Module - IV

Finance management
4.1 Introduction to financial management
Financial management is that managerial activity which is concerned with planning
and controlling of the firms financial resources. In other words it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly
to maximize the shareholders wealth)..
Financial management comprises the forecasting, planning, organizing, dire ci rig,
coordinating and controlling of all activities relating to acquisition and application of the
financial resources of an undertaking in keeping with its financial objective. Raymond
Chambers.
I mportance of financial management
Financial management is indeed, the key to successful business operations. Without
proper administration of finance, no business enterprise can reach its full potentials for
growth and success. Financial management is all about planning investment, funding the
investment, monitoring expenses against budget and managing gains from the investments.
Financial management means management of all matters related to an organizations
finances. The best way to demonstrate the importance of good financial management is to
describe some of the tasks that it involves -
1. Taking care not to over-invest in fixed assets
2. Balancing cash-outflow with cash-inflows
3. Ensuring that there is a sufficient level of short-term working capital
4. Setting sales revenue targets that will deliver growth
5. Increasing gross profit by setting the correct pricing for products or services
6. Controlling the level of genera] and administrative expenses by finding more cost- efficient
ways of running the day-to-day business operations, and
7. Tax planning that will minimize the taxes a business has to pay.
.
4.2 Objeectives financial management
The financial management is generally concerned with procurement, allocation and
control of financial resources of a concern. The various objectives of financial management
are discussed below.
1. Profit maximization - Maximization of profits is very often considered as the main
objective of a business enterprise. The shareholders, the owners of the business, invest
their funds in the business with the hope of getting higher dividend on their
investment. Moreover, the profitability of the business is an indicator of the sound
health of the organization, because, it safeguards the economic interests of various
social groups which are directly or indirectly connected with the company e.g.
shareholders, creditors and employees. All these parties must get reasonable return for
their contributions and it is possible only when company earns higher profits or
sufficient profits to discharge the obligations to them. The finance manager tries to
earn maximum profits for the company in the short-term and the long-term. This
implies that the finance manager has to make his decisions in a manner so that the
profits of the concern are maximized. Each alternative, therefore, is to be seen as to
whether or not it gives maximum profit.
2. Wealth/Value maximization - The traditional approach of financial management
was all about profit maximization. The traditional approach of fmancial management
had many limitations. Business may have several other objectives other than profit
maximization. Companies may have goals like; a larger market share, high sales,
greater stability and so on. The traditional approach did not take into account so many
of these other aspects. Modern approach is about the idea of wealth maximization.
This involves increasing the Earning per share of the shareholders and to maximize
the net present worth. The wealth maximization approach is concerned with the
amount of cash flow generated by a course of action rather than the profits.
3. Proper estimation of total financial requirements - Proper estimation of total
financial requirements is a very important objective of financial management. The
finance manager must estimate the total financial requirements of the company. He
must find out how much finance is required to start and run the company. He must
find out the fixed capital and working capital requirements of the company.
4. Proper utilization of finance - Proper utilization of finance is an important objective
of financial management. The finance manager must make optimum utilization of
finance. Once the funds are procured, they should be utilized in maximum possible
way at least cost.
5. Proper coordination - Financial management must try to have proper coordination
between the finance department and other departments of the company.
6. Reduce cost of capital - Financial management tries to reduce the cost of capital.
That is, it tries to borrow money at a low rate of interest. The finance manager must
plan the capital structure in such a way that the cost of capital it minimized.
7. Reduce operating risks - Financial management also tries to reduce the operating
risks. There are many risks and uncertainties in a business. The finance manager must
take steps to reduce these risks.
4.3 Functions of financial management
The finance department of an enterprise performs several functions in order to achieve
the above objectives. The scope of finance function is very wide. It consists of the following
activities.
1. Estimating capital requirements - The finance department must estimate the capital
requirements of the firm accurately for long term and short term needs. In estimating
the capital requirements of the business, the finance department must take help of the
budgets of various activities of the business e.g. sales budget, production budget,
expenses budget etc. prepared by the concerned departments.
2. Determining capital structure - Once the total of requirement of funds is
determined, a decision regarding the mix or composition of the sources of raising the
funds to be taken. The finance manager is required to determine the proportion of
equity and debt, which is known as capital . There are two main sources of funds,
shareholders funds and borrowed .fi1nds (fixed interest bearing)j These sources
have their own peculiar characteristics. The key distinction lies in the fixed
commitment. Borrowed funds are to be paid interest, irrespective of the profitability
of the firm. Interest has to be paid, even if the firm incurs loss and this permanent
obligation is not there with the funds raised from the shareholders. The borrowed
funds are relatively cheaper compared to shareholders funds, however they carry
risk.
3. Estimating cash flow - Cash flow refers to the cash which comes in and the cash
which goes out of the business. The cash comes in mostly from sales. The cash goes
out for business expenses. So, the finance manager must estimate the future sales of
the business. This is called sales forecasting. He also has to estimate the future
business expenses.
4. Investment decisions - These decisions relate to the selection of assets in which
funds will be invested by a firm. Funds procured from different sources have to be
invested in various kinds of assets. Long term funds are used in a project for various
fixed assets and also for current assets. The investment of funds in a project has to be
made after careful assessment of the various projects through capital budgeting. A
part of long term funds is also to be kept for financing the working capital
requirements. Asset management policies are to be laid down regarding various items
of current assets.
5. Dividend decisions - These decisions relate to the determination as to how much and
how frequently cash can be paid out of the profits of an organization as income for its
owners/shareholders. The dividend decision thus has two elements
the amount to be paid out and the amount to be retained to support the growth of the
organization.
6. Checking the financial performance - The finance manager has to check the
financial performance of the company. This is a very important finance function. It
must be done regularly. This will improve the financial performance of the company.

Capital
Capital generally refers to saved-up financial wealth, especially which used to start or
maintain a business. Capital is necessary for an enterprise to keep it dynamic and covers
money, land, building, machinery, materials etc., develops products, keeps workers and
machines at work and is necessary for the firms progress and creating value. Every business
needs funds for two purposes for its establishment and to carry out its day- to-day operations.
Capital required for a business can be classified under two main categories viz., fixed capital
and working capital.
Fixed capital
Long terms funds are required to create production facilities through purchase of fixed
assets such as land, plant and machinery, building, furniture, etc. Investments in these assets
represent that part of finns capital which is blocked on permanent or fixed basis and is called
fixed capital. The fixed capital cannot be disposed of without breaking up the business.
Working capital
Funds are also needed for short-term purposes for the purchase of raw material,
payment of wages and other dayto-day expenses etc. These funds are known as working
capital. From the viewpoint of manufacturing process, working capital means that part of
capital, which is required to keep the flow of production smooth and continuous. Working
capital, being lifeblood for any enterprise, its management becomes a crucial exercise for a
firm. The need of working capital arises due to the time gap between production and
realization of cash from sales. Working capital is used to obtain current assets which will turn
into cash in a short period. Fixed capital, however, makes reference to the funds that are
locked in long term assets. The duration of the working capital depends on the length of
production process, the time it takes to sell the product and the time you have to wait in order
to receive the cash. A difference between working and fixed capital is that working capital is
more liquid. The exercise of working capital management covers the following points to be
considered.
1. Estimating the working capital needs.
2. Procurement of working capital.
3. Optimum utilization of working capital.
Working capital is needed for the following purposes.
1. Adequate working capital is required to continue uninterrupted business operations.
2. For the purchase of raw materials, components and spaces,
3. To pay wages and salaries.
4. To incur day to day expenses and overhead costs such as fuel, power.
5. To meet the selling costs as packing, advertising etc.
6. To provide credit facilities to the customers.
7. To meet the short-term obligation of a business enterprise.
Factors affecting working capital
It is very difficult to determine the amount of working capital required, as there is no formula
for calculating it. Working capital requirement depends upon several factors. Following are
some of the factors which should be considered while determining the working capital.
1. Nature of business - Some businesses are such, due to their nature, that their
requirement of fixed capital is more rather than working capital. These businesses sell
services and not the commodities and that too on cash basis. As such, no funds are
blocked in piling inventories and also no funds are blocked in receivables. e.g. Public
utility services like railways, electricity boards, etc. Their requirement of working
capital is less. On the other hand, there are some business like trading activity, where
the requirement of fixed capital is less but more money is blocked in inventories and
debtors. Their requirement of the working capital is more.
2. Length of period of manufacture - In some business like machine tool industry, the
time gap between the acquisitions of raw material till the end of final production of
finished product itself is quite high. As such more amounts may be blocked either in
raw materials, or work in progress or finished goods or even in debtors. Naturally,
their needs of working capital are higher. On the other hand, if the production cycle is
shorter, the requirement of working capital is also less.
3. Rate of turnover - If in a business, the sale is faster i.e., a business has rapid turnover
then the amount of working capital required may be small as cash is realized from
sales. A business where the rate of turnover is slow, there is more requirement of
working capital in that business.
4. Terms of purchase and sales - Sometimes, due to competition or custom, it may be
necessary for the company to provide credit facility to the customers, as a result of
which more and more amounts is locked up which increases the working capital
requirements. Similarly a firm selling the product on cash will require less working
capital than that of selling the product on credit.
5. Price level changes - If the prices are rising very rapidly in the country the business
will require greater amount of working capital to maintain the same current assets and
vice versa.
6. Market conditions- In case of the high degree of competition prevailing in the market
the firm has to maintain larger inventories as customers are not inclined to wait for the
product. This needs higher working capital requirements. If there is good demand for
the product and the competition is weak, a firm can manage with smaller inventory of
finished goods, as customers can wait for the product if it is not available in the
market. Thus, a firm can manage with low inventory and will need low working
capital requirements.
7. Seasonality of operations - If the product of the firm has a seasonal demand like
refrigerators, the firms need high working capital in the periods of summer, as the
demand for the refrigerators is more and the firm needs low working capital in the
periods of winter, as the demand for the product is low.
8. Converting working assets into cash - If the assets of a business have liquidity i.e.,
they are readily saleable for cash then less amount will be set aside for working
capital. In case the assets are not quickly saleable for cash then a greater amount of
working capital will be required by it.
9. Size of labour force - If the size of labour force employed in the manufacture of a
product is fairly large; the business will need a greater amount of working capital. In
capital intensive industries lesser amount of working capital is required.

I mportant terms used in financial management

Share - Owned capital of a company divided into a large number of equal parts or units. Each
such part having the same face value is called share or a share is one unit into which the total
capital is divided. The amount collected by the company from the public towards its capital,
collectively is known as share capital and individually it is known as share.
Debenture - A debenture is a unit of loan amount. When a company intends to raise the loan
amount from the public, it issues debentures. A debenture is a document issued under the seal
of the company. It is an acknowledgment of the loan received by the company equal to the
nominal value of the debenture. A debenture holder is the creditor of the company.
Dividend - Dividends are payments made by an organization to its shareholder members out
of the organizations profits.
Securities - A security is a negotiable financial instrument representing financial value.
Securities are broadly categorized into debt securities (such as banknotes, bonds and
debentures) and equity securities, e.g. common stocks. Debt securities of include bonds,
debentures, and banknotes. Capital market is the market for securities (broadly classified into
debt and equity), where companies can raise long term funds.
Debt capital
The debt capital in a companys capital structure refers to borrowed money that is at
work in the business. This type of capital used in the business with the understanding that it
must be paid back at a predetermined future date. In the meantime, the owner of the capital
(typically a bank, or a wealthy individual), agree to accept interest in exchange for using their
money. Lending sources include not only banks, but also leasing companies, factoring
companies and even individuals.
Equity capital
Equity capital is otherwise known as net worth or book value. Equity capital refers to money
put up and owned by the shareholders (owners). Typically, equity capital consists of two
types; contributed capital, which is the money that was originally invested in the business in
exchange for shares of stock or ownership and retained earnings, which represents profits
from past years that have been kept by the company and used to strengthen the balance sheet
or fund growth, acquisitions, or expansion.
Factors determining capital structure
1. Trading on equity - The word equity denotes the ownership of the company. The use
of fixed cost sources of finance, such as debt and preference share capital to fmance
the assets of the company is known as financial leverage or trading on equity. If the
assets financed with the use of debt yield a return greater than the cost of debt, the
earnings per share (EPS) increase without an increase in the owners investment. The
EPS also increase when the preference share capital is used to acquire assets. But
usually the cost of debt is usually lower than the cost of preference share capital and
the interest paid on debt is tax deductible.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting
rights in a concern as compared to the preference shareholders and debenture holders.
Preference shareholders have reasonably less voting rights while debenture holders
have no voting rights. If the companys management policies are such that they want
to retain their voting rights in their hands, the capital structure consists of debenture
holders and loans rather than equity shares.
3. Period of financing- When company wants to raise finance for short period, it goes
for loans from banks and other institutions; while for long period it goes for issue of
shares and debentures.
4. Cost of capital- The process of raising the fund involves some cost. While planning
the capital structure, it should be ensured that the use of the capital should at capable
of earning the revenue enough to meet the cost of capital.
5. Stability of sales- When sales are high, thereby the profits are high and company is in
better position to meet the interest on debentures and dividends on preference shares.
If company is having unstable sales, then the company is not in position to meet
obligations. So, equity capital proves to be safe in such cases.
6. Market condition- During the depression period, the companys capital structure
generally consists of debentures and loans. While in period of inflation, the
companys capital should consist of share capital generally equity shares.
7. Sizes of a company- Small size business firms capital structure generally consists of
loans from banks and retained profits. While on the other hand, big companies having
goodwill, stability and an established profit can easily go for issuance of shares and
debentures as well as loans and borrowings.
4.9 Methods of financing

Finance is essential for a businesss operation, development and expansion. Funds can
be procured from different sources and therefore procurement is always considered as a
complex problem by business concerns. Funds procured from different sources have different
characteristics in terms of cost, risk and control. It is crucial for businesses to choose the most
appropriate source of finance for its several needs as different sources have its own benefits
and costs.
Broadly speaking, a company can have two main sources of funds viz., internal and
external. Internal sources refer to sources from within the company such as funds raised
from retained earnings or the saving of the company and personal capital. External sources
refer to outside sources consisting of equity finance (share capital) and debt finance
(debenture capital, loans and advances etc.). Funds available for a period of less than one year
are short term funds. Long term sources of finance are those that are repayable over a longer
period of time, generally for more than 1 year. Long-term sources of finance consist of
shares and debentures. Medium term source of finance consists of public deposits and loan
from banks. Short-term sources of finance consist of trade credit and bank overdraft. Let us
discuss some of the sources of funds.
Shares
When a big amount of capital is required is collected, it can be made possible through
the issuance of shares issued to public. Shares can be issued at any time; generally these are
issued at the time of starting of new business, expanding or reorganizing the existing concern.
Amount to be collected by shares is first decided. Then the value of shares issued to the
public should not exceed this predetermined value. A public company may have two different
types of shares carrying varying rights with respect to dividends and voting, namely,
preference shares or equity shares. Private companies may issue other types of shares as
well. The nominal value is generally Rs. 10 per share for equity shares and Rs. 100 per share
for preference shares.
1. Preference shares - A person holding these shares is entitled to get fixed rate of
dividend. He gets his rate of dividend before any amount paid to the ordinary
shareholders. Thus as its name suggests, it gets preference over other shares for
getting dividend. Similarly these shares get preference over other shares, if repayment
of capital is done. Preference shar holders have a_higher priority if a company is
liquidated than ordinary shareholders, although a 1owf priority than debt holders.
When these shareholders get above mentioned facility, these have limitation that they
will not get more than the fixed rate of dividend even when profit is very large. Issue
of preference shares does not create any charge against the assets of the company. The
promoters of the company can retain control over the company by issuing preference
shares, since the preference shareholders have only limited voting-rights..
2. Equity shares - An equity share, commonly referred to as ordinary share, represents
the form of fractional ownership in a business venture. These shares get their dividend
only after payment of the fixed dividend on preference shares. The advantage for the
holders of the ordinary share is that there is no hit limit, and thus they may get higher
dividend, if the profits are larger
Debentures
When company desires to raise the required finance through loans instead of sale of
shares, then debentures are issued. A debenture also carries a promise by the company to
make interest payments to the debenture-holders of specified amount, at specified time and
also to repay the principal amount at the end of a specified period. In this way, it is
advantageous because debentures holder cannot claim for ownership and he is to be paid
interest only.
Public deposits
These axe unsecured deposits invited by companies from the public mainly to V
finance working capital requirements. Public deposits can be invited by companies for a
period of 6 months to 3 years as per rules. However, they can be renewed from time to time.
Though, they are primarily sources of short term finance, the renewal facility enables them to
be used as medium term finance Public deposits are a major source of finance to meet the
working capital needs. The rate offered for the depositor is higher than that offered by banks
arid the cost of deposits to the company is less than the cost of borrowings from bank. The
borrowing company need not mortgage or hypothecate any of its assets to raise loan through
public deposits. The company can get advantage of trading on equity since the rate of interest
and the period for which the public deposits have been accepted are fixed. Public deposit is a
less costly method for raising short-term as well as medium term funds required by the
companies, because of fewer rules governing this as against bank credits. Tax leverage is
available as interest on public deposits is a charge on revenue. Public deposits are unsecured
deposits and in the event of a failure of the company, depositors have no assurance of getting
their money back.
Loans from banks
Commercial banks play an important role in funding of the business enterprises. Apart
from supporting businesses in their routine activities (deposits, payments etc) they play an
important role in meeting the long term and short term needs of a business enterprise. It is a
flexible source of finance as loans can be repaid when the need is met. Finance is available
for a definite period; hence it is not a permanent burden. Less time and cost is involved as
compared to issue of shares, debentures etc. Banks do not interfere in the internal affairs of
the borrowing concern; hence the management retains the control of the company. In case of
small-scale industries and industries in villages and backward areas, the interest charged is
low. Banks require personal guarantee or pledge of assets and business cannot raise further
loans on these assets. Too many formalities are to be fulfilled for getting term loans from
banks. These formalities make the borrowings from banks time consuming and inconvenient.
Bank overdraft
Bank overdraft is a short term credit facility provided by banks for its current account
holders. This facility allows businesses to withdraw more money than their bank account
balances hold. Interest has to be paid on the amount overdrawn Bank overdraft is the ideal
source of finance for short-term cash flow problems.
Trade credit
Trade credit is commonly used by business organizations as a source of short- term
financing. Trade credit is the credit extended by one trader to another for the purchase of
goods and services. Trade credit facilitates the purchase of supplies without immediate
payment. The volume and period of credit extended depends on factors such as reputation of
the purchasing firm, financial position of the seller, volume of purchases, past record of
payment and degree of competition in the market. Terms of trade credit may vary from one
industry to another and from one person to another. A firm may also offer different credit
terms to different customers.
Retained earnings
A company generally does not distribute all its earnings amongst the shareholders as
dividends. The portion of the profits which is not distributed among the shareholders but is
retained and is used in business is called retained earnings or ploughing back of profits.
Retained earnings are a permanent source of funds available to an organization. It is an
uncertain source of funds as the profits are fluctuating

Difference between debentures and shares

Cost management
Cost is the amount of expenditure (actual or notional) incurred on or attributable to a
specified article, product or activity. Cost management is the process by which companies
Control and plan the costs involved in a business. When properly implemented, cost
management will translate into reduced costs of production for products and services, as well
as increased value being delivered to the customer. Cost Management includes the activities
of managers in short-run and long-run planning and control of costs. Cost management has a
broad focus. It includes both cost control and lost reduction. As a matter of fact cost
management is often invariably linked with revenue and profit planning.
SL.No Debentures Shares
1 A debenture holder is a creditor only
and has no control over the affairs of
the company.
A shareholder is an owner of the company
2 A fixed rate interest is paid on
debentures

Dividend is paid on shares.
3 Interest is paid whether the company
runs in profit or loss.
Interest is paid based depending upon the
Profit/loss incurred by the company

4 A debenture holder gets his money
back after the stated number of years
Money of the shareholder is not refunded
to him

5. In the event of liquidation not the company, a debenture holder will get his money
before the shareholder gets something.

It is easiest to understand this concept if it is explained in the context of a single
project. For instance, before a project is started, the anticipated costs should be identified and
measured. These expenses should then be approved before any purchasing occurs. During the
process of completing a project, all incurred costs should be noted and kept in a record of
some kind, to help ensure that the costs are controlled and kept in line with initial
expectations, to the extent that this is possible. Taking this approach to cost management will
help a company determine whether they accurately estimated expenses at first, and will help
them more closely predict expenses in the future. Starting a project with Cost management in
mind will help to avoid certain pitfalls that may be present otherwise.
Many businesses employ cost management plans for specific projects, as well as for
the over-all business model. When applying it to a project, expected costs are calculated
while the project is still in the planning period and are approved beforehand. During the
project, all expenses are recorded and monitored to make sure they stay in line with the cost
management plan. After the project is finished, the predicted costs and actual costs can be
compared and analyzed, helping future cost management predictions and budgets.
Implementing a cost management structure for projects can help a business keep their over-
all budget under control.
Cost accounting is the process of calculating the cost of an article as a basis to fix its
selling price. Cost center is defined as a location, person or item of equipment (or group of
them) to which costs may be established and related to cost units for the purposes of cost
control. It is the smallest segment of activity or area of responsibility for which costs are
accumulated. Cost unit is a unit of product, service or a combination of them in relation to
which costs are ascertained or expressed or cost units are the units of physical measurement
like number, weight, area, volume, length, time and value. For example, in steel and cement
industry, the cost unit is tone.
The techniques and process of establishing cost involve three steps.
1. Collection of expenditure or cost data,
2. Classification of expenditure as per cost elements, function, etc. and
3. Allocation and apportionment of expenditure to the cost centres and cost units.
The system accumulates and classifies expenditure according to the elements of costs,
and then, the accumulated expenditure is allocated and apportioned to cost objects i.e., cost
centres and cost Units. Cost management identifies, collects, measures, classifies information
that is useful to managers for determining the cost of products, customers, and suppliers for
planning, controlling, making continuous improvements, and decision making. It is not only
concerned with how much something costs but also with the factors that drive costs, such as
cycle time, quality, and process productivity.
Elements of cost and cost ladder
Costs are normally broken down into three basic elements, namely, material, labour
and expense. Each of the cost elements can be further divided into direct and indirect cost.
Direct costs are those which can be identified with or related to the product or services, so
much so that an increase or decrease of an unit of product or service will affect the cost
proportionately. Indirect cost, on the other hand, cannot be identified or traced to a given cost
object in economical way and are related to the expenses incurred for maintaining facilities
for such production or services. Thus, the elements of cost consist of (a) direct materials and
indirect materials (b) direct wages and indirect wages and (c) direct expense and indirect
expense. The aggregate of direct materials cost, direct wages and direct expense is called
prime cost, while indirect materials cost, indirect wages and indirect expenses are collectively
called overhead cost.

Material cost
It is the cost of commodities supplied for production. It is of two types.
1. Direct material cost - A direct material is one which is used directly to the completion
of the product. eg. Fc, Ni, Cr, etc to make alloy steels. The amount paid for the direct
materials is known as direct material cost. Direct material is the material which can be
identified and directly varies with the output.
2. Indirect material cost - An indirect material is one which is not directly used in the
product itself eg. cotton waste, greases etc. The cost associated with indirect material
is called indirect material cost.
Labour cost
Labour cost is classified into two types. They are explained below.
1. Direct labour cost - A direct labour is the one who converts directly the material into
salable products. Direct labour cost refers to the wages paid to the workers who
actually produce goods. Direct wages are the wages which can be conveniently
identified. The wages of such employees are called direct labour cost. eg. wages of a
fabricator.
2. Indirect labour cost - There are several other workers in a factory who help direct
workers in connection with their work with regard to supply of materials, power etc.
and in respect of supervision and maintenance. These are indirect workers and wages
of indirect workers at different stages of production are indirect labour cost.
Expense
Expenses are classified as direct expenses and indirect expenses.
1. Direct expense - These are the expenses that can be directly, conveniently and wholly
allocated to specific cost. Examples of such expenses are hiring of a special
machinery required for a particular job, cost of defective work incurred in connection
with a particular job, costs of special designs or drawings etc.
2. Indirect expense - These are the expenses that cannot be directly, conveniently and
wholly allocated to cost. eg. rent of a building, telephone bill etc.
5.3.3 Overheads

It is defined as the cost of indirect material, indirect labour and such other expenses.
Overhead is an indirect expense incurred at various levels of activities of an enterprise. Thus,
all indirect costs are overheads. These expenses cannot be conveniently identified with or
allocated to cost centers or cost units. According to functions, classification of overhead
expenses may be done as follows.
1. Production or manufacturing overheads - It is the aggregate of all the indirect factory
expenses incurred in connection with manufacture of a product. They include the
following things.
a. Costs on lubricants, welding electrodes, cleaning materials etc
b. Salaries and wages to foremen, supervisors, inspectors, maintenance etc.
c. Expenses on factory lighting, heating, factory rent etc.
2. Administrative overheads- It is the aggregate of all the expenses regarding
administration. They include the following things.
a. Printing and stationery, office supplies
b. Salary of office staff, managers, directors, and other administrative
departments
c. General office rent, insurance, telephones, fax, travel etc.
3. Selling overhead - It consists of expenses in order to maintain and increase the
volume of sales. eg. Advertising, salaries and commissions of sales managers, indirect
labor such as salaries of salesmen and sales manager etc.
4. Distribution overheads - It is the aggregate of all the expenses incurred in connection
with sales and distribution of finished product and services. It is the cost of sales and
distribution services. It is expenses related to transporting products to customers and
storing them. eg. Warehouse charge, Cost of transportation
5. Research and development overheads - It is proportional to the size of the R&D
department.
Classification of cost
Some of the important categories in which the costs are classified are as follows.
1. Classification according to elements - Costs can be classified according to the
elements. There are three elements of costing, viz., material, labor and expenses. Total
cost of production/ services can be divided into the three elements to find out the
contribution of each element in the total costs.
2. Classification according to nature - As per this classification, costs can be classified
into direct and indirect. Direct costs are the costs which are identifiable with the
product unit or cost center while indirect costs are not identifiable with the product
unit or cost center and hence they are to be allocated, apportioned and then absorb in
the production units. All elements of costs like material, labor and expenses can be
classified into direct and indirect. They are mentioned below.
a. Direct and Indirect material
b. Direct and indirect labour
c. Direct and indirect expenses
3. Classification according to behavior - Costs can also be classified according to their
behavior. This classification is explained below.
a. Fixed costs - The cost which varies directly in proportion with every increase
or decrease in the volume of output or production is known as variable cost.
Some of its examples are wages of laborers, cost of direct material, power, etc.
b. Variable cost - The cost which does not vary but remains constant within a
given period of time and a range of activity inspite of the fluctuations in
production is known as fixed cost. Some of its examples are rent or rates,
insurance charges, management salary etc.
c. Semi-variable costs - Certain costs are partly fixed and partly variable. In
other words, they contain the features of both types of costs. These costs are
neither totally fixed nor totally variable. Maintenance costs, supervisory costs
etc are examples of semi-variable costs.
4. Classification according to functions - Costs can also be classified according to the
functions/activities. This classification can be done as mentioned below.
a. Production costs - All costs incurred for production of goods are known as
production costs.
b. Administrative costs - Costs incurred for administration are known as
administrative costs. Examples of these costs are office salaries, printing and
stationery, office telephone, office rent, office insurance etc.
c. Selling and distribution costs - All costs incurred for procuring an order are
called as selling costs while all costs incurred for execution of order are
distribution costs. Market research expenses, advertising, sales staff salary, are
some of the examples of selling costs. Transportation expenses incurred on
sales, warehouse rent etc are examples of distribution costs.
d. Research and development costs - In the modem days, research and
development has become one of the important functions of a business
organization. Expenditure incurred for this function can be classified as
research and development costs.



Components of cost

Components of total cost are as follows.
1. Prime cost - Prime cost consists of costs of direct materials, direct labors and direct
expenses. In other words prime cost represents the aggregate of cost of material
consumed, productive wages, and direct expenses. It is also known as basic, first or
fiat cost.
Prime cost = Direct material cost + Direct labour cost + Direct expenses (variable)
2. Factory cost - Factory cost comprises prime cost and works or factory overheads that
include costs of indirect materials, indirect labors and indirect expenses incurred in
the factory. It is also known as works cost, production or manufacturing cost.
Factory cost = Prime cost + Factory overhead
3. Cost of production - Office cost is the sum of office and administration overheads and
factory cost. This is also termed as administration cost or the office cost.
Cost of production = Factory cost + Administration overhead
4. Total cost - Selling and distribution overheads are added,, to the total cost of
production to get total cost or the cost of sales.
Total cost = Cost of production + Selling and distribution overhead
5. Selling price

Cost Ladder
Business enterprises are run on a profit making basis. It is thus necessary that the
revenue should be greater than the costs incurred in producing goods and services
from which the revenue is to be derived. Selling price is the price which includes total
cost plus margin of profit.
Selling price = Total cost + Profit