ENGINEERING ECONOMY

CHAPTER-1
INTRODUCTION

It involves the financial and economic evaluation of the

manufacturing projects. In short, economic decision making for
[Link] is called EE. This definition may seem restricted to
[Link] and systems only, EE is also the study of industrial
economics and economics and financial factors which influence the
industry.

The objective of EE is to familiarize and develop Commercial and

financial knowledge of engineers. Engineers are people who are familiar
with all the technicalities of machinery and production. Therfore they are
the best judges of the useful lives of an asset and they also have the
technical knowledge to calculate the number of units a proposed plant
would produce when operational. They can recommend quality control
checkpoint and they can introduce cost-effective measures more
effectively. Engineers are able to give the break up of all variable and
fixed costs relating to each unit produced. In order to perform all these
functions with the ultimate objectives of making a profit for the
organization, it is necessary for engineers to have some know-how of
financial analysis and evaluation methodologies.

EE focuses on those economic and financial aspects, which affect

the decision-making capacity of the engineer. In today’s competitive
world of business, it has become essential that engineers should practice
financial project analysis for engineering projects and make rational
decisions.

Importance of EE.

Knowledge of EE is useful at every level of Eng. work in an

organization. In a manufacturing concern such knowledge is useful
when, for e.g. company is evaluating three different inputs of raw
materials in different qualities with market surreys for the resulting
products. The engineers have to decide which one of the raw material
compositions would give maximum profits, but high quality is not always
the objective of most manufacturing process. the manufacturing industry
is capital intensive, for every new innovative development or
improvement, the manufacturing concerns have to introduce new plant
and machinery in order to change the specification of their products.
Before undertaking such extensive and expensive investments in plant
and machinery, the company has to make sure that its costs can be
justified by future benefits and revenues. For this purpose, companies
have to carry out various forms of investment appraisal techniques, the
role of the engineer during such decision-making processes is very
important.

Since manufacturing requires heavy investments in capital such as

plant and machinery, it becomes important to know the depreciation
rates for the machinery. This involves finding out how soon such
machinery would become obsolete, what are the. Maintenance costs and
how does the wear and tear of the machinery relate to activity levels.
Depreciation would be charged after considering all these aspects. the
company would then be able to determine the retirement and
replacement of an asset.

EE also includes the study of accounting practices for the

manufacturing concerns. Unique features of accounting for
manufacturing concerns are process costing, batch costing, cost
allocation activity based casting and absorption casting in order to
operate efficiently and have control over various casts, it is important to
adopt these types of accounting. Stocks valuation and stock level
control is perhaps the most vital aspect of manufacturing processing.
Everything depends on the availability of raw materials and their storage
capacity therefore it is important to know how to manage stocks. Value-
added tax and income taxes are the main types of taxes levied on
manufacturing companies, determining the affected of value-added tax
on sales is important and affects the pricing policy of the company.
Also companies carryout sensitivity analysis, which measures the impact
of factors on profitability. Price changes due to inflation and deflation
also have to be incorporated in any analysis report, which predicts future
cash flows. Manufacturing in every industry has become very complex
and for each industry different economic factor have different impacts. It
is necessary for every company to analyses each investment and
determine its profitability, the same is true for any change in process or
input of raw materials.

Business Economics.

Economics is the study of how economic agents or societies

choose to use scarce resources to satisfy unlimited wants .It examines
how resources can be optimally distributed to satisfy the needs of
individuals and society as a whole. Knowledge of economics helps
businesses become more profitable through proper allocation of
resources, and helps governments, take budgetary and trade related
decisions. To obtain a better understanding of the changing business
environments, managers/engineers need to analyses economic problems
at two levels microeconomics and macroeconomics.

Microeconomics is the study of the economic systems from the

perspective of households and business firms, it focuses in the nature of
individual consumption and production units within a particular market
or economic systems.

Macroeconomics deals with the overall performance of the

economic system, it focuses on issues such as unemployment, inflation,
economic growth and other related problems, which affect the economy
as a whole.

Thus, business economics is the application of economic

theory and methodology to decisions making problems faced by the
business firms. This definition shows that it is an attempt to apply
economic analysis in the formulation of business policies.

Microeconomics is the study of decisions that people and

organizations make with regard to the allocation of resources and prices
of goods and services. It also takes into account various policies like tax
policies and government regulation at individual level and at the firm
level. Thus, it encompasses supply and demand, and other forces that
determine price. It helps to analyze the reasons for variations in price
due to increase/decrease in supply, and factors influencing the demand
and supply. It takes into consideration the relationship between the
market force and optimum allocation of resources.

Microeconomics plays an important role in the study of

economic theory. It helps to analyze the behavior of consumers,
producers and markets. For example, price can be used as an
instrument to allocate scarce resources among alternative uses. Price
helps to determine what goods and services are produced, how they are
produced, and for whom they are produced. An example of this is
telecommunication charges, which are priced differently at peak times
and off-peak times, although the cost of carrying a call over the telecom
network is same during both the periods. Off-peak charges are set lower
to induce increased usage at these times, and thus ensure a more
optimum utilization of network capacity. Thus price can play a crucial
role in decision-making. Since price plays such an important role in
microeconomics, it is also some times referred to as price theory.

To make the best use of economic resources, the following questions

need to be answered:

• What to produce?
• How to produce?
• For whom to produce?

• What to produce ?

At the level of the government, scarcity of land, labor and capital

means that they cannot satisfy all the needs of economy. They have to
choose which goods and services to produce, with the limited resources
available. From an individuals point of view, he or she has to decide how
much to consume and how much to save.

• How to produce ?

This looks at the combination of resources and the quantity of

each resource to be used to produce a given level of output. The best
combination is the full employment of the available resources, to
produce the maximum output. Depending on resources available,
techniques of production can be labor intensive or capital intensive.
 • For whom to produce ?

This refers to distribution of goods and services between different

categories and sections of the population. For example, one needs to see
if the scarce resources are being used appropriately to cater to the needs
of the higher income groups and lower income groups.

The answers to these questions will depend on the extent of

government control on the economy.

Economic system or economy can be classified, into three broad

categories- the market, the command and the mixed economy.

Market economy: It emphasizes the freedom of individuals as

consumers and suppliers of resources, and allows market force to
determine the allocation of scarce resources through the price
mechanism. Based on market demand and supply, consumers are free to
buy goods/services of their choice and producers allocate their resource
based on the demand. Decision made by producers and consumers are
influenced greatly by price.

Thus, price plays a major role in a market economy. The role of

the government is negligible; consumers choose the goods they want and
producers allocate their resources based on the market demand for
different products. The United States is an example of market economy;
here, firms decide the type and quantities of goods to be made in
response to consumer demand.
Command economy: Here, the government takes all the decisions.
Thus, all decisions, from the allocation of resources to the distribution of
end products, are taken care-off by the government. In this, efficiency
can be achieved only when demands are accurately estimated and
resources allocated accordingly. The USSR was an example of command
economy. The government had complete control over the economy, and
consumers were just the price takers.

Mixed economy: It is a combination of a free market economy and a

command economy. Here, government controls the price fluctuations to
achieve certain objectives such as high level of employment and low level
of inflation. Here, the government organizes the manufacture or provision
of essential goods and services like education and health care.

Demand Theory: Demand in economics means effective demand,

which can be defined as a desire backed by willingness and ability to pay
for a particular product. Thus for a demand to be effective, three factors
are important;

♦ Desire to buy
♦ Willingness to buy
♦ Ability to buy
 We must clearly distinguish between demand and want. Want can
be defined as a desire to buy a particular product. But for the want to
become a demand, it must be backed by the ability to pay for the
product. For example, a person may have desired to buy a car. This
desire can be termed as want. This becomes a demand, only when he has
the ability to pay for the car.

LAW OF DEMAND

The law states that demand varies inversely with price not
necessarily proportionately thus the law can also be stated as a rise in
the price of a commodity or service is followed by a reduction in demand,
and a fall in price is followed by an increase in demand, if conditions of
demand remain constant.

The law is depicted in the demand schedulethe demand

schedule lists the prices and the quality demanded of particular product
at a given period of time. It indicates the changes in consumers
purchasing habits, depending on the price variation of a product. When
the price of product is low, more quality is consumed and vice-versa.

When the relationship between demand and price is illustrated

in a graphical form it is called demand curve. The demand curve slopes
downward from left to right, because as the price of a product goes up
the quantity demanded decreases. The curve is drawn with the
assumption that only the price changes. While other factors remain
same.
Price

Demand
DEMAND CURVE

Determinants of Demand.

The demand of a product largely depends on its price. But price

is not only factoring that influences demand the following are the
determinants of demand. .
• Income of consumer–consumption is influenced by the income of
a consumers with every increase in the income of consumers ,his
consumption pattern changed i.e. the purchasing power of the
consumer increases .on the other hand, any increase in price of a
product reduces the purchasing power of the consumer.

• Price of the substitute product - A substitute product is one that

provides the same level of satisfaction as the product already being
consumed by the consumer. For eg, bio-fertilizer proved to be good
substitute for chemical fertilizer.
• Price of complimentary product- Complementary product that
are consumed together .for eg car and petrol, shoe and polish etc,
are the complementary product .in this case if the price of one
product goes up the demand for the other product decreases.

• Changes in policies- The demand of particular product also

depends up on government polices, for eg if the governments
increase taxes on product, prices increase and hence the demand
decreases in the short run .change in Govt. polices may also have
a negative impact on the demand for a particular product .Ex
tobacco product (GUTKA,cigerate,and etc)

• Tastes and preferences of consumer- It also effect the demand

for a product .to an extent, prevailing fashion, advertasing and an
overall increase in standard of living influence tastes.

• Existing wealth of consumer- it can be in the forms of stocks,

b0nds, real estate, etc. that can be used purchase goods.

• Expectation regarding future price changes- if a consumer

expects a fall in the price of a product in the near future, he may
reduce his present consumption of that product howerver,the
extent to which he can reduce his present consumption depends
on the nature of product . If the product is essential or perishable
one, the consumer cannot postpone his purchase.
 • Special influence - Demand is also influenced by factors like
climatic changes, demographic changes etc. for eg, the demand for
woolen garments goes up only in winter. In India, demand for cars
is influenced by factors like per capita income, Introduction of new
models of cars, availability and cost of car ,financing schemes
Prices of other models of cars , prevailing duties and taxes,
depreciation norms , fuel cost, public transport etc .

Supply theory:

The supply of product refers to the various quantities of the

product, which a seller is willing and able to sell at the different prices in
a given period of time.

Law of supply:

It states that other factors remaining constant, higher the

price, greater the quantity supplied and lower the price, lower the
quantities supplied .Hence the price and quantity are positively related
This explains the reason why the supply curve slopes upwards.

The supply schedule refers to the quantity of a product a producer

or seller wishes to sell at a given price level. It explains the behavior of
seller at various price levels. In other words, it reveals the price at which
the sellers are willing to sell the maximum quantity of their products .it
can be represented in a tabular form where it depicts the quantity
supplied and price of the product at a given period of time.
Determinants of supply.

Cost of production - Variations in this may occur due to change in cost

of labour, raw materials, capital, techonological advancements, etc an
increase in this leads to a decrease of supply if due to technological
advancements and large scale production it decreases in the long run
there would be an increase in supply.

Availability of other products–The supplier can switch over their

production to any of their complementary or substitute product if their
cost of production is less.

Climatic changes-it also affects the supply of products when the

climatic conditions are favourable; production is usually more, which
may lead to fall in price for eg : agricultural production, is largely
dependent in climatic conditions.

Changes in government polices-A rise in direct or indirect taxes has an

immediate effect on the prices of [Link] India fast moving
consumer goods (FMCG) are witnessing a stagnant growth rate and
survey conducted by the Indian soap and toiletries makers association
(ISTMA) found that the low growth in the market was mainly due to the
high prices of these products. The reason for high prices are high taxes
and duties imposed by the government on FMCG goods.

Elasticity of demand:

The term elasticity expresses the degree of correlation between

demand and price. It is the rate at which the quantity demanded varies
with a change in price.

Elasticity of demand E is the measure of the responsiveness of

demand to changing prices. It is defined as the percentage changes in
quantity demanded causal by one-percent change in the demand
determinant (eg, price of the product, income of consumer) under
consideration, keeping other determinants constant. When demand, is
perfectly inelastic, responsiveness is maximum. Similarly, when demand
is perfectly in inelastic, responsiveness is zero. The demand for
necessities is generally highly inelastic, while the demand for luxury
products is highly elastic.

• Necessities (salt, sugar, etc)-no postponement-high inelastic.

• Luxury products (gold, etc)-postponement (high prices during
festivals. marriages)- highly elastic.

Thus, elasticity is the proportional (or percent) changes in one

variable due to the proportional changes in another variable. it can either
be a positive or a negative value. When the proportional changes varible,
then it is called unit elasticity ie E = 1
Perfectly elastics E > 1
Perfectly inelastic; E < 1

Factors governing the elasticity of demand;

• Demand for luxuries is elastic, while that of necessaries is
inelastic
• Demand of a commodity is elastic if it has substitutes.
• Demand is elastic if the commodity has a Varity of uses (for
instance, at the present price, people use electricity only for
lighting purposes. but if the price of electricity per unit falls.
people might start using it for cooking or heating the rooms
and other purposes)
• Demand is elastic if the use of commodity can be postponed.
• Demand is elastic for high prices, but inelastic for very low
prices.
• Demand is inelastic if the total sum spent on a commodity
forms only a very small part of the income
• Sensibility, acquired tastes and distances also affect the
elasticity of demand.

Elasticity of supply:
 It refers to the percentage change in quantity supplied of a product
due to one percent change in its price. when the change in the
quantity supplied changes more than proportionate to the change in
price leads to a less to a the supply is elasticity. On the other hand ,if
the change in the price leads to a less than proportionate change in
quantity demanded, the supply is inelastic.

Factors deterring the elasticity of supply;

• The nature of commodities- perishable commodities less
elastic
Durable commodities more elastic
• Time period-short period inelastic
long period elastic

• Scale of production-small scale inelastic

large scale elastic

• Technique of production-Advanced technology(capital intensive)

elastic less technology(labor intensive) less elastic
• Size of the firm and the number of products produced-high-
elastic
• Natural factors-for eg fir agricultural goods, climate monsoon,
fertility of soil are natural factors. if good production, then it is
elastic and vice-versa.
• Nature of production-by its nature of production, certain goods
are inelastic in supply, eg art works like painting, etc.
• Mobility of factors-high degree of mobility of production, supply
will be more elastic. immobility of factors causes inelasticity of
supply.
The laws of returns

Cultivators, manufacturers and other businessmen

increase the quantity of the various factor of production used in their
business in order to increase their output. The returns due to these
additional quantities of productive resources are not always fixed. In
some cases, the businessman finds that if he increases the quantity of
the various factors of production, the return (or the out put) due to
each successive dose (or unit) of productive resources will go on
increasing. This tendency of the returns to go on increasing due to
each successive close is known as the law of increasing returns and
encourage every businessman to expand his business .In some
cases, the return due to each successive close of productive resources
instead of increasing go on diminishing . This tendency of returns
due to successive doses go on diminishing is named as the law of
diminishing returns and prohibits the producer from increasing
his business beyond a certain measure. In other cases, the tendency
of the due to each successive dose remains fixed or all most constant
is known as the law of constant return. These three laws of returns
occupy a central position in production.

Problem solving & decision making:

An engineering economist draws upon the accumulated knowledge of

engineering and economics to fashion & employ tools to identify a
preferred course of action. The tools developed so far are not perfect.
The fundamental approach to economic problem solving is to
elaborate on the time-honored scientific method. The method is
anchored in two words. The real , every day working world & abstract
scientifically oriented world.
Problem in engineering & managerial
economy originate in the real world economy planning. Management
& control. The problem is confined & clarified by the data from the
real world. This information is combined with scientific principles
supplied by the analyst to formulate a hypothesis in symbolic terms.
This symbolic language aids the digestion of data.
By manipulating & experimenting with abstractions of
the real world. The analyst can simulate multiple configuration of
reality that other wise would be too costly or too inconvenient to
investigate. From this activity a prediction usually emerges.

The predicted behavior is converted back to

reality for testing in the form of the hard ware. Design or commands.
If it is valid the problem is solved.

If not the cycle repeated with the added information that the previous
approach was unsuccessful. Fortunately a host of successful
approaches have been discovered & validated for a economy analysis,
the changes now is to use them wisely

A. Intuition & analysis:

Most significant problem requires both analysis & personal

judgment. Initially the analysts settles on which evaluation technique
to utilize & how to apply it. As the solution produces progress, factors
that are difficult to quantify often arise. These are called intangibles;
they cannot be translated readily to monitory values. Intuitive ratings
are assigned to intangible to allow them to be included in the decision
process. Judgment also enters the process in deterring whether the
solution is well enough founded to be accepted. This intuition and
judgment complement analysis method by contributing to better
decision.

B. Strategy & tactics:

They are historically military terms associated with broad

plans from the high command & specific schedule, from lower
echelons, respectively. Strategic sets ultimate objectives, and the
associated tactics define the multiple maneuvers required to achieve
the objectives. Strategic and tactical considerations have essentially
the same meaning for economic studies.

There are several strategies are available to an organization.

A strategic decision ideally select the over all plan that makes the best
use of the organization resources in accordance with its long range
objectives. A strategic industrial decision would be a choice from
several different products designed to develop or products to promote.
The measures of merit for strategic alternatives are effectiveness. The
degree to which a plan meets economic targets, the relative values of
tactical choice or rated according to their efficiency the degree to an
operation accomplishes a mission with in economic expectations.
 The relation ship between strategic & tactics offers
some constructive insides. The effectiveness of each strategy is
initially estimated from the effect it will have on system objectives. It
serves as guide to the area in which tactics will produce the highest
efficiency.

The actual efficiency of each tactic is determined

from a study of the activities required to conduct the tactical
operation.

c. Sensitivity & suboptimisation: Decision-makers are interested in

the full range of possible out comes that would results variances in
estimates. Sensitivity analyses (SA) permits a determination of how
sensitive final results are to changes in the values of the input
estimates. SA can be conducted on any problem to explore the effects
of deviation from the original problem conditions.

Since most engineering economy problems extended over

a period of years, future cash flows are necessarily estimated. This
estimation may be quite reliable, but it is often enlightening to
observe how the attractiveness of alternatives varies as the initial
estimates are altered.

Whenever there are multiple objectives in a decision

situation, it is probable that there is no single course of action that
will optimize all the objectives simultaneously. In general,
suboptimisation occurs when there is a larger problem than the
analyst had visualized.
 It is always tempting to employ a classical textbook solution to a real
world problem. Whether or not it truly fits the actual conditions.

CHAPTER – 2: INTEREST AND INTEREST FACTORS:

Interest : it is the cost of using capital .it is a rental amount charged by

financial institutions for the money.

The concept of interest can be extended to capital assets, which

barrow from their owner, repaying through the earnings generated, this
economic gain from the use of money is what gives money its time value.
Because engineering projects require the investment of money it is
important that the time value of the money used be properly reflected in
the evaluation of these projects. Thus, it is the payment for capital. Like
other prices, it is a price paid for the use of capital and is expressed as a
rate of percent per annum. We cannot think of interest without a specific
amount and a specific period of time.
Interest Rate : or the rate of capital growth is the rate of gain received
from an investment .Usually it is stated on a per year basis and it
represents the percentage gain realized on the money committed to the
finn. Market forces involving supply and demand determine it. It is
determined by mutual agreement between borrower and lender and is
known as market rate.

In one aspect, interest is an amount of money received as a result

of investing funds, either by lending it or by using it in the purchase of
materials, labour, or facilities. Interest received in this connection is gain
or profit. In another aspect, interest is an amount of money paid out as a
result of borrowing funds. Interest paid in this connection is a cost.

Pure Interest : It is the payment for use of capital as such, It is a

payment made exclusively for use of capital.

Gross Interest : It consists of the pure interest charge for risk involved
and charge for management and account –keeping .

In economic environment, capital is the basic resource It can be

converted to production goods, consumer goods, or services. It has power
to earn and to satisfy wants.

From a lenders viewpoint, capital is a fluid resource. It can be

spent on goods expected to produce a profit or an personal satisfaction.
It can be hoarded or given away. It can also be loaned. If it is loaned, the
lender will normally expect some type of compensation. The common
compensation is interest. Interest compensates for the administrative
expense of making the loan, for the risk that the loan will not be repaid,
and for the loss of earning that would have been obtained if the money
had been invested for productive purposes.

From a borrowers viewpoint, a loan is both an obligation and an

opportunity. A borrower must expect to repay the loan .The failure to
repay leads to a damaged reputation, loss of possession, ans other
consequences. The loan offers an opportunity to do something
immediately that would otherwise have to be delayed. Also, borrower
agrees to pay a certain amount in addition to the sum immediately
received. This premium is the interest paid to avoid waiting for the
money.

The Time Value of Money:

It is the relationship between interest and time .the fact that

money has a time value means that equal rupee amount at different
points in time have different value as long as the interest rate that
earned exceeds zero.

Opportunity to earn interest

Rs.1/- Rs.1/-+
Interest

Now 1 2 3 (n-1) n
 Fig: Illustration of the time value of money

Thus engineering economy is concerned with the evaluation of

engineering alternative. These alternatives are usually characterized by
estimating the amount and timing of future receipts and disbursements.
Since that time value of money is concerned with the effect of time and
interest rate on monetary amounts, this effect must be given primary
consideration in engineering economy studies.

The rental rate for a sum of money is usually expressed as the

percent of the sum that is to be paid for its use for a period of one year.
Interest rates are also quoted for periods other than one year, known as
interest periods.

Simple Interest(SI):

Under this, the interest owed upon repayment of a loan is

proportional to the length of time the principal sum has been borrowed.
That is the interest earned is directly proportional to the capital involved
in the loan. Expressed as a formula, the interest earned “ I ” through
several time periods is found by:

I = Pi N
Where P = Principal (or) present Amount ( or) amount
borrowed.
. i = interest rate per period
N = Number of interest periods ( usually in years )
 Since P is fixed value, the annual interest charged is constant
therefore the total amount a borrower is obligated to pay a lender is F =
P + I = P+ Pi N = P(1+in)

Where F = future sum of money to be paid

When N is not a full year, there are two ways to calculate the SI
earned during the period of the loan. When ordinary SI is used, the year
is divided into twelve 30 days periods or a year is considered to have 360
days. In exact SI a year has precisely the calendar number of days and N
is the fraction of the number of days the loan is in effect that year.

Illustration:
An example of SI as rental cost of money is a loan of
Rs.1000/- for 2 months at 10% with ordinary SI the amount to be repaid
is :
F = P (1+iN) where N is 2/12 year giving
F = 1000(1+0.1X2/12) = 1000(1+0.01667) = Rs. 1016.67ps.

With exact SI when the two months are January & February in a
non leap year, the future sum is

F = P [1+(i) (31+28/365)

= 1000 (1 + 0.01616) = Rs. 1016.16 ps.

Compound Interest (CI):

 When a lone is made for several interest periods, interest is
calculated and payable at the end of each interest period. There are a
number of loan repayment plans. These range from paying the interest
when it is due to accumulating the interest until the loan is due. If the
borrower does not pay the interest earned at the end of each period and
is charged interest on the total amount owed (principal plus interest) the
interest is aid to be compounded. The interest owed in the previous year
becomes part of the total amount owed for this year. This years charge
includes interest that has been earned on previous interest charges.

Illustration :

The payments on a 4-year loan of Rs. 1000/- at interest per year

payable when due would be calculated as shown in

Table – A

Year Amount Interest to Amount Amount to be

owed at be paid at owed at paid by the
beginning end of end of borrower at end
of year (Rs) year ( Rs) year of year (Rs)
( Rs)
01 1000-00 160-00 1160-00 160-00
02 1000-00 160-00 1160-00 160-00
03 1000-00 160-00 1160-00 160-00
04 1000-00 160-00 1160-00 1160-00
Table – A : Calculation of C I when interest is paid annually.

Table – B

Y Amoun Interest to be Amount owed at Amount

ear t owed added to loan at end of year (Rs) paid by
at end of year (Rs) (1) +(2) borrowe
beginn (2) r at end
ing of of year
year (Rs)
( Rs)
(1)
01 1000- 1000-00 X 0.16 = 1000(0.16)1 00-00
00 160-00 =1160-00
02 1160- 1160-00 X 0.16 = 1000(0.16)2 00-00
00 185.60 =1345-00
03 1345- 1345-60 X 0.16 = 1000(0.16)3= 00-00
60 215.30 1560-90
04 1560- 1560-90 X 0.16 = 1000(0.16)4= 1810-64
90 249.75 1810-64

Table – B calculation of CI when interest is permitted to compound

In the first case, payment of interest at the time it is due avoids the
payment of interest on interest. The reverse is true in the second
payment scheme. Thus the effect of CI depends upon the payment
amount and when they are made.

Cash Flow Diagrams [CFD] :

 In most engineering economy studies, only small elements of an
enterprise are considered. The cash flow is the actual in flow (receipts)
and out flow (disbursements) at different points in time that occur over
the life of an investment to aid in identifying and recording the economic
effects of investments alternative a graphical description of each cash
transactions may be used this graphical descriptor, referred to as a cash
flow diagram, will provide the information necessary for analyzing an
investment proposal. CFD represents received during a period of time by
an upward arrow (an increase in cash). Located at the periods end. The
arrows height may be proportional to the magnitude of the receipts
during that period. Similarly disbursement during a period are
represented by a downward arrow (a decrease in cash ) .These arrows are
then placed on a time scale that spans all time periods covered by the
proposed investment.

Payments ( Receipts)

Rs 1000-00 Rs 160 Rs 160 Rs 1160

0 1 2 3 4

0 12 3 4

Rs 160 Rs 160 Rs 1160 Rs 1000-00

Payments (Expenditures)

Borrower Lender

Fig: Cash Flow Diagrams (values are taken from previous

Table –A)
 In the above example, the borrower receives Rs. 1000 and
this amount appears as a positive cash flow on the borrowers CFD. Each
year the borrower pays Rs.160 in interest; these amount plus repayment
of the Rs 1000 borrowed, appear as negative cash flow. Also the lender
experiences a negative cash flow of Rs. 1000, followed by positive cash
flows for interest received and also for repayment of the original amount
loaned. Since, there are two parties to every transaction, it is important
to note that the cash flow directions in CFDs depends upon the point of
view taken.

When an investment alternative has both receipts &

disbursements accruing simultaneously, a net cash flow may be
calculated. It is arithmetic sum of time .the utilization of net cash flow
implies that the net rupees received or disbursed have the some effect on
an investment decision as do an investments total receipts and
disbursements considered separately.

To facilitate describing investment cash flows, the following

notation will be adopted let

Ft = net cash flow at time, t

Where

Ft = < 0 represents a net cash disbursement

Ft = < 0 represents a net cash receipts

Chapter – 5 : Rate of Returns (R R)

RR is a percentage that indicates the relative yield on different

uses of capital. There are three RRs appear frequently in engineering
economy studies:
1. The Minimum acceptable rate of return (MARR) is the rate set by
an organization to designate the lowest level of return that makes
an investment acceptable.

2. The internal rate of return (IRR) is the rate on the unrecovered

balance of the investment in a situation where the terminal
balance is zero.

3. The External rate of return (ERR) is the rate of return, that is

possible to obtain for an investment under current economic
conditions.( for example, suppose that analysis of an investment
shows that it will realize an IRR of 50% Rationally it is not
reasonable to expect that we can invest in the external market and
get that high a rate. In engineering economy studies the external
interest rate most often will be set to the MARR.

Minimum Acceptable ( attractive ) Rate of return (MARR):

It is a lower limits for investment acceptability set by organizations

or individuals . it is a device designed to make the best possible use of a
limited source ie money. Rates vary according to the type of organization,
and they vary even within the organization. These variations usually
reflect the risk involved. For instance, RR required for cost reduction
proposal may be lower than that required for R & D projects in which
there is less certainly about prospective cash flows.

The decision criteria for investment have their objectives as

maximization of equivalent profit ie they should exceed the MARR. This
cut-off rate varies from organization to organization and at different
periods, depending on policy matters. Thus the target rate so ascertained
is considered as MARR (or) floor rate, which shall be the lowest rate of
return that will be considered acceptable.

MARR is also considered sometimes as opportunity cost, since any

money committed to an investment proposal will forego the opportunity
to invest that money at the MARR. If the MARR is too high many
investments with good returns may be rejected and at the same time, it
is too low, may lead to acceptance of proposals that are marginally
productive or results in economic loss.

Calculation:
1. Identify the maximum rate that can be earned if the funds are
not invested in projects, find the opportunity cost. Example,
investment in bank deposits as a safe alternative to investment
in projects.

In case of capital rationing to cater to the requirement of many projects

with the available limited capital resources- distribution shall be made
among the most beneficial alternative earning rate of returns higher than
MARR, by ranking the alternatives on contribution in excess of MARR.)
Internal Rate of return (IRR)

Also known as true rate of return method ( or ) discounted cash

flow method. It is the best known and most widely used RR methods. It
is represented by i in the traditional interpretation of interest rates, is the
rate of interest earned by an alternative investment on the unrecovered
balance of an investment. It can be calculated by equating the annual,
present, or future worth of cash flow to zero and solving for the interest
rate (IRR) that allows the equality. It should be added that solving for the
interest rate in this manner results in a polynomial equation that is a
function of i which may result in multiple roots of the equation ( i*). In
such cases the IRR may or may not be one of the equation root.

Calculations of IRR:

Determining the IRR is a function of the type of investment

( simple, pure and mixed) and the characteristics of the alternatives
( mutually exclusive or independent ). If we have independent projects,
we may fund combinations of the projects since an independent projects
does not affect the funding of another project ( except for capital
availability limitations which are very real in most situations analyzed by
the engineering economist ). The cash flows of several independent
alternatives that are considered as a group may be summed to form the
groups composite cash flow. Analysis can then be performed on this
composite cash flow. Where capital limitations are apparent in a
department and several independent alternatives are competing for
funding, combinations of alternatives may be formed where each
combinations first costs have to be equal to or less than the capital
available. In this case, mutually excusive combinations will usually be
realized, where selection of one group of independent alternatives will
preclude the selections of another. This can be due to alternatives being
in more than one group and /or capital limitations. Mutually exclusive
alternative may be analyzed by incremental IRR analysis, and the results
will be found to be completely consistent with the present / future /
annual worth’s methods. Incremental analysis assumes that we start
with a satisfactory low investment alternative. Analysis of a higher
investment alternative is then based on the differences between the cash
flows of the second alternative and acceptable alternative. These
differences in cash flows are incremental cash flows. The cash flow of the
second alternative is equal to the cash flow of the first alternative plus
the incremental cash flows. Thus if the incremental cash flow is
acceptable when, compared to the MRR, then the larger investment has
to be a better investment than the first alternative which was also
acceptable. Otherwise remove the larger investment from consideration.
This type of evaluation is continued until all alternative have been
evaluated, one of the mutually exclusive alternatives is then determined
to be the best investment.

IRR of a capital budgeting project is the which the net

present value (NPV) of a project equals zero. The IRR decision rule
specifies that all independents projects with an IRR greater than the cost
of capital should be accepted when choosing among the mutually
exclusive projects, the projects with the highest IRR should be selected
( as long as the IRR is greater than the cost of capital.

NPV = O = T∑ CFt = CFo + CF1 + ……+ CFT

(1+IRR)t (1+IRR)2 ( 1+IRR)T

where CFt = cash flow at time t.

 The determination of the IRR for a project, generally involves trials
and error or a numerical technique. Fortunately, financial calculators
greatly simplify this process.

The example below illustrates the determination of IRR consider

capital budgeting projects A&B which yield the following cash flows over
their five year lives the cost of capitals for both projects is 10%.

Year Project – Project –

A B
Cash Cash
Flow Flow
( Rs) ( Rs)
0 -1000 -1000
1 500 100
2 400 200
3 200 200
4 200 400
5 100 700

O = - 1000 + 500
+ 400
+ 200
+ 200
+ 100

(1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4 (1+IRR)4

IRR A = 16.82%

O = - 1000 + 100
+ 200
+ 200
+ 400
+ 70

(1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)4 (1+IRR)4

IRR A = 13.28%

Thus , if projects A & B are independent project, then both projects

should be accepted since their IRRs are greater than the cost of capital.
On the other hand, if they are mutually excluse projects, then project – A
should be chosen since it has the higher IRR.
Misconceptions of IRR:

1. IRR can be misleading & inconsistent when NPV of project does not
decline with discount rates.
2. It fails to indicate a correct choice between mutually exclusive
project under certain situation.
3. When used to evaluate non- conventional investment, it can yield
multiple IRR.
4. Requires estimates of cash flows, which is tedious task.
5. Relatively difficult to compute, when compared to other alternative
methods available.

Cost - of - Capital Concepts:

Cost of capital will be determined by the chief financial officer in

conjunction with the accounting department. It is derived from the
composition of the capital pool. The term pool is appropriately suggestive
of capital from many sources, pooled for funding purposes. The
proportion of capital from different sources obtained at different cost to
firm is represented by a weighted cost of capital. This cost sets the lower
bound for the MARR.

The actual RR expected from investments is normally greater than

the cost of capital. How much greater depends on the risk involved.
Riskier proposals are subject to higher discount rates to compensate for
the chance that they will not meet net-return expectations. But even a
minimum- risk investment, such as the purchase of government bonds,
must yield a return greater than the interest rate, a firm is charged on its
debts; otherwise, it would be sensible to direct currently available funds
toward debt retirement in anticipation of more rewarding future
investment opportunities.

The weight cost of capital Kwmay be calculated as

Kw = P1 K1 + P2 K2 ……. +PnKn

Where there are n types of financing sources in proportions p of

total capital, each source with its own cost, K.
For instance, if a firm is fenced from bonds, preferred stock, and
common stock with cost of 7,9and 12% and in proportions 20,30 and
50%, respectively, then
Kw = 7% (0.2) + 9% (0.3) +12%(0.5)
= 1.4% + 2.7% 6.0% = 10.1%

Consider the capital employed in a company. It is comprised of:

1. Share capital : It represents the amounts paid by shareholder for
the nominal value or par value of new shares. It is part of
shareholders funds and as such, is owned by the ordinary
shareholders.
2. Capital Reserves: It represent the excess (over and above the
nominal value or par value) paid by shareholder for new shares,
together with the surplus on the revaluation of certain fixed assets
( mainly land and buildings) These are part of shareholders
3. Revenue reserves: ( or retained earnings) represent the profit that
could have been taken out of the company by the ordinary
shareholders future growth. These are part of shareholder funds
and as such are owned by the ordinary shareholder.
4. long- term loans : ( ie loan with a lifetime greater than one year)
are provided external loan providers. They are not part of
shareholders funds, and as such, are not owned by the ordinary
shareholder.
 Chapter – 6
Depreciation & Income Tax

Depreciation:
It means a decrease in worth. Most assets have advantages of
possessing the latest technical improvements and operating with less
chance of breakdown or need for repair. Generally, production
equipment gradually becomes less valuable through wear. This lessening
in value is recognized in accounting practices as an expense of operating.

Any equipment, which is purchased today, will not work forever.

This may be due to wear and tear of equipment or obsolescence of
technology. Hence, it is to be replaced at the proper time for continuance
of any business. The replacement of the equipment at the end of its life
involves money. This must be internally generated from the earning of
the equipment. The recovery of money from the earning of on equipment
for its replacement purpose is called depreciation fund since we make an
assumption that the value of the equipment decreases with the passage
of time. Thus, depreciation means decrease in value of any physical asset
with passage of time.

Causes of Depreciation ( Declining Value ) :

1. Physical Depreciation: The everyday wear and tear of operation

gradually lessens the physical ability of an asset to perform its
intended function. A good maintenance program retards the rate of
decline but seldom maintains the precision expects from a new
machine. In addition to normal wear, accidental physical damage
can impair ability, wear and tear is an obvious cost of production,
2. Functional Depreciation: Demands made on an asset may
increase beyond its capacity to produce. A central heating plant
unable to meet the increased function.
3. Technological depreciation: Newly developed means of
accomplishing a function may make the present means
uneconomical steam locomotives last value rapidly as rail roads
trued to diesel power. New material improved safety and better
quality at lower cost from new developments make old design
obsolete.
4. Sudden failure: This refers to sudden loss in value due to the
technological characteristics inherent in the asset. However this
does include lass due to accident or misuse

5. Depletion: Consumption of an exhaustible natural recourse to

produced products or services is termed as depilation. Removal of
oil, timber, rock, or minerals from a site decreases the value of
holding. This decrease is compensated by a proportionate
reduction in earnings desired from the resource

6. Deferred Maintenance: manufactures provide instruction manual

along with equipment/machine supplied by them. This manuals
teals regarding change in lubricates after definite period .If these
are followed in time due to negligence or any other reason, the
efficiency gradually decreases. This is known as depreciation due
to deferred maintenance.

Methods of Depreciation:
 1. Straight line methods Fixed Installment Method:
In this a fixed sum is charged as the depreciation amount
throughout the lifetime of an asset such that the accumulated sum at
the end of the life of the asset is exactly equal to the the purchase
value of the asset. Here the assumption is that inflation is absent. The
drawback of this method is as follows:

A. The annual cost in respect of the asset would be:

a) Depreciation
b) Maintenance
It is the desire of the owner that the annual cost chargeable
to the revenue on account of the machine is uniform
throughout the life of asset. Taking into account, the fact
that the maintenance cost of the equipment would raise year
after year an account of ageing they prefer that higher doses
of depreciation and lower dose of maintenance charges in the
earlier years. As age of the machine advances, the
depreciation charge would decrease and maintenance charge
would increase, resulting in a constant charge to the revenue
on account of the equipment.
B. This method does not take time value of money into
consideration. But one should not forget that the method is
simple and easily understood. It is the reason for its wide
applications in the industry.

2. Diminishing ( Declining )Balance (or) Reducing Balance Methods:

The machine or equipment depreciates rapidly in the early years

and later on slowly. Therefore in this method the fund is more during the
early years when repair and renewals are not costly. The book value of
the machine goes on decreasing as its existence continues. Hence in this
a certain percentage of the current book value is taken as depreciation.

This is more realistic approach, since the depreciation charge

decrease with the life of the asset, which matches, with the earning
potential of the asset. The book value at the end of the life of the asset
may not be exactly equal to the salvage value of the asset. This is a major
limitation of the method.

3. Sinking Fund Method:

In this method a depreciations fund equal to the actual loss in the

value of the asset is estimated for each year. This amount is invested
elsewhere other than in the business itself, and the interest will be
earned on the fund. Therefore sinking fund investment will grow year –
by year with the amount of annual depreciation plus the interest earned
on the past investment. Thus in this, the book value decreases at
increasing rate with respect to the life of the asset. That is the
depreciated amount is invested elsewhere and at the end of the useful
life of the asset, the invested amount along with the interest could be got
back and used for the purchase of a new asset.

Note: Of all the methods, straight line method and diminishing value
method are the most recommended methods by statutory bodies like
company low board, tax department, Etc.

[Link] sum –of-the-year-digits method:

 In this, the scrap value of the asset is deducted from its
original cost and the remaining balance is spread over the asset’s
decreases at a decreasing proportion. That is, the book value of the
asset decreases at a decreasing rate. Here which assumes higher
depreciation charge in the beginning and low charges with the
passage of time. The advantage is that it provides greater
depreciation during the earlier year of assets life, when there is a large
profit from the asset. The drawback is that it is difficult (little bit) to
understand further this method does not take the time value of
money (interest) into account.

[Link] insurance policy method:

This method covers the risk if the machine becomes

unserviceable before its estimated life. In this, the machine or
equipment is insured with the insurance company and premiums are
paid on the insurance policy, when the policy matures, the company
provides sufficient sum to replace the unit by a new one. Thus the
depreciation amount is paid as a premium for an insurance policy at
the end of the useful life of the asset; the policy amount (the sum
assured) would be used to acquire a new asset.

[Link] hour basis method:

In this, the rate of depreciation is calculated by a fixed rate per hour

of production. The depreciation rate per hour is the ratio of the value
of asset to the estimated number of working hours (production hours)
of its life.
 7. Production unit method:

Here, the life of a machine is expressed in terms of the number of

units that a machine is expected to produce over its estimated life.

8. Annuity method:

In this the interest is charged on the cost of machine every

year on the book value, but the rate of depreciation remains constant for
each year. This method takes into account the time value of money (ie
interest) in deciding the depreciation charge for the various years during
the useful life of the asset. Annuity is a series of equal annual payments.
The value as on today of all the future annual payments is called the
‘present value’ of annuity. The depreciation can be treated as an annuity
over the life of the asset. It is calculated so as to equate the present value
of the asset to its cost of acquisition.

9. Revaluation method:

Here, an expert evaluates the depreciation every year.

The depreciation is equal to the difference between the values assigned to
the asset at the beginning and end of each year. This method is suited to
those assets which constantly change and the life of which is uncertain.
This appears to be most practical and satisfactory method particularly
where the books of the enterprise are closed at stated periods, say
annually, or half- yearly and final accounts are prepared.
Income tax (IT):

IT lays are the result of legislation over a period of time. Since

they are human- made they incorporate many diverse ideas, some of
which appear to be in conflict. These laws are expressed through a
number of provisions and rules intended to meet current conditions.

It is levied by the central government as well as the state

governments. State IT laws will not be considered because the
principles involved are similar to those for central tax laws, because
state IT rates are relatively small, and because there is a great
diversity of state IT law provisions.

Economy studies involving income taxes can be

simplified by the determination of applicable effective IT rates. An
effective IT rate as the term is used is a single rate that when
multiplied by the taxable income of a venture under consideration will
result in the IT attributable to the venture. Effective IT rates are
essentially incremental rates that are applicable over ranges of
income. By the use of effective rates the consideration of IT in
economy studies is reduced to two distinct factors.

• The determination of effective tax rates applicable to particular

activities or classes of activities.
• The application of the effective tax rates in economy studies.
 Types of taxes:

[Link] taxes: They are charged by local governments on land,

buildings, machinery, equipment, inventory, etc. The amount of the
tax is a function of the appraised value of the assets and tax rate. It is
not a significant factor in an engineering economics study because of
their small magnitude compared with income taxes and their similar
effect on competing proposals

[Link] taxes: are imposed on the production of certain products

such as toba cco, alchohol. Rarely affect economic comparison. Other
taxes that are sales tax an retail products, user’s tax, value- added tax,
unemployment tax, and social security contributions.

3. Income taxes: are levied on personal and corporate income at

increasingly higher rates for higher incomes. They are based on net
income after deductions allowed for permissible expenses. The tax
effects of different types of expenses on the cash flow of proposals
have significant influence on the proposal’s acceptability.

Interest and Income taxes:

Interest earned from funds loaned by an individual or

corporation is usually considered an income item when calculating IT.
An important exception is the interest earned from infrastructural
bonds, which are not taxed by the central government.

Interest paid for funds borrowed by an individual or

corporation to carry on profession, trade or business is deductible
from income as the expense of carrying on such activity. In addition
 interest paid on funds borrowed for home owner-ship is deductible
from the adjusted income in computing an individual’s income tax.

Depreciation and Income taxes:

Since the amount of taxes to be paid during any one year is

dependent up on deductions made for depreciation directives are issued
by governmental agencies as guide to the taxpayers in properly
handling depreciation for tax purposes. The taxpayer who incurs an
economic tax with the loss in value of an asset over time is entitled to
the depreciation deduction ordinarily, this is the taxpayer that owns the
asset if a tax payer owns only apportion of depreciable asset ,then only
that portion of the depreciations deductions can be claimed. In addition
the depreciation rules that are applicable to properly are determined by
the tax law in place at the time the properly is acquired.

Corporate income taxes:

A corporation, for central income tax purposes, includes

associate joint stock companies, insurance companies, and trusts and
partnerships that actually operate as associations or corporations.
Organizations of doctors, lawyers, engineers and other professionals
are generally recognized as corpora or such organizations have the
following characteristics.
• Associates organized to carry on business.
• Gains from the business hat are divided.
• Continuity of life and centralized management.
• Limited liability and free transferability of interests.

Organizations possessing a majority of these characteristics

must file corporate tax returns. It is due from corporations and
businesses whenever revenue exceeds allowable tax deductions. Revenue
includes sales to customers of goods and services, dividends received on
stocks, interest from loans and securities, rents, loyalties, and other
gains from ownership of capital or property. Deductions embrace a wide
range of expenses incurred in the production of revenue. Wages, salaries,
rents, repairs, interest, taxes, materials, employee benefits, advertising,
etc. Also, deductible, sometimes under special provisions, are losses from
fire and theft, contributions, depreciation and depletion, bond interest,
R&D expenditures, etc. the difference between revenue and deduction is
taxable income.
In general,

Taxable Income= Gross Income – expenses - Interest on debt

-Depreciation – other allowable deductions.

All corporate entities are required to maintain and prepare the

accounting information and the financial statements as per the
companies Act 1956 and the income tax Act 1961 amendment to meet
the changing scenario shall be taken into consideration too. We shall
observe the broad view of how the calculation of corporate tax is done,
after taking into consideration it’s operating and non-operating revenues
and expenses. The following are the steps to be followed:

1. Ascertaining the operating revenues during the period considered.

It is the gross revenue or gross sales value.
2. All the operating expenses are deducted from revenue identified in
step-1. Such expenses are generally categorized as cost of sales.
Which include the entire amount spent upto the point of sale.
3. Net operating profit is the outcome of this.
4. All non-operating incomes are added to this, and non-operating
expenses are deducted from this.
5. We get the net profit from business from above step. From this,
depreciation that is not actual expense shall be deducted to obtain
the amount on which tax is to be calculated.
6. Calculation of tax at the prescribed rate or the slab fixed by the
statutory bodies is done on the amount ascertained in step-5.
 Chapter- 7
Estimating and costing

Estimating:
The engineer must be able to state the probable cost at the
stage when only sketch plans are drawn. If the available funds are
known, the designer has to work backwards i.e. will have to design
the building which may be constructed within the available
amount

Estimating is a computation of the quantities

required and expenses likely to be incurred in the construction of
work. The amount estimated should be sufficient to cover the
probable expenditure on the work without any revisions. The
essentials of are estimate are:

. Drawings i.e. plans, elevations and sections of the work.

. Specifications should clearly lay down the nature and
class of work and materials to be used.
. Local rates at which the different types of work can be
executed for a contractor, a faulty estimate may mean a heavy loss
and more spoil his name.
. Cost estimating may be defined as the process of
determining the probable cost of the product before the start of
manufacture. It involves the knowledge of the following factor for
calculating the probable cost of the product:
 Design time, amount of material required, cost of material
required; production time required; labour charges, cost of
machinery; cost of overheads; use of previous estimates of
comparable parts; probable future changes; effect of volume of
production on costing rates Effect of changes in facilities on
costing rates.

Objectives of Estimating:

. To establish the selling price of a product, so as to ensure profit.

. To ascertain whether the proposed product can be manufactured
and marketed profitably.
. To determine whether the part can be manufactured economically
in the plant or to be purchased from outside (make or buy
decisions)
. To determine the most economical process, tooling or material to
manufacture the product.
.To establish the standard of performance that may be used to
control the costs
. To prepare production budget.
To evaluate alternate designs of product.
. Initiate means of cost reduction in existing production in existing
production facilities by using new materials.
. To determine standard cost which represents the best estimate that
can be made of what cost should be for material, labour and overhead
after eliminating inefficiencies and wastes.
Costing (or) cost accounting:

It may be defined as a systematic procedure for

recording accurately every item of expenditure incurred on the
manufacture of a product by different sections of any manufacturing
concern. The expenditure incurred on material, labour, machinery,
production, inspection, etc are accurately recorded and summed up to
find the factory cost of a product. Thus, it the classifying and
recording the appropriate allocation of expenditure for the
determination of costs of products/ services, and for presentation of
suitably arranged data for the purpose of control, and guidance of
management.

Aims of costing:
• Cost determination
• Cost control
• For fixing selling price.
• For filling up quotations and tenders
• To provide data for planning, budgeting and controlling the
costs
• For taking specific managerial decisions.
• To suggest changes in design of product.

Differences between Estimating & costing:

. Estimating is the process of determining anticipated or
probable cost of a product before it’s manufacturing is
undertaken. Costing is the process of calculating the actual
cost of the product after it as been manufactured.

• Estimating tells whether it is profitable to manufacture a

product or not , costing tells the profitability of the
product after its manufacture.
• The process of estimating requires technical skills where
as costing is the job of accountants.
• Estimating gives an idea about the expected or probable
or standard cost of a product where as costing determines
the actual cost of production.
• Estimating is based on assumptions and previous
experience while costing is based on facts.

Elements of cost:
In a manufacturing enterprise, the total cost may be
divided into two broad categories:
1. Manufacturing (or) production costs.
2. Non-manufacturing (or) non-production costs.

1. Manufacturing costs:

Manufacturing is a process of converting raw materials

into finished goods through the use of labour service and
other facilities in the factories. The three major elements
of manufacturing costs are.

a. Material cost.
b. Labour cost.
 c. Factory (mfg.) overhead cost.

a. Material. The substance from which the product is

made is known as material. It may be in the raw state
or manufactured state. It can be direct as well as
indirect.

Direct materials are those, which can be directly and

conveniently identified with the physical units of finished product. For
eg, the cardboards or tin sheets manufactured by a firm may be raw
material for a packaging – cases manufactures, crude oil for
petroleum products, leather used in the manufacture of shoes, wood
used to make a chair, etc.

Indirect materials are those materials that are used in the

manufacturing operation but do not become the part of a finished
product they do not enter into the finished goods and cannot be
identified with them for e.g. cotton waste, grease, oil, lubricants nails, etc
these are included under manufacturing Or factor overhead

b. Labour: like materials labour is also classified as direct and indirect

for conversion of materials into finished goods human effort is needed.
Such human effort is called lob our.

Direct labour is one, which is directly involved in converting raw

materials into finished goods. Cost spent on this can be directly traced to
the finished goods. For e.g.; lathe operator, welders, assembly workers,
etc.
 Indirect labour is that which is required to perform manufacturing
activities generally but not directly involved in the conversion of raw
materials into finished goods. Such labour doesn’t alter the construction,
composition or condition of the product. For example wages paid to
foreman, clerks timekeepers purchase and store assistants, maintenance
employees, salaries of salesman,Director’s fee, etc.

b. Factory overhead: This refers to manufacturing costs

other than direct material and direct labour costs. For
example indirect material. Indirect labour,
depreciation, repairs and maintenance, rent and
insurance, power, light, taxes, etc. It is not an
expense. It is a part of product cost and will become
expense only when products are sold. It is divided into
two categories:

Variable factory overhead is one, which varies, in direct

proportion to units of output. Example: Supplies.

Fixed factory overhead is non-variable with production.

Example: Depreciation, insurance, rent, supervisor’s salary, etc.

[Link]-manufacturing Costs:

A manufacturing firm also incurs costs, which are not part of

manufacturing costs. These costs are quite a substantial portion of the
total costs incurred by modern enterprises. It can be divided into four
types:
 a. Distribution/ marketing/ selling costs: These are incurred to
perform the marketing functions. These are sub-divided into two
types:
Order-getting costs are incurred to affect sales of
products. Costs spend on advertisement; salesman’s commission and
salaries are examples.

Order-filling costs are incurred on delivering products.

Examples are transporting costs, billing costs, record-keeping costs, etc.

b. Administrative costs: Examples are salaries of managers,

Director’s fees, public relations expenses, general accounting
costs, audit and legal fees, Head office expenses, etc.
c. R&D costs: These are incurred for developing new products and
process improving existing products/processes and searching for
new knowledge.
d. Financial Costs: It is the interest on working capital advance,
term loans, bank commission, etc.

By grouping the above elements of cost, the following are the

divisions of cost:
1. Prime cost = Direct materials+ Direct labour
2. Works/factory cost =Prime cost+ Works (or) factory
Overheads
3. Cost of production =Works cost+ Administration overhead
4. Total cost/Cost of sales =Cost of production+ Selling &
Distribution Overheads
NOTE: The difference between the total cost and selling price represents
profit or loss.

Methods of costing:

1. Job (Order) costing :It is concerned with the finding the cost of
each individual Job or contract. This method is adopted in
 shipbuilding, machine manufacturing, fabrication, building
contracts, etc. Here, each job has to be planned and its cost
determined separately on the basis of actual costs incurred or on
predetermined costs. Daily record of direct material, direct labour
and estimated overhead cost for each order is recorded in
production order or a cost sheet. Then the total cost is obtained
from the cost sheet.

2. Process costing: This method is employed when a standard

product is made which involves a number of distinct process
performed in a definite sequence. This used in industries such as
oil refining, chemical, paper making, paint, cement, etc. By –
products should be taken into account while calculating the cost of
each process of manufacture in this method. This indicates the
cost of a product at different stages as it passes through various
operations or process or departments.

For instance in the manufacture of cement, the operations of

mixing, grinding, burning, cooling, etc. are readily separable and cost
of each of these stages can be fairly accurately calculated. The total
time spent and materials used on each process as well as services
such as power, light and heating, are all charged. For this purpose, a
process cost sheet may be used.

3. Batch costing: it is form of job costing. Instead of costing each

item separately each batch of components is taken together and
treated as a job.

4. Departmental costing: In big industries like steel or automobile

industries, each department producing independently one or more
 components. This is used in such industries and the actual
expenditures of each department on various products are entered
on a separate cost sheet and the costing for each department is
separately undertaken.
5. Operating cost: This method is used in firms providing utility
services. For example In transport services, water works, electricity
boards, railways, etc., cost is determined on the basis of operating
expense and the charges are made as tonne-km, per thousand
liters, kilowatt-hour, etc.

6. Unit cost: This method is adopted by the firms, which supply a

uniform product rather than variety of products such as mines,
quarries, etc.

7. Multiple cost: This method is used in firms which manufacture

variety of standardized products, having no relation to one another
in cost, quality and type of process, etc. such as typewriter, cycle,
etc.

First cost: It is the initial cost of capitalized property, including the

transportation, installation and other related initial expenditures. It is
usually made up of number of cost elements that do not recur after an
activity is initiated. For example,

• For purchased equipment- purchase price plus shipping

cost, installation cost and training cost.
• For fabricated structure, engineering design and
development cost, test, and evaluation cost and
construction or production cost as well as shipping,
installation and training cost.
Marginal cost: It refers to additional cost that will be incurred as the
result of increasing output by one more unit. An increase of cost in
relation to some other factor, those relations in such expressions as an
incremental cost per ton, per gallon or per unit of production.

Selling price:It is the total of all the cost elements, direct as well as
indirect. It includes the direct materials, direct labour, other direct
expense and overheads such as manufacturing, administrative and
selling &distribution, etc. To the total of all these which forms cost of
sales, certain percentage of margin is added to determine the selling
price.
 Chapter – 8
Finance

Finance is the lifeblood of a business enterprise. This is because,

in the modern money – oriented economy, it is one of the basic
foundations of all kinds of economic activities. It has been said that
business needs money to make more money.

Financial Managementis an integral part of the overall

management, and not a totally independent area. It draws on related
disciplines and fields of study, namely, accounting, economics,
marketing, production, etc., The objective provides a framework for
optimum financial decision making.

Financial Accounting is the guide – post for the management

financial score of the firm is kept by the accounting system. It points out
the problems faced or likely to be faced by the firm. It also brings to its
notice regarding opportunities that are likely to arise. It is concerned
with external transactions ie., it records all dealings with outside the
firm. It covers purchases, sales, services etc., whether for cash or credit.
 Financial Information is the basis for financial planning, analysis
and decision-making. It is needed to predict, compare and evaluate the
firm’s earning ability. It is also required to aid in economic decision
making ie., investment and financial decision making. The financial
information of an enterprise is contains in the financial statements or
accounting reports.

Financial Statements of a business constitutes the general purpose

and external reports of that business enterprise. Thus, a firm
communicates financial information to the users through financial
statements and reports. It contain summarized information of the firms
financial affairs, organized systematically. Preparation of the statements
is the responsibility of the top management. As theses statements are
used by investors and financial analysts to examine firm’s performance
in order to make investment decisions, they should be prepared very
carefully and contain as much information as possible. The major
financial statements, which result from the process of accounting are ;

1. Profit & Loss (Income) Statement:It is a statement of revenues

and expenses for a specific period of time. It is a score – board of
the firm performance during a period of time. The general
accepted a convention is to show one year’s events (transactions)
in the profit & loss statements. It presents the summary of
revenues, expenses and net income (loss of a firm. Thus, it serves
as a measure of the firm’s profitability. Net profit indicates an
enterprises accomplishments (revenues) in relation to the efforts
required (expenses) in pursuing its operating activities. When
expenses exceed revenues for a period, a business enterprise
incurs a net loss.
 2. Balance Sheet:It shows the financial position of a business on a
certain date. For this reason, it is often called the statement of
financial position. It indicates the investing and financing
activities of a business enterprise at any point of time and shows a
firm’s assets, liabilities and equity capital usually at the close of
last day of a month or a year.

Assets are economic resources and provide future benefits to a

firms such as cash, inventories, building, machinery, goodwill, patent
etc., Liabilities are outsider’s claims on the assess of business such as
creditors, account payables, salaries payable, income tax payable etc.,

3. Funds Flow Statement:It is a statement of the sources from

which funds or cash were raised during a certain period. It helps
in having more detailed analysis and understanding of changes in
distribution of resources between two balance sheet dates.

Relation between Income Statement & Balance Sheet :

Both are not two separate and independent statements, but are
related to each other. The income statement is a link between the
balance sheet at the beginning of the period and the balance sheet at the
end of the period. Generally, the income statement is prepares to
compute net income, but it can be computed indirectly from the balance
sheet of the beginning and the end of the period. This fact emphasizes
the role of the income statement as a link between two consecutive
statements of the financial position.

Net income (or net loss) for a period is equal to the change in net
assets or owner’s equity during that period. Thus, as a starting point,
the difference in beginning and ending owner’s equity is the net income
(or net loss). However, equity also changes due to additional investments
and withdrawals by owners during that period. Therefore, owner’s
investment and withdrawals during the period should be adjusted to
compute the net income.

Standards of Financial Reporting:

The five major standards or conventions of the reporting function

of the financial statements are:

1. Full Disclosure: The purpose of the financial statements is to

communicate financial results of the firm’s activities to the users
as well as to provide them will all possible facts to make relevant
investment decisions. For a higher degree of reliability, they must
provide understandable, complete and fair disclosure of all relevant
information.

2. Materiality:The materiality standard deals with the relative

importance of the accounting information. Only the material
information needs the fully disclosed in the financial statements.
To illustrate, let us take an example of recording the amount spent
on stationery. If a firm has purchased stationery, it can keep
detailed records of the use of each item of stationery such as
pencils, pen, ink, files, paper etc., to determine the used and
unused stationery. Then the used stationery can be recorded as
expense and the unused stationery as asset.
 3. Consistency: It is essential for clear and correct understanding
and interpretation of the financial statements. It is needed to
ensure comparability of the financial statements for different
periods. Inconsistency in recording and reporting events can lead
to misleading interpretations and incorrect judgements about
facts, trends or the fairness of the financial statements.
4. Conservatism: The convention of conservatism means that all
the unfavorable events should be recognized at the earliest, and
the favorable events should be recorded only when they actually
take place. Thus, if an event can be recorded in alternative ways,
the accountant should ordinarily choose that alternatives that
results in lower income or lower asset value. In fact, financial
statements tend to be unrealistic and inconsistent in reporting
economic events when this standard of conservatism is followed. It
gives improper bias to the financial statements.

5. Fairness:The financial reports should be fair in sense that they

should not favor certain groups at the cost of others. Generally the
owner’s interests are given top priority, but the interests of others
should not be neglected completely. Fairness requires that the
statements should be a fair presentation or summary of the
economic events that were used to prepare them. It implies that
the statements are prepared in accordance with the accepted
accounting principles. The standard of fairness intends to ensure
justice and equity in reporting financial events of the firm.

Book – Keeping:

As the size of business grows, no businessman can remember all

his transactions and thus, he realizes the necessity of proper book
keeping. It is necessary in order to satisfy income tax authorities. It is
the process of analyzing, classifying and recording transactions in a
systematic manner in various sets of books. It may also be defined as
art and science of recording all dealings related to money, goods and
services in a systematic manner so that any information pertaining to
business can be easily supplied to the management or owner of the firm.

Proper book - keeping or properly maintained business records

shows:

1. All purchases, sales and its returns in an financial year.

2. Quantity and value of goods available with the firm.
3. Transactions with debtors and creditors.
4. Information about assets and liabilities of the firm.
5. Profit and loss accounts.
6. Cash available with the firm.
7. Financial soundness of the firm.
8. To have permanent records for all business transactions for future
references.
9. To know exact reasons leading to net profit/net loss of business.

Systems of Book – Keeping:

A. Single entry system: It is the system of recording cash and

personal accounts. Here, every transaction is between two
persons or firms. Every transaction affects two accounts. It
records only one side of the transaction and hence it does not
provide complete information about transaction. Thus us bit
generally used.

B. Double entry system: It is the system of recording

transactions which take s into account the debit and credit
 aspects of each transaction. Thus, it provides the complete
information of the business transaction.

Journal and Ledger:

Every business transaction is recorded on same day in a book

called Journal. It is a chronological listing of transactions. It records
many accounts related to many persons or concerns and it is difficult to
trace easily the accounts/transactions related to one person/concern.

From Journal, the transactions related to each person/concern are

sorted out, classified and entered in a book called Ledger. Thus, it
contains same information as given in Journal but properly arranged
accordingly to each person/concern.

Posting is the process of sorting and collecting of Journal entries to

various accounts and recording in respective ledger account.

Trial Balance:

After posting all Journal entries to ledger, a statement called trial

balance, is prepared to check the accuracy of posting into ledger. It
checks arithmetical accuracy of entries. It is a list of accounts and their
balances at any given date. It is used to test equality of balances
because at any time, the debits and credits should be equal in value. It
discloses the following types of errors:
• An item posted two times
• Mistake in posting
 • Mistake in addition/subtraction
• An item left from being posted.
• Money values wrongly recorded, eg., Rs.16000.00 in place of
Rs.1600.00.

Financial Accounting Cycle:

1. A transaction ie., a financial event takes place.

2. The above transaction I s recorded on paper as an evidence of the
transaction having takes place. This evidence is known as
Voucher.
3. The information contained in the Voucher is translated into
accounting language, by recording the source (credit) and the
associated use of funds (debit). The record thus evolved is called
Journal and the process of recording the information from
vouchers to Journal is called journalizingthe transactions. Once
entire information form the vouchers are transferred to the
Journal, the vouchers becomes functionally irrelevant (though they
are retained for audit purposes).
4. From the Journal, each account is recorded in another book called
Ledger or a [Link] ledger is the book, which keeps track
of each account head pertaining to assets, liabilities, expenses and
revenues separately.
5. The balances from these T – accounts are checked through a Trial
Balance.
6. From the trial balance two separate accounting documents are
produced, namely Profit & Loss account and the balance sheet.
7. All income and expenditure accounts are taken to profit & loss
account.
8. All assets and liabilities accounts are taken balance sheet.
9. The net result of profit & loss account, namely Profit or Loss (net)
is taken to balance sheet.
 [Link], the balance sheet tallies.

Chapter – 9
Financial / Ratio Analysis:

Other Names: Ratio Techniques / Ratio Accounting / Accounting

Ratios.

It is most widely used method for the analysis of financial

statements. Management should be interested in knowing the financial
strengths of the firm to make their best use and to be able to spot out
the financial weaknesses of the firm to take suitable corrective actions.
The future plans of the firm should be laid down in view of the firms’
financial strengths and weaknesses.

Objectives:

• To compare different companies in the same industry

• To compare different industries.
• To compare performance over a period of years.
• To assist management to perform its functions like planning,
forecasting, coordinating, controlling and communicating.
• To indicate the trends and future problems of the company.

Advantages:

• Simplifies financial statements

 • Facilitates inter-firm comparison
• Helps in planning
• Overall operating efficiency & performance of the firm.

Limitations:

• Difficult to decide on proper basis for comparison

• Price level changes make interpretations of ratios invalid
• No fixed Standards
• Differences in the definitions of items in the balance sheet and
income statement make interpretation of ratios difficult.

Nature:

Ratio analysis is a powerful tool of financial analysis. A ratio is

defined as the indicated quotient of two mathematical expressions and as
the relationship between two or more things. In financial analysis, a
ratio is used as an index or yard sticks for evaluating the financial
position and performance of a firm. The absolute accounting figures
reported in the financial statements do not provide a meaningful
understanding of the performance and financial position of a firm. An
accounting figure conveys meaning when it is related to some other
relevant information.

For example, an Rs.100000/= net profit may look impressive, but

the firms performance can be said to be good or bad only when the net
profit figure is related to the firm’s investment. The relationship between
two accounting figures, expressed mathematically, is known as a
financial ratio (simply, a ratio). A ratio helps the analysts to make
qualitative Judgement about the firm’s financial position & performance.
Classification:

1. Liquidity (or) Working Capital ratios

a. Current ratio
b. Quick / Acid Test / Liquid ratio
c. Super Quick ratio
2. Leverage (or) Long – term solvency ratios.
a. Debt – Equity Ratio
b. Proprietary / Equity / Net worth ratio
c. Solvency ratio
d. Debt to Total Capital ratio
3. Activity (or) Performance (or) Turnover ratios.
a. Inventory / Stock turnover ratio
b. Debtor’s turnover / Receivables turnover / Debtor’s velocity Ratio
c. Fixed assets turnover ratio
d. Total assets turnover ratio
e. Capital employed / Net assets turnover ratio
4. Profitability ratios
a. Gross Profit Margin
b. Net Profit Margin
c. Operating expense ratio
d. Earning per share
e. Dividends per share
f. Price – Earning ratio
g. Return on Investment
h. Earning Power

1. Liquidity ratios
It measures the firm’s ability to meet current operations. An
enterprise must have adequate working capital to run its day today
operations Inadequacy of working capital may bring the entire
 operations to stand still because of inability of the enterprise to pay for
wages, materials and other regular expenses.

The important liquidity ratios are as follows::

a. Current ratio: It is an indicator of the firms commitment to meet its

short – term liabilities. It is expressed as follows;

Current Assets
Current Current
=
Ratio Liabilities

Current Assets include cash and those assets which can be

converted into cash within a year such as debtors, inventories, cash at
bank and in hand, Bills Receivable, advances granted to employees &
others, prepaid expenses, etc.,

Current Liabilities include creditors, Bills payables, Bank

overdraft, Income Tax liability, etc.,

Ratio is greater than ONE means that the firm has more current
assets than current liabilities.

b. Quick ratio: It is a more refined measure of firm’s liquidity. The

current ratio does not measure accurately the liquidity of a firm. This
is because current assets include items such as stocks and prepaid
expenses, which are not easily realizable. Hence, the need for an
improved or refined liquidity ratio was felt. It affords the real test of
the liquidity of the enterprise. It is for this reason that quick ratio is
also known as acid – test ratio.
 Quick Quick (or) Liquid
= assets
Ratio
Current Liabilities

Quick assets include cash and book debts (debtors and bills
receivables) only. Inventories are excluded because it takes to sell
finished goods and convert raw material and work in process into
finished goods. There is also uncertainty as to whether or not the
inventories can be sold. Prepaid expenses also are excluded because
they cannot be converted into cash.

c. Super Quick Ratio: This is a variation of Quick Ratio.

Cash & Marketable

= Securities
Current Liabilities

Here, debtors’ are excluded from quick assets. The ratio is the most
vigorous measure of the firm’s liquidity position. However, it is not
widely used in Practice.

ILLUSTRATION: From the following, compute the types of liquidity

ratios.

1
Sundry Debtors 40000
.
2
Prepaid Expenses 20000
.
 3
Short – term investments 10000
.
4
Loose tools 5000
.
5
Bills payables 10000
.
6
Sundry Creditors 20000
.
7
Debentures 100000
.
8
Inventories 20000
.
9
Outstanding Expenses 20000
.
1
0 Bank Overdraft 10000
.

Current Assets

Current Ratio =

Current liabilities

40000 1
+ 20000 2
+ 10000 3
+ 20000 8

=
10000 5
+ 20000 6
+ 20000 9
+ 10000 10

90000
 = = 1.5
60000

Liquid Assets

Quick Ratio =

Current liabilities

Current Assets – Inventories – Prepaid

expenses

Quick Ratio =

Current liabilities

90000 – 20000 – 20000 50000

Quick Ratio = = = 0.83

60000 60000

Cash and Marketable securities

Super Quick Ratio =

Current liabilities

Liquid Assets – debtors

Current liabilities

50000 – 40000 10000

Super Quick Ratio = = =

0.17

60000 60000

2. Leverage ratio:

A firm should have a strong short as well as long term

financial position. They are calculated to indicate the current financial
condition of the firm. To judge the long term financial position of the
firm, they are calculated. These ratios indicate the funds provided by
owners and creditors. They are helpful to the owners in calculating
their interests and control in the enterprise. Thus they help the long
term creditors to determine the stake they undertake in investing the
funds in an firm.
 The principal leverage ratios are:

a. Debt-equity Ratio: it is the measure of the relative claims of

creditors and owners against the firms assets. It indicates the stake
of the long term creditors as against the owners thus it is a test of
long term solvency of the firm.

D/E Ratio = long term debt

Share holder’s equity

= total debt (or) total liabilities

share holders equity

A high ratio shows that claims of creditors are greater than those of
owners. A very high ratio is unfavorable from the firms point of view.
This introduces inflexibility in thr firms operations due to the increasing
interference and pressures from the creditors. A low ratio implies a
greater claim of owners than the creditors.

a. Proprietary Ratio : It is a variant of D/E Ratio. It establishes

relationship between the proprietor’s funds and the total tangible
assets. It also indicates the proportion between owned capital
(proprietor’s funds) and loaned capital (borrowed funds). This ratio
has particular importance to the creditors who can findout the
proportion of shareholder’s funds in the total assets used in the
business.

Shareholder’s funds
= Total tangible assets

A highratio will indicate a relative little danger to the creditors in

the event of forced reorganization or winding up of the company. A
lowratio indicates greater risk to the creditors since in the event of losses
a part of their money maly be lost besides loss to the proprietor’s of the
business. The ratio is higher, the better it is.

c. Solvency Ratio: It is a measure of the solvency of a firm.

Total assets
= Total liabilities

Higher the ratio, the stronger is its financial position of a business

organization.

Note : Solvent → assets > liabilities

Insolvent → liabilities > assets

d. Debt to Total Capital Ratio: It is a variation of D/E Ratio and gives the
similar indications as D/E Ratio.

Shareholder’s funds Long term debt (ie.,

= Equity Shares)
Permanent Capital

Where permanent capital includes the common shareholders

equity and preference shareholder’s equity. A low ratio represents
security to creditors in extending credit. A high ratio represents a
greater risk to creditors and to shareholders.

ILLUSTRATION: balance sheet of XYZ Co. as on 31.12.2004.

Liabilities Assets
Equity shares (35000 350000 Plant & Machinery 1000000
shares)
8% preference shares 200000 Less: Depreciation 250000
Reserves & surplus 200000 750000
Long-term loan (6%) 100000 Goodwill 140000
Debentures (7%) 250000 Stock 150000
Creditors 60000 Debtors 100000
Bills payable 20000 Prepaid expenses 25000
Accrued expenses 20000 Marketable 75000
securities
Provision for taxes 65000 Cash 25000
1265000 1265000

Trading and Profit & Loss accounts for XYZ Co.,

for the year ended 31.12.2004

Profit Loss
Opening Stock 175000 Sales : Credit 1200000
Add: Mfg. Cost 1075000 Cash 300000
1250000 1500000
Less: Closing Stock 150000
1100000 Gross Profit 400000
Gross Profit 400000 Other incomes 9000
1500000 409000
General Administrative 34500
expenses
Selling expenses 25000
Depreciation 50000
Interest 23500
Income Tax 126000
Net Profit 150000
409000
Preference dividend 16000 Reserves, 118500
beginning balance
Equity dividend 52500 Net profit during 150000
the year
Reserves (ending 200000
balance)
268500 268500

Soln:
Current Current assets 375000
= Current Liabilities = 165000 = 2.27
Ratio

Quick Liquid assets 200000

= Current Liabilities = 165000 = 1.21
Ratio

Liquid assets - 200000-100000

Super Quick
= debtors = 165000 = 0.616
Ratio Current Liabilities

Long term debt 350000

Debt-Equity Share holder’s
= = 750000 = 0.466
Ratio equity

Long term 350000

Debt to total debt
= Permanent = 1100000 = 0.318
capital ratio
Capital

Proprietary = Shareholder’s = 800000 = 0.91

875000
ratio funds
 Total tangible
assets

3. Activity Ratios :
The funds of creditors and owners are invested in various kinds ofr
assets to generate sales and profits. The better the management of
assets the larger the amount of sales. They are employed to evaluate the
efficiency with which the firm manages and utilizes its assets They are
called turnover ratios because they indicate the speed with which assets
are being converted or turned over its sales. The important activity
ratios are:

b. Inventory (stock)turnover ratio: It indicates the efficiency of the firm’s

inventory management. It is ratio which indicates the number of
times the stock is turned over (ie sold) during a year.

Cost of goods Sales (Opening Stock + [Link] )

sold Inventor Closing Stock
= Average = =
y Average inventory
inventory

A high ratio indicates good inventory management and vice-versa.

b) Debtors Turnover Ratio: A firm sells goods on credit or on cash

[Link] the firm extends credit to its customers, book debts(debtors
or accounts receivables) are created in firm’s [Link] are
expected to be converted into cash over a period of time (shot period) and
are included in current assets . The liquidity positions of the firm
depends on quality of debtors to a great extent.
Financial analysis employ two ratios to judge the quality or liquidity of
[Link] first ratio is debtors turnover ratio and can be calculated as
follows:

Debtors turnover ratio = Credit sales = Total sales

Average Debtors Debtors

Generally higher the value, the more efficient is management

The second ratio is the average collection period ratio. It brings out the
nature of the firm’s credit policy and quality of the debtors more clearly.
It can be calculated as follows:

[Link] period ratio = Days in Year

Debtor’s turnover

= Debtors x Days in the year

Sales

c) Fixed assets turnover ratio: It measures the effiency with which the
firm is utilizing its investments in fixed assets such as land , building
plant and machinery, furniture [Link] also indicates the adequacy of sales
in relation to investment in fixed assets.

= Sales
Net fixed asset (depreciated value of fixed assets)
A high ratio indicates efficient utilization of fixed assets in generating
sales. A low ratio indicates inefficient management and utilization of
fixed assets.

Total assets turnover ratio: The firm must manage its total assets
efficiently and should generate maximum sales through their proper
utilization. It indicates the efficiency or in efficiency in the use of total
assets of a firm. Also, it is a measure of the overall performs of the
business.

= Sales
Total assets

e) Capital employed ratio: Capital employed may be defined as the non –

current liabilities and owners equity. thus , it represents the permanent
capital or long run funds entrusted to the firm by the owners and
creditors. It includes the firms ability of generating sales per rupee of
long-term investment.

= Sales
Capital employed

The higher ratio, the more efficient the utilization of owners and long
term creditors funds.
IILUSTRATION:(refer previous problem on XYZ Co.)

1. Inventory turnover ratio = cost of the good sold

Average Inventory
= 1100000
=10 times
175000+150000
2

2. Debtors Turnover ratio = Credit sales = 1200000 = 12 times

Debtors 100000

The average collection period (Assume 360 days per year) is

= Days in Year = 360 = 30 days

Debtors Turnover ratio 12

Or
= Debtors x Days in years = 100000 x 360 = 30 days
Credit sales 1200000

3. Fixed assets turn over ratio = Sales = 1500000 = 2 times

Net fixed assets 750000
[Link] assets turnover ratio = sales = 1500000 = 1.19 times
Total assets 1265000

[Link] employed turnover ratio = Sales = 1500000 = 1.36 times

Capital employed 1100000

4. Profitability ratios:
A company should earn profits to survive and grow over a
long period of times. Profit is the ultimate output of a company and it will
have no future it is fails to make sufficient profits. Therefore, financial
manager should continuously evaluate the efficiency of its company in
terms of profits. The following are the types

a) Gross profit margin: It reflects the efficiency with which

management produces each unit of product. It indicates the
average spread between the cost of goods sold and the sales
revenue.

= Sales – cost of the goods sold = Gross profit

Sales Sales

A high ratio indicates that the firm is able to produce at

relatively lesser costs and it is sign of good management. A low ratio
implies that higher cost of goods sold due to the firms inability to
purchase raw materials at favorable rates , inefficient utilization or over-
investment of plant and machinery, resulting in higher cost of
production.
 b) Net profit margin : It is necessary to earn adequate net [Link]
profit is obtained when operating expenses and income tax are
subjected fron the gross [Link] is the overall measure of the firms
ability to turn each rupee of sales into net [Link] also indicates
the firms capacity to withstand adverse economic conditions.

= Net profit after taxes

Sales

A firm has higher ratio, it would be in an advantageous position to

survive in the face of falling sales prices, raising cost of production or
declining demand for the period.

c) Operating Expense ratio: It explains the change in the net profit

margin ratio. It indicates the efficiency of the management in the
conduct of the business.

Operating expense + cost of goods sold

=
Sales

A higher ratio is unfavorable since it will leave a small amount of

operating income to meet dividends, interest, etc.

d) Earning per Share :It helps in determining the market price of

equity shares of the company. Comparison between two companies
will help in deciding whether the equity share capital is being
effectively used or not. It also helps in establishing the companies
the market price of the equity shares of the company.
e)

= Net profit after taxes – preference dividend

Number of common shares outstanding

= Net profit avalible for equity shareholders

Number of equity shares

A higher ratio indicates the better performance and future

prospects of the company.

e)Dividends per share :Net profit after taxes belong to shareholders.A

large number of present and potential investors are more interested
in the divident per share rather than the earning per share.

Earning paid to shareholders

= Number of common shares outstanding

f) Price-earning ratio: It is used by the security analysis to evaluate

the firms’ performance as expected by the investors. It indicates
investor’s judgment or expectations about the firm’s performance. It
indicates the number of times the earnings per share is covered by its
market price. It helps the investor in deciding whether to buy or not
or buy the shares of a company at a particular market price.

= Market value per share

Earnings per share
g) Return on investment: The profitability of the firm is also measured
in relation to investment. The term investment may refer to total assets
or net assets .The funds employed in net assets is known as capital
employed.

h) Earning power: The net profit margin and investment turnover are the
two ratios employed to measure the firms operating efficiency.
Individually these ratios do not give a complete picture of the
effectiveness of the firms’ operations. For example the net profit margin
does not consider the profitability of investment, while the investment
turnover fails to consider profitability on sales. It is the return on
investment ratio, which is an adequate measure of the firms operating
effiency.

= rate of Investment

= Net profit Margin x Investment turnover

= Net profit after taxes X Sales

Sales capital employed

= Net profit after taxes

Capital employed
ILLUSTRATION: (Reffer the previous problem on XYZ Co.)
Soln:

1) Gross profir margin = Sales – cost of goods sold = Gross profit

Sales Sales

2) Net profit margin = Net profit after taxes 150000 = 10%

Sales 150000

3)Operating expense ratio = Cost of goods sold +operating expenses

Sales

= 121000 = 81%
1500000
4) Earning per share

Net profit after taxes – preference dividend

= Number of common shares outstanding

150000-16000
= 35000 =3.83%

5)Dividend per share

Earning paid to shareholders

= Number of common shares outstanding
 52500
= =1.50ps
35000

6) Earnings power

= Net profit after taxes

Capital employed

= 150000 = 13.6%
1100000

Comparative statements Analysis:

A simple method of tracing changes in the financial performance of
company is to compare comparative statements. They will contain items
at least for two periods. Changes (increase and decrease) –in income
statement and balance sheet over period can be shown in two ways:
• Aggregate changes
• Proportional changes

Aggregate changes can be indicated by drawing special columns for

aggregate amount or percentage or both, of increases and decreases.
Proportional or relative changes are shown by recording percentage
calculated in relation to a common base in special columns.
Foe example in the case of profit and loss statement, sales figure is
assumed to be common base (and equal to 100) and all other items are
expressed as percentage of total assets or total funds. The financial
statements prepared in turns of common base percentage are called
common-size statement. This kind of analysis is called vertical analysis
and it indicate static relationships since relative changes are studied at a
specific date.

Utility of Ratio analysis:

It is the most powerful tool of the financial analysis. As stated ,
many diverse groups of people are interested in analyzing the financial
information to indicate the operating and financial efficiency and growth
of the firm. They use ratios to determine those financial characteristics of
the firm in which they are interested. With the help of ratios , one can
determine

[Link] ability of the firm to meet its current obligations

[Link] extent to which the firm has used its long term solvency by borrowi
ng funds.
[Link] efficiency with which the firm is utilizing its assets in generating
sales revenue
[Link] overall operating efficiency and performance of the firm.

Performance analysis : A shot term creditor will be interested in the

current financial position of the firm while a long term creditor will pay
more attention to the solvency of the firm. The long term creditor will
also be interested the profitability of firm. If a short term creditor
analysis only the current position and find it satisfactory, he cannot be
certain about the safety of his claim, if the firms long term financial
position or profitability is unfavorable. The satisfactory current position
may become adverse in future if the current resources are assumed by
the unfavorable long-term financial condition.
Similarly, the good long term financial position is no guarantee for the
long term creditors claims if the current position or profitability of the
firm is bad.

3. Credit analyses: in this the analyst may use current

ration or quick asset ratio to judge the firms liquidity or
debt paying ability debt equality to determine stake of
owners in the business and firms and capacity to survive
in the long run. If the profitability is high the current
ration is low & D/E ratio is high (unreasonable) the
extension of credit may be approved to the firm because a
profitable company will grow & will have improvement in
its current ratios & other ratios.

4. Security analysis: the major focus is on the long term

profitability. Profitability is dependent on number of
factors & there fore the security analyst also analyses
other ratios. He would certainly be concerned with the
efficiency with which the firm utilizes its assets &
financial risk to which the firm is exposed. There fore
besides analyzing the profitability ratio, he will also
analyze activity & leverage ratios. The detailed analysis of
the earning power is important for security analysis.

5. Comparative analysis: for meaningful interpretation the

ratios of a firm should be compared with ratios of similar
firms & industry. The comparison will reveal whether the
firm is significantly out of line with its competitors if it is
significantly out line, the firm should under take a detail
analysis to spot out trouble areas.
 6. Trend analysis: it studied ratios of different (several)
years and isolates the exceptional instances occurring in
one or two periods. Although the trend analysis of the
companies ratios it self is informative, but it is more
informative to compare the trends in the companies ratios
with the trends in the industry ratios.

This comparison indicates how will company has been operating

overtime relative to its competitors & may also help to explain the trend
in the companies ratio.

Management has protect the interest of all concerned parties creditors

owners & others.

They have to ensure some minimum operating efficiency and keep the
risk of the firm at a minimum level. The survival depends upon their
operating performance.

From time to time management uses ratio analysis to determine the

firm’s financial strengths & weakness accordingly takes action to
improve the firm’s position.

PROBLEMS

1. Prepare a cost sheet (in Rs)

Direct material =50,000

 Direct wages = 15,000
Factory expenses = 5000
Office expenses = 1,000
Selling expenses = 500

Solution : Cost sheet for the period ending ……….

Direct material = 50,000

Direct wages = 15,000

Prime cost: 65,000

Factory Expenses 5,000

Work Cost: 70,000

Office expenses 1,000

2. Prepare a cost Sheet :

Raw materials Consumed Rs 80,000
Wages Rs 20,000
 Work expenses is charged at 100 % of wages. Office Overhead is
charged at 25% on works cost and selling overhead at 10% on works
cost.

Soln ; Cost sheet for thr period ending …………………

Raw materials consumed =

80,000

Wages =
15,000

Prime cost:
1,00,000

Work Expenses : 100% of wages

20,000

3. The following information has been obtained from the records of

XYZ co for the month of June 2004 (in Rs)
Cost of raw materials on 01.06.2004 30,000
Purchases of raw materials 4,50,000
Wages paid 2,30,000
Factory Overhead 92,000
Cost of work in process(01.06.2004) 12,000
Cost of raw materials (30.06.2004) 15,000
Cost of finished products (01.06.2004) 60,000
Cost of finished products (30.06.2004) 55,000
Selling and Distribution Overheads
20,000
 Sales 9,00,000
Administrative Overheads 30,000
Prepare a statement of cost
Soln : Statement of cost of production of goods manufactured for
the period ending on 30.06.2004

Opening Cost of raw materials = 30,000

Add : Purchases = 4,50,000

4,80,000

Less ;Closing stock of raw materials = 15,000

Value of raw material consumed :

4,65,000

Wages paid 2,30,000

Prime cost : 6,95,000

Factory Overhead
92,000

7,87,000

Add : opening stock of work in process 12,000

7,99,000

less : Closing stock of work in process 0000

Factory cost : 7,99,000

4. Prepare cost sheet from the following particulars

Direct materials 1,00,000

 Direct wages 25,000
Direct expenses 5,000
Wages of forman 2,500
Electric power 500
Lighting
Factory 1,500
Office 500

Rent :
Factory 5,000
Office 2,500

Salaries to salesman 1,250

Advertising 1,250
Sales 1,89,000

Soln : Cost sheet for the period ending ……………… ….

Direct materials 1,00,000
Direct wages
25,000
Direct expenses 5,000

Prime cost : 1,30,000

Wages of foreman 2,500

Electric power 500
Lighting factory 1,500
Factory rent 5,000

Work expenses 9,500

Works Cost
1,39,500
Office lighting 500
Office rent 2,500
Office expenses
3,000
Cost of production
1,42,500

Salaries to salesman 1,250

Advertising 1,250

Selling expenses : 2,500

Cost of sales :
1,45,000
Profit :
44,500

SALES :
1,89,500
 5. The following particulars relate to a firm which is engaged in
manufacturing electric fans. Prepare a cost statement assuming
10% profit on selling cost (in Rs).

Stock of raw material (01.01.2004) 12,500

Raw materials purchased 20,000
Stock of raw material (31.12.2004) 7,500
Manufacturing wages 8,300
Direct expenses
700
Work overhead 5,000
Office Overheads 3,000
Distribution Overheads 2,000
Number of electric fans produced 400

Soln :

COST STATEMENT
Stock of raw material (01.01.2004)
12,500

Add: purchases 20,000

32,500

Less ; Closing stock (31.12.04) 7,500

25,000

Add : Manufacturing wages

8,300

Direct expenses 700

PRIME COST : 34,000

Add : Work overhead

5,000

WORKS COST : 39,000

 Chapter-10
FINANCIAL AND PROFIT PLANNING

A firm should be managed effectively and efficiency. This is implies

that the firm should be able to achive its objectives by minimizing the
use of resources. Thus managing implies coordination and control of the
efforts of the firm for achieving the organizational objectives. The process
of managing is facilitated when management charts its future courses of
action in advance and takes decisions in a professional manner, utilizing
the individual and group efforts in a co ordinated and rational manner.
One systematic approach for attaining effective management
performance is financial planning and budgeting.

Financial planning indicates a firm’s growth, performance,

investments and requirements and equivalents of funds during a given
period of time, usually three to five years. It involves the preparation of
projected profits and loss account, balance sheet and funds flow
statement.

Profit planning is a detained plan of action during a period of one

year or less. Both financial and profit planning help a firm’s financial
manager to regulate flows of funds, which is his primary concern.
Financial planning:

Growth in sales is an important objective of all firms. An increase

in a firms market share will lead higher growth. The firm would need
assets to sustain the higher growth in sales. It may have to invest in
additional plant and machinery to increase its production capacity. Also,
it would need additional current assets to produce and sell more goods /
services. The firm would have to acquire raw materials and converts
them into finished goods after incurring manufacturing expenses. It may
have to sell goods on credit because of the industry norms or to push up
sales. This gives rise to debtors or accounts receivables. The suppliers of
raw materials may extend credit to the firm. The firm may use its
internally generated funds finance current and fixed assets. When the
firm grows at a high rate, internal funds may not be sufficient. Thus the
firm would have to raise external funds either by issuing equity or both.
The process of estimating the funds requirements of a firm and
determining the sources of funds is called financial planning.

The following are the steps involved in financial

planning:

1. Post performance: analysis of the firms past performance to

ascertain the relationships between financial variables, and the
firms financial strengths and weakness.

2. Operating characteristics: analysis of the firms operating

characteristics product, market, competition, production and
 marketing policies, control systems, operating risk etc to decide
about its growth objective.

3. Corporate strategy and investment needs: determining the

firms’ investment needs and choices, given its growth objective and
overall strategy.

4. Cash flow from operation: forecasting the firm’s revenues and

expenses and need for funds based on its investment and dividend
policies.
5. Financial alternatives: analyzing financial alternatives with in its
financial policy and deciding the appropriate means of raising
funds.

6. Consequences of financial plans: analyzing the consequences of

its financial plans for the long-term health and survival to firm.

7. Consistency: evaluating the consistency of financial policies with

each other and with the corporate strategy.
Thus financial planning involves the questions of a firms long-term
growth and profitability and investment and financial decisions. It
focuses on aggregative capital expenditure programmer and debt
equity mix rather than the individual projects and sources of
finance.

Profit planning (budgeting)

 Profit plan is a short-term financial plan. It is an action plan to
guide managers and engineers in achieving the objectives of a firm. It is a
comprehensive and coordinate plan expressed in financial terms for the
operations and resources of an enterprise for some specific period in the
future.

The basic elements of a profit plan are:

• it is a comprehensive and coordinated plan

• it is expressed in financial terms
• it is a plan for the firms operation and resources
• it is a future plan for a specific period

More specifically a comprehensive profit planning and controlling,

is a systematic and formalized approach for starting and communicating
the firms expectations and accomplishing the planning, coordination and
control responsibilities of management in such a way as to maximize the
use of given resources. It is only comprehensive approach to managing
so far developed that, if utilized with sophistication and good judgment,
fully recognizes the dominant role of the manager and provides a frame
work for implementing such fundamental aspects of scientific
management as management by objectives, effective communication,
participative management, dynamic control, continues feed back,
responsibility accounting and management flexibility.

Purposes:

• To state the firms expectation in clear and formal terms to avoid

confusion and facilitate their attainability.
 • To communicate expectations to all concerned with the
management of the firm so that they are understood, supported
and implemented.
• To provide a detailed plan of action for reducing uncertainty
and for the proper direction of individual and group efforts to
achieve goals.
• To coordinate the activities and efforts in such a way that the
use of resources is maximized.
• To provide a means of measuring and controlling the
performance of individuals and units to and to supply
information on the basis of which the necessary corrective
action can be taken.

Essentials of profit planning:

A successful and sound planning budgeting system is based

upon certain prerequisites. These prerequisites represent management
attitude, organizational structure and managerial approach necessary for
the effective and efficient application of the budgeting system.

The following are the essentials / fundamentals of a successful

profit planning.

1. Top management support: a budgeting system will be an utter

failure if it is not initiated and supported by the top management.
They must realize that it is an important tool. They must
understand the nature and characteristics, be convinced that this
particular approach to managing is preferable for their situation,
be willing to devote the effort required to make it operative, support
the programme, and view the results of the planning process as
performance commitments.
2. Clear and Realistic Goals: Budgeting is a means to achieve goals
and objectives. in absence of goal clarity , employees will lack a
proper direction, the efforts of management will be wasted. The
enterprise objectives and budget goals to be accomplished through
budgeting should be reasonable and realistic and should be
capable of attainment.
3. Assignment of Authority & Responsibility: A sound
organizational structure is essential for the success of the
budgetary system. Authorities and responsibilities of each manager
should be clearly identified and established. A sound
organizational structure and clear-cut assignment of authorities
and responsibilities provide an effective means to achieve the
objectives and budget goals in a coordinated and efficient manner.
In absence of clear-cut assignments, managers/ engineers would
not be effective and cannot be held accountable.
4. Creation of responsibility centers: for effective control of all
activities, a firm is divided in to meaningful segments,
departments. The sub units of an enterprise for the purpose of
control are called responsibility centers / decision centers. The
important criteria for creating centers are that the unit of the
organization should be separable and identifiable for operating
purposes, and that the performance measurement should be
possible.
5. Adaptation of the accounting system (responsibility
accounting): budgeting is based on the data generated by the
accounting system. Control of performance involves the
comparison of actual performance with the planned performance.
There fore, the accounting system should be suitably adapted to
facilitate the planning and control process; it should be structured
areas of responsibility.
6. Full participation: full participation of manager and their
subordinates at all a level should be sought in developing the
 budgeting system. If the employees have effectively participated in
developing the budget goals and targets, they will make special
efforts to see that the budgeting process succeeds. A meaningful
participation creates appositive motivation. It should be
understood well that the responsibility to prepare budgets lies on
line managers. The financial manager is a staff manager and his
role is to coordinate and supervise the preparation of budgets.
7. Effective communications: the basic purpose of communication
is to maintain mutual trust between two or more persons by
creating similar understanding of ideas or thoughts. It is a method
to bring people together in an enterprise. A sound budgeting
system requires effective communication of enterprise objectives
and budget goals and means of implementing budgets through the
organization so that a unified effort may be directed to accomplish
those objectives and goals.
8. Budget Education: for the success of budgeting, everyone in the
enterprise should have confidence in the budgeting system, and
should be involved and committed to it. The line executives should
be able to sell the idea of budgeting to their subordinates in order
to seek their meaningful participation and involvement. This
requires a continues budget education. The employees must be
educated about the nature, characteristics, value and methods of
budgeting seminars; conferences, lectures, discussions, executive
development programs etc. can be organized. Written material can
also be distributed.
9. Flexibility: the budgeting system should be flexible enough to take
advantage of all opportunities that arise from time to time.
Inflexibility impairs the initiative and freedom of manager and
subordinates in making decisions. A rigidly administered
budgeting programme causes tension and anxiety in implementing
the budget. Thus a flexible and comprehensive budgeting permits
management To read just plans when a new situation arises.
 Budget administration:

It need be emphasized again that the budget preparation

is a line function, while the organization of budgeting is a staff
function. The line executives have the responsibility of deciding what
the plans are to be. It is not the function of the staff organization to
decide what the plans are to be for areas of responsibility other than
its own. The primary responsibility of the staff organization is to assist
line executives in preparing budgets by providing data & technical
advice & coordinating the budget of various departments to form a
master budget.

Responsibilities:

[Link] committee: A joint effort of all managers is needed to prepare

budget all should participate in setting goals developing plans &
formulating policies. Generally the administration of budgeting may be
delegated to a budget committee. The members consist of executives
from each department. The budget director is the over all in charge of the
committee. He may be chief financial officer/ chief accountant/
controller. In fact this is a management committee it brings together
activities of all department in coordinated way & controls those activities
in an effective manner. It should be remembered that the committee has
an advisory roll only. But its advice is very significant & is carried out by
managers. As its first function the committee decides on general policies
for the enterprise & reviews and supply s economics information. It sees
that all departments prepare budgets provides them technical advice
whenever needed & reviews individual budget estimates. On reviewing it
may suggest modification. After necessary revision the budget committee
will finally approve the budget. The committee also ensures that the
budget goals of the department are not in conflict. With the enterprise
objectives. The committee also enforce control by scrutinizing the budget
reports & determining the responsibility for favorable & un favorable
results

[Link] director: the overall responsibility for the functions of

committee lies on the director. He is responsible for drawing up a
detailed timetable for the preparation of budgets and making necessary
adjustments and calculations to consolidate individual’s budgets in to a
master budget. He should be unbiased & objective in his approach. He is
a staff expert, who provides technical assistance to line executives. He
should keep good report with the line managers & should not enforce his
advice upon them.

[Link] manual: it is usually desirable to express objectives, goals

procedures, organizational structure and authority & responsibility in
writing. These matters are explicitly set out in a budget manual. It is a
written set of instructions and a reference for the implementation of a
budget programme. It tells what to do, how to do it, when to do it, and
which form to do it.

Types of Budgets:

Generally the large and medium firms have a comprehensive

system of budgeting – prepare budgets for all of their important
operation, but the small firms do not have a comprehensive system of
budgeting.
The three important components of the master budget are:

a. Operating budget
b. Financial budget
c. Capital budget

A. Operating Budget: it relates to the planning of the activities or

operations of the enterprise, such as production, sales and purchases. It
is composed of two parts –a programme, or activity, budget and a
responsibility budget.

a. Programme or activity budget: it specifies the operation or

functions or functions to be performed during the next year.
One logical way to prepare this budget is to plan for each
product the expected revenues and their associated costs. It
focuses on activities rather than persons. It is helpful in
ensuring balance among various operations or functions of an
enterprise.

b. Responsibility budget: it specifies plans in terms of individual

responsibilities. The focus is on individuals. The purpose is to
achieve control by comparing the actual performance of a
responsible individual with the expected performance. Of
course, an individual will be responsible only for the
controllable activities. The programme budget need not be
tailored to the organization structure of the enterprise, but this
must be, therefore, the programme budget must be converted in
to responsibility budget before actual implementation, and
communicated to the persons involved in the execution of the
plan so that they may precisely know what is expected of them.
 There are two ways in which the operating budget may be prepared, 1)
periodic budgeting and 2) continuous budgeting.

1. Periodic budgeting: it involves the preparation of the

budget for the forthcoming year with out providing for a
comprehensive version as the budget period passes. The
period is divided in to months; the annual budget
consists of the monthly estimates.

2. Continuous Budgeting: it provides for a system of

revising the budget for the changing conditions
continuously. The method involves the preparation of a
tentative annual budget with the provision that the
month or quarter just ended is dropped and same next
period in the future is added. It forces management
constantly to think in concrete terms about its short-
range planning.

B. Financial Budget: it is concerned with the financial implications of

operating budget the expected cash inflows and cash outflows, financial
position and the operating results. The components are cash budget,
proforma balance sheet and income statement & statement of changes in
financial position.

A. Cash Budget: the objective is to plan cash in such a way that the
company always maintain sufficient cash balance to meet its needs and
uses the idle cash in the most profitable manner.

[Link] financial statements: i.e. proforma income statement &

balance sheet show the end results of the budgeted operations. A cash
budget reveals the expected cash position of an enterprise while
proforma financial statements give information as to the future assets,
liabilities and revenue & expenses items. The analysis of the present and
past financial statement indicates the direction of change in the financial
position and performance of the enterprise. The fure can be planned to
follow the past direction or to change it.
The preparation of the cash budget & proforma statements compels
management to look ahead & balance its policies & activities. The
projected statement of changes in financial position can be prepared
from the proforma statements, to show the effect of the budgeted
operations on the financial resources of the film and accordingly, the
firm can plan its policies to pay dividends, refund debt, acquire fixed
assets, borrow loans or issue share capital.

C. Capital Budget: it involves the planning to acquire worthwhile

projects, together with the timings of the estimated cost and cash flows
of each project. Such projects require large sum of funds and have long
term implications for the firm. These are difficult to prepare because
estimates of cash flows over a long period have to be made which involve
a great degree of uncertainty.
These are prepared separately from the
operating budgets. In many companies, there is committee separate from
the budget committee to appropriate funds for capital investment
projects. In this the profitability of each project has to be carefully
evaluated. Various techniques can be used to determine the
profitableness of a project. The technique used should be objective –free
from personal biases and capable of clearly indicating whether the
project should be accepted or not.

Preparation of Profit Plan / Budget:

1. Sales Budget: it is the starting point of budgetary exercise. The sales

manager should be made directly responsible for the preparation and
execution of this budget. In this final form, it is a statements of planned
sales in terms of quantity and value, and analysed by products . the
following factors are to be considered while preparing sales budget.

Historical analysis of sales, salesman estimates, plant capacity, trade

prospects, proposed expansion or discontinuance of products, seasanal
fluctuations, potential market, availability of material, financial aspects,
nature and degree of competition in the industry, cost of distribution
goods, government rules & regulations, changing consumer tastes,
national & international political situation, etc

2. Production Budget: It is prepared after the sales budget. It is based

on sales forecasts, to prepare this; the sales forecasts for each product
are combined with information about the opening and closing levels of
stock of the finished products. The units of budgeted production may be
calculated as follows:
Budgeted production units=sales estimate + Expected
closing stock –Opening stock

3. Cost of production Budget/production cost budget: after

determining the volume of production, it I s necessary to determine the
cost of producing the output .It includes materials, Labour and Overhead
and therefore, separate budgets for each of these items will be prepared.

4. Labour/Personnel Budget: It is the forecast of the requirements of

direct and indirect labour of the various production and service
departments. During the budget period. It normally includes the cost of
direct labour only and this data can be obtained from production budget.
The direct labour hours to be spent depend on the units to be produced
and labour hours required per unit of production.

5. Purchase budget: After having prepared the production ,the

materials usage and this can be easily prepared. The material usage
depends upon the level of production and the levels of opening stock
and desired closing stock. The units of material to be produced and
labour hours required per unit of production .

6. Research Budget: Research costs should be incurred in order to

develop or improve products and methods. The development function
begins on a commercial scale when the development takes place. These
costs include payment to outside research organizations, salaries of
research staff, cost of equipment , cost of trial/test runs etc.

7. Capital Expenditure Budget: It shows the list of capital projects

after taking into account the available productive capacities, probable
reallocation of existing assets and possible improvement in the
production techniques . If necessary separate budgets may be prepared
for each item of assets like building budget, plant & machinery budget
etc.

8. Cash Budget: It shows the cash inflow and cash outflow expected in
the budget period . The major sources of cash inflows are cash sales ,
disposal of fixed assets long-term and short –term borrowings ,dividend
and interest income ,collection of account receivables etc. The major
source of cash outflows are cash purchases, payments of accounts
payables, payment towards wages salaries ret tax payment ,dividend
payment , firm to meet all its commitments in time and at the same time
prevent accumulations of unnecessary large balance with it.

10. Master/Final budget :It is the summary budget incorporating its

component functional budgets and which is finally approved ,
adopted and employed. It has four components Operating Budget,
Capital Expenditure budget ,Cash budget and Projected financial
position statement .It contains details regarding net sales , cash
position ,production casts and key account balances ( for eg :
debtors , fixed assets ,bill payables etc).It also shows the gross
and net profits and the important accounting ratios .

Advantages of budgeting

1. Forced planning :It compels management to plan for future .It

forces management to look ahead and become more effective and
efficient in administering the business operations.

[Link] operations : It helps to coordinate ,integrate and

balance the efforts of various departments in the light of the overall
objective of the enterprise. This results in goal congruency and
harmony among the departments.

3. Performance evaluation and control :It facilitates control by

providing definite expectations in the planning phase that can be used
as a frame of reference for judging the subsequent performance
4. Effective Communication : It improves the quality of
communication. The enterprise objectives, budget goals, plans ,authority
and responsibility and procedures to implement plans are clearly written
and communicated to all individuals in the enterprise. This results in
better understanding and harmonious relations among managers and
subordinates.

5. Optimum utilization of resources :It helps to optimize the use of the

firm’s resources –capital and human.

6. Productivity improvement :It increases the productivity of the

employees by seeking their meaningful participation in the formulation
of plans and policies ,bringing a harmony between individual goals and
enterprise objectives and by providing incentives to perform more
effectively.

7. Profit –mindedness: It develops an atmosphere of profit mindedness

and cost consciousness .

[Link] by exception :It permits to focus the management’s

attention on significant manner through budgetary reports .Thus ,it
facilitates this and thereby saves management time and energy
considerably.

9. Efficiency : It measures efficiency, permits management self-

evaluation and indicates the progress in attaining the enterprise
objectives.
Problems and Dangers(Limitations ) of Budgeting

Problems

1. Seeking the support and involvement of all levels of management.

2. Developing meaningful forecast and plan, specially the sales plan
3. Educating all individuals to be involved and gaining there full
participation.
4. Establishing realistic objectives, policies, procedures and
standards of desired performance.
5. Applying the budgeting system in a flexible manner.
6. Maintaining effective follow-up procedures and adapting the
budgeting system whenever the circumstances change.

Limitations

[Link] Judgment :Budgeting success hinges upon the

accuracy of estimates. Estimates are based on facts and managerial
judgment .The judgment can suffer from subjectivism and personal
bases. The adequacy of budgeting depends upon the adequacy of
managerial judgment .

2. Continuous adaptation: The installation of a perfect system for

budgeting is not possible in a short period .Business conditions
change rapidly and therefore budgeting programmed should be
continuously adapted. It is a dynamic process. Management should
not lose patience ; they should go on trying various techniques and
procedures in developing and using the budgeting system .
 3. Unnecessary details : It will be ineffective and expensive if it is
unnecessarily detailed and complicated. A budget should be precise in
format and simple to understand ; it should be flexible, not rigid in
application

4. Implementation: for the success of the budgetary programme, it is

essential that it is understood by all, and that the manager and
subordinates put effort for accomplishing budget goals. All persons must
have full involvement in the preparation and execution of budgets,
otherwise budgeting will not be effective.

5. Goal Conflict: the purpose of budgeting will be failed if carelessly set

budget goals conflict with enterprise objectives. This confuses means
with the end results. Budget goals are the definite targets to achieve the
overall enterprise objectives. They must be in harmony with the
enterprise aims.

6. Evaluation deficiencies: it will hide inefficiencies instead of revealing

them, if a proper evaluation system is lacking. There should be continues
evaluation of the actual performance. Standards are to be re examined
regularly.

7. Unrealistic targets: it will lower productivity, if unrealistic targets are

set and if it is used as a pressure tactic. To some extent, it may be used
as a pressure device, but its extent must be carefully determined.