caiib-fm-module d topics marginal costing marginal costing capital budgeting capital budgeting cash...

CAIIB-FM-Module D CAIIB-FM-Module D topicstopics

Marginal CostingMarginal CostingCapital BudgetingCapital BudgetingCash BudgetCash BudgetWorking CapitalWorking Capital

COSTINGCOSTING

Cost accounting system provides Cost accounting system provides information about costinformation about cost

Aim : best use of resources and Aim : best use of resources and maximization of returnsmaximization of returns

cost = amount of expenditure cost = amount of expenditure incurred( actual+ notional)incurred( actual+ notional)

Purposes +profit from each job/product, Purposes +profit from each job/product, division, division, segment+pricingdecision+control+profit segment+pricingdecision+control+profit planning +inter firm comparisonplanning +inter firm comparison

Marginal costingMarginal costing

Marginal costing distinguishes Marginal costing distinguishes between fixed cost and variable costbetween fixed cost and variable cost

Marginal cost is nothing but variable Marginal cost is nothing but variable cost of additional unitcost of additional unit

Marginal cost= variable costMarginal cost= variable costMC= Direct Material + Direct Labour MC= Direct Material + Direct Labour

+Direct expenses +Direct expenses

Marginal costing problemsMarginal costing problems

Sales (-) variable cost (=) Sales (-) variable cost (=) contributioncontribution

Contribution(/ divided by) sales Contribution(/ divided by) sales

(=) C.S. Ratio(=) C.S. RatioContribution=Fixed cost Contribution=Fixed cost

(=)Break even point(=)Break even point Fixed Cost (/ divided by) Fixed Cost (/ divided by)

contribution contribution per unitper unit = break = break even unitseven units

Basic formulaBasic formulaSales price (-) variable cost= contributionSales price (-) variable cost= contribution

SP lessSP less VCVC == ContributioContributionn

1010 66 == 44

99 66 == 33

88 66 == 22

77 66 == 11

66 66 == 00

55 66 == (1)(1)

44 66 == (2)(2)


SP = Rs.10, VC =Rs.6 Fixed Cost SP = Rs.10, VC =Rs.6 Fixed Cost Rs.60000Rs.60000

FindFind- Break even point (in Rs. & in units)Break even point (in Rs. & in units)- C/S ratioC/S ratio- Sales to get profit of Rs.20000Sales to get profit of Rs.20000


Sales Rs.100000Sales Rs.100000Fixed Cost Rs.20000Fixed Cost Rs.20000B.E.Point Rs.80000B.E.Point Rs.80000What is the profit ?What is the profit ?

Management decisions- assessing Management decisions- assessing profitability profitability

CONTRIBUTION/SALES=C.S.RATIOCONTRIBUTION/SALES=C.S.RATIOProducProductt

spsp vcvc ContribtioContribtionn

c/sc/s Ratio %Ratio % rankingranking

AA 2020 1010 1010 10/210/200

50%50% 11

BB 3030 2020 1010 10/310/300

33%33% 22

CC 4040 3030 1010 10/410/400

25%25% 33

DECISION when limiting DECISION when limiting factorsfactors

SPSP Rs.14Rs.14 Rs.11Rs.11

VCVC 88 77

ContributionContribution

Per unitPer unit66 44

Labour hr. puLabour hr. pu 22 11

Contri.per hrContri.per hr 33 44

DECISIONSDECISIONS

Make or buy decisionsMake or buy decisionsClose departmentClose departmentAccept or reject orderAccept or reject orderConversion cost pricingConversion cost pricing


cost‑volume‑profit analysis is reliant upon cost‑volume‑profit analysis is reliant upon a classification of costs in which fixed and a classification of costs in which fixed and variable costs are separated from one variable costs are separated from one another. Fixed costs are those which are another. Fixed costs are those which are generally time related and are not generally time related and are not influenced by the level of activity. influenced by the level of activity.

Variable cost on the other hand are directly Variable cost on the other hand are directly related to the level of activity; if activity related to the level of activity; if activity increases, variable costs will increase and increases, variable costs will increase and vice‑versa if activity decreases.vice‑versa if activity decreases.


USES OF COST‑VOLUME‑PROFIT ANALYSISUSES OF COST‑VOLUME‑PROFIT ANALYSIS The ability to analyse and use cost‑volume‑profit The ability to analyse and use cost‑volume‑profit

relationship is an important management tool. relationship is an important management tool. The knowledge of patterns of cost behaviour The knowledge of patterns of cost behaviour offers insights valuable in planning and controlling offers insights valuable in planning and controlling short and long‑run operations. The example of short and long‑run operations. The example of increasing capacity is a good illustrations of the increasing capacity is a good illustrations of the power of the technique in planning. power of the technique in planning.

The implications of changes in the level of activity The implications of changes in the level of activity can be measured by flexing a budget using can be measured by flexing a budget using knowledge of cost behaviour, thereby permitting knowledge of cost behaviour, thereby permitting comparison to be made of actual and budgeted comparison to be made of actual and budgeted perfor mance for any level of activity.perfor mance for any level of activity.


LIMITATIONS OF COST‑VOLUME-PROFIT LIMITATIONS OF COST‑VOLUME-PROFIT ANALYSISANALYSIS

A major limitation of conventional CVP analysis A major limitation of conventional CVP analysis that we have already identified is the assumption that we have already identified is the assumption and use of linear relation ships. Yet another and use of linear relation ships. Yet another limitation relates to the difficulty of divid ing fixed limitation relates to the difficulty of divid ing fixed costs among many products and/or services. Whilst costs among many products and/or services. Whilst variable costs can usually be identified with variable costs can usually be identified with production servic es, most fixed cost usually can production servic es, most fixed cost usually can only be divided by allocation and apportionment only be divided by allocation and apportionment methods reliant upon a good deal of judgement. methods reliant upon a good deal of judgement. However, perhaps the major limitation of the However, perhaps the major limitation of the technique relates to the initial separation of fixed technique relates to the initial separation of fixed and variable costs. and variable costs.

Marginal costingMarginal costing ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF

MARGINAL COSTING MARGINAL COSTING ADVANTAGESADVANTAGES 1.1. More efficient pricing decisions can be More efficient pricing decisions can be

made, since their impact on the contribution made, since their impact on the contribution margin can be measured.margin can be measured.

2.2. Marginal costing can be adapted to all Marginal costing can be adapted to all costing system.costing system.

3.3. Profit varies in accordance with sales, and is Profit varies in accordance with sales, and is not distorted by changes in stock level.not distorted by changes in stock level.

4.4. It eliminates the confusion and It eliminates the confusion and misunderstanding that may occur by the misunderstanding that may occur by the presence of over‑or‑under‑absorbed overhead presence of over‑or‑under‑absorbed overhead costs in the profit and loss account.costs in the profit and loss account.

Marginal costingMarginal costing 5.5. The reports based on direct costing are far The reports based on direct costing are far

more effective for management control than those more effective for management control than those based on absorption costing. First of all, the based on absorption costing. First of all, the reports are more directly related to the profit reports are more directly related to the profit objective or budget for the period. Deviations from objective or budget for the period. Deviations from standards are more readily apparent and can be standards are more readily apparent and can be corrected more quickly. The variable cost of sales corrected more quickly. The variable cost of sales changes in direct proportion with volume. The changes in direct proportion with volume. The distorting effect of production on profit is avoided, distorting effect of production on profit is avoided, especially in month following high production especially in month following high production when substantial amount of fixed costs are carried when substantial amount of fixed costs are carried in inventory over to next month. A substantial in inventory over to next month. A substantial increase in sales in the month after high increase in sales in the month after high production under absorption costing will have a production under absorption costing will have a significant negative impact on the net operating significant negative impact on the net operating profit as inventories are liquidated.profit as inventories are liquidated.


6.6. Marginal costing can help to pinpoint Marginal costing can help to pinpoint responsibility according to organisational responsibility according to organisational lines: individual performance can be lines: individual performance can be evaluated on reliable and appropriate data evaluated on reliable and appropriate data based on current period activity. Operating based on current period activity. Operating reports can be prepared for all segments reports can be prepared for all segments of the company, with costs separated into of the company, with costs separated into fixed and variable and the nature of any fixed and variable and the nature of any variance clearly shown. The responsibility variance clearly shown. The responsibility for costs and variances can then be more for costs and variances can then be more readily attributed to specific individuals readily attributed to specific individuals and functions, from top management to and functions, from top management to down management down management

Marginal costingMarginal costing DISADVANTAGES OF MARGINAL COSTINGDISADVANTAGES OF MARGINAL COSTING 1.1. Difficulty may be experienced in trying to Difficulty may be experienced in trying to

segregate the fixed and variable elements of segregate the fixed and variable elements of overhead costs for the purpose of marginal costing.overhead costs for the purpose of marginal costing.

2.2. The misuse of marginal costing approaches to The misuse of marginal costing approaches to pricing decisions may result in setting selling prices pricing decisions may result in setting selling prices that do not allow the full recovery of overhead costs.that do not allow the full recovery of overhead costs.

3.3. Since production cannot be achieved without Since production cannot be achieved without incurring fixed costs, such costs are related to incurring fixed costs, such costs are related to production, and total absorprtion costing attempts to production, and total absorprtion costing attempts to make an allowance for this relationship. This avoids make an allowance for this relationship. This avoids the danger inherent in marginal costing of creating the danger inherent in marginal costing of creating the illusion that fixed costs have nothing to do with the illusion that fixed costs have nothing to do with production.production.

CAPITAL BUDGETINGCAPITAL BUDGETING

It involves current outlay of funds in It involves current outlay of funds in the expectation of a stream of the expectation of a stream of benefits extending far into the benefits extending far into the futurefutureYearYear Cash flowCash flow

00 (100000)(100000)

11 3000030000

22 4000040000

33 5000050000

44 5000050000


A capital budgeting decision is one that involves A capital budgeting decision is one that involves the allocation of funds to projects that will have a the allocation of funds to projects that will have a life of atleast one year and usually much longer. life of atleast one year and usually much longer.

Examples would include the development of a Examples would include the development of a major new product, a plant site location, or an major new product, a plant site location, or an equipment replacement decision.equipment replacement decision.

Capital budgeting decision must be approached Capital budgeting decision must be approached with great care because of the following reasons:with great care because of the following reasons:

1.1. Long time period: consequences of capital Long time period: consequences of capital expenditure extends into the future and will have expenditure extends into the future and will have to be endured for a longer period whether the to be endured for a longer period whether the decision is good or bad. decision is good or bad.


2.2. . Substantial expenditure: it involves . Substantial expenditure: it involves large sums of money and necessitates a large sums of money and necessitates a careful planning and evaluation.careful planning and evaluation.

3.3. Irreversibility: the decisions are quite Irreversibility: the decisions are quite often irreversible, because there is little often irreversible, because there is little or no second hand market for may types or no second hand market for may types of capital goods. of capital goods.

4.4. Over and under capacity: an erroneous Over and under capacity: an erroneous forecast of asset requirements can result forecast of asset requirements can result in serious consequences. First the in serious consequences. First the equipment must be modern and secondly equipment must be modern and secondly it has to be of adequate capacityit has to be of adequate capacity


DifficultiesDifficulties There are three basic reasons why capital There are three basic reasons why capital

expenditure decisions pose difficulties for the expenditure decisions pose difficulties for the decision maker. These are:decision maker. These are:

1.1. Uncertainty: the future business success is Uncertainty: the future business success is today’s investment decision. The future in the today’s investment decision. The future in the real world is never known with certainty.real world is never known with certainty.

2.2. Difficult to measure in quantitative terms: Even if Difficult to measure in quantitative terms: Even if benefits are certain, some might be difficult to benefits are certain, some might be difficult to measure in quantitative terms.measure in quantitative terms.

3.3. Time Element: the problem of phasing properly Time Element: the problem of phasing properly the availability of capital assets in order to have the availability of capital assets in order to have them come “on stream” at the correct time.them come “on stream” at the correct time.

CAPITAL BUDGETINGCAPITAL BUDGETING Methods of classifying investmentsMethods of classifying investments IndependentIndependent DependentDependent Mutually exclusive Mutually exclusive Economically independent and statistically Economically independent and statistically

dependentdependent Investment may fall into two basic Investment may fall into two basic

categories, profit-maintaining and profit-categories, profit-maintaining and profit-adding when viewed from the perspective adding when viewed from the perspective of a business, or service maintaining and of a business, or service maintaining and service-adding when viewed from the service-adding when viewed from the perspective of a government or agency.perspective of a government or agency.


Expansion and new product investmentExpansion and new product investment

1.1. Expansion of current production to meet Expansion of current production to meet increased demandincreased demand

2.2. Expansion of production into fields closely Expansion of production into fields closely related to current operation – horizontal related to current operation – horizontal integration and vertical integration.integration and vertical integration.

3.3. Expansion of production into new fields not Expansion of production into new fields not associated with the current operations.associated with the current operations.

4.4. Research and development of new Research and development of new products.products.


Reasons for using cash flowsReasons for using cash flows Economic value of a proposed investment can be Economic value of a proposed investment can be

ascertained by use of cash flows.ascertained by use of cash flows. Use of cash flows avoids accounting ambiguitiesUse of cash flows avoids accounting ambiguities Cash flows approach takes into account the time Cash flows approach takes into account the time

value of moneyvalue of money For any investment project generating either For any investment project generating either

expanded revenues or cost savings for the firm, expanded revenues or cost savings for the firm, the appropriate cash flows used in evaluating the the appropriate cash flows used in evaluating the project must be incremental cash flow.project must be incremental cash flow.

The computation of incremental cash flow should The computation of incremental cash flow should follow the “with and without” principle rather than follow the “with and without” principle rather than the “before and after” principlethe “before and after” principle

Types of capital investmentsTypes of capital investments

New unitNew unitExpansionExpansionDiversificationDiversificationReplacementReplacementResearch & DevelopmentResearch & Development

Significance of capital budgeting Significance of capital budgeting

Huge outlayHuge outlayLong term effectsLong term effects IrreversibilityIrreversibilityProblems in measuring future cash Problems in measuring future cash

flowsflows

Facets of project analysisFacets of project analysis

Market analysisMarket analysisTechnical analysisTechnical analysisFinancial analysisFinancial analysisEconomic analysisEconomic analysisManagerial analysisManagerial analysisEcological analysisEcological analysis

Financial analysisFinancial analysis

Cost of projectCost of projectMeans of financeMeans of financeCost of capitalCost of capitalProjected profitabilityProjected profitabilityCash flows of the projectsCash flows of the projectsProject appraisalProject appraisal

Decision processDecision process

PLANNING PHASE

EVALUATION PHASE

SELECTION PHASE

IMPLEMENTATION PHASE

CONTROL PHASE

AUDITING PHASE

INVESTMENT OPPORTUNITIES

PROPOSALS

ONLINE PROJECTS

PROJECTS

ACCEPTED PROJECTS

PROJECT TERMINATION

PROPOSALSIm

pro

vem

ent

in p

lan

ning

& E

valu

atio

n p

roce

dure

Imp

rove

me

nt in

pla

nni

ng &

Eva

lua

tion

pro

cedu

re

NE

W I

NV

ES

TM

EN

T

OP

PO

RT

UN

ITIE

S

REJECTED

OPPORTUNITIE

S

Rejecte

d

Propo

sa

ls

Reject

ed

proje

ct

s

Methods of capital investment Methods of capital investment appraisalappraisal

DISCOUNTINGDISCOUNTING NON-DISCOUNTINGNON-DISCOUNTING

Net present value Net present value (NPV)(NPV)

Pay back periodPay back period

Internal rate of return Internal rate of return (IRR)(IRR)

Accounting rate of Accounting rate of return return

Profitability Index or Profitability Index or Benefit cost ratioBenefit cost ratio

Present value of cash flow Present value of cash flow stream- (cash outlay stream- (cash outlay

Rs.15000)@ 12%Rs.15000)@ 12%YearYear Cash flowCash flow PV factor PV factor

@12%@12% PVPV

11 10001000 0.8930.893 893893

22 20002000 0.7990.799 15941594

33 20002000 0.7120.712 14241424

44 30003000 0.6360.636 19081908

55 30003000 0.5670.567 17011701

66 40004000 0.5070.507 20282028

77 40004000 0.4520.452 18081808

88 50005000 0.4040.404 2020 2020

1337613376

Present value of cash flow Present value of cash flow stream- (cash outlay stream- (cash outlay

Rs.15000 )@10%Rs.15000 )@10%YearYear Cash flowCash flow PV factor PV factor

@10%@10% PVPV

11 20002000 0.9090.909 18181818

22 20002000 0.8260.826 16521652

33 20002000 0.7510.751 15021502

44 30003000 0.6830.683 20492049

55 30003000 0.6210.621 18631863

66 40004000 0.5640.564 22562256

77 40004000 0.5130.513 20522052

88 50005000 0.4660.466 23302330

1552215522


SolutionSolution IRRIRR NAV NAV Project AProject A 20% 20% 309309 Project BProject B 15%15% 1441 1441 These project are mutually exclusive These project are mutually exclusive The IRR ranks project A higher, whereas the NPV The IRR ranks project A higher, whereas the NPV

ranks project B first. ranks project B first. The conflict arises because B is ten times the size The conflict arises because B is ten times the size

of A. This gives a higher NPV but in relative terms of A. This gives a higher NPV but in relative terms it is less profitable with a lower percentage it is less profitable with a lower percentage return. Naturally, B is preferable because it gives return. Naturally, B is preferable because it gives the greatest increase in shareholder’s wealth.the greatest increase in shareholder’s wealth.


The advantages of IRR over NPV are:The advantages of IRR over NPV are: 1.1. It gives a percentage return which is It gives a percentage return which is

easy to understanding at all levels of easy to understanding at all levels of management.management.

2.2. The discount rate/required rate of return The discount rate/required rate of return does not have to be known to calculate IRR. does not have to be known to calculate IRR. It does have to be decided upon at sometime It does have to be decided upon at sometime because IRR must be compared with because IRR must be compared with something. The discussion as to what is an something. The discussion as to what is an acceptable rate of return can however be left acceptable rate of return can however be left until much later stage. In a NPV calculation until much later stage. In a NPV calculation the discount rate must be specified prior to the discount rate must be specified prior to any calculation being performed.any calculation being performed.


The advantages of NPV over IRR are:The advantages of NPV over IRR are: 1.1. NPV gives an absolute measure of profitability and NPV gives an absolute measure of profitability and

hence immediately shows the increase in shareholder’s hence immediately shows the increase in shareholder’s wealth due to an investment decision.wealth due to an investment decision.

2.2. NPV gives a clear answer in an accept/reject NPV gives a clear answer in an accept/reject decision. IRR gives multiple answers.decision. IRR gives multiple answers.

3.3. NPV always gives the correct ranking for mutually NPV always gives the correct ranking for mutually exclusive project while IRR may not.exclusive project while IRR may not.

4.4. NPVs of projects are additive while IRRs are not.NPVs of projects are additive while IRRs are not. 5.5. Any changes in discount rates over the life of a Any changes in discount rates over the life of a

project can more easily be incorporated into the NPV project can more easily be incorporated into the NPV calculation.calculation.

The NPV approach provides as absolute measure that fully The NPV approach provides as absolute measure that fully represents in value of the company if a particular project is represents in value of the company if a particular project is undertaken. The IRR by contrast, provides a percentage undertaken. The IRR by contrast, provides a percentage figure from which the size of the benefits in terms of wealth figure from which the size of the benefits in terms of wealth creation cannot always be grasped. creation cannot always be grasped.

The timing of the cash flows is critical for determining the Project's value.below the line for cash investments orabove the line for returns.

Rs.51 Lakh Rs.51 Lakh Rs.61 Lakh

Year 1 Year 2 Year 3Rs.102 lakh

Year 0

Net Present ValueYear Cash Flow Dis. Factor Present

@10% Value

0 -102 1 -1021 51 0.91 46.362 51 0.83 42.153 61 0.75 45.83

NPV 32.34

@27% Value0 -102 1 -1021 51 0.78740 402 51 0.62000 323 61 0.48818 30

NPV 0

The evaluation of any projectdepends on the magnitude of thecash flows, the timing and thediscount rate.The discount rate is highlysubjective. The higher the rate , theless a rupee in the future would beworth today.The risk of the project shoulddetermine the discount rate.

Internal Rate of Return(IRR)IRR is the rate at whichthe discounted cash flowsin the future equal thevalue of the investmenttoday. To find the IRR onemust try different ratesuntil the NPV equals zero.

Future valueFuture value

Assume that an investor has $1000 Assume that an investor has $1000 and wishes to know its worth after and wishes to know its worth after four years if it grows at 10 percent four years if it grows at 10 percent per year. At the end of the first year, per year. At the end of the first year, he will have $1000 X 1.10 or 1,100. he will have $1000 X 1.10 or 1,100. By the end of the year two, the By the end of the year two, the $1,100 will have grown to $1,210 $1,100 will have grown to $1,210 ($1,100 X 1.10). The four-year ($1,100 X 1.10). The four-year pattern is indicated below.pattern is indicated below.

BUDGETBUDGET

Quantitative expression of Quantitative expression of management objective management objective

Budgets and standardsBudgets and standardsBudgetary controlBudgetary controlCash budgetCash budget

PROFIT PLANNINGPROFIT PLANNING

Budget & budgetary controlBudget & budgetary controlMarginal costingMarginal costingCVP and break even pointCVP and break even pointComparative cost analysisComparative cost analysisROCE ROCE

PRICING DECISIONSPRICING DECISIONS

Full cost pricingFull cost pricingConversion cost pricingConversion cost pricingMarginal cost pricingMarginal cost pricingMarket based pricingMarket based pricing

PRICING DECISIONSPRICING DECISIONS PRICING AND ITS OBJECTIVESPRICING AND ITS OBJECTIVES The objective of pricing in practice will The objective of pricing in practice will

probably be one of the following:probably be one of the following: (a)(a) To ‘skim’ the market (in the case of new To ‘skim’ the market (in the case of new

products) by the use of high prices;products) by the use of high prices; (b)(b) To penetrate deeply into the market To penetrate deeply into the market

(again with new products) at an early stage, (again with new products) at an early stage, before competition produces similar goods;before competition produces similar goods;

(c)(c) To earn a particular rate of return on the To earn a particular rate of return on the funds invested via the generating of revenue; funds invested via the generating of revenue; andand

(d)(d) To make a profit on the product range as To make a profit on the product range as a whole, which may involve using certain a whole, which may involve using certain items in the range as loss leaders, and so items in the range as loss leaders, and so forth.forth.


Full cost pricingFull cost pricingThe object is to recover all costs The object is to recover all costs

incurred plus a percent age of profit. incurred plus a percent age of profit. It is a method best used where the It is a method best used where the product is clearly differentiated and product is clearly differentiated and not in immediate, direct competition. not in immediate, direct competition. It would not lend itself to situation It would not lend itself to situation where price tended to be determined where price tended to be determined by the market, by the market,


Conversion cost pricingConversion cost pricingConversion cost consists of direct Conversion cost consists of direct

labour cost and factory overhead, labour cost and factory overhead, ignoring the cost of the raw material ignoring the cost of the raw material on the grounds that profit should be on the grounds that profit should be made within the factory and not made within the factory and not upon materials bought from upon materials bought from suppliers.suppliers.


Marginal cost pricingMarginal cost pricing Briefly it is that cost which would not be incurred if Briefly it is that cost which would not be incurred if

the production of the product were discontinued. the production of the product were discontinued. An important advantage of differential cost of An important advantage of differential cost of pricing is the flexibility it gives to meet special pricing is the flexibility it gives to meet special short‑term circumstances, while accepting that full short‑term circumstances, while accepting that full costs must be recovered in the long term. This is by costs must be recovered in the long term. This is by no means always desirable in the short term. For no means always desirable in the short term. For example, there may be surplus productive capacity example, there may be surplus productive capacity in a factory, in which case any opportunity to in a factory, in which case any opportunity to accept an order which covers differential cost and accept an order which covers differential cost and makes a contribution to fixed cost and profit should makes a contribution to fixed cost and profit should be accepted. Any contribution is better than none. be accepted. Any contribution is better than none.


Market based pricingMarket based pricing

This can be based on the value to a This can be based on the value to a customer of goods or services and involves customer of goods or services and involves variable pricing. It also takes account of variable pricing. It also takes account of the price he is able and willing to pay for the price he is able and willing to pay for the goods or services. Businesses using the goods or services. Businesses using this approach develop special products or this approach develop special products or services which command premium prices.services which command premium prices.

The other market‑based approach is to The other market‑based approach is to price on the basis of what competitors are price on the basis of what competitors are charging. charging.

Operating leverageOperating leverageFinancial leverageFinancial leverage

OL= amount of fixed cost in a cost OL= amount of fixed cost in a cost structure. Relationship between sales structure. Relationship between sales and op. profitand op. profit

FL= effect of financing decisions on FL= effect of financing decisions on return to owners. Relationship return to owners. Relationship between operating profit and earning between operating profit and earning available to equity holders (owners)available to equity holders (owners)

Working capitalWorking capital

Current assets less current liabilities Current assets less current liabilities = net working capital or net current = net working capital or net current assetsassets

Permanent working capital vs. Permanent working capital vs. variable working capitalvariable working capital

Working capital cycleWorking capital cycle

cash> Raw material > Work in cash> Raw material > Work in progress > finished goods > Sales > progress > finished goods > Sales > Debtors > Cash>Debtors > Cash>

Operating cycle – it is a length of Operating cycle – it is a length of time between outlay on RM /wages time between outlay on RM /wages /others AND inflow of cash from the /others AND inflow of cash from the sale of the goods sale of the goods

Matching approach to asset Matching approach to asset financingfinancing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +EquityCapital

THE WORKING CAPITAL THE WORKING CAPITAL CYCLECYCLE

(OPERATING CYCLE)(OPERATING CYCLE)

Accounts Payable

Cash

RawMaterials

W I P

Finished Goods

Value Addition

AccountsReceivable

SALES

Operating cycle conceptOperating cycle concept A company’s operating cycle typically A company’s operating cycle typically

consists of three primary activities:consists of three primary activities: Purchasing resources,Purchasing resources, Producing the product andProducing the product and Distributing (selling) the product.Distributing (selling) the product.

These activities create funds flows that are both These activities create funds flows that are both unsynchronizedunsynchronized and and uncertain.uncertain.Unsynchronized because cash disbursements (for Unsynchronized because cash disbursements (for example, payments for resource purchases) example, payments for resource purchases) usually take place before cash receipts (for usually take place before cash receipts (for example collection of receivables).example collection of receivables).

They are uncertain because future sales and costs, They are uncertain because future sales and costs, which generate the respective receipts and which generate the respective receipts and disbursements, cannot be forecasted with disbursements, cannot be forecasted with complete accuracy. complete accuracy.

Working capital cycleWorking capital cycle


FACTORS DETERMINING WORKING CAPITALFACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry1. Nature of the Industry2. Demand of Industry2. Demand of Industry3. Cash requirements3. Cash requirements4. Nature of the Business4. Nature of the Business5. Manufacturing time5. Manufacturing time6. Volume of Sales6. Volume of Sales7. Terms of Purchase and Sales7. Terms of Purchase and Sales8. Inventory Turnover8. Inventory Turnover9. Business Turnover9. Business Turnover10. Business Cycle10. Business Cycle11. Current Assets requirements11. Current Assets requirements12. Production Cycle12. Production Cycle

Working capitalWorking capital Working Capital Determinants (Contd…)Working Capital Determinants (Contd…)

13. Credit control13. Credit control14. Inflation or Price level changes14. Inflation or Price level changes15. Profit planning and control15. Profit planning and control16. Repayment ability16. Repayment ability17. Cash reserves17. Cash reserves18. Operation efficiency18. Operation efficiency19. Change in Technology19. Change in Technology20. Firm’s finance and dividend policy 20. Firm’s finance and dividend policy 21. Attitude towards Risk21. Attitude towards Risk

TYPES OF WORKING CAPITALTYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC


Working Capital Levels in Different IndustriesWorking Capital Levels in Different Industries A retailing company usually has high levels A retailing company usually has high levels

of finished goods stock and very low levels of of finished goods stock and very low levels of debtors. Most of the retailer’s sales will be debtors. Most of the retailer’s sales will be for cash, and an independent credit card for cash, and an independent credit card company or a financial subsidiary of the company or a financial subsidiary of the retail business (which on occasions is not retail business (which on occasions is not consolidated in the group accounts). The consolidated in the group accounts). The retailing company, however, usually has high retailing company, however, usually has high levels of creditors. It pays its sup pliers after levels of creditors. It pays its sup pliers after an agreed period of credit. The levels of an agreed period of credit. The levels of working capital required are therefore low:working capital required are therefore low:

Working capitalWorking capital Excess of current assets over current liabilities are Excess of current assets over current liabilities are

called the net working capital or net current assets.called the net working capital or net current assets. Working capital is really what a part of long term Working capital is really what a part of long term

finance is locked in and used for supporting current finance is locked in and used for supporting current activities.activities.

The balance sheet definition of working capital is The balance sheet definition of working capital is meaningful only as an indication of the firm’s current meaningful only as an indication of the firm’s current solvency in repaying its creditors. solvency in repaying its creditors.

When firms speak of shortage of working capital they When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources. in fact possibly imply scarcity of cash resources.

In fund flow analysis an increase in working capital, as In fund flow analysis an increase in working capital, as conventionally defined, represents employment or conventionally defined, represents employment or application of funds.application of funds.


In contrast, a manufacturing In contrast, a manufacturing company will require relatively high company will require relatively high levels of working capital with levels of working capital with investments in raw materials, work-investments in raw materials, work-in-pro gress and finished goods in-pro gress and finished goods stocks, and with high levels of stocks, and with high levels of debtors. The credit terms offered on debtors. The credit terms offered on sales and taken on purchases will be sales and taken on purchases will be influenced by the normal contractual influenced by the normal contractual arrangements in the industry.arrangements in the industry.

Working capitalWorking capital DebtorsDebtors Volume of credit salesVolume of credit sales Length of credit givenLength of credit given Effective credit control and cash collectionEffective credit control and cash collection StocksStocks Lead time & safety levelLead time & safety level Variability of demandVariability of demand Production cycleProduction cycle No. of product linesNo. of product lines Volume ofVolume of – – planned outputplanned output – – actual outputactual output – – salessales PayablesPayablesVolume of purchasesVolume of purchases Length of credit allowedLength of credit allowed Length of credit taken – DiscountsLength of credit taken – Discounts Short‑term financeShort‑term finance All the aboveAll the above Other payments/receiptsOther payments/receipts Availability of credit Interest ratesAvailability of credit Interest rates

Working capitalWorking capital Cash LevelsCash Levels it is necessary to prepare a cash budget where it is necessary to prepare a cash budget where

the minimum balances needed from month to the minimum balances needed from month to month will be defined.month will be defined.

business is seasonal, cash shortages may arise in business is seasonal, cash shortages may arise in certain periods. Generally it is thought better to keep certain periods. Generally it is thought better to keep only sufficient cash to satisfy short‑term needs, and only sufficient cash to satisfy short‑term needs, and to borrow if longer‑term requirements occur to borrow if longer‑term requirements occur

The problem, of course, is to balance the cost of this The problem, of course, is to balance the cost of this borrowing against any income that might be borrowing against any income that might be obtained from investing the cash balances. obtained from investing the cash balances.

The size of the cash balance that a company might The size of the cash balance that a company might need depends on the availability of other sources of need depends on the availability of other sources of funds at short notice, the credit standing of the funds at short notice, the credit standing of the company and the control of debtors and creditors company and the control of debtors and creditors


DebtorsDebtors The debtors problem again revolves The debtors problem again revolves

around the choice between profitability around the choice between profitability and liquidity. It might, for instance, be and liquidity. It might, for instance, be possible to in crease sales by allowing possible to in crease sales by allowing customers more time to pay, but since this customers more time to pay, but since this policy would reduce the company’s liquid policy would reduce the company’s liquid resources it would not necessarily result in resources it would not necessarily result in higher Profits. higher Profits.

historical analysis or the use of established historical analysis or the use of established credit ratings to classify groups of credit ratings to classify groups of customers in terms of credit risk customers in terms of credit risk


1.1. Establish clear credit practices as a matter Establish clear credit practices as a matter of company policy. of company policy.

2.2. Make sure that these practices are clearly Make sure that these practices are clearly understood by staff, suppliers and understood by staff, suppliers and customers. customers.

3.3. Be professional when accepting new Be professional when accepting new accounts, and especially larger ones. accounts, and especially larger ones.

4.4. Check out each customer thoroughly before Check out each customer thoroughly before you offer credit. Use credit agencies, bank you offer credit. Use credit agencies, bank references, industry sources etc. references, industry sources etc.

5.5. Establish credit limits for each customer... Establish credit limits for each customer... and stick to them. and stick to them.

6.6. Have the right mental attitude to the control Have the right mental attitude to the control of credit and make sure that it gets the of credit and make sure that it gets the priority it deserves. priority it deserves.

Working capitalWorking capital 7. Continuously review these limits when you suspect 7. Continuously review these limits when you suspect

tough times are coming or if operating in a volatile tough times are coming or if operating in a volatile sector. sector. 8. Keep very close to your larger customers. 8. Keep very close to your larger customers. 9. Invoice promptly and clearly. 9. Invoice promptly and clearly. 10. Consider charging penalties on overdue accounts. 10. Consider charging penalties on overdue accounts. 11. Consider accepting credit /debit cards as a 11. Consider accepting credit /debit cards as a payment option. payment option. 12. Monitor your debtor balances and ageing 12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or schedules, and don't let any debts get too large or too old. too old.

DIMENSIONS OF RECEIVABLES MANAGEMENTDIMENSIONS OF RECEIVABLES MANAGEMENT

OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLESOPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

ProfitabilityProfitability

Costs &Costs &Profitability Profitability Optimum LevelOptimum Level

LiquidityLiquidity

StringentStringent LiberalLiberal

Working capital-FACTORINGWorking capital-FACTORING

FactoringFactoringDefinition:Definition: Factoring is defined as ‘a continuing legal Factoring is defined as ‘a continuing legal

relationship between a financial institution (the relationship between a financial institution (the factor) and a business concern (the client), selling factor) and a business concern (the client), selling goods or providing services to trade customers goods or providing services to trade customers (the customers) on open account basis whereby (the customers) on open account basis whereby the Factor purchases the client’s book debts the Factor purchases the client’s book debts (accounts receivables) either with or without (accounts receivables) either with or without recourse to the client and in relation thereto recourse to the client and in relation thereto controls the credit extended to customers and controls the credit extended to customers and administers the sales ledgers’.administers the sales ledgers’.


It is the outright purchase of credit It is the outright purchase of credit approved accounts receivables with the approved accounts receivables with the factor assuming bad debt losses.factor assuming bad debt losses.

Factoring provides sales accounting Factoring provides sales accounting service, use of finance and protection service, use of finance and protection against bad debts.against bad debts.

Factoring is a process of invoice Factoring is a process of invoice discounting by which a capital market discounting by which a capital market agency purchases all trade debts and agency purchases all trade debts and offers resources against them.offers resources against them.


Debt administration:Debt administration:The factor manages the sales ledger The factor manages the sales ledger

of the client company. The client will of the client company. The client will be saved of the administrative cost be saved of the administrative cost of book keeping, invoicing, credit of book keeping, invoicing, credit control and debt collection. The control and debt collection. The factor uses his computer system to factor uses his computer system to render the sales ledger render the sales ledger administration services.administration services.

Working capital-FACTORINGWorking capital-FACTORING Different kinds of factoring servicesDifferent kinds of factoring services Credit Information: Credit Information: Factors provide credit Factors provide credit

intelligence to their client and supply periodic intelligence to their client and supply periodic information with various customer-wise information with various customer-wise analysis. analysis.

Credit ProtectionCredit Protection: Some factors also insure : Some factors also insure against bad debts and provide without against bad debts and provide without recourse financing.recourse financing.

Invoice Discounting or FinancingInvoice Discounting or Financing : Factors : Factors advance 75% to 80% against the invoice of advance 75% to 80% against the invoice of their clients. The clients mark a copy of the their clients. The clients mark a copy of the invoice to the factors as and when they raise invoice to the factors as and when they raise the invoice on their customers.the invoice on their customers.


Services rendered by factorServices rendered by factor Factor evaluated creditworthiness of the customer Factor evaluated creditworthiness of the customer

(buyer of goods)(buyer of goods) Factor fixes limits for the client (seller) which is Factor fixes limits for the client (seller) which is

an aggregation of the limits fixed for each of the an aggregation of the limits fixed for each of the customer (buyer).customer (buyer).

Client sells goods/services.Client sells goods/services. Client assigns the debt in favour of the factorClient assigns the debt in favour of the factor Client notifies on the invoice a direction to the Client notifies on the invoice a direction to the

customer to pay the invoice value of the factor.customer to pay the invoice value of the factor.

Working capital-FACTORINGWorking capital-FACTORING Client forwards invoice/copy to factor along Client forwards invoice/copy to factor along

with receipted delivery challans.with receipted delivery challans. Factor provides credit to client to the extent Factor provides credit to client to the extent

of 80% of the invoice value and also notifies of 80% of the invoice value and also notifies to the customerto the customer

Factor periodically follows with the customerFactor periodically follows with the customer When the customer pays the amount of the When the customer pays the amount of the

invoice the balance of 20% of the invoice invoice the balance of 20% of the invoice value is passed to the client recovering value is passed to the client recovering necessary interest and other charges.necessary interest and other charges.

If the customer does not pay, the factor If the customer does not pay, the factor takes recourse to the client.takes recourse to the client.

Working capital-FACTORINGWorking capital-FACTORING Benefits of factoringBenefits of factoring The client will be relieved of the work relating to sales The client will be relieved of the work relating to sales

ledger administration and debt collectionledger administration and debt collection The client can therefore concentrate more on planning The client can therefore concentrate more on planning

production and sales.production and sales. The charges paid to a factor which will be marginally high The charges paid to a factor which will be marginally high

at 1 to 1.5% than the bank charges will be more than at 1 to 1.5% than the bank charges will be more than compensated by reductions in administrative expenditure.compensated by reductions in administrative expenditure.

This will also improve the current ratio of the client and This will also improve the current ratio of the client and consequently his credit rating. consequently his credit rating.

The subsidiaries of the various banks have been rendering The subsidiaries of the various banks have been rendering the factoring services.the factoring services.

The factoring service is more comprehensive in nature than The factoring service is more comprehensive in nature than the book debt or receivable financing by the bankers.the book debt or receivable financing by the bankers.

Working capital- Working capital- INVENTORY INVENTORY MANAGEMENTMANAGEMENT

Managing inventory is a juggling act. Managing inventory is a juggling act.

Excessive stocks can place a heavy burden Excessive stocks can place a heavy burden on the cash resources of a business. on the cash resources of a business.

Insufficient stocks can result in lost sales, Insufficient stocks can result in lost sales, delays for customers etc. delays for customers etc.

INVENTORIES INCLUDE INVENTORIES INCLUDE RAW MATERIALS, WIP & FINISHED RAW MATERIALS, WIP & FINISHED

GOODSGOODS

FACTORS INFLUENCING INVENTORY FACTORS INFLUENCING INVENTORY MANAGEMENTMANAGEMENT

Lead TimeLead Time Cost of Holding InventoryCost of Holding Inventory Material CostsMaterial Costs Ordering CostsOrdering Costs Carrying CostsCarrying Costs Cost of tying-up of FundsCost of tying-up of Funds Cost of Under stockingCost of Under stocking Cost of OverstockingCost of Overstocking


Cost of Working capitalCost of Working capital The other aspect of the working capital problem The other aspect of the working capital problem

concerns obtaining short‑term funds. Every source concerns obtaining short‑term funds. Every source of finance, including taking credit from suppliers, of finance, including taking credit from suppliers, has a cost; the point is to keep this cost to the has a cost; the point is to keep this cost to the minimum. The cost involved in using trade credit minimum. The cost involved in using trade credit might include forfeiting the discount normally might include forfeiting the discount normally given for prompt payment, or loss of goodwill given for prompt payment, or loss of goodwill through relying on this strategy to the point of through relying on this strategy to the point of abuse. Some other sources of short‑term funds are abuse. Some other sources of short‑term funds are bank credit, overdrafts and loans from other bank credit, overdrafts and loans from other institutions. These can be unsecured or secured, institutions. These can be unsecured or secured, with charges made against inventories, specifi c with charges made against inventories, specifi c assets or general assets.assets or general assets.


Disadvantages of Redundant or Excess Working Disadvantages of Redundant or Excess Working CapitalCapital

Idle funds, non-profitable for business, poor ROI Idle funds, non-profitable for business, poor ROI Unnecessary purchasing & accumulation of Unnecessary purchasing & accumulation of inventories over required level inventories over required level Excessive debtors and defective credit policy, Excessive debtors and defective credit policy, higher incidence of B/D.higher incidence of B/D.Overall inefficiency in the organization.Overall inefficiency in the organization.When there is excessive working capital, Credit When there is excessive working capital, Credit worthiness suffersworthiness suffers Due to low rate of return on investments, the Due to low rate of return on investments, the market value of shares may fallmarket value of shares may fall


Disadvantages or Dangers of Inadequate or Short Disadvantages or Dangers of Inadequate or Short Working CapitalWorking Capital

Can’t pay off its short-term liabilities in time. Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Economies of scale are not possible. Difficult for the firm to exploit favourable market Difficult for the firm to exploit favourable market situations situations Day-to-day liquidity worsens Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI Improper utilization the fixed assets and ROA/ROI falls sharply falls sharply

Working capital cycleWorking capital cycle Example: Example: X Company plans to attain a sales of Rs 5 crores. It has the following information X Company plans to attain a sales of Rs 5 crores. It has the following information

for production and selling activity. It is assumed that the activities are evenly spread for production and selling activity. It is assumed that the activities are evenly spread through out the year.through out the year.

(a) Average time raw materials are kept in store prior to issue for production.2months(a) Average time raw materials are kept in store prior to issue for production.2months (b) Production cycle time or work-in-progress cycle time.(b) Production cycle time or work-in-progress cycle time. 2months 2months (c) Average time finished stocks are kept in sale in unsold condition(c) Average time finished stocks are kept in sale in unsold condition 1/2 months 1/2 months (d) Average credit available from suppliers(d) Average credit available from suppliers 1 1/2 months 1 1/2 months (e) Average credit allowed to customer(e) Average credit allowed to customer 1 1/2 months 1 1/2 months (f)(f) Analysis of cost Analysis of cost plusplus profit for above sales: profit for above sales: %% Rs. In CroresRs. In Crores Raw MaterialsRaw Materials 5050 2.502.50 Direct LabourDirect Labour 2020 1.001.00 OverheadsOverheads 1010

0.500.50 ProfitProfit 2020 1.001.00 TotalTotal 100100 5.005.00 ----------------------

Working capital cycleWorking capital cycle Calculation of Wokring Capital Requirement:Calculation of Wokring Capital Requirement: 1.1. Total months to be financed to Raw MaterialTotal months to be financed to Raw Material

MonthsMonths Time in raw material storeTime in raw material store

22 Working progress cycleWorking progress cycle

2 2 Finished goods storeFinished goods store 1/21/2 Credit given to customerCredit given to customer 1 1/2 1 1/2

66 Less: Less: Credit available from suppliersCredit available from suppliers 1 ½ 1 ½

---------------- ---------------- Total months to be financed to Raw MaterialsTotal months to be financed to Raw Materials 4 ½ 4 ½

-------------------------------- 2.2. Total months to be financed to LabourTotal months to be financed to Labour Production cycleProduction cycle 2 2 In Finished stock storeIn Finished stock store ½ ½ Credit to customerCredit to customer 1 ½ 1 ½

Total Months to be financedTotal Months to be financed44

Working capital cycleWorking capital cycle 3.3. Total months to be finacned to overheadTotal months to be finacned to overhead Production cycleProduction cycle 22 In finished goods storesIn finished goods stores ½ ½ Credit to customerCredit to customer 1 ½ 1 ½

-------------------------- 44 Less:Less: Credit from suppliers Credit from suppliers

1 ½ 1 ½

-------------------------- Total months to be financedTotal months to be financed 2 ½ 2 ½ 4.4. Maximum working capital requiredMaximum working capital required Rs in croresRs in crores Raw Materials 4 ½ / 12 × 2.50Raw Materials 4 ½ / 12 × 2.50 0.940.94 Direct Labour 4 / 12 × 1.00 Direct Labour 4 / 12 × 1.00

0.33 0.33

OverheadsOverheads 2 ½ × 0.502 ½ × 0.50 0.100.10

-------------- Maximum Working CapitalMaximum Working Capital

1.37 1.37

--------------

E N DE N D

THANK YOU VERY MUCH FOR YOUR THANK YOU VERY MUCH FOR YOUR

PATIENCE; I TRUST IT WAS USEFUL. PATIENCE; I TRUST IT WAS USEFUL.

ANY QUERIES MAY BE ADDRESSED ANY QUERIES MAY BE ADDRESSED TOTO

[email protected]@rediffmail.com

[email protected]@gmail.com

caiib-fm-module d topics marginal costing marginal costing capital budgeting capital budgeting cash...

Documents

fixed cost rs

cost cost accounting

cost aim

variable cost marginal

units fixed cost

variable cost mc

maximization of returns

actual notional cost