form no. ac08 jansons institute of technologyjit.ac.in/pdf/eeca.pdf · 2016-07-01 · form no. ac08...

Form No. AC08

of 10 Rev.No.00;Rev.Date xx.xx.2015

Jansons Institute of Technology Karumathampatti, Coimbatore – 641 659

COURSE DELIVERY PLAN

Faculty Name : K.Prabhu Staff code : jit0152

Subject Name : Engineering Economics & Cost Analysis Subject code : MG2451

Academic Year : 2015 – 2016 Semester : VIII

Program & Branch : B.E Mechanical Engineering Section : -

Sl. No. Course Objectives (As given in the Syllabus) Mapping with corresponding program objectives

1. To learn about the basics of economics and cost analysis related to

engineering so as to take economically sound decisions

1. To Gain practical Mechanical Engineering knowledge in a broad range

of industries

2. To practice mechanical engineering in support of the design of

engineered systems through the application of the fundamental

knowledge, skills, and tools of mechanical engineering.

3. To enhance their skills through formal education and training,

independent inquiry, and professional development.

4. To work independently as well as collaboratively with others, while

demonstrating the professional and ethical responsibilities of the

engineering profession

5. To develop leadership qualities in their field of expertise and conduct

themselves in a professional and ethical manner

6. To enable them handle contemporary issues in the field of

Mechanical Engineering

Form No. AC08


Sl. No. Course Outcome (As given in the Syllabus) Mapping with corresponding program outcome

1. Student will able to analyze, understand and solve economic problems in

industries

1. Ability to consider realistic constraints such as economic,

environmental, social, ethical, manufacturing capacity with

sustainability by designing a system, component or process to solve

engineering problems in industries

2. Student will learn how to apply value engineering / analysis and

appropriate methods for measuring value

2. Ability to apply knowledge gained in the field of Mechanical

Engineering by conducting experiments with analysis and interpretation

3. Student will develop knowledge in cash flow and methods of cash flow 3. Ability to understand the impact of engineering solutions in a global,

economic, environmental and social context

4. Student will learn how to analyze and select the maintenance type /

time of replacement

4. Ability to handle contemporary issues

5. Student will develop knowledge on depreciation and methods of

depreciation

5. Ability to work professionally and to apply principles of Mechanical

Engineering to design and realize physical systems, components or

processes

6. Ability to develop innovative solutions to the problems in the field of

Mechanical Engineering

Form No. AC08


Lecture

Hour

Time

Allocated

(Mins)

Detailed Topics to be covered

Actual

Completion Deviations (with

reasons) if any HOD Principal

Date Period

UNIT I – INTRODUCTION TO ECONOMICS Corresponding course objective No’s met: 01

1

50 Introduction to Economics, Flow in an Economy

10

10

10

10

10

Economics

Resources

Micro-Economics and Macro-Economics

Objectives of Economics

Flow in an Economy

2

50 Law of supply and demand, Concept of Engineering Economics,

Engineering efficiency, Economic efficiency

10

10

10

10

10

supply and demand

Law of supply and demand

Elasticity of supply and demand

Concept of Engineering Economics

Engineering efficiency & Economic efficiency

3

50 Scope of engineering economics- Element of costs

10

10

10

30

Scope of Economics

Cost, Costing & Element of costs

Cost sheet – purposes and proforma

Problems solving

4 50 Element of costs

50 Problems solving

5

50 Marginal cost, Marginal Revenue, Sunk cost, Opportunity cost, V

ratio, Break-even analysis

10

20

20

Marginal cost, Marginal cost and Marginal Revenue

Sunk Cost & Opportunity cost

Contribution, PV ratio, Break even analysis, Margin of safety

6 50 Break-even analysis

Form No. AC08


50 Problem solving

7

50 Elementary economic Analysis – Material selection for product

Design selection for a product

10

20

20

Elementary economic Analysis

Material selection problem & procedure

Design selection problem & procedure

8

50 Process planning

10

20

20

Process planning

Process planning procedure

Problem solving

UNIT II – VALUE ENGINEERING Corresponding course objective No’s met: 01

9

50 Make or buy decision

10

20

20

Introduction

Factors affecting Make or buy decision

Approaches of Make or buy decision

10

50 Value engineering – Function, aims, Value engineering procedure

10

10

10

10

10

Introduction, Value & Types

Function

Aims / objectives

Value analysis Vs. Value engineering

Value engineering procedure

11

50 Interest formulae and their applications –Time value of money

10

10

10

10

10

Introduction

Time value of money

Economic Equivalence & calculations

Methods of calculating interest

Types of cash flow

12

50 Single payment compound amount factor & Examples

10

40

Introduction, Formula

Examples & problem solving

Form No. AC08


13

50 Single payment present worth factor & Examples

10

40



14

50 Equal payment series sinking fund factor & Examples

10

40



15

50 Equal payment series payment Present worth factor & Examples

10

40



16

50 Equal payment series capital recovery factor & Examples

10

40



17

50 Uniform gradient series annual equivalent factor & Examples

10

40



18

50 Effective interest rate & Examples

10

40



UNIT III – CASH FLOW Corresponding course objective No’s met: 01

19

50 Methods of comparison of alternatives

10

40

Introduction

Methods of comparison of alternatives

20

50 Present worth method & Examples

5

10

10

25

Introduction

Revenue dominated cash flow diagram & Formula

Cost dominated cash flow diagram & Formula


21 50 Present worth method & Examples

50 Problem solving

22 50 Future worth method & Examples

Form No. AC08


5

10

10

25

Introduction




23 50 Future worth method & Examples

50 Problem solving

24

50 Annual equivalent method & Examples

5

10

10

25

Introduction




25 50 Annual equivalent method & Examples

50 Problem solving

26

50 Rate of return method, Examples in all the methods

10

20

20


Steps, advantages & disadvantages


27 50 Rate of return method, Examples in all the methods

50 Examples & problem solving

UNIT IV - REPLACEMENT AND MAINTENANCE ANALYSIS Corresponding course objective No’s met: 01

28

50 Replacement analysis

5

10

10

25

Introduction

Causes / Reasons for replacement

Factors to be considered for replacing equipments

Failures

29 50 Types of replacement problem

50 Types of replacement problem

30

50 Maintenance analysis, Types of maintenance

5

10

Introduction

Objectives of maintenance

Form No. AC08


35 Types of maintenance

31 50 Problem on maintenance & replacement

50 Problem solving

32 50 Problem on maintenance & replacement

50 Problem solving

33 50 Determination of economic life of an asset

50 Problem solving

34 50 Replacement of an asset with a new asset

50 Problem solving

35

50 Capital recovery with return and concept of challenger and

defender

15

35

Capital recovery with return

Concept of challenger and defender

36

50 Simple probabilistic model for items which fail completely

10

40



UNIT V - DEPRICIATION Corresponding course objective No’s met: 01

37

50 Depreciation- Introduction

10

10

15

15

Introduction

Definitions

Causes for Depreciation

Reasons for providing Depreciation

38

50 Straight line method of depreciation, Examples

10

40



39

50 Declining balance method of depreciation, Examples

10

40



40 50 Sum of the years digits method of depreciation, Examples

10 Introduction, Formula

Form No. AC08


40 Examples & problem solving

41

50 Sinking fund method of depreciation/ Annuity method of

depreciation, Examples

10

40



42 50 Service output method of depreciation, Examples

10

40



43

50 Evaluation of public alternatives- introduction, Examples

10

40



44

50 Inflation adjusted decision, procedure to adjust inflation

5

10

35

Introduction

procedure to adjust inflation


45

50 Examples on comparison of alternatives and determination of

economic life of asset.

5

10

35

Introduction

Inflation adjusted economic life of machine


Note: where tutorial is included in the syllabus, course plan also to indicate the hours during which tutorials are planned meeting the syllabus

requirements on the total hours of tutorials to be covered.

Form No. AC08


Assignments (Minimum of 2 assignments):

Unit and Portions Mode of assignment* Planned Date Actual Date Remarks

1 unit & 2 unit

30 % of portions Home Assignments

2 unit & 3 unit


4 unit & 5 unit


Note(*): Mode of Assignment can be individual/ group/ class/ home assignments/ seminar presentations/ mini projects as decided by the individual faculty

etc.

CIA Test Planning:

Test No. Portions to be completed Portions covered in the test Date of test Remarks

1 1 unit & 2 unit - 30 % of portions



Any other method identified by the faculty in order to ensure the achievement of the course objective / outcome:

Method Supporting course objective Course Outcome Method of assessment

Form No. AC08


TEXT BOOKS:

1. Panneer Selvam.R, “Engineering Economics”, Prentice Hall of India Ltd, New Delhi, 2001.

2. Suma Damodaran, ”Managerial Economics”, Oxford university press 2006.

REFERENCES:

1. Chan S.Park, “Contemporary Engineering Economics”, Prentice Hall of India, 2002.

2. Donald.G.Newman, Jerome.P.Lavelle, “Engineering Economics and analysis” Engg. Press, Texas, 2002.

3. Degarmo, E.P., Sullivan, W.G and Canada, J.R, “Engineering Economy”, Macmillan, New York, 1984

4. Grant.E.L, Ireson.W.G, and Leavenworth, R.S, “Principles of Engineering Economy”, Ronald Press, New York,1976.

5. Smith, G.W., “Engineering Economy”, Lowa State Press, Iowa, 1973.

6. Truett & Truett, “Managerial economics- Analysis, problems & cases” Wiley India 8th edition 2004.

7. Luke M Froeb / Brian T Mccann, “Managerial Economics – A problem solving approach” Thomson learning 2007

Date: Course Faculty HOD Principal

MG2451

ENGINEERING ECONOMICS AND COST ANALYSIS

UNIT I

INTRODUCTION TO ECONOMICS

Introduction to Economics- Flow in an economy, Law of supply and demand, Concept of

Engineering Economics – Engineering efficiency, Economic efficiency, Scope of engineering

economics- Element of costs, Marginal cost, Marginal Revenue, Sunk cost, Opportunity cost,

Break-even analysis- V ratio, Elementary economic Analysis – Material selection for product

Design selection for a product, Process planning.

1.1 INTRODUCTION

Efficient functioning of any business organization would enable it to provide goods/services at a

lower price. In the process of managing organizations, the managers at different levels should

take appropriate economic decisions which will help in minimizing investment, operating and

maintenance expenditures besides increasing the revenue, savings and such other gains of the

organization.

These can be achieved through Engineering Economics which deals with the methods that enable

one to make economic decisions towards minimizing costs and/or maximizing benefits to

business organizations.

This chapter discusses the elements of economics and the interaction between its various

components.

This is followed by an analysis of the need and scope of engineering economics. Later, elements

of cost and break-even analysis are presented.

1.2 ECONOMICS

It is a study of economic problems of the people concerning production, consumption, exchange

and distribution of wealth.

Economics is the science that deals with the production and consumption of goods and services

and the distribution and rendering of these for human welfare.

The following are the economic goals / objectives of economy:

A high level of employment

Price stability

Efficiency

An equitable distribution of income

Economic Growth

1.3 FLOW IN ECONOMY

Fig. Flow of goods, services, resources and money payments in a simple economy.

Households and businesses are the two major entities in a simple economy.

Business organizations use various economic resources like land, labor and capital which

are provided by households to produce consumer goods and services which will be used

by them.

Business organizations make payment of money to the households for receiving various

resources.

The households in turn make payment of money to business organizations for receiving

consumer goods and services.

This cycle shows the interdependence between the two major entities in a simple

economy.

1.4 LAWS OF SUPPLY AND DEMAND

Laws of supply

Laws of supply - states that the quantity of a commodity supplied varies directly with the price,

other determinants of supply remaining constant.

If the cost of inputs increases, then naturally, the cost of the product will go up. In such a

situation, at the prevailing price of the product the profit margin per unit will be less.

The producers will then reduce the production quantity, which in turn will affect the

supply of the product.

For instance, if the prices of fertilizers and cost of labor are increased significantly, in

agriculture, the profit margin per bag of paddy will be reduced.

So, the farmers will reduce the area of cultivation, and hence the quantity of supply of

paddy will be reduced at the prevailing prices of the paddy.

If there is advancement in technology used in the manufacture of the product in the long

run, there will be a reduction in the production cost per unit.

This will enable the manufacturer to have a greater profit margin per unit at the

prevailing price of the product. Hence, the producer will be tempted to supply more

quantity to the market.

Weather also has a direct bearing on the supply of products. For example, demand for

woolen products will increase during winter. This means the prices of woolen goods will

be increased in winter.

So, naturally, manufacturers will supply more volume of woolen goods during winter.

Factors influencing supply

The shape of the supply curve is affected by the following factors:

Selling price: As the price increases, sellers like to sell more and vice-versa.

Cost of production: As cost of production rise due to increase in the variable factors,

supply decreases.

Cost of the inputs:

The change in technology affects the supply function.

If the objective of firm is sales maximization, the supply would be larger.

If the number of producers producing the same product increases, the market supply

increases.

During inflationary period, if sellers expect a further rise in prices, supply will decrease

in the market.

Imposition of taxes by the government will reduce the supply.

Weather

Prices of related goods

Law of demand

Law of demand states that other things being equal demand increases when price falls and

contracts when price rises.

Market demand is the total quantity demanded by all the purchasers together.

Elasticity of Demand - Elasticity of demand may be defined as the degree of responsiveness of

quantity demanded to a Change in price.

An interesting aspect of the economy is that the demand and supply of a product are

interdependent and they are sensitive with respect to the price of that product.

From Fig. it is clear that when there is a decrease in the price of a product, the demand

for the product increases and its supply decreases.

Also, the product is more in demand and hence the demand of the product increases.

At the same time, lowering of the price of the product makes the producers restrain from

releasing more quantities of the product in the market.

Hence, the supply of the product is decreased. The point of intersection of the supply

curve and the demand curve is known as the equilibrium point.

At the price corresponding to this point, the quantity of supply is equal to the quantity of

demand. Hence, this point is called the equilibrium point.

Factors influencing demand

The shape of the demand curve is influenced by the following factors:

Income of the people

Prices of related goods

Tastes of consumers

Population and its distribution

Consumer’s expectations

Assumptions of Law of Demand

There is no change in consumers Tastes and preferences

Income of the people remains constant

Prices of other goods should not change

There is no substitute for the commodity

The commodity should not confer any distinction

The demand for the commodity is continuous

People should not expect any change in the price of the commodity

1.5 CONCEPT OF ENGINEERING ECONOMICS

Science is a field of study where the basic principles of different physical systems are

formulated and tested.

Engineering is the application of science. It establishes varied application systems based

on different scientific principles.

From the discussions in the previous section, it is clear that price has a major role in

deciding the demand and supply of a product.

Hence, from the organization’s point of view, efficient and effective functioning of the

organization would certainly help it to provide goods/services at a lower cost which in

turn will enable it to fix a lower price for its goods or services.

The following section discusses the different types of efficiency and their impact on the

operation of businesses and the definition and scope of engineering economics.

.

1.6 TYPES OF EFFICIENCY

Efficiency of a system is generally defined as the ratio of its output to input. The efficiency can

be classified into technical efficiency and economic efficiency.

Technical efficiency

It is the ratio of the output to input of a physical system. The physical system may be a diesel

engine, a machine working in a shop floor, a furnace, etc.

The technical efficiency of a diesel engine is as follows:

In practice, technical efficiency can never be more than 100%.

This is mainly due to frictional loss and incomplete combustion of fuel, which are considered to

be unavoidable phenomena in the working of a diesel engine.

Economic efficiency

Economic efficiency is the ratio of output to input of a business system.

‘Worth’ is the annual revenue generated by way of operating the business and ‘cost’ is the total

annual expenses incurred in carrying out the business. For the survival and growth of any

business, the economic efficiency should be more than 100%.

Economic efficiency is also called ‘productivity’. There are several ways of improving

productivity.

Increased output for the same input

Decreased input for the same output

By a proportionate increase in the output which is more than the proportionate increase in

the input

By a proportionate decrease in the input which is more than the proportionate decrease in

the output

Through simultaneous increase in the output with decrease in the input.

1.7 DEFINITION AND SCOPE OF ENGINEERING ECONOMICS

As stated earlier, efficient functioning of any business organization would enable it to provide

goods/services at a lower price.

In the process of managing organizations, the managers at different levels should take

appropriate economic decisions which will help in minimizing investment, operating and

maintenance expenditures besides increasing the revenue, savings and other related gains of the

organization.

Definition

Engineering economics deals with the methods that enable one to take economic decisions

towards minimizing costs and/or maximizing benefits to business organizations.

Scope

The issues that are covered are elementary economic analysis, interest formulae, bases for

comparing alternatives, present worth method, future worth method, annual equivalent method,

rate of return method, replacement analysis, depreciation, evaluation of public alternatives,

inflation adjusted investment decisions, make or buy decisions, inventory control, project

management, value engineering, and linear programming.

1.8 ELEMENTS OF COSTS

Costing or cost accounting means classifying, recording and allocating the appropriate

expenditure for determining the cost of production and achieved by keeping a continuous record

of all the costs involved in manufacturing.

Costing or cost accounting gives the actual expenditure incurred on the production of the

component based on the records of expenditure on various activities involved.

Fixed Costs and Variable Costs:

The Fixed Costs are the items of expenditure which remain more or less constant irrespective of

the quantity or volume of production. Examples of fixed costs are: Supervisory charges, cost of

lighting, cost of cleaning the works, operator charges, rent of building, interest on capital,

depreciation of plant and building.

The Variable Costs are those items of expenditure which vary with quantity or volume of

production. Examples are: direct material cost, cost of energy or fuel consumed, cost of tools

used, cost of consumables, repair and maintenance charges and storage charges.

The total cost of the product can be divided into following two major groups:

Direct costs are costs of those factors which directly contribute to the final product and hence

can be directly charged or allocated to the manufacture of a specific product. Examples: cost of

raw materials, cost of labor processing the materials, cost of equipment and special tooling, jigs

and fixtures used in the manufacturing of the product.

Indirect costs are costs which cannot be directly allocated to the manufacture of a particular

product. Examples: Wages of inspection and supervisory staff, selling and distribution expenses,

administrative expenses, overhead charges, and cost of indirect materials like lubricants,

coolants, grease, repair and maintenance cost.

Elements of Cost: For the purpose of calculations, the total cost of the product is divided into

the following:

(A) Material cost, (B) Labor cost, (C) Other expenses.

(A) Material Cost

Material cost consists of the cost of materials which are used in the manufacture of product. It is

divided into the following:

Direct material cost: It is the cost of those materials which are directly used for the manufacture

of the product and become a part of the finished product. This expenditure can be directly

allocated and charged to the manufacture of a specific product or job and includes the scrap and

waste that has been cut away from original bar or casting.

Indirect material cost: In addition to direct materials a number of other materials are necessary

to help in the conversion of direct materials into final shape. Though these materials are

consumed in the production, they don’t become a part of the finished product and their cost

cannot be directly booked to the manufacture of a specific product. Such materials are called

indirect materials. The indirect materials include oils, general tools, grease, sand papers,

coolants, cotton waste etc. The cost associated with indirect materials is called indirect material

cost.

In some cases certain direct materials like nails, screws, glue, putty etc., are used in such small

quantity that it is not considered worthwhile to identify and charge them as direct materials. In

such cases these materials are also charged as indirect materials.

(B) Labor Cost

It is the expenditure made on the salaries, wages, overtime, bonuses, etc. of the employees of the

enterprise. It can be classified as:

Direct labor cost: Direct laborer is one who actually works and processes the materials to

convert it into the final shape. The cost associated with direct labor is called direct labor cost.

The direct labor cost can be identified and allocated to the manufacture of a specific product.

Examples of the direct labor are the workers operating lathes, milling machines or welders, or

assemblers in assembly shop. The direct labor cost may be allocated to a product or job on the

basis of time spent by a worker on a job.

Indirect labor cost: Indirect laborer is one who is not directly employed in the manufacturing of

the product but his services are used in some indirect manner. The indirect labor includes

supervisors, inspectors, foreman, storekeeper, gatekeeper, maintenance staff, crane driver etc.

The cost associated with indirect labor is called indirect labor cost. The indirect labor costs

cannot be identified with a particular job or product but are charged on the total number of

products made during a particular period in a plant.

To make the concept of direct and indirect labor cost clear, consider an operator working on a

drilling machine. The operator in this case is direct labor whereas the man supervising the job,

inspector and storeman supplying the material are indirect labor.

(C) Other Expenses

In addition to the material cost and labor cost, several other expenses such as rent of building,

depreciation of plant and machinery, cost of packing materials, transport and distribution

expenses, wages and salaries of administrative staff and executives are also incurred by the

manufacturer. All this expenditure including the indirect material cost and indirect labor cost is

called other expenses.

Simply, we can say that except direct material and direct labor costs all other expenditure

incurred by the manufacturer is known as “Other Expenses”. Expenses are further classified as:

(a) Direct expenses: Direct expenses include all that expenditure which can be directly allocated

and charged to a particular job. The direct expenses include cost of special jigs or fixtures,

patterns, tooling made for job, or cost of research and development work done for that specific

job.

(b) Indirect expenses: Except direct expenses, all other indirect expenditure incurred by the

manufacturer is called indirect expenses. The indirect expenses are also called overhead

expenses or on-cost.

The indirect expenses are further classified as:

(i) Factory expenses.

(ii) Administrative expenses.

(iii) Selling and distribution expenses.

(i) Factory expenses: Factory expenses comprise of the indirect expenses incurred from the

receipt of the order to the completion of production. In addition to indirect material and indirect

labor cost it includes rent of factory building, license fee, electricity and telephone bills of

factory, insurance charges etc.

Factory expenses are also called “Works expenses”, or “Factory or Works overhead”.

(ii) Administrative expenses: Administrative expenses or office expenses include the

expenditure incurred on control and administration of the factory. It includes the salaries of

office and administrative staff, rent of office building, postage and telephone charges, water and

electricity charges for office, Director’s fee, legal and audit charges etc. Administrative expenses

are also known as ‘Administrative overheads’.

(c) Selling and distribution expenses: This is the expenditure incurred on Sales Department for

selling the product, i.e., wages, salaries, commission and travelling allowances of salesmen and

officers in Sales Department, cost of advertisement, packing, delivery and distribution expenses,

rent of warehouses etc.

1.9 COST OF PRODUCT (LADDER OF COSTS)

The components of cost discussed above can be grouped as follows:

1. Prime cost = Direct material cost + Direct labour cost + Direct expenses

2. Factory cost = Prime cost + Factory expenses

3. Production cost = Factory cost + Administrative expenses

4. Total or Ultimate cost = Production cost + Selling and distribution expenses.

5. Selling price = Ultimate cost + Profit

The above relations can be illustrated on a chart (Ladder of costs)

1.10 EXAMPLES

1. Calculate prime cost, factory cost, production cost, total cost and selling price per item from

the data given below for the year 2003-04:

Particulars Rs.

Cost of raw material in stock as on 1-04-2003 25,000

Raw material purchased 40,000

Direct labor cost 14,000

Direct expenses 1,000

Factory / Works overhead 9,750

Administrative expenditure 6,500

Selling and distribution expenses 3,250

No. of items produced 650

Cost of raw material in stock as on 31-03-2004 15,000

Net profit/item is 10 percent of total cost of the product.

Solution:

For 650 units produced during 2003-04

(i) Direct material used = Stock of raw material on 1-04-2003 + raw material purchased

– Stock of raw material on 31-03-2004 = 25,000 + 40,000 – 15,000 = Rs. 50,000

(ii) Direct labor = Rs. 14,000

(iii) Direct expenses = Rs. 1,000

Prime cost = 50,000 + 14,000 + 1,000 = Rs. 65,000

Factory cost = Prime cost + Factory expenses = 65,000 + 9,750 = Rs. 74,750

Production cost = Factory cost + Administrative expenses = 74,750 + 6,500 = Rs. 81,250

Total cost = Production cost + Selling expenses = 81,250 + 3,250 = Rs. 84,500

Selling price = 84,500 + 10 percent of 84,500 = 84,500 × 1.10 = Rs. 92,950

Prime cost/item = 65,000 / 650 = Rs. 100

Factory cost/item = 74,750 / 650 = Rs. 115

Production cost/item = 81,250 / 650 = Rs. 125

Total cost/item = 84,500 / 650 = Rs. 130

Selling price/item = 92,950 / 650 = Rs. 143

2. From the following data for a sewing machine manufacturer, prepare a statement showing

prime cost, Works/factory cost, production cost, total cost and profit.

Particulars Rs.

Value of stock of material as on 1-04-2003 26,000

Material purchased 2,74,000

Wages to labor 1,20,000

Depreciation of plant and machinery 8,000

Depreciation of office equipment 2,000

Rent, taxes and insurance of factory 16,000

General administrative expenses 3,400

Water, power and telephone bills of factory 9,600

Water, lighting and telephone bills of office 2,500

Material transportation in factory 2,000

Insurance and rent of office building 2,000

Direct expenses 5,000

Commission and pay of salesman 10,500

Repair and maintenance of plant 1,000

Works Manager salary 30,000

Salary of office staff 60,000

Value of stock of material as on 31-03-2004 36,000

Sale of products 6,36,000

Solution:

(i) Material cost = Opening stock value + Material purchases – Closing balance

= 26,000 + 2,74,000 – 36,000 = Rs. 2,64,000

Prime cost = Direct material cost + Direct labor cost + Direct expenses

= 2,64,000 + 1,20,000 + 5,000 = Rs. 3,89,000

(ii) Factory overheads are:

Rent 16,000

Depreciation of plant and machinery 8,000

Water, power and telephone bills of factory 9,600

Material transportation in factory 2,000

Repair and maintenance of plant 1,000

Work Manager salary 30,000

Factory overheads 66,600

Factory cost = Prime cost + Factory expenses = 3,89,000 + 66,600 = Rs. 4,55,600

(iii) Administrative/office expenses are:

Depreciation of office equipment 2,000

General administrative expenses 3,400

Water, lighting and telephone bills of office 2,500

Rent, insurance and taxes on office building 2,000

Salary of office staff 60,000

Office expenses 69,900

Production cost = Factory cost + Office expenses = Rs. 4,55,600 + Rs. 69,900 = Rs. 5,25,500

(iv)Selling overheads are:

Commission and pay to salesmen = Rs. 10,500

Total cost = Production cost + Selling expenses = 5,25,500 + 10,500 = Rs. 5,36,000

(v) Profit = Sales – Total cost = 6,36,000 – 5,36,000 = Rs. 1,00,000

1.11 OTHER COST

1. Marginal Cost

Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost

of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same

product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.

2. Marginal Revenue

Marginal revenue of a product is the incremental revenue of selling an additional unit of that

product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling

21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21st unit is

Rs. 85.

3. Sunk Cost

This is known as the past cost of an equipment/asset. Let us assume that an equipment has been

purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its

present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present

value of the equipment for further analysis. So, the purchase value of the equipment in the past is

known as its sunk cost. The sunk cost should not be considered for any analysis done from now

onwards.

4. Opportunity Cost

In practice, if an alternative (X) is selected from a set of competing alternatives (X, Y), then the

corresponding investment in the selected alternative is not available for any other purpose. If the

same money is invested in some other alternative (Y), it may fetch some return. Since the money

is invested in the selected alternative (X), one has to forego the return from the other alternative

(Y). The amount that is foregone by not investing in the other alternative (Y) is known as the

opportunity cost of the selected alternative (X). So the opportunity cost of an alternative is the

return that will be foregone by not investing the same money in another alternative.

Consider that a person has invested a sum of Rs. 50,000 in shares. Let the expected annual return

by this alternative be Rs. 7,500. If the same amount is invested in a fixed deposit, a bank will pay

a return of 18%. Then, the corresponding total return per year for the investment in the bank is

Rs. 9,000. This return is greater than the return from shares. The foregone excess return of Rs.

1,500 by way of not investing in the bank is the opportunity cost of investing in shares.

1.12 TERMS USED IN BREAK-EVEN ANALYSIS

(i) Fixed cost: Fixed costs remain fixed in the short-run. Examples are rent, insurance,

depreciation, factory supervisor's salaries, directors' salaries, and so on.

(ii) Variable costs: The variable cost per unit varies with the volume of production. The variable

costs include cost of direct materials, direct labor, direct expenses and operating supplies such as

lubricating oil and so on.

(iii) Total cost: The total of fixed and variable costs.

(iv) Total revenue: The sales proceeds (selling price per unit x number of units sold).

(v) Contribution margin: The contribution margin is the difference between the selling price per

unit and the variable cost per unit. It is also determined as (fixed cost per unit +profit per unit).

(vi) Profit = Contribution - Fixed cost.

(vii) Contribution margin ratio: It is the ratio between contribution per unit and the selling price

per unit.

(viii) Margin of safety in units: The excess of actual sales (in units) minus the breakeven point

(in units).

(ix) Margin of safety in sales volume: The excess of actual sales (in rupees) minus the break-

even point (in rupees).

(x) Angle of incidence: The angle formed where total cost curve cuts the total revenue curve

(xi) PN ratio: The ratio between the contribution and sales.

1.13 ASSUMPTIONS IN THE BREAK-EVEN ANALYSIS

The following assumptions are made while plotting a break-even chart:

The total cost of production can be divided into two categories - (a) Fixed cost, (b)

Variable cost.

Fixed cost remains constant i.e., it is independent of the quantity produced and includes

executive’s salaries, rent of building, depreciation of plant and equipment etc.

The variable cost varies directly and proportionately with the volume of production. If

V = Variable cost per unit and Q is the quantity produced, variable cost = V x Q.

The selling price does not change with change in the volume of sales. If P is the selling

price per unit, the total sales income = P x Q.

The firm deals with only one product, or the sales mix remains unchanged.

There is a perfect synchronization between production and sales. This assumes that

everything produced is sold and there is no change in the inventory of finished goods.

Productivity per worker and efficiency of plant, etc., remains mostly unchanged.

Any change in anyone of the above factors will affect the break-even point and the profits will be

affected by factors other than volume. Hence, the result of the break-even analysis should be

interpreted subject to the limitations of the above assumptions.

1.14 PLOTTING THE BREAK-EVENCHART

The cost and the sales income (revenue) in rupees are plotted along the vertical axis.

The quantity (volume of production) is plotted along the horizontal axis.

Fixed cost is represented by a straight line parallel to the horizontal axis.

The variable costs are superimposed upon the horizontal line representing the fixed cost.

This top line then represents the total cost line.

The sales income line passes through the origin.

The point of intersection of the sales income line and the total cost line represents the

break-even point.

The shaded area between the total cost line and the sales income line on the left hand side

of B.E.P. indicates loss; whereas the shaded area on the right hand side of B.E.P. shows

profit.

1.15 Break-Even Analysis

The main objective of break-even analysis is to find the cut-off production volume from where a

firm will make profit.

Let s = selling price per unit

v = variable cost per unit

FC = fixed cost per period

Q = volume of production

The total sales revenue (S) of the firm is given by the following formula:

S = s Q

The total cost of the firm for a given production volume is given as

TC = Total variable cost + Fixed cost = v Q + FC

The linear plots of the above two equations are shown in Fig.

The intersection point of the total sales revenue line and the total cost line is called the

break-even point.

The corresponding volume of production on the X-axis is known as the break-even sales

quantity.

At the intersection point, the total cost is equal to the total revenue.

This point is also called the no-loss or no-gain situation.

For any production quantity which is less than the break-even quantity, the total cost is

more than the total revenue.

Hence, the firm will be making loss.

For any production quantity which is more than the break-even quantity, the total revenue will be

more than the total cost. Hence, the firm will be making profit.

Profit = Sales – (Fixed cost + Variable costs)

= s Q – (FC + v Q)

The formulae to find the break-even quantity and break-even sales quantity:

The contribution is the difference between the sales and the variable costs. The margin of safety

(M.S.) is the sales over and above the break-even sales. The formulae to compute these values

are

Contribution = Sales – Variable costs

Contribution/unit = Selling price/unit – Variable cost/unit

M.S. = Actual sales – Break-even sales

= Profit × sales / Contribution

M.S. as a per cent of sales = (M.S./Sales) 100

1.16 Break-even point

The point of intersection of the total cost line and the income line is called as the break-even

point. The break-even point is that junction here income and costs are exactly in balance. Thus

there is neither profit nor loss for that particular volume of production.

Break-even point indicates minimum operating level below which it is dangerous to fall. As the

performance reaches towards this non-profit point, corrective measures should be taken to cut

down the cost, (increase output or raise selling price.) The spread to the right of BEP shows the

profit potential while to the left represents the loss potential BEP is also called as the "no-profit-

no-loss point."

1.17 Margin of Safety

Margin of safety is the distance between the break-even point and the output being produced. A

large margin of safety indicates that the business can earn profit even if there is a great reduction

in output. If the margin of safety is relatively small then it indicates that the profit will be

considerably small even if there is a small drop in output. A low margin of safety level indicates

high fixed costs and profits are not possible unless the output level is sufficient enough to absorb

fixed costs.

Margin of safety is generally expressed as:

Ratio of budgeted sales to sales at BEP.

Ratio of actual sales to sales at BEP.

Percentage of budget to BEP.

Percentage of budget to actual sales at BEP.

Percentage of the difference between actual sales and break-even sales to budgeted sales.

In case unsatisfactory margin of safety the following measures should be taken:

Increase in the sale price.

Reduction in fixed costs.

Reduction in variable costs.

Increase in output.

Stop production of non-profitable items and pay more attention towards profitable items.

Mathematically:

Margin of Safety = (Sales - Sales at BEP / Sales) x 100

= Profit x Sales / (Sales - Variable costs)

1.18 Angle of Incidence

The angle between the sales income line and the total cost line is called as angle of incidence. A

large angle of incidence indicates large profit and extremely favorable business position

management aims to widen the angle of incidence to improve the rate of profitability. A narrow

angle shows that even though fixed overheads are recovered, the profit accrued shows a low rate

of return. This indicates a large part of variable costs in total cost.

1.10 Profit/Volume Ratio (P/V Ratio)

P/V ratio is a valid ratio which is useful for further analysis. Profit volume ratio measures the

profitability in relation to sales. The contribution at given output is defined to be the difference

between total sales and total variable costs. The P/V ratio is the ratio of contribution to sales. It

represents the relationship between contribution and turn-over. So, it is a measure to compare

profitability of different products. Higher the P/V ratio, the high yielding is the product.

The different formulae for the P/V ratio are as follows:

P/V ratio = Contribution / Sales = Sales − Variable costs / Sales

The relationship between BEP and P/V ratio is as follows:

BEP =Fixed cost / P/V ratio

Uses of P/V ratio

The P/V ratio can be used to study a variety of problems viz.:

Determination of B.E.P.

To know profit for given sales volume.

To now sales volume for achieving some desired profit.

P/V ratio can be increased by

Increasing the selling price.

Changing the mix of sales.

Reduction in variable costs.

1.19 ADVANTAGES OF BREAK-EVEN CHART

Management can employ break-even chart to project the cost and income picture under various

anticipated future conditions and for alternative business programme. Hence, the chart is useful

to the management.

To show the relative importance of different classes of costs, how they vary with volume

of production, and how they may be controlled.

To show the impact of changes in sales volume on profit.

To predict the effect of price and cost changes on the break-even point.

To show the gain needed in sales volume (or productivity) to maintain profits when

prices or costs change in a specific way e.g. when prices decline but wages and the cost

of material do not.

To select the proper size plant or to predict the effect of changes in plant size or

modernization of plant on the break-even point. Therefore, through break-even chart

management can estimate what amount of investment in plant capacity is economically

justified for the projected volume of sales.

To compare the profitability of two or more firms.

1.20 LIMITATIONS OF BREAK-EVEN ANALYSIS

In practice all the costs are not always either fixed costs or variable costs. There are some

semi-variable overhead costs.

In the long run all costs are variable, so the break-even analysis holds good only for short

run requirements.

Break even analysis assumes, that profits are a function of output ignoring the fact that

they are also affected by technological changes, improved management, improvement in

quality, versatility, etc.

It is suitable only when the firm produces one type of product.

1.21 APPLICATION OF BREAK-EVEN ANALYSIS

Make or Buy Decision

Choosing a Product Mix when there is a Limiting Factor

Drop or add decision

Impact of changes in cost or selling price on BEP

Determining the BEP when there is an increase in the fixed cost

1.22 EXAMPLE:

Alpha Associates has the following details:

Fixed cost = Rs. 20,00,000

Variable cost per unit = Rs. 100

Selling price per unit = Rs. 200

Find

(a) The break-even sales quantity,

(b) The break-even sales

(c) If the actual production quantity is 60,000, find (i) contribution; and (ii) margin of

safety by all methods.

Solution

Fixed cost (FC) = Rs. 20,00,000

Variable cost per unit (v) = Rs. 100

Selling price per unit (s) = Rs. 200

(a) Break-even quantity = FC / s – v = 20,00,000 / 100 = 20,000 units

(b) Break-even sales = (FC / s – v) x s = 20,000 x 200 = Rs. 40,00,000

(c) (i) Contribution = Sales – Variable cost = s x Q – v x Q = 200 x 60000 – 100 x 60000

= 1,20,00,000 – 60,00,000

= Rs. 60,00,000

(ii) Margin of safety M.S. = Sales – Break-even sales = 60,000 x 200 – 40,00,000 =

= Rs. 80,00,000

M.S. as a per cent of sales = 80,00,000 / 1,20,00,000 x 100 = 67%

1.23 Elementary Economic Analysis

Whether it is a business situation or a day-to-day event in somebody’s personal life, there are a

large number of economic decisions making involved. One can manage many of these decision

problems by using simple economic analysis.

For example, an industry can source its raw materials from a nearby place or from a far-off

place. In this problem, the following factors will affect the decision:

Price of the raw material

Transportation cost of the raw material

Availability of the raw material

Quality of the raw material

Consider the alternative of sourcing raw materials from a nearby place with the following

characteristics:

The raw material is more costly in the nearby area.

The availability of the raw material is not sufficient enough to support the operation of

the industry throughout the year.

The raw material requires pre-processing before it is used in the production process. This

would certainly add cost to the product.

The cost of transportation is minimal under this alternative.

On the other hand, consider another alternative of sourcing the raw materials from a far-off place

with the following characteristics:

The raw material is less costly at the far off place.

The cost of transportation is very high.

The availability of the raw material at this site is abundant and it can support the plant

throughout the year.

The raw material from this site does not require any preprocessing before using it for

production

1.24 EXAMPLES FOR SIMPLE ECONOMIC ANALYSIS

In this section, the concept of simple economic analysis is illustrated using suitable examples in

the following areas:

Material selection for a product

Design selection for a product

Design selection for a process industry

Building material selection for construction activities

Process planning/Process modification

1.24.1 Material Selection for a Product/Substitution Of Raw Material

The cost of a product can be reduced greatly by substitution of the raw materials. Among various

elements of cost, raw material cost is most significant and it forms a major portion of the total

cost of any product.

So, any attempt to find a suitable raw material will bring a reduction in the total cost in any one

or combinations of the following ways:

Reduced machining/process time

Enhanced durability of the product

Cheaper raw material price

Therefore, the process of raw material selection/substitution will result in finding an alternate

raw material which will provide the necessary functions that are provided by the raw material

that is presently used.

In this process, if the new raw material provides any additional benefit, then it should be treated

as its welcoming feature.

EXAMPLE

In the design of a jet engine part, the designer has a choice of specifying either an aluminium

alloy casting or a steel casting. Either material will provide equal service, but the aluminium

casting will weigh 1.2 kg as compared with 1.35 kg for the steel casting.

The aluminium can be cast for Rs. 80.00 per kg and the steel one for Rs. 35.00 per kg. The cost

of machining per unit is Rs. 150.00 for aluminium and Rs. 170.00 for steel. Every kilogram of

excess weight is associated with a penalty of Rs. 1,300 due to increased fuel consumption.

Which material should be specified and what is the economic advantage of the selection per

unit?

Solution:

(a) Cost of using aluminium metal for the jet engine part:

Weight of aluminium casting/unit = 1.2 kg

Cost of making aluminium casting = Rs. 80.00 per kg

Cost of machining aluminium casting per unit = Rs. 150.00

Total cost of jet engine part made of aluminium/unit

= Cost of making aluminium casting/unit + Cost of machining aluminium casting/unit

= 80 x1.2 + 150 = 96 + 150 = Rs. 246

(b) Cost of jet engine part made of steel/unit:

Weight of steel casting/unit = 1.35 kg

Cost of making steel casting = Rs. 35.00 per kg

Cost of machining steel casting per unit = Rs. 170.00

Penalty of excess weight of steel casting = Rs. 1,300 per kg

Total cost of jet engine part made of steel/unit

= Cost of making steel casting/unit + Cost of machining steel casting/unit + Penalty for

excess weight of steel casting

= 35 x 1.35 + 170 + 1,300(1.35 – 1.2)

= Rs. 412.25

DECISION

The total cost/unit of a jet engine part made of aluminium is less than that for an engine made of

steel. Hence, aluminium is suggested for making the jet engine part. The economic advantage of

using aluminium over steel/unit is Rs. 412.25 – Rs. 246 = Rs. 166.25

1.24.2 Design Selection for a Product

The design modification of a product may result in reduced raw material requirements, increased

machinability of the materials and reduced labor.

Design is an important factor which decides the cost of the product for a specified level of

performance of that product.

The elementary economic analysis applied to the selection of design for a product is illustrated

with example problems.

EXAMPLE

Two alternatives are under consideration for a tapered fastening pin. Either design will serve the

purpose and will involve the same material and manufacturing cost except for the lathe and

grinder operations.

Design A will require 16 hours of lathe time and 4.5 hours of grinder time per 1,000 units.

Design B will require 7 hours of lathe time and 12 hours of grinder time per 1,000 units. The

operating cost of the lathe including labor is Rs. 200 per hour. The operating cost of the grinder

including labor is Rs. 150 per hour. Which design should be adopted if 1,00,000 units are

required per year and what is the economic advantage of the best alternative?

Solution

Operating cost of lathe including labor = Rs. 200 per hr

Operating cost of grinder including labor = Rs. 150 per hr

(a) Cost of design A

No. of hours of lathe time per 1,000 units = 16 hr

No. of hours of grinder time per 1,000 units = 4.5 hr

Total cost of design A/1,000 units = Cost of lathe operation per 1,000 units + Cost of

grinder operation per 1,000 units

= 16 x 200 + 4.5 x 150 = Rs. 3,875

Total cost of design A/1,00,000 units = 3,875 x 1,00,000/1,000 = Rs. 3,87,500

(b) Cost of design B

No. of hours of lathe time per 1,000 units = 7 hr

No. of hours of grinder time per 1,000 units = 12 hr

Total cost of design B/1,000 units = Cost of lathe operation/1,000 units + Cost of grinder

operation/1,000 units

= 7 x 200 + 12 x 150 = Rs. 3,200

Total cost of design B/1,00,000 units = 3,200 x 1,00,000/1,000 = Rs. 3,20,000

DECISION

The total cost/1,00,000 units of design B is less than that of design A. Hence, design B is

recommended for making the tapered fastening pin. Economic advantage of the design B over

design A per 1,00,000 units = Rs. 3,87,500 – Rs. 3,20,000 = Rs. 67,500.

1.25 Process Planning

Process plan

It is the detailed instructions for making a part or a component. It includes such information as

the operations, their sequence, machines, tools, speeds and feeds, dimensions, tolerances, stock

removed, inspection procedures and time standards (i.e., cycle time).

Process planning

It may be defined as the determination of the processes and the sequence of operations required

for making the product. It consists of devising, selecting and specifying processes, machine tools

and other equipment to transform the raw material into finished product as per the specifications

called for by the drawings.

Process planning can be defined as an act of preparing a detailed processing documentation for

the manufacture of a piece part or assembly.

Process Planning Activities

Analysis of the finished part requirements as specified in the engineering design

Determining the sequence of operation required

Selecting the proper equipment to accomplish the required operations

Calculating the specific operation setup times and cycle times on each machine

Documenting the established process plans

Communicating the manufacturing knowledge to the shop floor

1. Analyze finished part requirements

Component drawing should be analyzed to identify its features, dimensions, and

tolerance specifications

Part’s requirement defined by its features, dimensions, and tolerance specifications will

determine corresponding processing requirements

2. Determine operating sequence

Basic aim is to determine the type of processing operation that has the capability to

generate various types of features, given the tolerance requirements

There are two ways of viewing decision process

First view is to consider processing evaluation of part from rough state to finished final

state. In this view material is removed or modified on rough part in stages in order to

transform it into finished part

Second view is to consider part evaluation from finished state back to rough/ initial state.

In this view material is added back onto the part.

3. Select machines

Machine selection requires determining how the part would be processed on each of the

alternative machines so that best machine can be selected

At this phase, firm has to decide whether to make or buy the component part

Break even analysis is most convenient method for selecting optimum method of

manufacture or machine amongst the competing ones

Factures which influence the selection of machine are,

Ø Economic considerations

Ø Production rate and unit cost of production

Ø Durability and dependability

Ø Lower process rejection

Ø Minimum set-up and put away times

Ø Longer productive life of machines or equipment

Ø Functional versatility

4. Material selection parameters

Function

Appearance

Reliability

Service life

Environment

Compatibility

Productivity

Cost

5. Calculate processing time

Determination of set-up times requires knowledge of available tooling and sequence of

steps necessary to prepare the machine for processing given work piece

For establishing accurate set-up times, detailed knowledge of equipment capacity,

tooling, and shop practice required

Calculation of part processing time requires determination of sequence of processing

steps on each machine. This is called as OUTPLANNING

After calculation of processing time, appropriate times for loading, part unloading,

machine indexing, and other factors involved in one complete cycle for processing a part

must be included to compute the expected machine cycle time

Allowances are added with machine cycle time to calculate standard cycle time for

processing one piece

Appropriate machine rates are added with calculated cycle time to calculate expected

standard cost for given operation

6. Document process planning

Process plan is documented as job routing or operation sheet

Operation sheet also called “route sheet”, “instruction sheet”, “traveler”, “planner”

Information provided by route sheet are,

Ø Part identification

Ø Description of processing steps in each operation

Ø Operation sequence and machines

Ø Standard set-up and cycle times

Ø Tooling requirements for each operation

Ø Production control information showing the planning lead time at each operation

Reasons for documentation

To have a record on hoe a part is processed in order to plan future parts with similar

design requirements in a consistent manner

To provide a record for future job quoting, cost estimating, and standard costing systems

To act as a vehicle for communication

7. Communicate process knowledge

Communication is essential to ensure that part will be processed according to most

economical way

Process documentation and communication provide basis for improved part consistency

and quality in manufacturing

Process Planning Sheet

The whole information determined by the process planning is recorded in a tabular form in a

sheet called process planning sheet. This document is provided to the shop personnel for their

use. The character of this sheet will vary for different organizations depending upon the

production conditions and degree of details required.

In general the following data is listed for each component of the product in the process sheet.

Information regarding the main product, of which the component being manufactured is a

part i.e., name and part number of the main product.

Name, part number, drawing number of the component and number off i.e., no. of

components required per product.

Information concerning the blank i.e., raw material used, size and weight of stock.

Operations are listed in proper sequence along with the shops in which these operations

will be performed.

Information regarding machines used for each operation.

Data on jigs, fixtures and other special tools required.

Inspection devices needed for inspection.

Cutting data i.e., speeds, feeds & depth of cut for each machining operation.

Elements of standard time such as set-up time, handling time and machining time for the

job.

A typical process sheet is shown in Table.

The process planning sheet is prepared by the process engineer in consultation with the

tool engineer, industrial engineer, or methods engineer.

USES OF PROCESS SHEET

A process sheet is a very important document which forms a basis for all planning,

scheduling and dispatching functions.

Also it helps in advance planning and for purchase of raw materials design and

manufacture of special tools, jigs, fixtures and inspection devices.

It helps in estimating the cost of the product before it is an actually manufactured.

It also helps in planning for man power required for doing the job.

MG2451


UNIT II

VALUE ENGINEERING

Make or buy decision, Value engineering – Function, aims, value engineering procedure. Interest

formulae and their applications –Time value of money, Single payment compound amount

factor, Single payment present worth factor, Equal payment series sinking fund factor, Equal

payment series payment Present worth factor equal payment series capital recovery factor-

Uniform gradient series annual equivalent factor, Effective interest rate, Examples in all the

methods.

2.1 INTRODUCTION – Make or buy

In the process of carrying out business activities of an organization, a component/product can be

made within the organization or bought from a subcontractor. Each decision involves its own

costs.

So, in a given situation, the organization should evaluate each of the above make or buy

alternatives and then select the alternative which results in the lowest cost. This is an important

decision since it affects the productivity of the organization.

In the long run, the make or buy decision is not static. The make option of a component/product

may be economical today; but after some time, it may turn out to be uneconomical to make the

same.

Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3 years. This is

mainly to cope with the changes in the level of competition and various other environmental

factors.

Make or Buy Decisions - is a determination whether to produce a component part internally or to

buy it from an outside supplier. The Organization should evaluate the costs and benefits of

manufacturing a product or product component against purchasing it and then select the

alternative which results in the lower cost.

2.1.1 CRITERIA FOR MAKE OR BUY

Criteria for make

The following are the criteria for make:

The finished product can be made cheaper by the firm than by outside suppliers.

The finished product is being manufactured only by a limited number of outside firms

which are unable to meet the demand.

The part has an importance for the firm and requires extremely close quality control.

The part can be manufactured with the firm’s existing facilities and similar to other items

in which the company has manufacturing experience.

Criteria for buy

The following are the criteria for buy:

Requires high investments on facilities which are already available at supplier’s plant.

The company does not have facilities to make it and there are more profitable

opportunities for investing company’s capital.

Existing facilities of the company can be used more economically to make other parts.

The skill of personnel employed by the company is not readily adaptable to make the

part.

Patent or other legal barriers prevent the company for making the part.

Demand for the part is either temporary or seasonal.

2.1.2 APPROACHES FOR MAKE OR BUY DECISION

Types of analysis followed in make or buy decision are as follows:

1. Simple cost analysis

2. Economic analysis

3. Break-even analysis

2.2INTRODUCTION- value analysis

Value analysis is one of the major techniques of cost reduction and cost prevention. It is a

disciplined approach that ensures necessary functions for minimum cost without sacrificing

quality, reliability, performance, and appearance. According to the Society of American Value

Engineers (SAVE), Value Analysis is the systematic application of recognized techniques which

identify the function of a product or service, establish a monetary value for the function and

provide the necessary function reliably at the lowest overall cost.

It is an organized approach to identify unnecessary costs associated with any product, material

part, component, system or service by analyzing the function and eliminating such costs without

impairing the quality, functional reliability, or the capacity of the product to give service.

2.2.1 WHEN TO APPLY VALUE ANALYSIS

One can definitely expect very good results by initiating a VA programme if one or more of the

following symptoms are present:

1. Company’s products show decline in sales.

2. Company’s prices are higher than those of its competitors.

3. Raw materials cost has grown disproportionate to the volume of production.

4. New designs are being introduced.

5. The cost of manufacture is rising disproportionate to the volume of production.

6. Rate of return on investment has a falling trend.

7. Inability of the firm to meet its delivery commitments.

2.2.2 Value Analysis vs. Value Engineering

Often the terms value analysis and value engineering are used synonymously. Though the

philosophy underlying the two is same, i.e. identification of unnecessary cost, yet they are

different. The difference lies in the time and the stage at which the techniques are applied.

Value analysis is the application of a set of techniques to an existing product with a view to

improve its value. It is thus a remedial process.

Value engineering is the application of exactly the same set of techniques to a new product at the

design stage, project concept or preliminary design when no hardware exists to ensure that bad

features are not added. Value engineering, therefore, is a preventive process.

2.2.3 Value

The term ‘value’ is used in different ways and, consequently, has different meanings. The

designer equates the value with reliability; a purchase person with price paid for the item; a

production person with what it costs to manufacture and a sales person with what the customer is

willing to pay.

Value, in value investigation, refers to “economic value”, which itself can be divided into four

types: cost value, exchange value, use value, and esteem value.

Cost value: It is the summation of the labor, material, overhead and all other elements of cost

required to produce an item or provide a service compared to a base.

Exchange value: It is the measure of all the properties, qualities and features of the product,

which make the product possible of being traded for another product or for money.

In a conventional sense, exchange value refers to the price that a purchaser will offer for the

product, the price being dependent upon satisfaction (value) which he derives from the product.

Value derived from the product consists of two parts “use value” and “esteem value”.

Esteem value: It involves the qualities and appearance of a product (like a TV set), which attract

persons and create in them a desire to possess the product.

Therefore, esteem value is the price paid by the buyer or the cost incurred by the manufacturer

beyond the use value.

Use value: It is known as the function value.

The use value is equal to the value of the functions performed. Therefore, it is the price paid by

the buyer (buyer’s view), or the cost incurred by the manufacturer (manufacturer’s view) in order

to ensure that the product performs its intended functions efficiently. The use value is the

fundamental form of economic value. An item without “use value” can have neither “exchange

value” nor “esteem value”.

2.2.4 Applications

The various application areas of value engineering are machine tool industries, industries making

accessories for machine tools, auto industries, import substitutes, etc

2.2.5 Performance

The performance of a product is the measure of functional features and properties that make it

suitable for a specific purpose. Appropriate performance requires that

(a) The product reliably accomplishes the intended use of work or service requirement

(functional requirements)

(b) The product provide protection against accident, harmful effects on body and danger to

human life (safety requirements)

(c) The product give trouble-free service cover during its specified life span (reliability

requirements)

(d) Service and maintenance work can be carried out on the product with ease and with simple

tools (maintainability requirements)

(e) Appearance of the product creates an impression on the buyer and induces in him or her the

desire to own the product (appearance requirements).

Performance and cost must be interwoven. Desired performance at the least cost should be

achieved by selecting appropriate materials and manufacturing operations, which is the measure

of value. Therefore, the value of the product is the ratio of performance (utility) to cost. Thus,

Value = Performance (utility) / Cost

Value can be increased by increasing the utility for the same cost or by decreasing the cost for

the same utility. Satisfactory performance at lesser cost through identification and development

of low cost alternatives is the philosophy of Value analysis.

2.3 FUNCTION

Function is the purpose for which the product is made. Identification of the basic functions and

determination of the cost currently being spent on them are the two major considerations of value

analysis.

Function identifies the characteristics which make the product/component/part/item/device to

work or sell. “Work functions” lend performance value while “sell functions” provide esteem

value.

Verbs like “support”, “hold”, “transmit”, “prevent”, “protect”, “exhibits”, “control”, etc., are

used to describe work functions, while “attract”, enhance”, “improve”, “create”, etc., are used to

describe “sell” functions. For example, in a “bus driver cabin”, the functional analysis of some of

the parts are given in Table

Component of study Functional analysis

Verb Noun Steering

Wheel Control Direction Gear box

Change Speed Brake system Stop

Vehicle Wiper Clear Water

Horn Make Sound

Side mirror Show Side traffic

2.3.1 Classification of the functions

Rarely do all functions assume equal importance. Usually, some functions are more important

than others. Functions can be classified into the following three categories:

1. Primary function

2. Secondary function

3. Tertiary function

1. Primary functions are the basic functions for which the product is specially designed to

achieve. Primary functions, therefore, are the most essential functions whose non-performance

would make the product worthless, e.g. a photo frame exhibits photographs, a chair supports

weight, a fluorescent tube gives light.

2. Secondary functions are those which, if not in-built, would not prevent the device from

performing its primary functions, e.g., arms of a chair provide support for hands. Secondary

functions are usually related to convenience. The product can still work and fulfill its intended

objective even if these functions are not inbuilt and yet they may be necessary to sell the product.

3. Tertiary functions are usually related to esteem appearance. For example, Sun mica top of a

table gives esteem appearance for the table.

2.4 Objectives of value engineering/value analysis

Increased profits – With the cost reduction of a product, the profits of an organization

increased. This results in time reduction. It also ensures greater returns on invested capital. The

competitive position of company also improves.

Improved product Design – With the modification in design, the customer will get a new and

more acceptable product.

Efficiency – It increases the efficiency of employees as it motivates them to come forward with

their creative ideas. It also makes contributions to improve human factors such as creativity,

team work and positive attitude among employees. The team approach also improves the

decision making.

Time consideration – A product has value for the customer if it is available to him on time. So

time element has great importance in value engineering. It may have no value if it arrives later.

Improvement in quality – This results in improvement in quality, reliability, performance and

maintainability of a product.

2.4.1 Aim / objectivesof value engineering/value analysis

The aims of value engineering are as follows:

1. Simplify the product.

2. Improves quality of the product.

3. Promotes standardization and production of quality products are economically achieved

4. Use (new) cheaper and better materials.

5. Modify and improve product design.

6. Improve organizational efficiency.

7. Develop logical approach to solve problems

8. Use efficient processes.

9. Reduce the product cost.

10. Increase the utility of the product by economical means.

11. Save money or increase the profits.

12. Ensures greater returns on investment.

The value content of each piece of a product is assessed using the following questions:

1. Does its use contribute to value?

2. Is its cost proportionate to its usefulness?

3. Does it need all its features?

These three questions pertain to the function of the part which may decide the elimination of

parts.

Is there anything better for the intended use?

Can company or vendor standard be used?

Can a usable part be made by a lower-cost method?

Is it made with the proper tooling, considering volume?

Does the part yield suitable profit?

Can another vendor furnish the same at a lower cost?

2.4.2 Advantages

The advantages of value engineering are as follows:

1. It is a much faster cost reduction technique.

2. It is a less expensive technique.

3. It reduces production costs and adds value to sales income of the product.

2.5 VALUE ANALYSIS PROCEDURE

Some of the most important phases that can be implemented in value analysis procedure are as

follows:

1. The Orientation Phase

2. The Information phase

3. Functional phase

4. Creation phase

5. Evaluation phase

6. Investigation phase

7. The Recommendation and Implementation phase.

1. The Orientation Phase:

In this phase the project for study is identified and selected. It is advisable to chose/select a

specific problem which is manageable e.g. it would be inadvisable to apply value analysis on a

whole car. The fuel injection system or clutch system may be a specific problem. Likewise do

not work on problem as a whole but break it into elements and study each element separately.

Constitute a team consisting of experts of various fields/departments such as from design, Sales

purchase and accounts etc. this phase can be represented as:

Identify and select ……………The project to be studied.

Establish ………………………… Priorities.

Plan …………………………………A specific project.

Constitute…………………………A team.

Prepare…………………………… Terms of reference for the selected project.

Fix …………………………………… Responsibility for data collection.

When we speak of a team, the emphasis is on team work which signifies the subordination or

personal preferences to group consensus.

2. Information phase:

Normally this phase consists of following three portions:

(i) Collection of facts:

This is probably the most tough task and all efforts should be made to collect all the relevant

information rather facts. These may relate to specifications; drawings parts, names of suppliers,

manufacturing methods use, used methods of purchase followed and annual requirements of

various items/materials etc. It should be ensured that information collected is based on facts only.

(ii) Determination of costs:

For each element being studied complete and accurate cost must be obtained. Considerable

importance should be given to the accuracy of these costs since these would form basis for value

analysis. The direct costs (e.g. labor, materials) for each of the assemblies, subassemblies and

parts of the project as well indirect cost (e.g. cost of indirect labor, Materials, jigs & fixtures,

packing materials etc.) should be taken into consideration.

(iii) Fixation of costs of specifications and requirements:

It has been observed that specifications and requirements are simply statements of the desired

results to be incorporated in the final product. Thus it is desirable to segregate the specifications

and actual requirement by analysis of the facts.

It is often found that over designing at the start of product development is a common

phenomenon. So it is essential to find out what s it that is really required. Thus requirements

should not be based on imposed specifications but oasis should be facts.

3. Function Phase:

The objectives of this phase are

To decide the area of analysis and the functions that it actually performs; because if the

value of an item/product is to be determined it is essential to determine its use or

function.

To relate these functions to the cost and worth of providing them; since the term

functions in “Value Analysis” means that which makes the product work or sell.

From the above, two important relations can be determined and these reveals the importance of

function.One is the relationship between value and function. Another relationship is between

work and sell.Here, the word “work” directly relates to “value” and the word “sell” relates

between value & function.

The rules of conation definitions are:

All the functions should be accomplished in two words-a-verb and a noun.

All the functions must be categorized into two levels of importance basis of primary and

secondary etc.

Basic are those which serve the primary purpose and secondary are those which serve other

purposes not directly accomplishing the basic but supporting it.

As per first rule the objective is to identify simply and unambiguously the tasks to be carried out

by the product/item under consideration. It is preferable if it is done in two words i.e. a verb and

a noun e.g. the various functions of a bulb are-gives light, removes darkness, illuminates space.

Increase visibility etc.

The work and sell functions are expressed by different categories of verbs and nouns: e.g. for

work functions we use action verbs (like support, create, enclose and insulate etc.) and

measurable nouns (like weight, current, density, force and voltage etc.) which establish

quantitative statements. For expressing sell functions; passive verbs (like increase, decrease,

improve etc.) and non measurable nouns (like beauty, convenience, style form and features etc.)

which establish qualitative statements.

After having defined the functions, the next step is to establish the worth of each basic

function.The objective of evaluating functional relationship is to:

Determine which the poor value functions are and whether the value analysis effort

should be continued.

Obtain a reference point from which the cost of alternatives can be compared.

Formulate a target cost, to provide a psychological incentive to discourage a premature

relaxation of the value analysis effort.

In this way establish descending order of importance of the functions with relative value of

importance.

4. Creation Phase:

In value analysis as in method study a persistent critical examination of facts is extremely

important. Creative phase objective is to produce ideas and to formulate alternative ways for

accomplishing the essential functions and improving the value of the problem under

consideration.

This effort starts as soon as enough information has been collected, reviewed and understood.

The first step is to ask and answer questions like:

WHAT (What is achieved)

WHY (Why is it essential)

HOW (How it is achieved?) Why that way?

WHERE (Where does it take place?) Why there?

WHEN (When is it done?) Why then?

WHO (Who does it?) Why that man?

Creative problem solving techniques are utilized to discover alternatives that will provide

essential or required functions at the lowest possible cost. Consider whether the function can be

eliminated whether it can be achieved in simpler way or it can be combined or integrated with

any other Isolate items/ components that contribute nothing to the use function e.g. consider if

the inspection can be eliminated or whether SOC can be replaced by 100% inspection or whether

the tolerances are realistic or if the reduced surface finish is acceptable.

Similarly as are materials concerned consider if.

Cheaper components/parts can be purchased from outside market instead of making.

Whether alternative cheaper materials can be used.

If the design changes can reduce the material used.

If the dimensions can be reduced.

If a new design can reduce the number of components used.

If redesign will combine two or more functions or will eliminate any component/part or

function.

If with redesign excess material, scrap or number of rejects will be reduced.

Thus creativity may be defined as the process of combining already existing elements into

something that is new as far as creator is concerned for the purpose of solving problems.

The followings are the simple steps in creative thinking:

(A) Identification of the problem:

Ask what is the problem

List out the objectives of the problem.

Define the situation of the problem.

Try to develop the challenges.

Define the problem in various ways and from several angles and then try to identify the

teal problem.

(B) Determination of the Facts:

Make all observations.

List out the elements of the problem.

Ask creative question such as what, when how, where, why and who.

Determine what is good regarding the problem,

Do not make assumptions.

Do not assume No without basis or beware of “automatic” No.

(C) Idea Determination:

Apply brain storming.

Use fertile imagination and do not judge the situation.

Incubate your ideas.

(D) Determination of Solution:

Evaluate your ail ideas.

Make a fair comparison.

Determine inter relationships

Anticipate objections if any.

Determine and develop place and time for appropriate action.

5. Evaluation Phase:

The objectives of evaluation phase are:

To select for further analysis the most promising of the ideas generated during the

creative phase.

To subject the ideas to a preliminary screening to identify those which satisfy the

following criteria?

Will the idea work?

Is it cheaper than present design?

Is it feasible to implement?

Will it satisfy the user requirements?

If the answer to any of the above is “no” can it be modified or combined with another to

give a yes answer.

To find out which is the most suitable proposal and obtain its cost?

The generation of a quantity of ideas does not accomplish anything until these ideas are put to

use. Before these can be utilized continued creativity must be applied. This may be done on a

single idea or a combination of ideas.

Now the estimated cost is to be determined on all ideas i.e. what will be the potential cost of

utilizing the ideas (under consideration) and what are the resultant savings implied. After that an

assessment of good and bad features of taking the lowest cost idea or group of ideas should be

made. Attempts should be made to by refinement of an idea and again evaluating it for the

purpose of minimization of bad features.

When such rough solutions along with their estimated costs are established, they are compared to

determine which one will provide the greatest possibility of attaining the value- level target. Now

the selection of ideas which are to be carried through further development is made. The

combined creative ideas that have been refined to basically workable solutions and have greatest

possible return on further investment are subjected to “investigation phase” techniques.

6. Investigation Phase:

The objectives of this phase are:

To bring partially developed or selected untried ideas to fruitarian and to find out their

feasibility and limitation.

To prepare a work plan for converting the selected ideas into tangible proposals.

In this phase, further refining of the selected ideas is made to convert them into workable and

salable solutions. Use company and industrial standards because within a standard lies a tried

and tested solution to a problem. This type of solution is utilized if it also the lowest total cost

approaches.

Adopt the following procedure:

(i) Consul specialists and vendors:

These people must always be consulted because of their specialized knowledge. They can

pinpoint problems in their specialized field and bring new information to effect the solution of

the problem.

(ii) Utilized specialty products, processes and procedures:

The use of these in many cases provide a lower cost way of providing the function or functions

These need evaluation and are utilized when they accomplish a lower total cost than would

standard products, processes and procedures.

7. Recommendation and Implementation Phase:

The objectives of this phase are:

To prepare and submit the planned proposals along with benefits and limitation to the

management.

To review submitted proposals if not acceptable to the management.

The recommendation phase and its included techniques are the culmination and warp up of all

the previous efforts exerted throughout the job plan. Upon these techniques and their diligent

fulfillment hinges success or failure of all the foregoing work. In this phase the selected

alternative is presented to the decision maker.

The selected proposal should contain an accurate description of the change as accurate cost,

whether estimate or factual must be presented as part of the final recommendation so as to

support the validity of the savings potential calculation.

The final recommendation need not in fact should contain all the data accumulated but should

however contain sufficient data for the decision maker to select the course of action to be taken.

After the recommendations have been carefully accepted, the implementation phase should be

carefully monitored and followed up by the value analysis team. It may be noted that most of the

value analysis projects collapse primarily due to the resistance to change by the actual users.

2.6. BASIC PRINCIPLES OF BRAIN STORMING

Some of the important principles of brain storming which are useful in creation phase of value

analysis are

(i) A quality idea comes from quantity of ideas. If the number of ideas generated is more, the

more good solutions do turn up.

(ii) Creative ideas emerge from unconventional thinking. This is possible when members of the

group “talk off the top of their heads” and voice weird ideas as they flash through their minds,

regardless of how stupid or impractical they may appear. Often, non-technical personnel can

prove to be the greatest innovators in technical areas since their viewpoints are objective and

they do not know that some of their ideas are technically not feasible at all. So it is preferable to

include one or two non-technical persons in the study team. Members are to be told by the team

leader in the beginning of the session itself, not to breathe a word of criticism of even the

weirdest idea.

(iii) Spontaneous evaluation of ideas curbs imaginative thinking and retards the flow of creative

ideas. The group should not evaluate the alternatives suggested by its member immediately since

immediate evaluation may curb imaginative thinking and slow down the flow of creative ideas.

(iv) Hitch-hiking on the ideas often leads to better ideas. Participants have to improve upon ideas

of other members either directly or by combining more ideas in addition to contributing ideas of

their own. A brilliant idea may not be a practical one initially, or it may look to be silly or useless

but discussions can convert it into a valuable one.

(v) Creativity is a regenerative process and the recording of ideas as they emerge helps serve as a

catalyst to generate more ideas. Memory may not retain all ideas or recall them when they are

needed. So, a stenographer may be asked to record ideas simultaneously. A tape recorder can

also be used for this purpose or even ideas can be written on a blackboard. These recorded ideas

can be reviewed at some later date.

(vi) When ideas cease to flow, short diversions enable the mind to rebound with new ideas after

recuperation. Members of the syndicate may reach a stage where new ideas do not come. At such

a stage, short diversions—rest, favorite sport, hobby, lunch or tea break, etc.—may be taken

during which members are advised to sleep over the ideas and report fresh after the break. Such

short diversions enable mind to recoup and rebound with new ideas.

2.7 INTEREST FORMULAS AND APPLICATIONS

2.7.1 INTRODUCTION

Interest rate is the rental value of money. It represents the growth of capital perunit period. The

period may be a month, a quarter, semiannual or a year. Aninterest rate 15% compounded

annually means that for every hundred rupeesinvested now, an amount of Rs. 15 will be added to

the account at the end ofthe first year. So, the total amount at the end of the first year will be Rs.

115.At the end of the second year, again 15% of Rs. 115, i.e. Rs. 17.25 will be addedto the

account. Hence the total amount at the end of the second year will beRs. 132.25. The process

will continue thus till the specified number of years.

2.7.2 TIME VALUE OF MONEY

If an investor invests a sum of Rs. 100 in a fixed deposit for five years with aninterest rate of

15% compounded annually, the accumulated amount at the endof every year will be as shown in

Table.

The formula to find the future worth in the third column is

F = P (1 + i)n

Where P = principal amount invested at time 0,

F = future amount

i = interest rate compounded annually,

n = period of deposit.

The maturity value at the end of the fifth year is Rs. 201.14. This means thatthe amount Rs.

201.14 at the end of the fifth year is equivalent to Rs. 100.00at time 0 (i.e. at present). This is

diagrammatically shown in Fig. Thisexplanation assumes that the inflation is at zero percentage.

Alternatively, the above concept may be discussed as follows: If we wantRs. 100.00 at the end of

the nth year, what is the amount that we should depositnow at a given interest rate, say 15%? A

detailed working is shown in Table 3.2

From Table 3.2, it is clear that if we want Rs. 100 at the end of the fifthyear, we should now

deposit an amount of Rs. 49.72. Similarly, if we wantRs. 100.00 at the end of the 10th year, we

should now deposit an amount ofRs. 24.72.

Also, this concept can be stated as follows:A person has received a prize from a finance

company during the recentfestival contest. But the prize will be given in either of the following

two modes:

1. Spot payment of Rs. 24.72 or

2. Rs. 100 after 10 years from now (this is based on 15% interest ratecompounded

annually).

If the prize winner has no better choice that can yield more than 15%interest rate compounded

annually, and if 15% compounded annually is thecommon interest rate paid in all the finance

companies, then it makes nodifference whether he receives Rs. 24.72 now or Rs. 100 after 10

years.

On the other hand, let us assume that the prize winner has his own businesswherein he can get a

yield of 24% interest rate (more than 15%) compoundedannually, it is better for him to receive

the prize money of Rs. 24.72 at presentand utilize it in his business. If this option is followed, the

equivalent amountfor Rs. 24.72 at the end of the 10th year is Rs. 212.45. This example

clearlydemonstrates the time value of money.

2.7.2 FORMULA

While making investment decisions, computations will be done in many ways. To simplify all

these computations, it is extremely important to know how to use interest formulas more

effectively. Before discussing the effective application of the interest formulas for investment-

decision making, the various interest formulas are presented first.

Interest rate can be classified into simple interest rate and compound interest rate.

In simple interest, the interest is calculated, based on the initial deposit for every interest period.

In this case, calculation of interest on interest is not applicable.

In compound interest, the interest for the current period is computed based on the amount

(principal plus interest up to the end of the previous period) at the beginning of the current

period.

The notations which are used in various interest formulae are as follows:

P = principal amount

n = No. of interest periods

i = interest rate (It may be compounded monthly, quarterly, semiannually or annually)

F = future amount at the end of year n

A = equal amount deposited at the end of every interest period

G = uniform amount which will be added/subtracted period after period to/ from the amount of

deposit A1 at the end of period 1

Single-Payment Compound Amount

Here, the objective is to find the single future sum (F) of the initial payment (P) made at time 0

after n periods at an interest rate i compounded every period.The cash flow diagram of this

situation is shown in Fig.

The formula to obtain the single-payment compound amount is

F = P(1 + i)n = P(F/P, i, n)

Where(F/P, i, n) is called as single-payment compound amount factor.

Single-Payment Present Worth Amount

Here, the objective is to find the present worth amount (P) of a single future sum(F) which will

be received after n periods at an interest rate of i compounded at the end of every interest

period.The corresponding cash flow diagram is shown in Fig.

The formula to obtain the present worth is

P = = F(P/F, i, n)

Where (P/F, i, n) is termed as single-payment present worth factor.

Equal-Payment Series Compound Amount

In this type of investment mode, the objective is to find the future worth of n equal payments

which are made at the end of every interest period till the end of the nth interest period at an

interest rate of i compounded at the end of each interest period. The corresponding cash flow

diagram is shown in Fig.

In Fig, A = equal amount deposited at the end of each interest period


i = rate of interest

F = single future amount

The formula to get F is

F =A = A(F/A, i, n)

Where (F/A, i, n) is termed as equal-payment series compound amount factor.

Equal-Payment Series Sinking Fund

In this type of investment mode, the objective is to find the equivalent amount (A) that should be

deposited at the end of every interest period for n interest periods to realize a future sum (F) at

the end of the nth interest period at an interest rate of i. The corresponding cash flow diagram is

shown in Fig.

In Fig. A = equal amount to be deposited at the end of each interest period


i = rate of interest

F = single future amount at the end of the nth period

The formula to get F is

A = F = F (A/F, i, n)

Where (A/F, i, n) is called as equal-payment series sinking fund factor.

Equal-Payment Series Present Worth Amount

The objective of this mode of investment is to find the present worth of an equal payment made

at the end of every interest period for n interest periods at an interest rate of i compounded at the

end of every interest period. The corresponding cash flow diagram is shown in Fig.

Here, P = present worth

A = annual equivalent payment

i = interest rate


The formula to compute P is

P = A = A (P/A, i, n)

Where (P/A, i, n) is called equal-payment series present worth factor.

Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent amount (A) which is to

be recovered at the end of every interest period for n interest periods for a loan (P) which is

sanctioned now at an interest rate of I compounded at the end of every interest period.

In Fig P = present worth (loan amount)

A = annual equivalent payment (recovery amount)

i = interest rate


The formula to compute P is as follows:

A = P = P(A/P, i, n)

Where,

(A/P, i, n) is called equal-payment series capital recovery factor.

Uniform Gradient Series Annual Equivalent Amount

The objective of this mode of investment is to find the annual equivalent amount of a series with

an amount A1 at the end of the first year and with an equal increment (G) at the end of each of

the following n – 1 years with an interest rate i compounded annually. The corresponding cash

flow diagram is shown in Fig.

The formula to compute A under this situation is

A = A1 + G‒

Where(A/G, i, n) is called uniform gradient series factor.

Effective Interest Rate

Let i be the nominal interest rate compounded annually. But, in practice, the compounding may

occur less than a year. For example, compounding may be monthly, quarterly, or semi-annually.

Compounding monthly means that the interest is computed at the end of every month. There are

12 interest periods in a year if the interest is compounded monthly. Under such situations, the

formula to compute the effective interest rate, which is compounded annually, is

Effective interest rate, R = (1 + i/ C )C− 1

Where, i = the nominal interest rate

C = the number of interest periods in a year.

http://www.yourarticlelibrary.com/ergonomics/phases-that-be-implemented-in-value-analysis-

procedure/34650/

MG2451


UNIT III

CASH FLOW

Methods of comparison of alternatives – present worth method (Revenue dominated cash flow

diagram), Future worth method (Revenue dominated cash flow diagram, cost dominated cash

flow diagram), Annual equivalent method (Revenue dominated cash flow diagram, cost

dominated cash flow diagram), rate of return method, Examples in all the methods.

3.1 INTRODUCTION

The primary objective of the traditional Income Statement and Balance Sheet is to report to the

interested parties the operational performance and economic position of an enterprise. An

intelligent reader can gather sufficient idea about costs, revenues, profit/loss assets, liabilities and

owners equity from these statements. Under the Companies Act, a company is required to

include the figures of previous year in the financial accounts so that the interested parties may

compare individual figures for better understanding of the corporate performance and economic

position. The schedules attached to published account explain important items for the knowledge

of the concerning parties. The format of published accounts has been revised from time to time

with a view to providing more and more information to the shareholders, creditors and others.

Nobody can deny the usefulness of the traditional form of annual accounts which form an

important basis for making financial decisions.

No doubt the annual accounts in their traditional forms are very important but they suffer from

certain limitations. The serious limitation of a Balance Sheet is that it is a static document as it

shows the economic position at a point of time and fails to show fully the movements or changes

in the assets, liabilities and owners equity. From the financial accounts in their usual form, it is

not clear as to how the funds were generated and how they were utilized between the closing

dates of two Balance Sheets. In order to provide such information, another document known as

Statement of Changes in Financial Position is prepared. This document shows the changes in the

financial position between the closing dates of the Balance Sheets.

In this connection it is important to understand clearly the meaning of the word 'Fund' which is

used in three different senses. In a narrow sense, fund means each and the statement based on

this concept is known as Cash Flow Statement. In a broader sense, fund means all financial

resources which flows through working capital accounts and fixed capital accounts and a fund

flow statement based on this concept is almost a new form of Balance Sheet. The APB

(Accounting Principles Board, U.S.A.) has recommended the preparation and presentation of

statement of changes in financial position according to the broadest sense of the term 'Fund.'

However, the meaning of the 'Fund' in both the narrow as well as broader senses do not find

favor with many academicians and practitioners who prefer to consider Fund in the sense of

Working Capital i.e., Current assets minus Current liabilities. In this chapter, we shall illustrate

the preparation of statement of changes is financial position based on all the three concepts of

Fund.

Funds Flow Statement is known by different names such as: (i) Where Got Where Gone

Statement, (ii) Statement of sources and application of funds, (iii) Statement of changes in

working capital, (iv) Statement showing summary of financial operations, (v) Statement of

sources and application of working capital, (vi) Statement of changes in financial position, (vii)

Funds Flow statement, etc. It may be noted that there is no official name of the statement as its

preparation is still obligatory. Only few enlightened firms in India publish this statement for the

guidance of their members and creditors. However, it is advisable that the title of the statement

reflects the concept of fund on which it is based.

3.2 CASH FLOW STATEMENT

We have seen the preparation of Funds Flow Statement which treated 'Fund’ in the sense of

working capital. The statement of changes in financial position can also be prepared on the basis

of the cash concept of the word 'Fund.' It is knows as Cash Flow Statement if Fund is considered

in the sense of cash.

The preparation of Cash Flow Statement is important to understand the paradoxical situation in

which a firm finds difficulty in honoring its short period business commitments despite the

existence of sufficient working capital as indicated by the Fund Flow Statement (working capital

basis). This happens when a large proportion of working capital is tied up in the form of

inventories and other working assets.

The Fund Flow Statement based on working capital concept does not take into account the

qualitative structure of working capital.

Cash is a peculiar component of working capital. It should be distinguished from other

components in any scheme of short-period financial planning. The Cash Flow Statement enables

a firm to know the availability of cash from different sources and the manner of its utilization.

A projected Cash Flow Statement tells the management about the case position at different

timings. The management can arrange for additional necessary cash in case cash outflow exceeds

the cash inflow in any particular period of time. Similarly surplus cash, if any, can be invested

for effective utilization of cash balances.

3.3 CONSTRUCTION OF CASH FLOW STATEMENT

A Cash Flow Statement is prepared to show the movements of cash between the closing dates of

two Balance Sheets. It starts from the opening cash and ends with the closing balance of cash

showing different sources from where cash was received and the manner in which it was utilized

during the period for which Cash Flow Statement is prepared. The usual transactions resulting in

cash inflows are:

Issue of shares;

Issue of debentures;

Sale of investments;

Sale of assets;

Cash from business operations.

Cash outflows due to its application for various purposes such as-(a) Redemption of preference

shares, (b) Redemption of debentures, (c) Repayment of loans, (d) Payment of taxes, (e) Payment

of dividend, (f) Cash losses due to operations.

The preparation of Cash Flow Statement is not difficult if a complete set of information in the

form of Profit and Loss Account and Balance Sheet is given. An increase of share capital,

debentures and loans clearly means that cash inflow took place due to additional issue of shares

and debentures and obtaining further loans during the year. A decrease in current year’s figures

of the liabilities will mean liquidation of liabilities and hence an application of cash.

A comparison of non-current assets like Land and Buildings, plant and machinery, furniture,

trade investment, etc. will tell whether there had been increase or decrease in cash or an item

resulted in cash inflow or cash outflow. For instance, an increase in current year's amount of

furniture clearly means cash outflow due to purchase of additional furniture. Conversely, a

decrease in current years amount of furniture means sale and hence an application of cash. We

have already seen how variations in non-current assets and liabilities generate or use funds

(cash). Again the general rules can be laid down as under:

Increase in Non-current liability = Cash Inflow, Decrease in Non-current liability = Cash

Outflow

Increase in Non-current asset = Cash Outflow, Decrease in Non-current asset= Cash Inflow

Note: The net cash inflow or outflow can be arrived at only after preparing the relevant account

by allowing for appropriate adjustments, if any.

3.4. FORMAT OF A CASH FLOW STATEMENT

A cash flow statement can be prepared in the following form:

3.5 DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUND FLOW

ANALYSIS

Following are the points of difference between Cash Flow Analysis and a Funds Flow Analysis.

1. A Cash Flow Statement is concerned only with the change in cash position while a Fund Flow

Analysis is concerned with change in working capital position between two balance sheet dates.

Cash is only one of the constituents of working capital besides several other constituents such as

inventories, accounts receivable, prepaid expenses.

2. A Cash Flow Statement is merely a record of cash receipts and disbursements. Of course, it is

valuable in its own way but it fails to bring to light many important changes involving the

disposition of resources. While studying the sort-term solvency of a business one is interested

not only in cash balance but also in the assets which can be easily converted into cash.

3. Cash flow analysis is more useful to the management as a tool of financial analysis in short

period as compared to funds flow analysis. It has rightly been said that shorter the period covered

by the analysis, greater is the importance of cash flow analysis. For example, if it is to be found

out whether the business can meet its obligations maturing after 10 years from now, a good

estimate can be made about firm's capacity to meet its long-term obligations if changes in

working capital position on account of operations are observed. However, if the firm's capacity

to meet a liability maturing after one month is to be seen, the realistic approach would be to

consider the projected change in the cash position rather than an expected change in the working

capital position.

4. Cash is part of working capital and, therefore, an improvement in cash position results in

improvement in the funds position but the reverse is not true. In other words "inflow of cash"

results in "inflow of funds" but inflow of funds may not necessarily result in "inflow of cash"

Thus, a sound funds position does not necessarily mean a sound cash position but a sound cash

position generally means a sound funds position.

5. Another distinction between a cash flow analysis and a funds flow analysis can be made on the

basis of the techniques of their preparation. An increase in a current liability or decrease in a

current asset results in decrease in working capital and vice versa. While an increase in a current

liability or decrease in a current asset (other than cash) will result increase in cash and vice versa.

Some people, as stated before, use the term 'funds' in a very narrow sense of ,cash' only. In such

an even the two terms 'Funds' and 'Cash' will have synonymous meanings.

3.6 UTILITY OF CASH FLOW ANALYSIS

A Cash Flow Statement is useful for short-term planning. A business enterprise needs sufficient

cash to meet its various obligations in the near future such as payment for purchase of fixed

assets, payment of debts maturing in the near future, expenses of the business, etc.

A historical analysis of the different sources and applications of cash will enable the

management to make reliable cash flow projection for the immediate future. It may then plan out

for investment of surplus or meeting the deficit, if any. Thus, a cash flow analysis is an important

financial tool for the management. Its chief advantages are as follows:

1. Helps in efficient cash management. Cash flow analysis helps in calculating financial policies

and cash position. Cash is the basis for all operations and hence a projected cash flow statement

will enable the management to plan and coordinate the financial operations properly. The

management can know how much cash is needed, from which source it will be derived, how

much can be generated internally and how much could be obtained from outside.

2. Helps in internal financial management. Cash flow analysis provides information about funds

which will be available from operations. This will help the management in determining policies

regarding internal financial management, e.g., possibility of repayment of long-term debt,

dividend policies, planning replacement of plant and machinery, etc.

3. Discloses the movements of cash. Cash flow statement discloses the complete story of cash

movement. The increase in, or decrease of, cash, and the reason therefore can be known. It

discloses the reasons for low cash balance in spite of heavy operating profits or for heavy cash

balance in spite of low profits. However, comparison of original forecast with the actual results

highlights the trends of movements of cash which may otherwise go undetected.

4. Discloses success or failure of cash planning. The extent of success or failure of cash planning

can be known by comparing the projected cash flow statement with the actual cash flow

statement and necessary remedial measures can be taken.

3.7 LIMITATIONS OF CASH FLOW ANALYSIS

Cash flow analysis is a useful tool of financial analysis. However, it has its own limitations.

These limitations are as under:

1. Cash flow statement cannot be equated with the Income Statement. An income Statement

takes into account both cash as well as non-cash items, and, therefore, net cash flow does not

necessarily mean net income of the business.

2. The cash balance as disclosed by the cash flow statement may not represent the real liquid

position of the business since it can be easily influenced by postponing purchases and other

payments.

3. Cash flow statement cannot replace the Income Statement or the Funds Flow Statement.

Each of them has a separate function to perform.

3.8 PRESENT WORTH METHOD OF COMPARISON

In this method of comparison, the cash flows of each alternative will be reduced to time zero by

assuming an interest rate i. Then, depending on the type of decision, the best alternative will be

selected by comparing the present worth amounts of the alternatives.

The sign of various amounts at different points in time in a cash flow diagram is to be decided

based on the type of the decision problem.

In a cost dominated cash flow diagram, the costs (outflows) will be assigned with positive sign

and the profits, revenue, salvage value (all inflows), etc. will be assigned with negative sign.

In a revenue/profit-dominated cash flow diagram, the profit, revenue, salvage value (all inflows

to an organization) will be assigned with positive sign. The costs (outflows) will be assigned

with negative sign.

In case the decision is to select the alternative with the minimum cost, then the alternative with

the least present worth amount will be selected. On the other hand, if the decision is to select the

alternative with the maximum profit, then the alternative with the maximum present worth will

be selected.

3.8.1 REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the present worth method of

comparison is

P represents an initial investment and Rj the net revenue at the end of the jth year. The interest

rate is i, compounded annually. S is the salvage value at the end of the nth year.

To find the present worth of the above cash flow diagram for a given interest rate, the formula is

PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)

2] + ... + Rj[1/(1 + i)

j] + Rn[1/(1 + i)

n] + S[1/(1 + i)

n]

In this formula, expenditure is assigned a negative sign and revenues are assigned a positive sign.

If we have some more alternatives which are to be compared with this alternative, then the

corresponding present worth amounts are to be computed and compared. Finally, the alternative

with the maximum present worth amount should be selected as the best alternative.

3.8.2 COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the present worth method of

comparison is

P represents an initial investment, Cj the net cost of operation and maintenance at the end of the

jth year, and S the salvage value at the end of the nth year.

To compute the present worth amount of the above cash flow diagram for a given interest rate i,

we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)

2] + ... + Cj[1/(1 + i)

j]+ Cn[1/(1 + i)

n] – S[1/(1 + i)

n]

In the above formula, the expenditure is assigned a positive sign and the revenue a negative sign.


corresponding present worth amounts are to be computed and compared. Finally, the alternative

with the minimum present worth amount should be selected as the best alternative.

3.9. FUTURE WORTH METHOD

In the future worth method of comparison of alternatives, the future worth of various alternatives

will be computed. Then, the alternative with the maximum future worth of net revenue or with

the minimum future worth of net cost will be selected as the best alternative for implementation.


A generalized revenue-dominated cash flow diagram to demonstrate the future worth method of

comparison is presented in

P represents an initial investment, Rj the net-revenue at the end of the jth year, and S the salvage

value at the end of the nth year.

The formula for the future worth of the above cash flow diagram for a given interest rate, i is

FW(i) = –P(1 + i)n + R1(1 + i)

n–1 + R2(1 + i)

n–2 + ... + Rj(1 + i)

n–j + ... + Rn + S

In the above formula, the expenditure is assigned with negative sign and the revenues are

assigned with positive sign.


corresponding future worth amounts are to be computed and compared. Finally, the alternative

with the maximum future worth amount should be selected as the best alternative


A generalized cost-dominated cash flow diagram to demonstrate the future worth method of

comparison is given in



The formula for the future worth of the above cash flow diagram for a given interest rate, i is

FW(i) = P(1 + i)n + C1(1 + i )

n–1 + C2(1 + i)

n–2 + ... + Cj(1 + i)

n–j + ... + Cn – S

In this formula, the expenditures are assigned with positive sign and revenues with negative sign.


corresponding future worth amounts are to be computed and compared. Finally, the alternative

with the minimum future worth amount should be selected as the best alternative.

3.10. ANNUAL EQUIVALENT METHOD

In the annual equivalent method of comparison, first the annual equivalent cost or the revenue of

each alternative will be computed. Then the alternative with the maximum annual equivalent

revenue in the case of revenue-based comparison or with the minimum annual equivalent cost in

the case of cost based comparison will be selected as the best alternative.


A generalized revenue-dominated cash flow diagram to demonstrate the annual equivalent

method of comparison is presented in

P represents an initial investment, Rj the net revenue at the end of the jth year, and S the salvage

value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following

expression for a given interest rate, i:

PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)

2 + ... + Rj/(1 + i)

j + ... + Rn/(1 + i)

n + S/(1 + i)

n

In the above formula, the expenditure is assigned with a negative sign and the revenues are

assigned with a positive sign.

In the second step, the annual equivalent revenue is computed using the following formula:

Where (A/P, i, n) is called equal payment series capital recovery factor.


corresponding annual equivalent revenues are to be computed and compared. Finally, the

alternative with the maximum annual equivalent revenue should be selected as the best

alternative.


A generalized cost-dominated cash flow diagram to demonstrate the annual equivalent method of

comparison is presented in




relation for a given interest rate, i.

PW(i) = P + C1/(1 + i)1 + C2/(1 + i)

2 + ... + Cj/(1 + i)

j + ... + Cn/(1 + i)

n – S/(1 + i)

n

In the above formula, each expenditure is assigned with positive sign and the salvage value with

negative sign. Then, in the second step, the annual equivalent cost is computed using the

following equation:

Where (A/P, i, n) is called as equal-payment series capital recovery factor.

As in the previous case, if we have some more alternatives which are to be compared with this

alternative, then the corresponding annual equivalent costs are to be computed and compared.

Finally, the alternative with the minimum annual equivalent cost should be selected as the best

alternative.

If we have some non-standard cash flow diagram, then we will have to follow the general

procedure for converting each and every transaction to time zero and then convert the net present

worth into an annual equivalent cost/revenue depending on the type of the cash flow diagram.

Such procedure is to be applied to all the alternatives and finally, the best alternative is to be

selected.

3.10.3 ALTERNATE APPROACH

Instead of first finding the present worth and then figuring out the annual equivalent

cost/revenue, an alternate method which is as explained below can be used. In each of the cases

presented in Sections 3.10.1 and 3.10.2, in the first step, one can find the future worth of the cash

flow diagram of each of the alternatives.

Then, in the second step, the annual equivalent cost/revenue can be obtained by using the

equation:

Where (A/F, i, n) is called equal-payment series sinking fund factor.

3.11. RATE OF RETURN METHOD

The rate of return of a cash flow pattern is the interest rate at which the present worth of that cash

flow pattern reduces to zero. In this method of comparison, the rate of return for each alternative

is computed. Then the alternative which has the highest rate of return is selected as the best

alternative.

In this type of analysis, the expenditures are always assigned with a negative sign and the

revenues/inflows are assigned with a positive sign.

A generalized cash flow diagram to demonstrate the rate of return method of comparison is

presented in

In the above cash flow diagram, P represents an initial investment, Rj the net revenue at the end

of the jth year, and S the salvage value at the end of the nth year.


expression at a given interest rate, i.

PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)

2 + ... + Rj/(1 + i)

j + ... + Rn/(1 + i)

n + S/(1 + i)

n

Now, the above function is to be evaluated for different values of i until the present worth

function reduces to zero, as shown in Fig.

In the figure, the present worth goes on decreasing when the interest rate is increased. The value

of i at which the present worth curve cuts the X-axis is the rate of return of the given

proposal/project. It will be very difficult to find the exact value of i at which the present worth

function reduces to zero.

So, one has to start with an intuitive value of i and check whether the present worth function is

positive. If so, increase the value of i until PW(i) becomes negative. Then, the rate of return is

determined by interpolation method in the range of values of i for which the sign of the present

worth function changes from positive to negative.

form no. ac08 jansons institute of technologyjit.ac.in/pdf/eeca.pdf · 2016-07-01 · form no. ac08...

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