Earnings per share (EPS) = Net profit available to equity holders / Number of ordinary shares outstanding
4. Importance of Ratio Analysis The 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 in assessing 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 between the two periods. Along with changes in the cash position the cash flow statement also outlines the reasons for such inflows or outflows of cash which in turn helps to analyze the functioning of a business. 6. Classification of Cash Flow Activities The cash flow statement should report cash flows during the period classified into following categories: • 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 known amounts 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 a company) 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 by comparing these accounts given in the comparative balance sheets. The results will be cash receipts and payments during the period responsible for the increase or decrease in cash and cash equivalent items. • Calculation of the net cash provided or used by operating activities: It is by the analysis of Profit and Loss Account, Comparative Balance Sheet and selected additional information. • Calculation of the net cash provided or used by investing and financing activities: All other changes in the Balance sheet items must be analysed taking into account the additional information and effect on cash may be grouped under the investing and financing activities.

• 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. The net cash flow provided or used in each of these three activities may be highlighted. Ensure that the aggregate of net cash flows from operating, investing and financing activities is equal to net increase or decrease in cash and cash equivalents. 8. Reporting of Cash Flow from Operating Activities There 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 and presented in the cash flow statement. The difference between cash receipts and cash 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 Statement It 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 shows the inflow and outflow of funds i.e., sources and application of funds during a particular period. • Sources of Funds (a) Long term fund raised by issue of shares, debentures or sale of fixed assets and (b) Fund generated from operations which may be taken as a gross before payment of dividend and taxes or net after payment of dividend and taxes. • Applications of Funds (a) Investment in Fixed Assets (b) Repayment of Capital

1. Cost of Capital Cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds of the business/new project and eventually deciding whether the business/new project is worth undertaking or now. It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of share at its current level. It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected 2. Components of Cost of Capital The 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 its incremental 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 under consideration by the firm was accepted. 3. Measurement of Specific Cost of Capital

The first step in the measurement of the cost of the capital of the firm is the calculation of the cost of individual sources of raising funds. (a) Cost of Debt A debt may be in the form of Bond or Debenture. (i) Cost of Debentures: The cost of debentures and long term loans is the contractual interest rate adjusted further for the tax liability of the company. • 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 repaid every year rather than at maturity. In such a situation, the principal will go down with annual payments and interest will be computed on the outstanding amount (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 Capital It may be defined as “the cost of raising an additional rupee of capital”. To calculate the marginal cost of capital, the intended financing proportion should be applied as weights to marginal component costs. The marginal cost of capital should, therefore, be calculated in the composite sense. The marginal weights represent the proportion of funds the firm intends to employ. 6. Capital Structure Capital structure refers to the mix of a firm‟s capitalisation (i.e. mix of long term sources of funds such as debentures, preference share capital, equity share capital and retained earnings for meeting total capital requirment). While choosing a suitable financing pattern, certain factors like cost, risk, control, flexibility and other considerations like nature of industry, 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 structure which can provide the highest earnings per share (EPS) over the firm‟s expected range of earnings before interest and taxes (EBIT). EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen 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.

• Modigliani-Miller Approach: Modigliani-Miller derived the following three propositions. (i) Total market value of a firm is equal to its expected net operating income dividend by the discount rate appropriate to its risk class decided by the market. (ii) The expected yield on equity is equal to the risk free rate plus a premium determined as per the following equation: Kc = Ko + (Ko– 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 an optimal capital structure which minimises cost of capital. 9. Over Capitalisation It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest. 10. Under Capitalisation It is just reverse of over-capitalisation. It is a state, when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity. 11. Leverages In financial analysis, leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc. 12. Types of Leverages Operating Leverage: It exists when a firm has a fixed cost that must be defrayed regardless of volume of business. It can be defined as the firm‟s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Degree of operating leverage (DOL) is equal to the percentage increase in the net 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 of the percentage increase in earning per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT).

Degree of Financial Leverage = EBIT / EBT
Combined Leverage: It maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm. Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the sales changes will have on EPS.

Degree of Combined Leverage = DOL× DFL

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

• 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 term Refer to those requirements of funds which are for a period exceeding 5 -10 years. All investments in plant, machinery, land, buildings, etc., are considered as long term financial needs. 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 term Refer to those funds which are required for a period exceeding one year but not exceeding 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 financing External commercial borrowings Euro-issues Foreign Currency bonds (iii) Short term Investment in these current assets such as stock, debtors, cash, etc. assets is known as meeting of working capital requirements of the concern. The main characteristic of

short term financial needs is that they arise for a short period of time not exceeding the accounting period. i.e., one year. 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 is purchased 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 rate on such funds. • Seed Capital Assistance: The Seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons possessing relevant 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 the investors. 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 with minimum average maturity of 3 years.

• 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 a certain number of a company's regular shares. ADRs allow US investors to buy shares of these companies without the costs of investing directly in a foreign stock exchange. • Global Depository Receipt (GDRs): These are negotiable certificate held in

the bank of one country representing a specific number of shares of a stock traded on the exchange of another country. These financial instruments are used by companies to raise capital in either dollars or Euros. • Indian Depository Receipts (IDRs): IDRs are similar to ADRs/GDRs in the sense that foreign companies can issue IDRs to raise funds from the Indian Capital Market in the same lines as an Indian company uses ADRs/GDRs to raise foreign capital.

1. Capital Budgeting • Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the goal of investor‟s wealth maximization. The capital budgeting decisions are important, crucial and critical business decisions due to substantial expenditure involved; long period for the recovery of benefits; irreversibility of decisions and the complexity involved in capital investment decisions. • One of the most important tasks in capital budgeting is estimating future cash flows for a project. The final decision we make at the end of the capital budgeting process is 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 Flows It is helpful to place project cash flows into three categories: a) Initial Cash Outflow The 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 Flows After 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 is calculated as follows:-

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 period c) Terminal-Year Incremental Net Cash Flow For the purpose of Terminal Year we will first calculate the incremental net cash flow for the period as calculated in point b) above and further to it we will make adjustments in order to arrive at Terminal-Year Incremental Net Cash flow as follows: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 flow 3. Techniques of Capital Budgeting (a) Traditional (non-discounted) The most common traditional capital budgeting techniques are Payback Period and Accounting (Book) Rate of Return. (b) Time-adjusted (discounted) The most common time-adjusted capital budgeting techniques are Net Present Value Technique, Profitability Index, Internal Rate of Return Method, Modified Internal Rate of Return and Discounted Payback period. 4. Payback Period: The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equal the total initial cash outlays 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 investment measures the average annual net income of the project (incremental income) as a percentage of the investment Accounting rate of return = Average annual net income / Investment 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 present values (the time of the initial investment or year 0). Net present value = Present value of net cash flow - Total net initial investment 7. Desirability Factor/Profitability Index: In certain cases we have to compare a number of proposals each involving different amounts of cash inflows, then we use „Desirability factor‟, or „Profitability index‟. The desirability factor is calculated as below :

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 the discount rate that equates the present value of the expected net cash flows with the initial cash outflow. 9. Multiple Internal Rate of Return: In cases where project cash flows change signs or reverse during the life of a project e.g. an initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow , there may be more than one IRR. 10. Modified Internal Rate of Return (MIRR): Under this method , all cash flows , apart from the initial investment , are brought to the terminal value using an appropriate discount rate(usually the Cost of Capital). This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash in flow as mentioned above. The discount rate which equates the present value of the terminal cash in flow to the zeroth year outflow is called the MIRR. 11. Capital Rationing In capital rationing the firm attempts to select a combination of investment proposals that will be within the specific limits providing maximum profitability and ranks them in descending order according to their rate of return.

1. Working Capital Management • Working Capital Management involves managing the balance between firm‟s 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 firm‟s investment in current assets. Net Working Capital: It refers to the difference between current assets and current liabilities. • 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 current assets that is carried by the business at all times to carry out minimum level of its activities. Temporary Working Capital: It refers to that part of total working capital, which is required 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 their financing. To decide the levels and financing of current assets, the risk return trade off must be taken into account. In determining the optimum level of current assets, the firm should balance the profitability – Solvency tangle by minimizing total costs.

4. Working Capital Cycle Working Capital Cycle indicates the length of time between a company‟s paying for materials, entering into stock and receiving the cash from sales of finished goods. It can be determined by adding the number of days required for each stage in the cycle. 5. Computation of Operating Cycle Operating Cycle = R + W + F + D – C Where, R = Raw material storage period W = Work-in-progress holding period F = Finished goods storage period D = 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, the generation of external and internal funds for business, the management of currencies and cash flows and the complex, strategies, policies and procedures of corporate finance”. 7. Management of Cash It involves efficient cash collection process and managing payment of cash both inside the organisation 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; and iii. The surplus cash (if any) should be invested in order to maximize returns for the business. 8. Cash Budget Cash Budget is the most significant device to plan for and control cash receipts and payments. This represents cash requirements of business during the budget period. The various purposes of cash budgets are: i. Coordinate the timings of cash needs. It identifies the period(s) when there might either 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 its accounts payable;

iv. Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage of cash) on favorable terms. 9. Preparation of Cash Budget The Cash Budget can be prepared for short period or for long period. Cash budget for short period: Preparation of cash budget month by month would require the following estimates: (a) As regards receipts: • 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 of loan, payment of assets acquired, etc. Cash Budget for long period: Long-range cash forecast often resemble the projected sources and application of funds statement. The following procedure may be adopted to prepare long-range cash forecasts: (i) 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 current liabilities. (iii) Deduct: (a) Dividends to be paid. (b) Cost of assets to be purchased. (c) Taxes to be paid. (d) Debentures or shares to be redeemed. (e) Increase in working capital. 10. Cash Management Models William J. Baumol’s Economic Order Quantity Model, (1952): According to this model, optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum. The formula for determining optimum cash balance is: Miller-Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic. When changes in cash balance occur randomly the application of control theory serves a

useful purpose. The Miller-Orr model is one of such control limit models. 11. MANAGEMENT OF MARKETABLE SECURITIES Management of marketable securities is an integral part of investment of cash as this may serve both the purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to park excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles. • Safety: Return and risks go hand in hand. As the objective in this investment is ensuring liquidity, minimum risk is the criterion of selection. • Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities fluctuate more with changes in interest rates and are therefore, more risky. • Marketability: It refers to the convenience, speed and cost at which a security can be converted into cash. If the security can be sold quickly without loss of time and price it is highly liquid or marketable. 12. Inventory Management Inventory management covers a large number of problems including fixation of minimum and maximum levels, determining the size of inventory to be carried, deciding about the issues, receipts and inspection procedures, determining the economic order quantity, proper storage facilities, keeping check over obsolescence and ensuring control over movement of inventories. 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 debtors is low, the sales may be restricted, since the competitors may offer more liberal terms. Therefore, management of sundry debtors is an important issue and requires proper policies and their implementation. • There are basically three aspects of management of sundry debtors: (i) Credit policy: The credit policy is to be determined. It involves a trade off between the profits on additional sales that arise due to credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. This seeks to decide credit period, cash discount and other relevant matters. (ii) Credit Analysis: This requires the finance manager to determine as to how risky it 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 of credit policies and execution of such policies. • Important Sources of Financing of Receivables (i) Pledging: This refers to the use of a firm‟s receivable to secure a short term loan. (ii) Factoring: In factoring, accounts receivables are generally sold to a financial institution (a subsidiary of commercial bank-called “Factor”), who charges commission and bears the credit risks associated with the accounts receivables

purchased by it. 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 and also 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 the contrary, temporary working capital may be financed by the short-term sources of finance. • Broadly speaking, the working capital finance may be classified between the two categories: (i) Spontaneous Sources: Spontaneous sources of finance are those which naturally arise in the course of business operations. Trade credit, credit from employees, credit from suppliers of services, etc. are some of the examples which may be quoted in this respect. (ii) Negotiable Sources: On the other hand the negotiated sources, as the name implies, are those which have to be specifically negotiated with lenders say, commercial banks, financial institutions, general public etc.


Classification of Costs
1. Nature of Element 1.1 Material: Cost of Material used in production 1.2 Labour: Cost of Workers 1.3 Expenses: Costs other than Material and Labour 2. Traceability to Object 2.1 Direct Costs: Which can be allocated directly to the product 2.2 Indirect Costs: Which cannot be directly allocated to the product 3. Functions 3.1 Production Costs Cost of whole process of Production 3.2 Selling Costs: Cost for creating demand of the product produced 3.3 Distribution Costs: Costs starting from packing of the product till reconditioning of empty products 3.4 Administrative Costs: Cost of formulating policy, controlling the organisation, costs not directly related to production 3.5 Development Costs: Development Costs for trial Run 3.6 Pre- Production Costs: Costs starting with implementation of decisions and

ending with the commencement of the production process 3.7 Conversion Costs: Cost of transforming direct material into Finished Products 3.8 Product Costs: Costs necessary for production 4. Variability 4.1 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 variable 5. Controllability 5.1 Controllable Costs: Costs which can be influenced by the action of a specific member of an undertaking 5.2 Uncontrollable Costs: Costs which can not be influenced by the action of a specific member. 6. Normality 6.1 Normal Costs: Costs which are expected to be incurred in normal routine 6.2 Abnormal Costs: Costs which are over and above normal costs 7. Decision Making 7.1 Relevant Costs (Marginal Costs, Differential Costs, Opportunity Costs, Out of Pocket): Costs which are relevant and useful for decision making 7.2 Irrelevant Costs (Sunk costs, Committed costs, Fixed costs): Costs which are not relevant or useful to decision making 8. Cash Outflow 8.1 Explicit Costs: Costs involving immediate payment of cash 8.2 Implicit Costs: Costs not involving immediate cash payment

Types of Costing
1. Uniform Costing: Standardised principles and practices of costing are used by a number of different industries. 2. Marginal Costing: Only Variable Costs or costs directly linked are charged to the product or process 3. Standard Costing:Standard Costs are compared with actual costs, to determine variances 4. Historical Costing:Where costs are recorded after they have incurred 5. Direct Costing: Direct Costs are charged to the product or process, Indirect Costs are charged to the profit from the product or process. 6. Absorption Costing: All costs (variable and Fixed) are charged to the product or process

Methods of Costing
1. Job costing; Where all costs can be directly charged to a specific job 2. 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 than job costing. 4. Single or Output Costing: Cost ascertainment for a single product. 5. Process Costing:The cost of production at each stage is ascertained separately 6. Operating Costing : Ascertainment of Costs in cases where services are rendered 7. Multiple Costing:Combination of two or more methods of costing, used where the nature of the product is complex and method cannot be ascertained


1. Maximum Level: It indicates the maximum figure of inventory quantity held in stock 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 to non-availability of inventory. 3. Re-order level: This level lies between minimum and the maximum levels in such a way that before the material ordered is received into the stores, there is sufficient quantity on hand to cover both normal and abnormal consumption situations. 4. Danger level: It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made. 5. ABC Analysis: It is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved. Items are 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, smaller part, should stock the quantity equal to the minimum stock or even the re-ordering level, and the other to keep the remaining quantity. Issues are made out of the larger part; but as soon as it becomes necessary to use quantity out of the smaller part of the bin, fresh order is placed. 7. System of budgets: The exact quantity of various types of inventories and the time when they would be required can be known by studying carefully production plans and production schedules. Based on this, inventories requirement budget can be prepared. Such a budget will discourage the unnecessary investment in inventories. 8. Perpetual inventory: Perpetual inventory represents a system of records maintained by the stores department. It in fact comprises: (i) Bin Cards, and (ii) Stores Ledger. 9. Continuous stock verification: Continuous stock taking means the physical checking of those records (which are maintained under perpetual inventory) with actual stock. 10. Economic Order Quantity (EOQ): It is the calculation of optimum level quantity which minimizes 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 moving items, in return with items needed for production to avoid unnecessary blockage of resources. 12. Input output ratio : Inventory control can also be exercised by the use of input output ratio analysis. Input-output ratio is the ratio of the quantity of input of material to production and the standard material content of the actual output. 13. Inventory turnover ratio: Computation of inventory turnover ratios for different items of material and comparison of the turnover rates provides a useful guidance for measuring inventory performance. High inventory turnover ratio indicates that the material in the question is a fast moving one. A low turnover ratio indicates over-investment and locking up of the working capital in inventories 14. Valuation of Material Issues: Several methods of pricing material issues have been evolved which are as follows: a) First-in First-out method: The materials received first are to be issued first when material requisition is received. Materials left as closing stock will be at the price of

latest purchases. b) Last-in First-out method: The materials purchased last are to be issued first when material requisition is received. Closing stock is valued at the oldest stock price. 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 quantities purchased 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 recoverable value 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 further processing. d) Defectives: Goods which can be rectified and turned out as good units by the application of additional labour or other services.

Basic Formulas
1. Maximum Level = Reorder Level + Reordering Quantity – Minimum Consumption during the period required to obtain delivery. Or RL + RQ – MnC Or Safety Stock + EOQ 2. Minimum Level = Reorder Level – (Normal usage per period × Average delivery time) 3. Average Stock Level =

2 Maximum Level +Minimum Level
Minimum Level + ½ Reorder Quantity 4. Reorder Level = Maximum Reorder period × Maximum Usage = Normal Usage × (Minimum Stock Period + Average Delivery Time) = Safety Stock + Lead Time Consumption 5. 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

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, compare total 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 Cost Note: For calculation of total inventory carrying cost, average inventory should betaken as half of EOQ. Average inventory cost is normally given as a percentage of cost per unit
CHAPTER 3 LABOUR Basic Concepts

1. Labour Cost: Cost incurred for hiring of human resource of employees 2. 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 no productive purpose. 4. Normal Idle Time: Time which can not be avoided or reduced in the normal course of business. 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 to Costing Profit and Loss account. 6. Time Keeping: It refers to correct recording of the employee‟s attendance time 7. Time Booking: It is basically recording the details of work done and the time spent by workers 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: It‟s 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 to resignation, retirement and retrenchment. If the labour turnover is high, it‟s a sign of instability and may affect the profitability of the firm. 11. Incentives: It is the simulation for effort and effectiveness by offering monetary inducement or enhanced facilities. 12. Time Rate System: The amount of wages due to a worker is arrived at by multiplying the time 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 rate increases 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 by rate 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.

Basic Concepts

1. Overheads: Overheads represent expenses that have been incurred in providing certain ancillary facilities or services which facilitate or make possible the carrying out of the production process; by themselves these services are not of any use. 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 in the 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 cost to cost centres or departments. 6. Re-apportionment- The process of assigning service department overheads to production departments is called reassignment or re-apportionment. 7. Absorption- The process of recovering overheads of a department or any other cost center from its output is called recovery or absorption. 8. Methods used for re-apportionment of service department expenses over the production departments: • Direct re-distribution method- Under this method service department costs are apportioned over the production departments only, ignoring the services rendered by 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. The sequence here begins with the department that renders service to the maximum number 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 to production departments. In such cases various service departments have to share overheads of each other. The methods available for dealing with reciprocal services are (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 material consumed 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

materials as well as labour contribute in raising factory overheads. Hence, the total of the two i.e. Prime cost should be taken as base for absorbing the factory overhead. c) Percentage of direct labour cost : This method also fails to give full recognition to the element of the time which is of prime importance in the accounting for and treatment of manufacturing overhead expenses except in so far as the amount of wages is a product of the rate factor multiplied by the time factor. d) Labour hour rate Method: This method is an improvement on the percentage of direct wage basis, as it fully recognises the significance of the element of time in the incurring and absorption of manufacturing overhead expenses. e) Machine hour rate method: By the machine hour rate method, manufacturing overhead expenses are charged to production on the basis of number of hours machines are used on jobs or work orders. 10. Types of Overhead Rates a) Normal rate: This rate is calculated by dividing the actual overheads by actual 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 one single overhead rate for the whole factory. It is to be distinguished from the departmental overhead rate which refers to a separater d) Departmental overhead rate: Where the product lines are varied or machinery is used to a varying degree in the different departments, that is, where conditions throughout the factory are not uniform, the use of departmental rates is to be preferred. 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 Formulas
1. Overhead Absorption Rate or Overhead Recovery Rate = Amount of overhead incurred /

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

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

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

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, as it is also indirect cost for production departments.

1. Cost Control Accounts: These are accounts maintained for the purpose of exercising control 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 and financial transactions are recorded in the same set of books. 3. Non- Integral System of Accounting: A system of accounting where two sets of books are maintained- (i) for costing transactions; and (ii) for financial transactions 4. Reconciliation: In the Non-Integral System of Accounting, since the cost and financial accounts are kept separately, it is imperative that those should be reconciled, otherwise the 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

1. Job Costing : According to this method costs are collected and accumulated according to jobs, contracts, products or work orders. Each job or unit of production is treated as a separate entity for the purpose of costing. Job costing is carried out for the purpose of ascertaining cost of each job and takes into account the cost of materials, labour and overhead etc Meaning 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 is used as a cost unit, whereas under batch costing, a lot of similar units which comprises the batch may be used as a cost unit for ascertaining cost. In the case of batch costing separate cost sheets are maintained for each batch of products by assigning 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.

1. Contract costing:- Contract or terminal costing, as it is termed, is one form of application 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 of executing 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 to the contract price. If extra work is substantial, it is better to treat it as a separate

contract. If it is not substantial, expenses incurred should be debited to the contract account as “Cost of Extra work”. 4. Cost of work certified : All building contractors received payments periodically known as “running payment” on the basis of the architect‟s or surveyor‟s certificates. But payments are not equal to the value of the work certified, a small percentage of the 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 by the contractor but has not been certified by the contractee‟s architect. It is always shown at cost price. 6. Retention money : A contractor does not receive full payment of the work certified by the surveyor. Contractee retains some amount (say 10% to 20%) to be paid, after sometime, 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 yet completed; and (iii) the amount of profit taken as credit. In the Balance Sheet, the workinprogress 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 cost of the contract. 10. Cost plus Contract : Under Cost plus Contract, the contract price is ascertained by adding a percentage of profit to the total cost of the work. Such type of contracts are entered into when it is not possible to estimate the Contract Cost with reasonable accuracy due to unstable condition of material, labour services, etc. 14. Operating Costing: It is a method of ascertaining costs of providing or operating a service. This method of costing is applied by those undertakings which provide services 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 to material required and process of manufacture. In such cases, cost of each article is computed 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 of a contract can reasonably be foreseen. Of the profit which in the light of all the circumstances can be foreseen with a reasonable degree of certainty to arise on completion of the contract there should be regarded as earned to date only that part which prudently reflects the amount of work performed to date. The method used for taking up such profits needs to be consistently applied.” 6. The computation of escalation claim is based on wording of escalation clause. Normally it is calculated on stipulated quantity of material and labour hours based on price and rate differential. 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 contractee‟s account. On receipt of money from contractee, his personal account will be credited and cash or bank account, as the cause may be will be debited. At the time of balance sheet preparation, Contractee‟s Account will be shown on the „Assets side‟ as debtors.

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

Basic Concepts
1. Operating Costing: It is a method of ascertaining costs of providing or operating a service. This method of costing is applied by those undertakings which provide services 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 a large variety of articles are produced, each differing from the other both in regard to material required and process of manufacture. In such cases, cost of each article is computed separately by using, generally, two or more methods of costing.

Basic Formulas
1. Absolute (weighted average) tonnes-kms: Absolute tonnes-kms., are the sum total of tonnes-kms., arrived at by multiplying various 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.

1. Process Costing:- Used in industries where the material has to pass through two or more processes for being converted into a final product. 2. Operation Costing:- It is the refinement of process costing. It is concerned with the determination 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 units produced under the process. The amount realised by the sale of normal process loss units should be credited to the process account. (ii) Abnormal process loss - The total cost of abnormal process loss is credited to the process account from which it arise. the total cost of abnormal process loss is debited to costing profit and loss account. (iii) Abnormal gain- The process account under which abnormal gain arises is debited with the abnormal gain and credited to Abnormal gain account which will be closed by transferring to the Costing Profit and loss account.

3. Equivalent production units: This concept use in the industries where manufacturing is a continuous activity. Converting partly finished units into equivalent finished units. 4. Equivalent production means converting the incomplete production units into their equivalent 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 workinprogress which are as follows: (i) First-in-First Out (FIFO) method. Under this method the units completed and transferred include completed units of opening work-in-progress and subsequently introduced units. Proportionate cost to complete the opening work-in-progress and that to process the completely processed units during the period are derived separately. The cost of opening work-in-progress is added to the proportionate cost incurred on completing the same to get the complete cost of such units. In this method 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 the process are the first to be completed. This assumption has a different impact on the costs of the completed units and the closing inventory of work-in-progress. The completed units will be shown at their current cost and the closing inventory of work-in-progress will continue 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, the cost of opening work-in-progress and cost of the current period are aggregated and the aggregate cost is divided by output in terms of completed units. The equivalent production in this case consists of work-load already contained in opening work-inprocess and work-load of current period. 6. Inter-Process Profits The output of one process is transferred to the next process not at cost but at market value or cost plus a percentage of profit. The difference between cost and the transfer price is known as inter-process profits.

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 sale value are known as joint products. (ii) Co-Products - Two or more products which are contemporary but do not emerge necessarily from the same material in the same process. (iii) By-Products - “products recovered from material discarded in a main process, or from the production of some major products 2. Method of apportioning joint cost over joint products: The commonly used methods for apportioning total process costs upto the point of separation over the joint products are as follows : (i) Physical unit method (ii) Average unit cost method (iii) Survey method (iv) Contribution margin method

(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 at the cost of the main product. (b) Standard cost in technical estimates- The standard may be determined by averaging costs recorded in the past and making technical estimates of the number 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 method may 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 to the 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 Loss Account and no credit be given in the Cost Accounts. The credit to the Profit and Loss Account here is treated either as miscellaneous income or as additional sales revenue. 2. The sale proceeds of the by-product may be treated as deductions from the total costs. The sale proceeds in fact should be deducted either from the production cost or from the cost of sales. (ii) When the by-products are of considerable total value - The joint costs may be 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 (if sold). (iii) Where they require further processing -The net realisable value of the byproduct at the split-off point may be arrived at by subtracting the further processing 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 the provisions 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).

Basic Concepts
1. Absorption Costing: a method of costing by which all direct cost and applicable overheads are charged to products or cost centers for finding out the total cost of production. Absorbed cost includes production cost as well as administrative and other cost. 2. Break even chart: A mathematical or graphical representation, showing approximate profit or 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 a cash loss.

5. Cost Breakeven Point: It is the level of activity where the total cost under two alternatives are 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 which only cost and income differences in between alternative courses of action are taken into consideration. 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 of production. 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 fixed cost 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 and the sales value. 13. Margin of Safety: This is the difference between the expected level of sales and the break even sales

1. Budget: It is statement of an estimated performance to be achieved in given time, expressed in currency value or quantity or both. 2. Budget Centre: A section of an organization for which separate budget can be prepared and control exercised. 3. Budgetary Control: Guiding and regulating activities with a view to attaining predetermined objectives, effectively and efficiently. 4. Budget Manual: The Budget manual is a schedule, document or booklet which shows, in written forms the budgeting organisation and procedures. 5. Budget Period: The period of time for which a budget is prepared and used. It may be a year, quarter or a month. 6. Components Of Budgetary Control System : 1. Physical budgets Those budgets which contain information in terms of physical units about sales, production etc. for example, quantity of sales, quantity of production, inventories, and manpower budgets are physical budgets. 2. Cost budgets Budgets 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 cost budgets. 3. Profit budgets A budget which enables in the ascertainment of profit, for example, sales budget, profit and loss budget, etc. 4. Financial budgets A 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 Controlling 8. Functional budgets - Budgets which relate to the individual functions in an organisation are

known as Functional Budgets. For example, purchase budget; sales budget; production budget; plant-utilisation budget and cash budget. 9. Master budget - It is a consolidated summary of the various functional budgets. It serves as the 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 are called long-term budgets. Such budgets are helpful in business forecasting and forward planning. Capital expenditure budget and Research and Development budget are examples of long-term budgets. 11. Short-term budgets - Budgets which are prepared for periods less than a year are known 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 be immediately 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 is called basic budget. 13. Current budgets - A budget which is established for use over a short period of time and is related to the current conditions is called current budget. 14. Fixed budget – According to Chartered Institute of Management Accountants of England, “a fixed budget, is a budget designed to remain unchanged irrespective of the level of activity actually attained”. 15. Flexible budget According to Chartered Institute of Management Accountants of England, “a flexible budget is 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.”

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