H.S. Kumawat-Modern Entrepreneur and Entrepreneurship - Theory, Process and Practice

MODERN ENTREPRENEUR
AND
ENTREPRENEURSHIP
(Theory, Process and Practice)
"This page is Intentionally Left Blank"
MODERN ENTREPRENEUR
AND
ENTREPRENEURSHIP
(Theory, Process and Practice)
H.S. KUMAWAT
SUNRISE
, PUBLISHERS & DISTRIBUTORS
E-566, Vaishali Nagar, Jaipur - 302021 (Raj.)
Published by:
SUNRISE PUBLISHERS & DISTRIBUTORS
E-566, Vaishali Nagar,
Jaipur - 302021 (Raj.)
Ph.:9413156675,9772299149
Email: sunrisepd@gmail.com
First Published - 2009
Reserved
ISBN: 978-93-80207-01-8
All rights reserved. No part of this book may be reproduced in any

form or by any mean without permission in writing from the publisher.
Printed at: Jaipur

CONTENTS
Preface v
1. Decision by Modern Entrepreneur 1
2. Methods for Comparing Investment Alternatives 10
3. Replacement Analysis 32
4. Farm Management 44
5. Pre-Fabricated Irrigation Channels 61
6. Purchasing Methods 74
7. Stores Control 86
8. Credit System 106
9. Kinds of Credit 124
10. Treasury Bill Market 138
11. Office Machines 160
12. Production Control 182
13. Typical Production-control Procedure 203

14. Decision-Making Framework for Export Operation 217
15. Privatisation 225
16. Industrial Sickness 247
17. Service Sector and Modern Entrepreneur 266
18. Commercial Banks 283
19. Insurance 292
20. Warehousing 313
21. Price Discrimination and Modem Entrepreneur 325
22. Leadership in Modem Entrepreneur 352
23. Organisation of Foreign Trade by Modem Entrepreneur 374
24. Import Decisions by Modem Entrepreneur 385
25. Bilateral Trade and Rupee Payment Agreements 398
26. Export Trade 405
PREFACE
The book has been written to meet the requirements of the

syllabus prescribed for B.Com., B.B.A., M.Com., and M.B.A. courses
of Indian Universities. The book is exhaustive in every sense and
cover a large spectrum of subject. In the present economic conditions
Entrepreneurship is a subject with wide connotation. The present
book deals with the subject matter which is changing which have
acquired a critical significance at national and intemationallevel.
I hope the book would receive an overwhelming response from
the students, professors and other professionals and they will find
it an invaluable text. It will also serve as an excellent reference for
practising managers in their day-to-day application and
understanding of the subject.
Inspite of all efforts some errors might have crept in, for which
I will be grateful to the teachers and students, if same are brought to
my notice. Suggestions for further improvement of the book will be
gratefully acknowledged.
Author
"This page is Intentionally Left Blank"
Chapter
1
**
DECISIONS BY MODERN
ENTREPRENEUR
Every business organisation big or small has to invest huge

capital for installation of the plant as well as during the process of
manufacturing the product or service. The decisions regarding
capital expenditures have far reaching consequences on the
performance of the business organisation, e.g., capital hired/
acquired on long term credit creates a continuing liability to the
business organisation. Capital investments can be divided into
folluwing three major categories:
Capital investments
Fixed Assets
I
Operational Expenses Replacement/innovation
expenses.
(i) Investment on Fixed Assets: These are the expenditures on
men, material and machine/ equipment required for manufacturing.
The planning of this type of expenditure is to be done either before
the installation of the plant or before the start of actual production.
One important feature of such expenditures is that once acquired,
the capital assets cannot be disposed off without any loss. Similarly
if additional assets does not adequately increase the earnings, then
these may adversely affect the financial obligations of the company.
It is observed that for producing any type of goods the company can
2 Decisions by Modem Entrepreneur
use varying amounts and kinds of input, i.e., man, machine and
material. Thus, there are a number of alternatives in which the
capital expenditure can be made.
(ii) Expenditures during course of production: This is also
known as cost of production. It is a running expenditure and its
magnitude depends on the nature of inputs. Wrong capital
investment and misuse may result in increasing operating costs
and proportionate decrease in return on investments. Thus,
balancing expenditures against expected saving in future operating
costs need proper analysis of various financial aspects of the
operations of a company. This expenditure can also be done in a
number of alternative ways.
(iii) Replacement/Innovation Expenses : It is a natural
phenomenon that in every system the efficiency of various factors
of production deteriorates with time or sometimes the plant or
machinery fails completely. Thus, adversely affecting the whole
system. In such cases either the plant or machinery is to be replaced
completely or there is a need of some remedial measure, i.e.
maintenance, to restore the level of efficiency at the desired level.
Replacement investments may be desired due to innovations in
production technology i.e. for the modernisation of the production
system.
The capital expenditure may also relate to:
(a) cost reduction by (i) replacement of machinery and
equipment (ii) plant rearrangement programme or
mechanisation of the production process.
(b) providing facilities to manufacture Omponents which are
currently purchased.
(c) installation of new plant and machinery for taking up a
new product on product lihes.
In view of many uncertainties, scientific and systematic
planning and control of capital expenditure is of great significance
in modem management. The process of capital expenditure involves
planning the availability and controlling the allocation and
expenditure of long-term investment funds by determining:
Decisions by Modem Entrepreneur 3
(i) How much money is needed for the capital expenditure in

future period?
(ii) How much money will be available with the organisation
for investment?
(iii) How the funds available will be allocated to the projects
under consideration?
The most common feature of all these expenditures is that there
are a number of alternative ways to plan these expenditures to get
the desired result and every company wants to formulate an
investment policy which is most efficient and economic to the
organisation as a whole. Thus, the study of entrepreneurship is a
procedure to select the most profitable investment or replacement
strategy.
In this chapter a number of techniques for selecting the most
appropriate investment/replacement alternative in different
situations have been discussed in detailed manner.
Present Value Concept:
Every capital expenditure made today has some opportunity
cost associated with it i.e. there will be some return available on it
depending upon the period of return. Alternately, whenever some
capital expenditures are made, then the arrangement for these is
done either through borrowing from some agencies and paying
interest on that or paying it from one's savings which otherwise
could have fetched some interest. Thus in each case some return in
monetary terms is associated with each investment. This return
depends on the amount of investment as well as the period for
which the money is to be invested. The money borrowed or invested
from savings is known as principal and the money paid as interest
or loss of return on savings due to investment is known as interest.
The sum of Principal (P) and Interest (I) is known as amount
(A). Mathematically, the relationship between the three can be written
as:
Amount = Principal + Interest
A = P + (1)
4 Decisions by Modern Entrepreneur
Thus, the present value of a sum to be spent within a given
period depends on the rate of interest and the period within which
the amount is to be repaid.
There are two methods of paying interest (i) Simple interest and
(ii) Compound interest.
(a) Simple interest: It is amount paid yearly or some other
specified period on the principal amount e.g. if an amount P is
borrowed at a fixed interest rate r per rupee per year, then in one
year the interest will be iP. next year also the interest will be iP, and
in rth year again the interest will be iP. So if total investment is to be
paid back in r years, then the total interest paid in r years will be
I = iP + iP + ..... iP r times
= riP ... (2)
Thus putting the value of / from (2) in (1), we get
A=P+riP
= P(l + ri) ... (3)
Note: Generally interest rate is specified in percentage i.e. t%
per year.
t
r= - peryear ...(4)
100
It is evident from (3), that the amount A increases progressively
in arithmetic progression.
(b) Compound Interest: In this case, the whole amount A is to
be paid at the end of the period. Here every year the interest accrued
is also added to the Principal amount of previous year to get the
new principal for next year i.e. at the end of first year the new
principal will be
PI = P + iP = P(l + i)
at the end of second year the principal will be
P2 =P1 +iP1 =P 1(1+i)
P(l +i) (1 +i) = P (1 +i)2
and at the end of r th year the principal will become
A = Pr - 1 + iPr - 1 = Pr _ 1(1+i)
= P(!+W-1 (1 +i) = P(l +i)f ... (5)
or A=P(CAF) .. .(6)
where CAF known as compound amount factor is (1 +i)r
From (5), we get
A
P = - - =A (PWF) ...(7)
(l+W
where PWF = _1_ is known as present worth factor.

(l+W
There are standard tables of CAF and PWF for different values
of i and r. The values of P or A can be immediately determined with
the help of these tables. The method is explained by the following
examples.
Example 1: Find the amount paid in 10 years for a Principal of
Rs. 1000 at (i) simple interest of 10% and (ii) compound interest of
10% per year.
Solution: Here t= 10% i.e. = t/100 = 10/100 =C.1 per year, r=10
(i) From (3) A = P (1 Hi)
=1000(1 + 10 x 0.1)= Rs. 2000/-
(ii) Now from (6)
A=P(CAF)
Here, P = Rs. 1000 and CAF at the rate of 10% in 10yrs
from Table A-I = 2.594
Thus A = 1000 (2.594) = Rs. 2594/-
Example 2 : If the amount paid after 5 years is Rs. 5000/- then
find the Principal at (i) simple interest, rate of 5%, (ii) compound
interest of 5%.
Solution: (i) Here i = 5/100 = 0.05, A ~ Rs. 5000, r = 5 years
and we want to find P
From (3), A = P(1 Hi)
6 Decisions by Modern Entrepreneur
i.e. 5000 = P[l + 5 (0.05)} = P [1.251

P = (5000/1.25) = Rs. 4000
(ii) From (7), P = A (PWF)
(From Table A-2 for 1= 5% and r=5, PWF= 0.7835)
= 5000 x 0.7835 = Rs. 3917.50
(iii) There are some situations, where the borrower agrees to
repay some fixed amount at fixed intervals of time i.e. the money is
repaid in fixed installments. If the total amount A accrued in r years
is paid in r, installments of Rs. K, then
A = K[(l +W -l]/i = K(CAFS) ...(8)
where CAPS =[(1+i)f-1J/i is known as uniform annual series
compound amount factor.
Now, knowing A, we can write
K = (Ai) j [(1+i)f-1] = A(SFF) where SFF=ij[(l+i)f~l)) ... (9)
K= [P(1+W.i)j[(1+i)f-1] is Sinking Fund Factor
= P(CRF) ...(10)
where CRF = [i(1+i)r]![(1+i)f-1] is known as Capital Recovery
Factor.
or P = [K(1+W-1)j[(1+W.i)] = K(PWFS) ...(11)
where PWFS =[K(l+i)f -I]! [(1 +W. i] is known as uniform annual
series present worth factor.
Standard values of CAFS, SFF, CRF and PWFS (for given i and
r) are respectively given in Tables.
The use of Tables is illustrated with the following examples:
Example 3 : Mr. X deposits Rs. 500 j ~ every year at an interest
rate of 10% for 5 years. Find the total amount at the end of 5 years.
Solution: From (8), A = K(CAFS)
Here, K = Rs. 500, CAFS for 10% and r = 5 from Table A-3 is
equal to 6.105.
Hence A =500 (6.105) = Rs. 3052.50
Example 4 : A person wants to have Rs. 10,000 in his account

after a period of 5 years. The interest rate is 4%. Find his annual
installment.
Solution: From (9), K = A (SFF)
Here A = Rs.I0000 and SFF at4% and r=5 from table A-4 =
0.18463.
Hence K = 10000 (0.18463)
= Rs. 1846.30
Example 5 : Mohan wants to borrow a sum of Rs. 20000 and
desires to pay it in 10 equal installments. The annual interest rate is
5%. Find the" size of the installment.
Solution: Here P = 20,000, r = 10 and t = 5%.
Now from (10), K = P(CRF)
From A-5, CRF for r=10 and t = 5% = 0.12950
Henct! K = 20000 (0.12950) = Rs. 2590.00 per year.
Example 6: There is an opportunity to invest some money with
an assurance to get back Rs. 6000/- after 10 years. The investor
wants to earn an interest of 1% per year. How much he should
invest?
Solution: Here the following things are known:
t = 15% per year, r = 10 years, and A = Rs. 6000/-
From (7) we get, P = A (Pwf)
and from A-2, Pwf for r = 10 and and t = 15% = 0.2394.
Hence, P = 6000 x 0.2394 = Rs. 1436.40
Example 7 :A company sets aside for a reserve fund the sum of
Rs. 20,000 annually to enable it to payoff a debenture issue of Rs.
2,39,000 at the end of 10 years. Assuming that the reserve
accumulates at 5% per annum compound, find the surplus after
paying off the debenture stock.
Solution: Here K = Rs. 20,000, r = 10 years, and t = 5%
From (8), A = K (CAFS) CAFS from table A-3 for r = 10 and
8 Decisions by Modem Entrepreneur
t = 5% = 12.578
A = 20000 x 12.578 - Rs. 251560
Thus the surplus after paying Rs. 2,39,000 will be
Rs. 251560 - Rs. 239000 = Rs. 12560.
Example 8 : On his 48th birthday a man decides to make a gift of
Rs. 5000 to a hospital on his 60th birthday. He decides to save this
amount by making annual installments up to and including his
60th birthday to a fund which gives 35% compound interest, the
first payment being made at once. Calculate the amount of each
annual payment.
Solution: Here t = 31.5%, r = 12 years and, A = 5000
Now from (9), K = A(SFF)
From Table A-4 we interpolate the value of SFF for r = 12 and
t = 3.5% = 0.068505
K = SOOO (0.068505) = Rs. 342.525 928.
The Loss Value of a Plant:
The plant installed today start immediately to loose its value
due to following two main reasons namely, Depreciation and
Obsolescence.
Depreciation: The production capacity introduced by some
Capital investment tends to decline with time. There is also
diminution in the intrinsic value of an asset due to use as well as
with passage of time. This diminution may also be due to bad
handling, poor maintenance, accidents etc. This decline in the value
of investment is known as Depreciation. Depreciation rate can be
calculated in two ways:
(i) Straight line method : Here we assume that there is a
constant rate of decline during an aS,set's life. Thus same absolute
value is deducted from the value of the asset's for each period of
use.
P(n -1)
i.e. Value = P - N
Decisions by Modern Entrepreneur 9
where n is the year at which the value is to be calculated and N is

the total life of the assets. Alternately the depreciation rate can also
be calculated by the formula
F-S
D=--
N
where D: annual depreciation rate
F : investment cost
5: estimated salvage value
N : estimated life of investment.
(ii) Declining Balance Method: Here some constant percentage
from book value is deducted.
,
Thus value of the asset after n years can be
Value = p(l_R)n-l
where R is the depreciation rate.
~lternately
Fixed percentage x F
D= N
Obsolescence: Loss in the intrinsic value of an asset due to its

suppression which is the outcome of reduction in the market demand
of the product manufactured by the plant or change in the design of
the plant etc. is known as obsolescence. This may lead to formulation
of suitable replacement policy.
***
Chapter
2
METHODS FOR COMPARING

**
INVESTMENT ALTERNATIVES
In plax;ming any production strategy one very often faces a

situation when decisions on investment and replacement proposals
are to be taken. There are a number of alternatives, each involving
huge capital expenditure. Evidently for making an appropriate
decision an economic analysis is more useful for differentiating
between various alternatives. The basic steps involved for critical
appraisal of different alternatives are:
(i) To evaluate the cost of products and other investment
capital requirements i.e. how much money is needed for
desired expenditure during the period under consideration.
(ii) Determination of anticipated returns and life of the invested
capital.
(iii) Timing of the investment in relation to anticipated
requirements.
(iv) How much money can be made available for the purpose
and what will be the sources and expenditure for these
funds? The funds can be generated in different ways. Some
of these can be:
(a) Hire-purcJzase: Contracts can be negotiated for long
periods with the interest tied to the bank rate.ln some
Methods for Comparing Investment Alternatives 11
cases payments can fluctuate with a known seasonal

variation in output.
(b) Leasing: Here the user never accurately owns the
machinery leased. The use of the plant is considered to
be more important than its ownership.
(c) Hiring: In fact this is some sort of leasing but in it a
maintenance contract is also implied or required.
Methods to compare alternative proposals can be divided into
following two main categories:
Present Value Approach:
(a) Present value basis.
(b) Uniform annual value basis.
(c) Last basis.
(d) Discounted cash flow method.
Annual Cost Approach:
(a) Pay-back period
(b) Return on investment.
Present value Approach:

(a) Present Value Basis: In this method, investment in capital
expenditure decisions are based on the amount by which the present
value of a projected income stream exceeds the cost of an investment.
Here both the streams of inflows and outflows are discounted at a
calculated rate. The basic assumption behind all discounting is
that the cash inflows are re-invested at the discounting rate in net
projects as soon as they arise.
Thus in this approach present values of all future expenditures
and revenues are calculated for different alternatives and the Net
present value of total cost is compared. The alternative with
minimum net present value is considered to be most appropriate.
Case (i) In the absence of any annual income:
If there is an initial investment of P rupees with a recurring
expenditure of K rupees per year for r years and at the end of r years
the salvage value is 5, then the present value of total cost is given by
12 Methods for Comparing Investment Alternatives
P + KPwfs - SPwf
where Pwfs and Pwf can be calculated at the given interest rate for
a period of r years from tables.
The procedure is explained by the following example.
Example 1 : An entrepreneur is planning to install a small
machine in his factory. The relevant data about the two alternative
machines are as under:
Machine A Machine B
Present investment in Rs. 1,00,000 1,50,000
Annual operating cost in Rs. 20,000 12,000
Salvage value in Rs. 5,000 2,000
Estimated life in years 10 10
As financial advisor of the company you have been asked to
select the best machine, considering normal rate of return to be 12%
per year.
(Pwf-series at 12% for 10 years = 5.650
Pwf single payment at 12% for 10 years = 0.332).
Solution: Here we should calculate the present value of total
cost incurred on each of the. machines in 10 years by using formula.
For Machine A,
P = 1,00,000, K = 20,000,5 = 5000, Pwfs = 5.6~ and
Pwf= .332
Present of total cost value = P + KPwfs - SPwf
= 1,00,000 + 20,000 (5.650) - 5000 (0.322)
= 1,00,000 + 1,13,000 - 1610
= 2,13,000 -1610 = Rs. 2,11,390
For Machine B,
P = 1,50,000, K = 12,000 and 3 = 2,000
Present of total cost value = 1,50,000+ 12000 (5.650)-2000 (0.322)
= 1,50,000 + 6,78,00 - 644 = 2,17,800 - 644 = Rs. 2,17,156
Evidently, present value of total cost for Machine A is lesser
than that for Machine B.
Hence the company should select machine A.

Case (ii) : There is some fixed annual income from the
investment, say R every year. Then the present value of this annual
income for the given period can be calculated by using Pwfs.
Then the present value of net income
= Present value of Total Revenue - Present value of total cost
The alternative for which present value of net income is
maximum is considered to be most appropriate.
Alternately, calculate present value index for each alternative,
and the alternative for which present value index is maximum is
considered to be the best.
Present value index is given by p
Present value of future income

P.V.1. = ---I-ru-.t-i-al-in-v-es-tm-e-n-t---
Present value of annual income

or P.V.1. = P resent va1ue 0 f tota1cost
Present value index provide some valuable information about

the investment policy i.e.
lf P.V.!. < 1 return is less than normal interest on
investment
= 1 break even situation
> 1 return is more than normal interest on
investment.
The method is explained by the following examples.
Example 2: To start a business it needs an investment of Rs.
50,000: The income in next 25 years is expected to be Rs. 8,000/ - per
year with an expenditure of Rs. 3,000 per year. The value of the
establlshment at the end of 25 years is expected to be Rs. 18,000. If
minimum interest rate is 10% then would you recommend the
investment?
(Pwfs - 10% - 25) = 9.077, (Pwf - 10% - 25) = 0.0923.
Solution: Here P = Rs. 50,000

K = Rs. 3000 per year
r = 25 years
i=lO%
R = Rs. 8000 per year.
Now from Present value of total cost
=Rs. 50,000 + 3000 (9.077) - 18000 (0.0923)
= Rs. 50,000 + 27231 - 1661.40
= Rs. 77231 - 1661.40 = Rs. 75569.60.
Present value of total income = Rs. 8000 x 9.077
= Rs.72616.
Now present value of total income is less than the present value
of total cost. Thus it is not advisable to recommend the investment.
Aliter:

Present va1ue 0 f In d ex = I
Initia investment
Now present value of future income
= (income per year) Pwfs + (value of the establishment at
the end of 25 years) Pwtf - Annual expenditure (Pwfs)
= (8000 x 9.077) + 18000 (0.0923) - (3000 x 9.077)
= Rs. 72616 + Rs. 1661.40 - Rs. 27231
= Rs. 74277.40 - Rs. 27231 = Rs. 47046.40
47046.40
Hence PVI = - - - = 094.
50,000 .
Since PVI < 1, the project is not to be recommended for

investment.
Example 3 : A company is considering to purchase a new

grinder. The cost data of alternative grinders are as follows:
Grinders
A B C
Present value in Rs. 20,000 15,000 17,000
Annual operating cost in As. 2,000 1,500 1,400
Annual repair cost in As. 1,000 1,100 1,100
Scrap value after 12 yrs. Rs. 2,000 - 1,000
Estimated life in years 12 12 12
Recommend the grinder to be purchased when the minimum

rate of return is 8%.
Solution: Total annual expenditure on each grinder can be
calculated by Annual operating cost + Annual repair costs. Thus
for the three grinders this cost will be Rs. 3000 for A, Rs. 2600 for B
and Rs. 2500 for C. Now present value of total cost for each grinder
can be calculated from (12). It is
P.V. = P +K(Pwfs -8%-12) -S (Pwf-8%-12)
Pwf single payment at 12% for 10 years = 0.332).
Now for Grinder A
P.V.= 20000 + 3000 (7.536) - 2000 (0.3971)
=20000 + 22608 - 794.20
= Rs. 41813.80
For Grinder B
= 15000 + 2600 (7.536) - 0 (0.3971)
= Rs. 34593.60.
For Grinder C
P.V.= 17000 + 2500 (7.536) - 1000 (0.3971)
=17000 + 18840.00 - 397.10
= Rs. 35442.90
The present value of total cost is minimum for grinder B. Hence
grinder B should be purchased.
Case (iii) Operating Costs Varying: In practice running costs are
never fixed. Actually these are found to be varying from period to
period. Suppose a machine's expected life is r years, with running
expenditures each year being Rl1 R2 ... Rr respectively. Now for the
calculation of present value of these expenditures, we shall use Pwf
with a period of one year for R1, two years for R2 and r years for Rr.
Thus the present value of all running expenditures at an interest
rate of t% per year will be given by the expression
R1(pwf - t% -1 year) + R2 (Pwf -1 % - 2 years)
+ ... + Rr (Pwf - t% - r years) ... (14)
The net total cost can be determined in the usual manner.
The method is illustrated by the following example:
Example 4 : A company is considering to replace a grinder X
presently of worth Rs. 10,000 by a new grinder Y of Rs. 20000 but
will be economic in running expenditures. The expected life of
grinder A is 5 years with running expenditure of Rs. 4000 in first
year and then an additional increase of Rs. 400 per year for next
four years. For the new grinder annual running cost is Rs. 1000 per
year and its scrap value is Rs. 2000. As an advisor to the company,
find
(i) The present value of the cost of old and new grinders,
considering 12% normal rate of return.
(ii) Suggest whether the old grinder be replaced by the new
grinder assuming the life of the new grinder to be 5 years.
Solution: The following is the summary of costs associated
with two grinders
Grinders X V
Initial Price Rs. 10000 20000
Salvage Value Rs. 2000
Running Cost 1st. year Rs. 4000 1000
2nd. year Rs. 4400 1000
3rd. year Rs. 4800 1000
4th. year Rs. 5200 1000
5th. year Rs. 5600 1000
Estimated life in years 5 5
Normal interest rate 12% 12%
(i) Present Value of Total Cost for X

=10,000 + 4000 (Pwf-12%-one year) + 4400 (Pwf-12%)
- two years) + 4800 (Pwf-12/o-three years)
+ 5200 (Pwf-12 -four years)
%
+ 5600 (PY\. f-12/o-five years)

= 10,000 + 4000 (0.8929) + 4400 (0.7972) + 4800 (0.7118)
+ 5200 (0.6355) + 5600 (0.5674)
= 10,000 + 3571.60 + 3507.68 + 3416.64
+ 3304.60 + 3177.44";' 26977.96
Present Value ofTotal Cost for Y
= 20000 + 1000 (Pwfs -12% - 5years)
- 2000 (Pwf -12%-5 years)
=20,000 + 1000(3.005) - 2000 (0.5674)
= 20,000 + 3005 -1134.80
= 20,000 + 1870.20
= Rs. 21,870.20
(li) Evidently old grinder should be replaced by the new one.
('IJ) Annual Basis: Here net annual cost is calculated for each
alternative and the alternative for which this cost is minimum is
considered to be the best. CRF and SFF are used for the given period.
Let P: Principal Value
S : Salvage Value
r: Estimated life in year
t: Normal rate of interest.
Case (i) Running expenditure annually be R.
Annual Capital Cost = P (CRF-t%-r years)
- S(SFF-t%-r years) ... (15)
Annual Running Cost = R
Total Annual Cost = Annual Capital Cost + Annual Running
Cost Case (ii) With annual expenditure, there is also annual

income from the investment.
Here we calculate
Annual income
Annua I Va Iue In d ex = - - - - - - - -
Annual net total cost
Annual value of net total income

or
Annual value of present investment
Annual value of Net income =R (CRF- t%-r years)

+ S (SFF-t%-r years)
The alternative with maximum annual value index is
considered to be most appropriate.
The methods are illustrated by the following examples:
Example 5 : There are two investment alternatives A and B.
They are briefly described as follows:
Alternatives
A B
Initial investment in As. 20,000 30,000
Expected life in years 5 5
Salvage value in As. 2000 3500
Annual operating costs 10000 8000
The company feels that if invested elsewhere, its money would
yield a return of 10% per year. Find which of the alternatives is
more economical.
(CRF-I0%-5) =0.2638, (SFF-1O%-5) =0.1639
Solution: In this example CRF and SFF are given. So comparison
of the two alternatives can be done on annual basis only, using (15).
Alternative A
Annual net total capital cost = (20000) (CRF-I0%-5)
- 2000 (SFF-I0%-5)
=20000 (0.2638) - 2000 (.1639)
= Rs. 5276 - Rs. 327.80 = Rs. 4948.20
Net Annual Total Cost =Annual Capital Cost +Annual expenditure

= Rs. 4,948.20 + Rs. 10000
= Rs. 14948.20
For alternative B
Annual Capital Cost = 30000 (CRF-10%-5)-3500 (SFF-10%-5)
= Rs. 7340.35
Net Annual Total Cost = Rs. 7340.35 + 8000
= Rs. 15340.35
Evidently alternative A is more economical.
Example 6 : Project X requires at present, investment of Rs.
25000. Estimated annual receipts for 25 years are Rs. 5000 3.nd
estimated annual disbursements as Rs. 5000. An alternative project
Y requires a present investment of Rs. 35000, estimated annual
receipts of Rs. 1000 for 25 years and estimated annual disbursements
of Rs. 3000. Each project is estimated to have a salvage value of Rs.
5000 at the end of 25 years. The minimum attractive rate of return is
10%. Which project would you recommend?
Solution: Here annual income for project X is zero (5000-5000=0)
Hencefromformula:
Annual Income 0
Annual Value Index = = =0
Net Annual Cost Net Annual Cost
For Project Y,
Net Annual Income = 1000 - 3000 = - 2000
Net Annual Total Cost = 35000 (CRF-10%-25)
-5000 (SFF-10%-25)
= 35000 (0.11017) - 5000 (0.01017)
= 3805.10
2000
Annual Value Index = = - 0.53
3805.60
Since annual value index for both the projects is less than or,e,
none of them is feasible.
Example 7: If N.K. Ltd. wishes to have a minimum rate of return

of 10% per annum on its investment, which of the following two
plans should be preferred:
Plan A Plan B
Initial cost in As. 40000 60000
Expected life in years 5 5
Salvage value in As. 4000 18000
Excess of annual receipts
over disbursements in As.
1st year 8000 8000
2nd year 8000 8000
3rd year 8000 10000
4th year 8000 12000
5th year 8000 12000
(CAF-10%-5) = 0.26380, (SFF-10%-5) = 0.1638
(Pwf--10%-1) = 0.9091 (Pwf-10%-4) = 0.6830
(Pwf--10%-2) = 0.8264 (Pwf-10%-5) = 0.6209
(Pwf--10%-3) = .7513
Solution: For Plan A
Annual Net income = 8000 + 4000 (SFF-1 0%-5)
= 8000 + 4000(0.1638)
= 8000 + 655.20 = 8655.20
Using formula Annual Value of Present Investment
= 40000 (CRF-1O%-5)
= 40000 (0.2638) = 10,552
Annual Net Income
Annual Value Index for Plan A =-------
Initial Investment
8655.20
= 10,552.00 = 0.8 approx.
PlanB
Present Value of Annual Income
= Rl (Pwf-10%-l) + R2 (Pwf-10%-2) + R3 (Pwf-10%-3)
+ R4 (Pwf-l 0%-4) + Rs (Pwf-l 0'10-5)
= 8000 (0.9091 ) + 8000 (0.8264) + 1 0000 (0.751 3)

+ 12000 (0,6830) + 12000 (0.6209)
= Rs. 37043.80
=Rs. 37043.80 (CRF-10%-5) + 18000 (SFF-10%-5)
= Rs. 9772.15 + Rs. 2948.60 = Rs.12720.55
Annual Total Cost = 60,000 (CRF-10%-5) = Rs. 15828
12720.55
Annual Value Index for Plan B = =0.8 approx.
15828.00
It is observed that annual value index in both the cases is less
than one. Hence none of the plans is advisable.
(c) Last Basis: In this case the value of all the expenditures
and incomes is projected over the expected years to the last year.
Thus the total cost of the project after r years is then given by
= P (CAF-f%-r years) + R(CAPS-t %-ryears) -5 ... (17)
where CAP and CAPS can be seen from standard tables:
The alternative for which Total cost is minimum is considered
to be most appropriate.
The method is illustrated by the following example.
Example 8 : If R.K. Ltd. wish to have a minimum return of 10%
per annum on its investment, which of the following plans would it
prefer?
Plan A Plan B
Initial cost in Rs. 2,00,000 2,50,000
Scrap value after 15 yrs. in Rs. 1,50,000 1,80,000
Excess of annual revenue
over disbursements in Rs. 25,000 30,000
(CAF-10%-15) = 4.177, (CMFS-10%-15) = 31.772.
. Solution: Here we are given CAP and CAPS.So we should use

the last basis approach to make a final decision. Now for Plan A:
Total cost =200,000 (CAF-1O%-15) -1,50,000
= Rs. 6,85,400.
The annual income projected over 15 years

=25000 (CAFS-1O%-15) = R<;. 7,94,300
Thus net Profit in Plan A = Revenue-Cost
= Rs. 7,94,300 - Rs. 6,85,400 = Rs. 1,08,900
Similarly for Plan B the net profit will be Rs. 88,910. It is observed
that net profit for Plan A is more than for Plan B. Hence plan A is
better than Plan B.
(d) Discounted Cash Flow Method:
This method is based on the concept that monies recovered
over a period of time are not worth the same amounts at anyone
point of time e.g. Re 1/- today and Rs. 1/- in a year time have quite
different values today. Similarly a profit of Rs. 1000/- obtained in a
stream of Rs. 200/- per year for 5 years has a different value to a
stream ofRs.100/- per year for 10 years. The former is worth more
than the later. Based on this principle an attempt is made to discount
all income receivable at various points of time during the life of a
given project. Similarly expenditure on a project also may be spread
over a number of years and one may find its present worth.
Here discounting is the act of taking a sum in the future and
calculating its present value, assuming some particular rate of
return. Discounting can be considered inverse of compounding.
The principle appears to be simple but in practice it is complicated
to determine rate of return. Mathematically, the discounted value is
defined as:
X
Discounted value = - - -
(I + i)n
where X is the amount to be discounted, n is the period of discount
and i is the interest rate.
There may be situations where annual earnings are not
constant, investment is incremental and the lives of the investments
as uneven. In such case we can use the following formula:
where I investment in Rs.

n economic life in years
time variable
Rt revenue for a given period.
Et expenses for a given period.
S(n): scrap value at the end of the economic life
discount rate.
II. Annual Cost Approach: There are two main techniques in
this approach, namely
(a) Pay-back method
(b) Rate of return method.
(a) Pay-back method: Whenever any investment is made some
amount of return is always expected. Also it is hoped that the
investment will be recovered within reasonable period of time. The
period of recovery is of great significance for investment decisions.
It is commonly known as Pay-back period and is defined to be the
period within which the initial investment amount is recovered by
net cash inflows. The rationale underlying the use of pay-back
method is that the sooner the capital investment can be recovered,
the sooner it can be reinvested in revenue producing projects.
In pay-back method, the period of recovery for each alternative
investment strategy is calculated and then various alternatives are
ranked in terms of recovery period viz. alternative with minimum
recovery period is ranked first and so on. Payback period is the time
required for each investment to return earnings equal to the cost of
investment.
The method is based on the concept of net cash-inflows which
is defined to be
Net cash-inflow = [Cash-inflow from earnings-expenditure
on operating costs)
Note: Expenditure on operating costs is known as cash outflow. It
should include income tax on earnings but should exclude depreciation
costs.
Now cash-inflow can be of two types (i) Even cash flow which
is equal for different years and (ii) un-even cash inflow which is not
same for different years In this case cumulative sum of cash-inflows
is calculated for each year.
The formula for pay-back period is given by
b k . d Amount Invested
Pay- ac peno = Ann 1 h nfl ...(18)
ua cas 1 ow
The method is illustrated by the following example:
Example 9 : In an investment of Rs. 40,000 the organisation
expects (i) an even cash flow of Rs. 5000 per year and (ii) uneven
cash-inflow of Rs. 8000, Rs. 8000, Rs. 10,000 and Rs. 15,000 for first
four years respectively. Find the pay-back period in each case.
Case(i) From (18)
P b k . d Amount Invested 40,000 8

ay- ac peno = Annual cash inflow = 5000 = years
Case (ii) In the case of uneven cash-inflows, we calculate

the cumulative cash-inflow year wise to know the year by which
the investment amount is likely to be recovered. The calculations
can be done in the following tabular form:
Years Cash-inflow Cumulative cash-inflow
8000 8000
2 8000 16,000
3 10,000 26,000
4 15,000 41,000
It can be observed that up to 3rd year only Rs. 26,000 will be
recovered. The balance of Rs. 14,000 will be recovered in fourth
year. In this case:
Pay back Period in years.
Amount Invested - Amount revmoved upto 3rd year
= 3 + (Total cash inflow upto 4th year - Total inflow upto 3rd year)
40,000 - 26,000
= 3 + (14/15) years
41,000 -26,000
= 3 years 11 months
The following are the main drawbacks of payback method:
(i) Highly profitable projects do not necessarily pay-off in the
initial years. Larger gains may occur later.
(ii) It completely ignores the time value of the money received
during and after the pay-back period.
(iii) It does nO.t measure the rate of return.
(b) Return on investments method: Here profit is considered as
return on investment. For various alternatives, profit is calculated
after allowing for depreciation (but before taxation) expressed as a
percentage of original investment. Mathematically
Percentage return on investment
Average annual income after depreciation
but before taxation
= xl00
Annual cash inflow
In this method allowance is made for decrease in the value of
the asset due to wear and age and the cost of interest charged is
spread uniformly over the projected life of the asset.
These methods may be classified as:
(i) Unadjusted rate of return method.
(ii) Time adjusted rate of return method.
(i) Unadjusted rate of return method: The method is based on
certain information's extracted from various financial statements.
Here future earnings on investment are not converted to get its
present value, that is why it is known as unadjusted return method.
The rate of return on investment is calculated for each alternative
and the one providing maximum return is considered to be the best.
Unadjusted rate of return is given by
Average Annual net income
Unadjusted Rate of Return = A . t
verage Inves ment
Average ammia cash inflor - Annual depreciation

. x 100 .. .(19)
Average Investment
Now average investment can be calculated by any of the

methods given below, depending upon the nature of the information
available.
(a) Average investment =
(uncovered capital in the beginning +uncovered capital at
theend)/2
(b) Average investment = (Initial investment + Scrap value)/2
(c) Average investment = [(capital recovered)/2] + Scrap value
... (20)
Example 10 : Rank the investment proposals in order of their
profi tability using rate of return method:
Proposal It:lvestment Annual Cash flow Life In years
in Rs. in Rs.
A 25000 3000 10
8 3000 1000 5
C 12000 2000 8
0 20000 4000 10
E 40000 8000 10
Solution: Assuming scrap value to be zero and depreciation
rate to be linear, we can find depreciation for each proposal by
dividing the investment from life in years. The calculations can be
done in the following tabular form:
Proposals Average Depreciation Cashin in flow rate of return
investment - Depreciation
25000 = 12500 25000 = 2500 500 = 0.04

A 2 10 3000-2500=500 12500
3000 = 1500 3000 = 600 400 = 0.27
B 2 5
2000-600=400 1500
12000 = 6000 1200 =1500 500 = 0.33
C 2000-1500=500
2 8 1500
20000 = 10 000 20000 = 2000 2000 = 0.20
0 ,2 10 4000-2000=2000 10,000
40000 = 20,000 40000 = 4000 4000 = 020
E: 2 10 8000-4000=4000 20,000
A
25000 = 12500 25000 = 2500
3000-2500=500 ~=004
2 10 12500
Thus the ranking of the proposals are C, B, D, E and A.

Example 11 : A limited company is considering the purchase of
one of the two machines with following details: Find the best choice
by rate of return method:
Machine X Machine Y
Life 3 years 3 years
Capital Cost As. 1,00,000 As. 1,00,000
Earnings after tax
1st year As. 80,000 As. 20,000
2nd year As. 60,000 As. 70,000
3rd year As. 40,000 As. 1,00,000
Solution: Now Average annual cash inflow for the two machines
is
Machine A = 80,000 + 60,000 + 40,000 = Rs. 60,000

3
M h' B - 20,000+70,000+1,00,000 - Rs 3 00
ac me - 3 - . 6 ,3
. . f or A = 100,000
D epreclatIon 3 3 3333
. . 100,000
DeprecIatIon for B = = 33333
3
Average investment for both the machines is
R
s. D ' . f or'j\ = 100,000
epreclatlOn 2 = 50,000.
Hence from (19)
rate of return for A = 60,000 -33333 = 0.53

50,000
rate of return for B = 63300 - 33333 =0.60

50,000
(b) Time Adjllsted rate of return method: According to National
Association of Accountants, America, "Time adjusted rate of rehlrn
is the maximum rate of interest that could be paid for the capital
employed over the life of an .investment without loss on the project."
There are many other names of this method viz. Discounted rate of
return method, Internal rate of return method etc. This method is
particularly useful when the rate of return on investments is not
known exactly.
The method consists of following steps:
(i) Find the ratio of cost of investment and annual cash-in
flow.
(ii) For the value obtained in (i), find present value factor from
Pwfs table for the given period.
In the case of uneven cash-inflows, trial and error method can
be used.
The method is illustrated by the following examples:
Example 12 : An investment of Rs. 12000 provides the annual
cash inflows of Rs. 2000, Rs. 3000, Rs. 5000 and Rs. 6000 respectively
in 1st, 2nd, 3rd and 4th years. Find Time adjusted rate of return.
Solution: Here there is an uneven cash inflow. So we shall
apply trial and error method to find time adjusted rate of return.
First of all we find average annual cash-inflow
= 2000 + 3000 + 5000 + 6000 = 4000
4
Hence
present value factor = Investment = 12000 =3.0

A verage cash inflow 4000
In Pwfs table, we find that in the row of fourth year, the value
3.0 lie in the column of 12%. Hence at first iteration the time adjusted
rate of return is found to be 12%. Now at this rate of return, we can
calculate the present value of cash- infllows for different years in
the following tabular form:
Year Cash inflow Pwf at 12% Present Value in Rs.
1 2000 0.8929 1785.80
2 3000 0.7972 2391.60
3 5000 0.7118 3559.00
4 6000 0.6355 3813.00
Total 11549.40
It can be seen that with rate of return to be 12% the total amount
recovered in 4 years is Rs. 1 1549.40, which is less than the total
investment of Rs. 12000. So the time adjusted rate of return should
be somewhere between 12% and 13%.
The following are the drawbacks of rate of return method:
(i) It fails to give full effect to the time value of money, especially
in cases where investments are made at different periods of time or
when income from investments is not likely to accrue at a uniform
rate.
(ii) The method does not recognize the true return on capital
investments.
In both these techniques no account is taken of the time at which
the earnings are made.
Example 13 : Bajaj Auto Parts Ltd. is screening projects for capital
expenditure. They have only Rs. 1,00,000 for investment. The
following proposals have been submitted:
Project Investment Cash Flow EconomiC life
Rs. Rs. years
A 31,300 6,000 10
B 97,400 20,000 20
C 98,075 25,000 10
D 27,200 4,000 15
If cost of capital is 20%, please recommend projects according
to:
(a) Pay-back period method
(b) Rate of return meth'Od
(c) Present value index method. Solution:
(a) Pay-back Period method:
Amount investment
Pay back period = Annual Cash inflow
The pay-back period for each project can be calculated in the

following tabular form:
30 Methods for Comparing Investment Altemativeb
Project Amount invested Annual cash inflow Pay-back period
3(300
A 31,300 6000 --=52 years
6000 .
97400
B 97,400 20,000 ~ = 4.87 years
98075
C 98,075 25,000 25:000 = 3.92 years
27,200
0 27,200 4000 - - = 6.80 years
4000
The pay-back penod for project C 1S least. Hence 1t 1S
recommended.
(b) Rate o/Return Method: Assuming Depreciation to be linear
and the zero scrap value for each project, the depreciation and
average investment values for each project can be calculated in the
following tabular form :
Amount Average
Project invested Average investment Depreciation
I 1/2=AI D=II economic life
A 31,300 15650 3130
B 97,400 48700 4870
C 98,075 49037.50 9807.50
0 27,200 13600 1813.34
Now using formula,
Annual Cashi in flow - Depreciation 100

R = Ra teof retum= x
Average investment
6000-3130
Thus for Project A : R = x 100 = 18%
15650
20,000 - 4870
Project B : R = x 100 = 31%
48700
Pr' C = 25,000-9807.50 xl00=31%

oJect . R 49037.50
4000 -1813.34
Project D : R = x 100 = 16%
13600
The rate of return is same for Project Band C being 31 %. Any of

these can be recommended.
(c) Present value index method:
From formula,

Present va1ue In d ex = al
Initi investment
Here salvage value is assumed to be zero. The present value of
future income
=Cash inflow (Pwfs -t%-r)
6000 (Pwfs-20%-10)
P.V.1. for Project A = 31300
= 6000 x 4.1925 = 0.80

31300
20000 (Pwfs - 20% - 20)
P.V.1. for Project B = --~-~--~
97400
= 20000 x 4.8696 =0.99

97400
P V I f p . C 25000 (Pwfs-20%-10)
. . . or rOJect = 98075
= 25000 x 4.1925 = 1.07

98075
4000 (Pwfs - 20% -15)
P.V. I. for Project D = 27200
= 4000 x 4.6755 =0.69

27200
The present value index of future income is maximum for project
C . Hence it should be recommended.
***
Chapter
3
**
REPLACEMENT ANALYSIS
The problem of replacement is an everyday phenomena. It is

experienced in systems where machines, individuals or capital
assets are the main job performing units. It is a common phenomena
that performance / efficiency of a fixed asset in a system deteriorates
with time. The remedy is either to replace the fixed asset with some
new fixed asset or to restore the level of performance by some sort of
maintenance. Also, there comes a stage where maintenance of any
fixed asset becomes so much expensive that it is more profitable to
replace the fixed asset. Thus there is a necessity to formulate a most
economic replacement policy which is in the best interest of the
system.
The major reasons for replacement are:
(i) Deterioration: Decline in performance due to wear and
tear indicated by increase in maintenance costs; reduction in product
quality and rate of production, increase in labour costs, loss of
operating time etc.
(ii) Obsolescence: It may be due to advancement in technology.
This reduces profits, impairs competition, causes loss in the value
of machinery.
(iii) Inadequacy: Equipment's capacity may not be sufficient to
meet the demand or it is not able to increase the production rate to
desired level.
Replacement Analysis 33
(iv) Working conditions: Causing unsafety to workers and

leading to accidents, making the environment noisy and smoky etc.
(v) Economy: The existing units have outlived their effective
life and it is not economical to continue with them.
(vi) The existing units breakdown, perished or destroyed all of
a sudden.
Some special characteristics of replacement are:
(i) replacement reduces maintenance costs but it involves a
high average capital cost.
(ii) many people feel that an equipment should not be replaced
until it is physically worn out. But this attitude is never in
the interest of the organisation. On the contrary the
equipment's must be constantly reviewed and updated,
otherwise these may become obsolete.
Replacement Models and Their Solutions:
The study of replacement is some kind of application mostly
concerning comparison of alternative replacement policies. The
various factors relevant to replacement analysis can be divided
into two main categories; namely,
(i) Technical: Deterioration, Obsolescence, Inadequacy.
(ii) Financial: Initial cost; operating costs; labour costs, material
costs; maintenance costs, salvage value, insurance etc.
A well designed replacement policy should compare
thoroughly an existing equipment with its possible replacement. In
order to make a sound economic comparison strategy all the factors
should be converted into costs.
The different types of replacement problems can be broadly
classified in following situations:
(i) Replacement of Items Whose Efficiency Deteriorates with Time:
The simplest replacement model in such cases is one where the
deterioration rate is predictable in terms of increasing maintenance
costs and decrease in salvage value with time. The expenditure on
replacement items is considered here as cost of replenishment in
inventory analysis and maintenance costs are like holding costs.
There are two methods to find appropriate solution in this case viz.
34 Replacement Analysis
(i) delermination of cost per unit of time and (ii) present value concept
representing time value of money.
(ii)Replacement ofitems that fail completely and are expensive to be
replaced: In such situation the items are assumed to have relatively
constant level of efficiency until they completely fail. Here
replacement strategy is formulated in anticipation of failures due to
which probability of failures are considered in analysis. A policy is
formulated to balance the wasted life of items replaced before failure
against the costs incurred when items completely fail.
(iii) Staff replacement problem.
Replacement of Items Which Deteriorate with Time: In this
situation the efficiency is measured as the discounted value of all
future costs associated with each alternative e.g. the maintenance
cost of a machine always increases with time and at some stage
maintenance cost becomes so large that it is more economical to
replace the machine by a new one. The criteria evolved in such
cases can be broadly divided in three categories namely,
(i) Replacement of items whose maintenance cost increases
with time, and (a) the value of money remains same during
the period (b) the value of money changes with time.
(ii) Criteria of present value for comparing replacement
alternatives.
Case (i) Replacement of fixed asset whose maintenance costs
increases with time.
A. The value of money remaining same during the period.
Here we use the following notations :
C Purchase price of the item.
S Scrap value of item taken to be same over time.
g (t) : Maintenance / running cost at time '1'.
Now g (t) can be discrete or continuous ftmction of time. In the
case of g (t) to be discrete we can use the summation sign to calculate
the total maintenance cost in a given perioa otherwise integrals can
be used e.g. in some given period 'n' the total maintenance cost will
be
n
M(n) = L g(t), when t is discrete
t=O
and Jong(t) dt, when t is continuous.
Thus the total cost incurred on the item in some period n is

given by
Total cost =cost of the item + total maintenance cost in period 'n'
- scrap value = C + M(n) - 5
Thus the average cost incurred per year on the item is given by
C+M(n)-S
G(n) = ----'-~
n
Now it is advisable to replace the item when G (n) is maximum.
Without going into the mathematical treatment it can be seen that G
(n) will be minimum when
9(n) < G(n-1)
and G(n) < g(n+1)
So we get the following replacement criteria in this case. Do not
replace the item if the next year maintenance cost is less than the
average cost of the previous year and replace the item if next years
average cost is less than the maintenance cost of next year i.e. when
Average Cost is least.
The method is explained by the follOWing examples:
Example 1 : The cost of a machine is Rs. 6100 and its scrap
value is Rs. 100. The maintenance costs are found to be :
Year 1 2 3 4 5 6 7 8
Maintenance
Cost in Rs. 100 250 400 600 900 1200 1600 2000
When should the machine be replaced?

Solution: Here C = 6100, 5 = 100 and the maintenance costs are
given at discrete values of time~ The total average costs in different
years can be calculated in the following tabular form:
Cumulative value of (2)

C+M(n)-S
Year g(n) M(n) C + M(n)-S G(n) = n
(n) i.e. col. (4)/col(1)
(1 ) (2) (3) (4) (5)
1 100 100 6100 6100
2 250 350 6350 3175
3 400 750 6750 2250
4 600 1350 7350 1837.50
5 900 2250 8250 1650.00
6 1200 3450 9450 1575.00'
7 1600 5050 11050 1578.57
8 2000 7050 13050 1631.25
"Average cost is minimum. Hence the machine should be replaced at the
end of the sixth year.
Example Z: A manufacturer finds from his past records that the
costs per year associated with a machine with purchase price of
Rs. 5000 are as given below:
Year(n) 2 3 4 5 6 7 8
Running
cost g(n) 1500 1600 1800 2100 2500 2900 3400 4000
Scrap S(n) 3500 2500 1700 1200 1000 500 500 500
Determine the optimal replacement policy:
Solution: Here C =5000 and 5 (n) =scrap value is decreasing
with time. So the value of C - 5 will change with time in this case.
The calculations can be done in the following tabular form.
Year S(n) C-S(n) g(n) Cumula- Col(3)+(5) G (n)
(n) tive C+M(n) col(6)/(1)
g(n) = - S(n)
M(n)
(1 ) (2) (3) (4) (5) (6) (7)
1 3500 1500 1500 1500 3000 3000
. 2
3
2500
1700
2500
3300
1600
1800
3100
4900
5600
8200
2800
2733
4 1200 3800 2100 7000 10800 2700
5 1000 4000 2500 8500 13500 2700

6 500 4500 2900 12400 16900 2816
7 500 4500 3400 15800 20300 2900
8 500 4500 4000 19800 24300 3037
'minimum
The average cost G (n) is minimum in 5th year. Hence 5 years is
the optimal replacement interval.
Example 3 : A truck owner has three trucks, two of which are
two years old and the third is one year old. The cost price, operating
costs and resale value of these trucks are same as given below: Year
Running 1 2 3 4 5 6 7 8
cost 1000 1200 1400 1800 2300 2800 3400 3400
Resale 3000 1500 750 375 200 200 200 200
Value
The cost price is Rs. 6000/-.

He is considering a new type of truck with 50% more capacity
than one of the old ones at an unit price of Rs. 8000/- . He estimates
that the running costs and resale price for the new truck will be:
Year 2 3 4 5 6 7 8
Running
costs 1200 1500 1800 2400 3100 4000 5000 6100
Resale
price 4000 2000 1000 500 300 300 300 300
Assuming that the loss of flexibility due to fewer trucks is of no
significance, and that he will continue to have sufficient work for
three of the old trucks, what should his policy be?
Solution: First of all we have to calculate average total cost
for each of the two types of trucks.
On the basis of the calculations as illustrated in Example 23 the
average total cost for each of the category will be
Years Average Cost New Type
(n) for Type I
4000 5200 The following observations
2 3350 4350 are made from these
3 2950 3833 calculations. (i) The minimum
4 2756 3600 average total cost for both

5 2700 3540 type of trucks corresponds to
6 2717 3616 5th year. Thus the
7 2814 3814 replacement policy should
8 2962 4100 be after every five years for each
one of them.
Now for 3 old trucks 2 new trucks will be required, since the
capacity of new truck is 50% more than the capacity of old truck.
The minimum Average cost/year for 3 old type trucks will be
Rs.3 x 2700 = Rs. 8100
and that for two new type trucks will be
Rs. 2 x 3540 = Rs. 7080
Hence it is desirable to replace 3 old trucks by two new type
trucks as the minimum average cost with a fleet of two new trucks
comes out to be less.
Now the decision of when to replace can be made by preparing
the following table:
Total Annual Cost of Old Trucks
Year Average Average total Average Total average
Annual cost of 2 year cost of cost of 3
Total cost old trucks one year old trucks
old truck
1 4000 2 x 2150 =4300 2700 7000
2 2700 2 x 2175 =4350 2150 6500
3 2150 2 x 2475 =4950 2175 7125
4 2175 2 x 2800 =5600 2475 8705
5 2475 2 x 3400 =6800 2800 9600
6 2800 2 x 4000 =8000 3400 11400
7 3400
8 4000
The annual average cost for two large trucks is Rs. 7080. We
can see that total costs for smaller trucks will not exceed than for
the large trucks until the third year from now. Thus all three small
trucks should be replaced by larger ones after two years from now.
B. The value of money changes with time.
There can be two situations in this case,
(a) the value of money decrease at a constant rate 'd'. 'd' is
known as depreciation ratio or discounted factor. Here we want to
find the optimum value of time at which the item should be replaced.
If d is the per unit depreciation rate, t.hen the present value of
one unit of money after a period oft years is given by 1/(1 +dt
(b) the manufacturer takes a loan at some given interest and
agrees to pay in a prescribed number of fixed installments. Then we
want to find appropriate period of making the repayment of loan.
Case (a) Let the maintenance costs in X years be C 1,C 2 ... , C x
respectively, A, the purchase price of the item and' d' be the per unit
depreciation value. Then the present value of the total expenditure
with a X-yearly replacement policy is given by
G(X) = (A + ~Cjdi-l)/ (l-d X

)
Then the following criterion can be used for optimum

replacement policy: (i) Do not replace if the operating cost of next
period is less than the weighted average of the previous costs. Where
weights are 1, d, d 2, .......... respectively.
(ii) Replace if the operating cost of next period is greater than
the weighted average of the previous costs.
Example 4 : N.K. Ltd. pays Rs. 10,000 for its automobiles. Their
operating and maintenance costs are about Rs. 2500 per year for the
first two years and then g~ up by approximately Rs. 1500 per year.
When such cars be replaced?
The discount rate is 10% per year.
Solution: Here discount rate i =0.1 and the depreciation ratio
d =_1_=0.9091
1 +0.1
= A = 10,000.
The value of G (X) can be calculated in the tabular form page
226.
Now Cs > G (4) and C4 < G(3)

Hence the optimum length of time to hold the machine before
replacing it is 4 years.
Replacement of Items that Fail Completely and are Expensive
to be Replaced.
It is a common characteristic that the probability of failure of
any item in a system increases with time. The system may be such
that the whole system may breakdown if any item fails. This
breakdown implies loss in production, idle inventory, labour and
other units of the system. The nature of item which needs replacement
may be such that immediate replacement is not available. Thus
there is a necessity of formulating some appropriate replacement
policy in such cases. There are two main strategies:
(i) Individual Replacement Policy: Whenever any item fails, it
should be replaced immediately.
(ii) Group Replacement Policy: All items are replaced after a
certain period p inspite of these being in working order with a
provision that if any item fails before this time p it can be replaced
immediately. This approach decreases the probability of breakdown
in the system.
Such policy requires following two fold considerations, namely,
(1) the rate of individual replacement during the period.
(ll) the total cost incurred on individual and group
replacements during the chosen period.
The period for which the total cost is minimum is taken to be
optimal.
The following information is required in this procedure:
(A) probability of failure at different periods of time.
(B) loss incurred due to these failures.
(C) cost of individual replacements.
(0) cost of group replacements.
The following criteria should be used:
Group replacement should be made at the end of tth period if
the cost of individual replacement for tth period is greater than
average cost per period by the end of period t and one should not
adopt a group replacement policy if the cost of individual
replacement at the end of (t-1)th period is not less than the average
cos t per period through time (t-1).
Example 5 : A Computer contains 10,000 resistors. When any
resistor fails, it is replaced. The cost of replacing a resistor
individually is Rs. 1/- only. If all the resistors are replaced at the
same time, the cost per resistor would be reduced to 15 paise. The
percent surviving say S (t) at the end of month and P(t) the probability
of failure during the month tare
t 0123456
S(t) 100 97 90 70 30 15 0
P{t) 0.03 0.07 0.20 0.40 0.15 0.15
What is the optimum replacement plan?
Solution: The whole problem can be divided into two parts.
1. There is a policy of individual replacement.
2. There is a policy of group replacement.
It should be noted that no resistor survives for more than 6
months. Thus a resistor which has survived for 5 months is sure to
fail during sixth month. We assume that the resistors failing during
a month are replaced just at the end of the month.
Let Ni denote the number of resistors replaced at the end of ith
month.
The different values of Ni can be calculated in the following
way:
No = Number of resistors in the beginning = 10,000.
N} = Number of resistors being repliiced by the end of 1st
month.
= Number of resistors during the 1st month X probability
that a resistor fails during 1st month of its installation.
= 10,000 x 0.03
300.
N2 Number of resistors replaced by the end of second

month.
= (Number of resistors in beginning X probability that
these fail in 2nd month) + (Number of resistors replaced
in first month X Probability that these will fail during
second month)
N OP2 +N IP I
= 10,000 x 0.07 + 300 x 0.03
= 709
N3 N OP3 + NIP I + N 2P I
= 10,000 x 0.20 + 300 x 0.07 + 709 x 0.03
= 2042
N4 - NoPs + N IP3 + N 2P2 + N 4P I
= 10,000 x 0.40 + 300 x 0.20 + 709 x 0.07 + 2042 x 0.03
= 4171
Ns NoPs + N IP4 + N 2P3 + N 3P2+N4P I
10,000 x 0.15 + 300 x 0.40 + 709 x 0.20 + 2042 x 0.07
+ 4171x 0.03
= 2030
N6 = NoP6 + NIPS + N 2P4 + N 3P3 + N 4P 2 + NSP I
= 10,000 x 0.15 + 300 x 0.15 + 709 x 0.40 + 2042 x 0.20
+ 4171 x 0.07 + 2030 x 0.03
= 2590
It can be seen from above calculations that Nj increases up to
fourth month and then qecreases. It can also be seen that Nj will
later tend to increase and the value of Nj will oscillate till the system
acquires a steady state.
The expected life of each resistor is
= ~~Pi' where "t is the month and Pi is the corresponding
probability of failure.
= 1 x 0.03 + 2 x 0.07 + 3 x 0.20 + 4 x 0.40 + 5 x 0.15
+ 6 x 0.15
= 4.02 months
Average number of replacements every month
N 10000
(mean age) 4.02
=2487.5 -~488-resistors.
Hence average cost of monthly individual replacement- policy
=Rs. 2488/-(the cost being Rs. II - per resistor).
Now let us consider the policy of group replacement.
End of Total cost of group replacement Cost/month
month in Rs. in Rs.
300 x 1 + 10,000 x 0.35 3800.00
= 3800
2 (300 + 709) x 1 + 10,000 x 0.35 = 4509 2254.50
3 (300 + 709 + 2042) x 1 + 10,000 x 0.35 = 6551 2183.66
4 (300 + 709 + 2042 + 4171) x 1 + 10,000 x 0.35
=10722 2680.50
5 (300 + 709 + 2042 + 4171 + 2030) x 1 + 10,000
x 0.35 = 12752 2550.40
6 15442 2557.00
Hence the minimum cost per month is obtained by group

replacement of all resistors after three months with an average cost
of Rs. 2183.66 per month.
***
Chapter
4
**
FARM MANAGEMENT
With the advent of green revolution in India, there has been

shift from the traditional system of subsistence type of farming to
the new market oriented commercial type of agriculture. The change
is being brought about by the employment of scientific and
technological advances. Some of the seed are seed of high yielding
varieties, fertilizers, plant protection chemicals, new implements
and equipment's, improved cropping system, improved water
management and use etc. The changes in input use entail the
expenditure of larger sums of money to purchase the inputs and
consequently have increased the demands for additional funds and
sources of credit to finance the agricultural operations. Farming is
changing from a way of life to a business-oriented agriculture.
With this change, farmers are favoured with new opportunities
and possibilities but are faced with more complex problems of farm
organization and operation and are in need of greater management
skills to cope with the changes.
Farmers need information on various physical and biological
relationship involved in crops and livestock production and also
need information on price trends, credit availability and government
programmes and policies.
Farm Management 45
Farm Management Deals with Managerial Input:
With the increasing need of managerial input for modern
agriculture, 'Farm management' as a subject has gained immense
importance among the subjects related to agricultural production.
Although the farm is an economic and social institution
developed over many centuries, the scientific management of farm
as a business is relatively new. Because of its recent origin, the term
farm-management is understood in various ways by different
people. There are many definitions of farm management but to
understand as to what this term actually means there can be
expression as blow:
"Farm management is the science which deals with rational
decisions on the use of scarce farm resources, having alternative
uses to obtain the maximum profit and family satisfaction on a
continuous basis from the farm as a whole and under sound farming
programmes."
Farm management science as compared with other fields of
agricultural science has many important features. This is a practical
and integrating science which is profitability oriented and has
macro:approach considering farm unit as a whole. Farm-
management is the field of agriculture science which is primarily
and basically related to human being and its concern with crops
and livestock is only secondary.
For successful farm management there is need on the part of
farmEr to possess ability and capacity to make correct decisions.
Nielson has elaborated the decision making process by proposing
following eight functions.
1. Formulation of goals or objective of the farm;
2. Recognition and definition of a problem or opportunity;
3. Obtaining information-observation of relevant facts;
4. Specification and analysis of alternatives;
5. Decision making-choosing an alternative;
6. Taking action;
46 Farm Management
7. Bearing responsibility for the decision or action taken.

8. Evaluating the outcome.
Farm Planning an Effective Tool to Help Farmer make Better
Production Decision:
At the micro-level efforts have been directed primarily to
extending new inputs, such as fertilizer, irrigation, improved seeds
and new techniques of production viz, improved methods of sowing,
manuring, fertilizing and irrigation to the farmer. Very little has
been done to improve the managerial ability of the farmer. In other
words, there has been greater emphasis on providing farm people
with new information and inputs rather than m helping them apply
these to their own situations. Farm planning aims at providing
such help to the farmer.
Farm Planning as Related to Credit :
In under-developed conditions "farm planning" is considered
to provide a method by which the farmer with limited available
assets can be made credit worthy and thus be able to obtain the
needed production supplied and other capital needs In other words,
the farm plan provides the farmer with the technical possibility of
achieving additional yield and eventually guarantees additional
incomes. This additional income forms a source of credit which
enables the farmer to borrow funds from institutions to buy mater
also needed for production increase. In this case, the plan is regarded
as planned repaying capacity for loans.
Concept of Farm Planning:
In farm planning the fundamental concept is to look at the farm
as a single operating unit. The kit of the farm planner should include
the micro-economic principle, technical knowledge pertaining to
different aspects of agricultural science, and information relating
to the farm and farmer. The job of a farm planner is to use these
information's to help the farmer to ~ake changes in the:
(i) Crop and livestock enterprises on the farm-selection of a
product-mix,
(ii) inputs used on the farm-selection on an input complex,
Farm Management 47
(iii) techniques of production-choice as to how to produce and
(iv) marketing procedures choice as to when, where and how
to market farm products and purchase farm inputs.
Several economic models, presented in the following table, are
available to a farm planner for generating answers to these questions,
either separately or simultaneously;
Economic Models for Farm Planning
Models based on perfect knowledge Models based on imperfect knowledge
and certainty i.e. Models for risk and un-certainty.
1. Production function models: 1. Modified programming models.
(a) without any resource restriction 2. Diversification models.
(b) with resource restriction 3. Probabilistic models.
2. Budgeting models: 4. Game Theoretic models
(a) Conventional budgeting models
(i) Partial budgeting model
(ii) Whole farm budgeting model
(b) Linear programming model
Here we shall concern ourselves only with conventional
budgeting models.
Farm budgeting is a method of analyzing plans for the use of
agricultural resources at the command of the decision-maker. The
portion of the farm business analyzed may range from a particular
organisation to the total farm business. The farmer is generally called
"Partial budgeting" and latter "Complete budgeting".
The technique begins with assessing the present organization
of the farm and proceeds to working out alternative farm plans. The
final phase of budgeting is normally the computation of an estimated
return of a nature relevant to the problem considered.
Following five steps are generally followed in conventional
budgeting procedures;
(i) existing farm resources are inventoried
(ii) the systems to be budgete,d are selected
(iii) the technical coefficients of production are specified
48 Farm Management
(iv) prices for inputs and products are specified and

(v) costs and returns are calculated.
Farm Planning and Budgeting

Let us assume that a farmer in Jaipur District owns a one hectare
of unirrigated land, one pair of bullock, and one Buffalo. The farmers
family consists of 6 members with 3 adult members, mainly engaged
in farming.
(A) Resource Restrictions (constraints) 2009-2010
Resource Season/Period Quantity
(i) Land Kharif 0.8 hectare
(ii) Land Rabi 0.2 hectare
(iii) Human labour 3 adults male
(iv) Cash to meet crop expenses. Rs. 200 00
The cropping pattern followed during 2009-2010 is given in
table-1 During the Kharif Maize for is grow his family consumption.
Table No. 1
Crop/Season Area in hectares
Kharif Maize + Urd 0.6
Groundnut 0.2
Fallow 0.2
Rabi Gram 0.2
The farmer has all the necessary farm implements, however he
hires human labour whenever necessary at the peak season period.
The soil of the farm is loam without the irrigation facilities,
Table 2
Cost and Return from Cropping Pattern
Crop/Season Area in Yield of Yield of Gross Total Net
hectares main by product returns cost returns
product
Kharif
Maize + Urd 0.6 4.2 Q.M. 12.00 624.00 425.00 574.00
1.5 Q.U. 1.00 385.00
Farm Management 49
1009.00
Groundnut 0.2 1.6 1.5 335.00 256.00 79.00
Aabi
Fallow 0.2 -
.- - - -
Gram 0.2 1.5 1.5 285.00 119.00 166.00

1.00 1629.00 800.00 819.00
In the month of May, 81 the farmer constructed a pacca well on

his farm which can command only 0.9 hectares of land. The water
quality is good and adequate water is in the well. The farmer has
also purchased necessary equipment's for irrigation purpose.
Selection of Activities:
Keeping in mind the resource constraints given in table-I, the
land acreage is to be allocated on the basis of maximum net returns,
per unit area from different crops.
Physical Norms for Important Crop of the Region
Table-3
Items Crop Varieties
Maize Maize Groundnut Groundnllt Wheat Gram
Local Hybrid Local Improved Hybrid Hybrid
1. Fertilizer if' (Kg)
N 28 60 - 20 80 20
P - 40 - 60 40 40
K - - - - - -
2 Plant protection in (Rs. - 100.00 - 12000 100.00 130.00
3 Seed in (Kg) 30 20 100 100 100 75
4. Human labour in
man days 70 110 50 90 120 64
5. Bullock pair days 19 30 11 12 30 16
6 Yield of main products
in aIls 7.00 30.00 800 1500 3500 1500
Price of Inputs and Output

Price of inputs (As.) Output prices (As.)
N@As. 3/- Kg. Wheat@As. 125/- quintal
P@As. 2/- Kg. Gram@As. 170/- quintal
50 Farm Management
Seed: Maize@Rs. 120/- quintal
Maize local @1.5/Kg. Urd@Rs. 250/- quintal
Maize Hybrid @4.00/Kg. Groundnut@Rs. 200/- quintal
Groundnut local @2/- Kg.
Groundnut improved @4/ Kg.
Urd local @3 5/Kg.
Enterprize Budget
Table 4
(in Rupees)
item of Maize Maize Groundnut Groundnut Kharif Wheat Grar.1
expenditure Local Hybrid Local Improved pulses HYV Improved
(Urd)
With one Improved practice
Fertilizer
N 84 100 60.00 60.00 240.00 60.00
P III 120.00 0000 00.00 00.00
Planet Protection 100 120.00 10000 130.00
Seed 45 III 200 400.00 70.00 250.00 150.00
Human labour 350 550 250 450.00 165.00 600.00 320.00
Bullock 228 360 132 144.00 120.00 36000 192.00
Total 707 1350 5lI2 1294.00 49500 1630.00 93200
Interest on working . 3535 6750 29.10 74.50 24.75 81.50 4660

caprtal @ 10% for 6 months
Total cash expenditure 742.35 1417.50 611.10 136850 519.75 171150 978.60
Yield of main products 840.00 3600.00 1600.00 300000 2000.00 437500 2550.00
Yield of by products 28000 1200.00 00.00 520.00 150.00
Gross return 1120.00 480000 1600.00 3000.00 200000 4895.00 2700.00
Net returns 377.65 238300 98900 2632.00 1570.00 3184.00 1722.00
Plan for 0.9 hectare of Irrigated Farm 2010-2011

In his alternative plan for the year 2010-2011, the farmer would
like to grow 6.00 quintals of maize and quintals gram 1.5 for his
family consumption in kharif and rabi seasons respectively. These
activities are called predetermined activities, which the farmers plan
to undertake irrespective of their profitability.
Farm Management 51
TableS
Resource Kharif land Rabi land
(hectares) hectares
A. Total available 1.00 0.9
(i) Kharif crop Maize hybrid. 0.2
Grouudnut 0.8
B. Rabi Gram 0.1
Wheat H. Y. V. 0.8
Table-6
Cost and Returns from Cropping Pattern.
Area Yield of Yield of Gross Total Net returns
main product by product returns. cost.
qtls
Kharif
Maize 0.2 6.00 18.00 900.00 283.50 616.50
Groundnut 0.8 12.00 12.00 2520.00 109480 1425.20
Rabi
Gram 0.1 1.5 1.5 285.00 97.86 187.14
Wheat 0.8 28.00 42 3920.00 1369.20 2550.80
1.9 7625.00 2845.36 4779.64
Comparison o/Suggested Plan with the Existing Plan
Table No.7 indicates that the cost and returns from the existing
plan will be increased by implementing the suggested plan. The
total net returns of Rs. 819.00 in the existing plan increase to Rs.
4779.64 in the alternative plan, which is an increase of about 57.6
percent. This increase in net return is due to the conversion of
unirrigated area into irrigated area and the adoption of improved
technology of the selected enterprises.
52 Farm Management
Table No. 7
Existing plan Suggested plan
Area in Net Area in Net
hectare return hectare return
1. Kharif Maize + 0.6 574.00 Maize Hybrid 0.2 616.50
Urd Local
Groundnut 0.2 79.00 Groundnut 0.8 1425.20
Local Improved.
2. Rabi Gram 0.2 166.00 Gram 0.1 187.14
Improved.
Wheat 0.8 225080
H.Y.V.
1.00 819.00 1.90 4779.64
Improved Designs of Bullock Cart For Farm Use
In recent years bullock cart has become main nude of transport

for goods as well as people. Even in the villages where there are no
all whether roads, the bullock cart transport patiently, the moving
goods from village to nearest towns. The bullock cart is very
important mode of transportation in our Indian economy. This is
because of two important reasons. First, the system continues to be
the most dependable and cheapest mode of transport in a majority
of villages. This would remain so since a cheaper substitute to the
bullock cart has yet to be devised. Secondly, in the present situation
of increase in fuel prices, truck and railway are not economical for
carrying all the goods produced in villages.
Inspite of the importance of bullock cart, proper attention has
not been given for improving the design of these carts to achieve
better efficiency and overall rural development. It is the time we
give, the farmers a good transport vehicle with better payload, less
drudgery to the bullocks, less/ damage to our highways and metal
roads and less road accident. There are 13 million carts haJ.lling
70% of the rural goods traffic. Aggregate investment in the animal
drawn transportation system is estimated at about Rs. 3,000 crores.
This system transports about 10,000 million tonnes of goods every
year.
Farm Management 53
Improved Designs:
With the aforesaid background in mind the two improved
designs for the bullock cart has been developed. One which is
developed by Punjab Agriculture University, Ludhiana. and another
which is developed by Research Center for improved Agricultural
Implements, Mahatma, Phule Krishi Vidhyapeeth, Pune is known
as Jyoti bullock eart. The special features of the improved designs
are given as below:
1. Pneumatic Wheels: Pneumatic wheels have been suggested
in place if wooden wheels. The wheels for this purpose may be
taken from un-serviceable vehicles.
2. Hand Brake: At present there is no provision for stopping
the cart under unfavourable driving conditions. The hand brake
provision suggested for the improved design operates mechanically
and is similar to 'bicycles' brakes. It is located on right hand side
near the sitting place.
3. Lights: Both front and rear lights have been provided in
the design. The lights are simply kerosene oil lamps.
4. Rear Support: The rear support is made adjustable. It can
be folded during unloading operation and thus facilitates in time
and labour saving.
5. Forage Box: A forage box of 0.57 cubic meter capacity (1.5
m x 0.6m xO.6m) made from wood has been provided in the rear
portion of the cart. The farmers may keep forage for their bullocks in
the forage box during long journey.
6. Sitting Place: A cushioned seat made from coconut fibbers
have been provided for comfortable sitting. The seat is adjustable
and it can be adjusted in two positions as shown in the drawings.
7. Personal Belonging Box: This is provided for putting the
blankets, food, tools etc. The size of box is 75 cm x 45 cm and located
in the front portion of the cart just near the sitting place.
The cart can handle grains up to a capacity of 25 quintals by
normal health bullocks. The cost of the cart having all the above
features comes around Rs. 3000- only. It is easily fabricated by a
village artisan.
54 Farm Management
]yoti Bullock Cart (Improved design) :

In this cart taper roller bearings readily available in the market
are used in place of cast iron bush bearings, width of steel rim of the
wooden wheel is increased from 25 and 50 mm to 60 mm. On the
steel rim solid rubber tyre is fitted to minimize damage caused to
roads. Rubber tyres are used out of used tyres of truck. Capacity of
chassis is increased 2.5 times by providing extension of pipe frame
to the traditional wooden chassis of the indigenous cart. Cushions
are provided to the yoke where bullocks are hitched to the cart.
Tipping arrangement is provided for quickly (;:,.nptying the loaded
cart.
Self engaging brakes are provided to the wheels. The brakes are
so designed as to engage when bullocks lean back for controlling
the speed of cart on steep down grades of the road. For this at the
junction of yoke and beam of lever is provided Bullocks try to pull
back the yoke when cart moves on the downgrades of the road. The
cable attached to the other cud of the lever will then try to engage
the brakes.
Hand brake is also provided to operate it in case of emergency.
For using the cart as transport vehicle a platform is provided on the
extended portion of the chassis for sitting the passengers. Excluding
the above provisions to the cart, rest of the portion of the cart is just
like a traditional cart.
Comparison Between Existing Indigenous Bullock Cart and
Jyoti Bullock Cart.
S. Item Different Indigenous bullock Jyoti bullock cart
No. carts found in various areas.
1. Dia of wheel, cm 115,120,124,136,148 133
2 Hubdia, cm 23.5, 28.5, 29, 30 25.5
3. Hub length 28,32,33,40 35.0
4 Iron tyre width, mm 50 60
5. Solid rubber lyre No. Yes from used truck lyres
6 Bearing and its tyre No. Taper roller bearings
7. Brake No. (a) Expanding shoe type
operating automatically due
to rear movemnetof yoke on
the neck of the bullocks.
(b) Emergency hand brake.
F,) rm Management 55
.; Chassis dimensions
(a) Length, cm 200,207,224,226 Lower292 , upper210
(b) Width, cm 32,90,102, 105 Lower98, upper 153
9. Volume,cubicmeter 1.05,1.07,1.08 1.29+1 .31=2.6
10. Load carrying capacity
Kg . 500800 (1) 2 tonnes on highway
(2) 1 ton on farm road .
11 . Cost Rs. RS.2200/ 3000/
56 Farm Management
Improved Design of Bullock Cart

Scale-l ern = 80 ems.
Isometric view of the Bullock Cart
1. Front Support 2. Bullock Neck Holder 3. Sitting Place
4. Hand Brake 5. Front Light 6. Hori Zontal Sport
7. Vertical Support 8. Personal Belonging 9. Pneumatic Tyres
10. Plat Form 11 . Forage Box 12. Rear Light
13. Rear Support
Housing for Cattle
An efficient management will be incomplete without a well

planned and adequate housing for cattle. Houses for animals are
necessary and should be as little as house like as possible, but
should be designed in a way to give protection from rain, drainage
winds, excessive heat, cold and dampness. Properly planned house
reduces tr..e labour charges and increase the profit of the cattle owner.
Selection of Site: While selecting a site for the construction of
cattle-shed, following points should be kept in mind:
1. Select a site at a higher elevation to give slope for the
drainage of rainwater and the cattle yard water. Avoid low
lying areas and proximity to places of bad odour.
2. Care should be taken to avoid fertile soil for cultivation.
Choose an area which have rocks beneath, this will reduce
the cost of foundation work.
3. Efforts should be made to locate the long axis of the building
in north-south direction to derive maximum benefit of the
sun.
4. Building should be easily accessible and should have
sufficient supply of fresh, clean and soft water.
5. Surrounding should not be infested with wild animals and
6. On exposed sites, attention should be given to the use of
existing trees as wind breakers or planting of quick growing
trees if none is present.
Fann Management 57
The most common practice in this country's to tie the cow with
chain or rope on a kachcha floor. The animals move too far in, and
out of the standing space, defecating all around and even trampling
and wasting the feed.
In advanced countries, three systems of stalling dairy cows are
in general use:
1. Cow house System: in this system the cows are housed and
milked in the same building. There are separate stalls and
stanchions for every in divid ual cow.
2. Milking House or the Lounging Barn System : cows are
housed in cow sheds but milked in a special milking parlour. In
lounging barns the animals remain loose and are offered roughage's.
3. The Open Air or Bail System: no housing is provided,
instead the cows live continuously in the fields in movable
enclosures, where they are also milked. In this system the expense
on permanent building is avoided and the fertility of the soil is
maintained. This system is not suitable under Indian conditions as
sufficient fallows or pasture lands are not available throughout the
year.
Cow sheds can be arranged in a single row if the number of
cows are small, say up to 16, or in a double row if the herd is large.
In double row housing, the stable should be so arranged that the
cows face out or face in Preference should be given to face out system
as it provides ample space behind the animal for milking and cleaing
operations, chances of spreading diseases are less, animals get more
fresh air, it is easy to supervise milking operation, and it is easy to
detect diseases or any change in the hind quarters.
Floor: should be of some impervious material which is easy to
clean and is not slippery. Paving with bricks or grooved cement
concrete floor will serve the purpose Surface should be laid with a
gradient of 1" to 1 1,1" from mangers to excreta channel 65 to 70 sq. ft.
of floor space is sufficient for an adult cow.
Walls: should have smooth surface which will not allow
lodgement of dust and moisture. In plains, walls should be about 4- .
5 feet in height and pillars provided to support the roof. The open
space in between the pillars will serve for light and air circulation.
58 Farm Management
Roof: Roof of the barn may be of asbestos sheet or tiles.
Corrugated Iron sheets with aluminum painted top will also serve
the purpose. The height of the roof, at the sides, should be 8 ft. and
15 ft. at the ridge. A good building should provide about 800 cu ft.
air space per eow.
Mangers : Cement concrete continuous mangers are best to
prevent feed wastage. Mangers should have 1'- 4" height in front
and 2W to 3' height in back. Width should be kept between 21h-3'.
Alleys :The central walk should be 5W wide and should show
a slope of 1" from center to the gutters. The feeding alley in face out
system may be 3 feet wide.
Gutter: should be 2' wide with a gradient of I" for every 10'
length.
Doors: Single row cow shed should have 5' wide and 7' high
door. In Case of double row shed the width should not be less than
9 feet.
Stalls: The length may be kept as 5W-6' and width as 2'-214'.
The above mentioned housing system suits little to the village
conditions because of it's cost and labour requirement.
Loose Housing: It is the most suitable, economic and efficient
system of housing under Indian farm conditions, in this system
animals are kept loose except for milking and treatment periods.
The system is preferred over other system because of the following:
(i) Cost of construction is low.
(ii) Structure can be expanded without much charges.
(iii) Animals in heat can be detected easily.
(iv) Animals feel more comfortable.
(v) Provides optimum exercise to animals
(vi) Better management can be practiced,
Farm Management 59
Space Requirement:
Floor space per animal Manager length animal
(Sq. ft.) (inches)
Covered area Open area
Cow 20-30 80-100 20-24
Buffaloes 25-35 80-100 24-30
Young stock 15-20 50-60 15-20
Pregnant cows (Pen) 100-200 180-200 24-30
Bulls (Pen) 120-140 200-250 24-30
Cattleshed for 20 Cows:

A covered shed measuing 40 x IS ft. with an uncovered loafing
area of 40 x 3S ft. would be sufficient to accommodate 20 cows. For
young calves, we need to provide fully covered houses with good
ventilation as they need protection against extremes of weather.
Under this plan, we should have a fully covered space of 10 x 15 ft.
size for the calves having facilities to provide feed and water to the
animals.
The boundary wall of the cattle-shed should be S' in height. In
side, along the 40' length, there would be a 2~ ft. wide feeding
manager. A water trough of the size 8' x2~ x2~ may be constructed
on opposite side in the loafing area. Near the manger, under the
roofed shed 9' wide floor should be paved with bricks. Beyond that,
there should be an open unpaved area (40x3S) surrounded by S'
wall with one gate. A plan for such a house along with the plan for
calves shed and their sections are shown In the fig. 1 & 2. It will be
preferred if the animals face north while eating under the shed, this
will provide the animals protection against-northerly chilly winds
when they are sitting. The roof may be of corrugated cement sheet or
asbestos sheets. Cement concrete roofing or use of slabs (Pati) may
be recommended when first floor is to be used as storage system for
fodder etc.
Calve Shed :
On one side of main cattle shed there shall be fully covered
shed of 10'x IS' to accommodate young calves. This may also serve
as calving pen under adverse climate conditions. Attached to the
covered areas there should be a 20'x 10' open loafing area.
60 Farm Management
In this way, both cattle shed and calves shed will need in alISO'
x 50' area. Person with limited resources can build kachcha
boundary wall with the provision of chhappar shed. There should
be a modest source of clean and fresh water as the daily water
requirement per animal for drinking and washing operations, is
estimated at 300 liters.
Material requirement for the construction of cows shed and
calves shed for calculating the cost, the rates prevailing in the local
market may be taken into account)
Material Quantity
1. M. S. pipe 4" 127 ft.
2. M. S. angle iron 240 kg.
3. A. C. sheets 45
4. " class bricks 4000
5. Cement 60 bags
6. J sand 50 c. ft.
7. Door 4'x6W One
8. Gate 4' wide Two
Labour:
1. Mason 60 rnanunits.
2. Helper 200 rnanunits.
3. Skilledman (mazdoors) 400 rnanunits.
***
Chapter
5
PRE-FABRICATED IRRIGATION
**
CHANNELS
Production in agriculture may be increased either through more

area under crop production or by better use of existing resources of
production. Also, with the limit on area to be brought under
cultivation emphasis rests on efficient utilisation of resources.
Irrigated area in our country is about 24.6% which could be
increased without much investment on new projects, if proper
utilisation of existing surface and sub-surface water is achieved.
Water management, therefore, involves improvements in "project-
water management" and "on-farm water management" aspects.
Let us examine water use status on a typical farmer's field with
22500 liters of water pumped per hour, (average discharge of a 5 hp
pump). About 30% water is lost in unlined channels due to seepage
and around 3% gets lost through evaporation. Of the rest water,
35% is lost because of uneven fields, and poor control practices.
Thus, Only 9562,5 liter of water is beneficially used by the crops.
The situation in various irrigation command areas is equally
dismal. Water utilisation in an irrigation project area is depicted in
table 1. It is obvious that with reduction in seepage losses in main
canals and distributries. On-farm water losses tend to increase due
to extra availability of water and lack of appreciation of judicious
water-use by farmers in such areas.
62 Pre-fabricated Irrigation Channels
Table 1 : Water Utilisation in Command Area of An Irrigation
Project
S. System Losses % Loss Total Utilisat-
No Main Distri- Ditches in the loss ion%
canals butories (field) field% %
1. Whole system 15.0 7.0 22.0 27.0 71.0 29.0
unlined.
2. Only main canals 4.0 8.0 25.0 30.0 67.0 33.0
lined.
3. Main canals & 4.0 2.0 26.0 32.0 64.0 36.0
distributries
lined.
4. Whole system 4.0 2.0 6.0 42.0 54.0 46.0
lined.
5. Whole system lined 4.0 2.0 6.0 6.0 18.0 82.0
+ levelling of
fields/sprinkler
irrigation
Lining of irrigation channels, thus, can play an important role

in bringing more area under drop production with little investment
in our agriculture. Briefly, advantages of lining irrigation channels
are as under:
(a) Seepage losses are reduced. Excessive seepage resulted
saline and alkaline soils in Punjab, Utter Pradesh, Haryana,
Bihar and parts of Rajasthan states.
(b) Repair and maintenance of channel is less and labour
requirements are low.
(c) Aqatic weeds are eliminated resulting in more water for
crops.
(d) Damage by rodents is reduced.
(e) For the same discharge, lined channels occupy less land
area than unlined channels.
Common Lining Materials For Irrigation Channels:
Different lining types of materials are in use ranging from
farmers practice to an efficient cement/ chemical lining. Selection of
the material depends on investment capacity of the farmer,
Pre-fabricated Irrigation Channels 63
availability of the material, useful life and cost of lining. Some of the
materials/practices, are classified below:
1. Clay Linings:
(a) Mixing clay along with irrigation water.
(b) Underlying 2.5 em thin clay layer at 15 em depth and sides
in earthen channel and compacting the ditch,
(c) Soil cement linings in different ratios.
2. Hard Surface Linings:

(a) Stone masonry lining (joined with lime/ cement mortar)
(b) Brick mrsonry lining (joined with lime/ cement mortar)
(c) Baked clay tiles (joined with lime/ cement mortar)
(d) Cement concrete linings:
(i) In-place casting
(ii) Pre-fabricated channels
(iii) Semi circular pipes
(iv) Shoterete lining
(v) Coal tar (bitumin) lining
3. Linings from Chemical Materials:
(a) Polyethylene (Black) sheets.
,
(b) Alkathene sheets. Cement concrete linings:
Cement concrete linings are becoming popular because of their
longer life and ease of preparation. However, recent scarcity of
cement has given a jolt to speeding use of concrete channels. In
place casting of concrete channels is economical in areas served by
tube well irrigation or state owned canals (for trows higher than
0'028 cum/ sec.) However, pre-fabricated channels have popularity
amongst farmers as they cost less and can be prepared by themselves.
Table 2 illustrates specifications of various sections in use, with
preference for 6 and 10.3 lit/ see sections depending upon the water
resources. Bigger section:s being bulky pose problems of damage in
transportation.
Table-2 Specifications of Common Channel Sections
S Available SpecWicallons. ems. CosV Cost of
No. water Width height thickness meter. Rs. I1e
discharge To bottom out n Out Bott- Rs. Insta- mould
htres/sec plnside inside side sIde side om Prep. lIatlon As.
1. 6 0 (5 hp pump) 150 12.5 20.0 15.0 175 2.5 2.5 4.90 3.65 Il!O.O
2. 10.3 (5-7hppump) 25.0 22.5 :nO 15.0 17.5 2.5 2.5 528 4.02 140.0
3. 29 2 (canaJltube
well area) 32.0 26.0 38.0 23.0 28.0 3.0 5.0 1170 8.70 100.0
4. 43.6 (canal area) 35.0 31.0 43.0 27.0 33.0 4.0 6.0 13.l!O 10.56 175.0
Preparation of Per Fabricated Concrete Channels:

(a) Cement, sand (free from clay) and small aggregates (1 cm
long) in 1:2; 3 ratio are thoroughly mixed.
(b) Inner sides of outer mould and outsides and bottom of inner
mould Ere brushed with old and used engine oil for easy
removal of the mould upon setting of cement. This practice
is repeated after preparation of 6-8 pieces.
(c) With minimum (workable) amount of water usually 25 liter
in one cement bag) the concrete mixture is prepared.
(d) The outer mould (two sides joined with links, fig 1) is set on
a flat ground, in the shade, and the bottom of the channel is
prepared by pouring the concrete_ Uniform spread (2.5 cm
thick) should be achieved_
(e) Now, inner mould is set in and sides of the channels are
easted by pouring concrete in equal amounts on both sides
(to avoid sliding of the mould) in 2-3 operations. Uniformity
is achieved by constant taming of concrete mix with iron
bar. Extra concrete is taken off.
(f) After 45-50 minutes and slight taping of the outer mould
with a mallet, inner mould is taken out, carefully.
(g) Hinges of the outer mould are lessened and outer mould is
separated, leaving the shaped concrete channel as shown
in fig. l.
Curing and Installation of Pro-Fabricated Channels:
The channels, so casted, are dried in the shade for 2-3 days and i
water sprinkled over for curing. After this time the sections may be!
kept in water stilling basin of the farmer for 10-15 days for final
curing.
The channels are installed on a well compacted earthen bund.
Sections are laid side by side and a space of 1 cm is left for joints.
The bund may be given approximate slope (0. 2-0. 5%). The joints
are made of cement mortar (1:2 mixture). Curing of the joints is done
by blocking the channel with earth on both sides and water allowed
to stand for 3 days. A thin slurry of cement water is brushed on
inner sides and bottom of the channel for smoothness of the section.
Various water distribution structures should be incorporated in
the installation.
Economic Analysis and Feasibility:
The cost of pre-fabricated channels will differ from place to
olace depending upon the labour rates and-availability of materials.
However, estimates at Udaipur with one labour casting 16 meters/
dayoflO.3liters/sec section is given in table 3. Various components
in cost estimates are (i) labour in preparation and installation of
channels (ii) materials in preparation and installation. Preparation
cost per meter is Rs. 5.28 and installation of the same on a bund
with soil support on both sides, at 0.2% slope comes to Rs. 4.02.
However, if the labour component provided by the farmer is not
considered and sand and aggregates are brought from the nearby
river /nalahbed, the cost of preparation is reduced to Rs. 3.46 per
meter.
Table 3 : Cost estimates for 40 meter prefab channels (10.3 lit/sec.)
Particulars No./Qty. Rate/Unit Amount
Rs. Rs.
(a) Preparation of cement
concrete channels.
(i) Cement bags 5 Nos 27.70 138.50
(ii) Sand 0.4 cum 35.00/cum 14.00
(iii) Aggregates 0.54 cum 48.60/cum 26.25
(iv) Labour 2.5 man days 7.00/day 17.50
(v) Oil - - 5.00
(vi) Rent for moulds 4 moulds 10.00
Subtotal 211.25
(b) Installation of channels:
(i) Cement bag 1 No. 27.70 27.70
(ii) Sand 0.2 cum 35.00/cum 7.00
(iii) Labour 18 mandays 7.00/day 126.00
Sub Total 160.70
(c) (i) Cost /meter (a) 5.28

(ii) CosVmeter (b) 402
(iii) Total cosVmeter 9.30
Cement concrete channels of specifications as given in table 1

can be used in situation as obtained under various discharges. In
command areas, however, there has been a tendency to use brick
lined channels in preference to bigger pre-fab channels and in-situ
lining of concrete (5 em thick). Such sections are very much in use in
Rajasthan canal and Chambal command areas (fig. 2). For the sake
of comparison, economics of brick lined section (0.07 cum/sec) is
presented in table 4.
Table 4 : Cost estimates of brick channels (70 lit/sec) per running
meter.
S.No. Item Unit Qty Rate Amount (Rs.)
1. Earth work 10 cum 0.76 32.00 2.43
2. Dressing of bed
and side slope 10 cum 1.72 3.50 0.60
3. Cement concrete
foundation (1 : 4 : 8) 1 cum 0.05 124.30 6.22
4. Brick work in cement
mortar (1 :4) 1 cum 0.133 254.10 33.80
5. Cement plaster
(1 : 4) 1 sqm 1.20 6.20 7.44
Total 50.49
Add. 5% miscellaneous 2.53
53.02
Feasibility of Pre-fab Channels:

Extensive work on demonstration and installation of pre-fab
channels (6 & to.3lit/sec) around College of Agriculture, Jobner
(Jaipur Distt.) and Udaipur has shown ado-Ptability and preference
for these channels by the farmers on account of longer life (20 yrs)
and ease of maintenance. A recent study conducted on well irrigated
farmers of Jaipur distt. by the team of College of Agriculture, Jobner
for various categories of the farmers, resulted cost-benefit ratios of
1.19,2.54,2.17 and 3.31 for small, semi-medium, medium and large
Table 5 : Cost-benefit-ratios of adoption of pre-fab channels in Jaipur District.
Type of farm %seepage Capital Length.of Annual %increase in %increase Benefit Remarks
loss(sandy outlay on unlined maintenance irrigated in cropping cost ratio
to sandy lining of channels on lined area intensity at 10%
loam soils) channels channels rate of
per farm (Rs.) (100 m) Rs. interest
Small (0-2 ha) 21.33 2188.46 249.0 29.58 3.6 7.14 1.19 Cost/meter
Semi medium
(2-4 ha) 27-41 2249.98 256.0 30.41 6.16 19.1 2.54 Rs.8.55
Medium
(4-10 ha) 26.08 2496.08 284.0 33.74 14.76 2.17
Large
(10 ha and above 20.85 4869.11 554.0 65.82 18.07 3.31

farms, respectively with percentage increase in irrigated area of

3.6,6.16,10.4'1 and 9.33 for the same categories by adoption of pre-
fab concrete channels ( 6 lit/sec). Salient results of this study are
presented in table 5.
Installation of such channels by the farmers is quite a paying
proposition as percentage increase over existing returns had been
11.8. 12,49,6.37 and 11 for small, semi-medium, medium and large
farms. Total benefits per annum for such categories were Rs. 335 22,
Rs, 703.82, Rs. 669.14 and Rs. 1956.53 due to saving in irrigation
bill (Rs. 275.02 Rs. 571.17, Rs. 419.25 and Rs 36502 respectively)
and increase in crop production had been Rs. 60.20, Rs. 132.65. Rs
174.89 and Rs. 1591.51 respectively.
However, due to some capital outlay on lining of irrigation
channels, farmers may not be coming forward despite of the gains.
Scarcity of cement is another bottleneck in extensive use of" re-fab
channels by the farmers, Banks and other credit, institutions can
play an important role by advancing loans and formulating projects
for channel lining. Efforts of various developmental agencies could
be pooled for procurement of materials and installation of such
channels. For small farmers up to 12% rate of interest such channels
are feasible whereas for other categories interest, rates up to 20%
result in profitable proposition as evident in table 6.
Table 6 : Net Benefit Cost Ratios At Different Rates of Interest.
Type of farm Rate of interest
10% 12% 14% 16% 18% 20%
1. Small 1.19 1.64 0.92 0.83 0.75 0.68
2. Semi-medium 2.54 2.24 1.98 1.77 1.60 1.46
3. Medium 2.17 190 1.68 1.51 1.36 1.24
4. Large 3.31 2.90 2.57 2.30 2.08 1.89
Conclusion:
Pre-fab concrete channels (6 lit/sec, and 10.3 lit/sec) prepared
from 1:2:3 ratio of cement, sand and aggregate are economical and
can be easily adopted by the farmers. Small farmers should be
charged a lower rate of interest (up to 12%) by the banks and other
credit institutions, so as to popularize judicious use of water by the
farmers. This could be arranged through subsidies etc. Saving of
water through such channels will reflect higher crop production
and better returns of capital in Indian agriculture.
Fisheries In Rural Development

Our country is blessed with rich and variegated inland fishery
resources. Through application of modem technologies the scientific
management of reservoir fisheries can generate self employment
and thus improve socio-economic conditions of fishermen and fish
farmers. The high yields that are now possible along with the fish
seed trade provide direct and indirect employment to the un-
employed and underemployed, particularly in the rural areas.
Further, being labour intensive, fish culture in itself has the potential
to check the influx of rural population to over crowded cities in
search of jobs.
Agriculture made man change his aptitude from a wandering
tribe to a well settled being. If man had taken the fish culture in the
manner he looked the agriculture perhaps he would have
consolidated his position on land providing him greater choice &
certainty of his aquatic demand at a lesser cost. What prevented
him from giving due recognition to this immense potential of water
resources on land could be a subject of debate in the years to come.
Table 7 : Inland Water Resources of India and Rajasthan and Their
Stocking Needs
Resources (Water spread area) Present production Total need of fish
of fish seed/yield seed (fingerlings)
Expected yield
INDIA
2,700 kg long Rivers 1 billion 16 billion
1,12,000 km long irrigation canals 8 lakh tonnes 128 lakh tonnes.
2.9 million ha. of reservoirs,
1.6 million ha. of ponds & tanks
2.6 million ha. of brackish water.
Rajasthan:
31akh ha. 12 million 325 million
.105 lakh tonnes 1.7 lakh tonnes .
)
There is an urgent need to develop specific programmes for

creating employment upgrading income of fish farmers. Exploitation
of fishery potential is an integral part of the rural development.
Rajasthan with its reservoir resources and fairly higher productivity
appears to be on the there should of BIl'_e Revolution. Rajasthan
fishery being mostly a capture type of reservoir fishery can get a
tremendous boost, if bank schemes are formulated and institutional
finances are arranged for the unexploited and under exploited
waters. To start with, some level of subsidy for supporting the
venture would be necessary, but later on the projects will depend
on their inherent economic and financial viability. The integrated
reservoir fisheries projects should be aimed to provide a package of
practices such as water management, development of seed fish
farms, storage facilities, constituting fishermen cooperatives,
ancillary industries development, marketing research and training
etc.
In view of the above, irrigation and fisheries should go together
and be viewed as complementary programmes for construction of
reservoirs From the very beginning of the planning of irrigation
projects, the requirement of fisheries should be fully built in. Good
fish is a product of healthy fish seed and to establish a flourishing
fish industry the procurement of quality fish seed is essential. The
fish seed farms are important to increase the production of fish as
well as to serve as a training cum demonstration farms for
prospective farmers.
The establishment of fish seed farms and fish culture in long
seasonal ponds have many folds, purpose, impact and benefits
such as:
Purpose : Fish seed production, self employment, increased
income.
Components : Farm construction, hatchery management and seed
production.
Impact : Fish seed supply to fish farmers, gram Panchayats,
fishermen cooperatives, source of employment for
landless labours and unemployed youth.
Benefits : Solving protein deficiency, generate income and
emplo:rment in rural areas.
The Following Data Indicate a Cost Benefit Ratio of one Hectare
Fish Seed Farm
Capital cost In Rupees.
(a) Cost, of land 23,000
(b) Cost of construction of farm (6000 m2 ) 10,000
(c) Cost of construction of shed 3,000
Total 38,000
2. Cost of nets, hapas and other equipment: 6,000
3. Operating cost:
(a) Cost of breeder: 60 sets 1,400
(b) Pituitary gland: 200 nos 400
(c) Feeding charges: 300
(d) Preparation of nursery ponds 550
Total 2,650
4. Establishment charges:
(a) Manager: 1 @ Rs. 400/- p. m. 4,800
(b) Fishermen: 2 @ 200/- p. m. for 6 months. 2,400
(c) Seasonal collies: 3 @ Rs. 7/- per day 1,265
(d) Watchman: 1 @ Rs. 200/- for 12 months. 2,400
(e) Other contingencies and miscellaneous expenditure. 1,000
Total 11,865
This fish seed farm requires 60 sets of breeders; conservative

estimation of success is 50%. Each set will yield 2.00 lakhs of eggs.
Total eggs obtained 30x2.0 lakhs: 60.0 lakhs. 70% fertilized
eggs i. e. 421akhs. 80% hatching-33.60 lakhs spawn. Farm hatchlings
to fry stage at about 30% survival: 10 lakhs fry. Total cost of 10
lakhs seed at Rs 4,000/ - per lakhs = 40,000. "
Expenditure and Income Statement:
Expenditure:
1. Depreciation on cost of construction : 1,300
including shed @ 10% (on Rs. 13.000/-)
2. Depreciation on cost of nets, hapas and 1,800
other equipment's @ 30% (on Rs. 60001-)
3. Interest on capital @ 12% (on Rs. 44.0001-) 5,280
4. Operational cost 2,650
5. Establishment charges 11,865
Total 22.895
Income:
1. Sale proceeds of 10 lakhs fry : 40,000
2. Sale proceeds of spent brooder 200
3. Miscellaneous receipts from grass vegetables etc. 200
Total: 40,400
Net profit (Rs. 40, 400 - 22,895) =Rs. 17,505.00
Economics of composite Fish culture in one hectare pond.
Fingerlings
I I I
Catla Aohu Grass Common Silver Mrigal Gourami
Carp Carp Carp
500 500 500 625 1250 625 75
No. / As.
5075 1 500
,1.
Cow dung 2500 kg Artificial feed oil
Rs. 200 ~ INPUT /" cake and rice bran
2400 kg. Rs. 1500
I 1 ha water I
Inorganic Manure Labour incidentals
1700 kg Rs. 2370 and depriciation
cost of Nets 400
OUT PUT
at the end of one
year
4210 kg of fish @ Rs. 8/- Per kg.
Total income-Rs. 33,6801-
Net income- Rs. 25.1101-
***
Chapter
6
ee
PURCHASING METHODS
One of the important problems in the control of production is

that of having the required material on hand when needed. In ideal
conditions material would arrive from the sources, whence it is
purchased, just when it is needed and in the desired quantity. Such
ideal conditions can rarely be realized, and usually a sufficient
amount of raw material must be carried in stores, the storeroom
acting as a reservoir to equalize the variations between the plant
and the sources of supply. It is the primary function of the
purchasing department to make all purchases of material and
supplies as required, and it is the primary function of the
storekeeping department to guard and care for all purchased
materials and to ensure that they are issued only on the proper
authority and in the correct amounts. Purchasing and storekeeping
are, therefore, closely connected. Included in these functions also
are the receiving of purchased goods and their inspection before
acceptance. In comparatively small companies all four of these
functions are usually conducted as one department under one head.
In large plants purchasing is an independent function and receiving
and inspecting are usually combined with storekeeping. In very
large enterprises receiving and inspecting are sometimes organized
as an'independent function,
Purchasing Methods 75
Organization of Purchasing Department:

The position that the function of purchasing may occupy in the
company organization depends upon the size of the plant and upon
the degree to which general policies enter into its operation. In small
companies it is not uncommon to find purchasing under the
supervision of the treasurer, stores, of course, being under the
direction of the shop superintendent. In companies of moderate
size the purchasing agent is usually responsible to the factory
manager. In very large companies, consisting of several plants that
are separated geographically and in which general policies are
important, there is usually a general or central purchasing
organization to direct policies and to make such contracts as affect
all of the plants, with a local purchasing agent at each plant to care
for routine matters.
The best arrangement will, therefore, depend somewhat upon
circumstances, but in any case responsibility for all purchases
should be centralized, and purchasing by several persons or
departments should never be tolerated, as it always leads to loose,
extraVagant ideas and methods, higher purchase prices, and
needless waste. The opportunity for dishonesty is also much
increased. A good purchasing agent is always a valuable man; and
as the size and complexity of a business increase, his value rises. It
is axiomatic that he must possess the business training and natural
commercial instinct that will make him a keen student of market
conditions and a judge of values.
It is equally important that he be able to systematize his
department so that it runs smoothly in connection with the other
departments, serving them quickly and well. If, in addition, he is
well informed on the technical and practical side of the industry,
his efficiency will be increased many fold. For these reasons a Clan
promoted from the shop or engineering department will, all other
things being equal, make a better purchasing agent than one
promoted from the clerical force of the oftice. Purchasing, however,
involves a knowledge of business methods and forms, of which
shop men and engineers are, unfortunately, seldom will informed;
hence, purchasing agents are usually recruited from the clerical
force.
76 Purchasing Methods
The internal organization of a purchasing department will vary

with the size of the enterprise. In the small plant a purchasing
agent with an assistant or two may suffice; in the large enterprise
the department must be large and consequently organized with
care. Figure 47 shows an organization suggested by P. M. Marshall
for a large enterprise with several branches that are separated
geographically. It is assumed in this plan that the volume of
business, both at the central purchasing division and at each
departmental division, is large enough to permit of specialization.
In each division, therefore, the work of purchasing is functionalized
under three sections, namely, buying clerical, and service. The
buying section does all the purchasing, this work again being
separated into classes and a specialist assigned to each class. The
clerical section performs all clerical work and keeps all records.
The service section follows up all orders, conducts relations with
other departments, and makes all necessary adjustments. Such a
highly developed department is, of course, necessary and possible
only in very large organizations.
Sources of Supply:
A major function of the purchasing department is to keep fully
informed concerning sources of supply of all type materials. Viewed
broadly, all industrial effort is concerned with the transforming of
natural resources into useful forms and the transportation of the
same to the places where they are needed. As each increment of
labour is bestowed upon the material while it passes through the
process, it rises in value. Thus, coal is mined in one place; iron ore
in another. Both are transported to a convenient place, arriving
there worth a few cents per hundred pounds. By means of the coal
the iron is there transformed into pig iron worth perhaps 1 cent per
pound. This pig iron may be transformed in the same plant into
steel rails worth 1% cents per pound, or it may be again transported
to an engine works and made into steam engines worth 20 cents per
pound. Or it may be shipped to a crucible steel works and made
into crucible steel bars worth 16 cents per pound, and these steel
bars may be transformed elsewhere into watchsprings worth many
dollars per pound. This is true, in a general sense, of all the products
of industry, material values being, in the main, accumulated labour
values, the value of the original material in its natural state often
being a negligible part of the mark~t value.
In some cases the transformation of the raw product into useful
form is accomplished in one plant. Thus, table salt, kerosene, and
similar commodities may each be made in a single reduction works
and placed directly upon the market. In most cases however, this is
not so, most market products being the result of several distinct
stages of manufacture, each stage separated widely by character
and geographical distance. This is so from the nature of the case
and from the complexity of modern manufacturing. The man who
smelts pig iron would not be expected to produce, also, all the
finished products into which it enters; in fact, he may be compelled
to supply a widely diversified field of industry in order to secure
the quantity necessary to manufacture pig iron economically. These
general conditions apply to all those who in tum transform pig
iron into other forms and equally again to those who in turn use
these other forms for other purposes.
What, then, appears to one manufacturer as finished product
appears to some other manufacturer as raw material, and the extent
to which any manufacturer may depend upon other branches of
industry varies widely. In very few instances is he entirely
independent of other lines of industry. It is a fundamental
requirement, therefore, that the purchasing department have full
and accurate knowledge of the material requirements of the plant
and of the sources of supply of these requirements. This latter
information is obtained from personal knowledge, from records of
transactions already consummated, and from trade catalogues,
"buyers' guides," and other publications containing such
information in condensed form. A well-organized purchasing
department will have this information carefully classified and
indexed so as to make it readily available.
The materials that enter into any given finished product are, in
general, of two kinds: direct and indirect; and even though a
manufacturer may control the direct material from its natural sources
to the market, he must, in most instances, depend on other people
,78 Purchasing Methods
for many of his indirect supplies and his tools of production. If,
however, the required quantity of any material, direct or indirect,
becomes great enough, it may pay the manufacturer to extend his
control of that particular material a little further back toward the
natural sources. Thus, a growing concern may not have enough
demand for castings to operate a foundry; but as the business
increases, it may pay to build one, even though no reduction in
price is so obtained, in order to control the supply of castings and
thus facilitate deliveries. If the quantity increases so that foundry
work can be prosecuted as economically as in the foundries from
which castings were formerly purchased, the profit formerly paid
these foundries is thereby saved. The electrical manufacturing
companies in this country depended originally on other sources for
their porcelain and mica products, and small companies still do so.
As the quantities incident to great growth have appeared, some of
the larger electrical works have put up their own porcelain works
and have installed presses for making mica products. Some have
even put in wire-drawing plants, not so much with a view, perhaps,
of obtaining lower priced wire as for convenience and better control
of deliveries.
The importance, therefore, of the control of the several streams
of material coming into an industrial plant will depend on their
relative bearing on questions, of economy of manufacture, or
convenience as affecting delivery of finished goods. It may be highly
important to control a large stream for financial reasons. It may be
no less important to control a very small one because of its effect on
deliveries. The lack of a small detail will hold up the delivery of a
machine as effectually as will a larger one, and thus control of the
sources of supply may vary from the simple case where all materials
are fully controlled to the other extreme where nothing but
assembling is carried on, the finished parts coming from many
factories ready to be assembled. The first extreme is rare, but many
cases of the latter are to be found.
Purchase Requisitions:
The demand for materials grows naturally out of the needs of
the business and cannot, therefore, originate with the purchasing
agent. In a shop devoted to general repairs, the requisitions for

materials would, most naturally, originate with the foremen in
charge of work, since they will know better than anyone what is
wanted. In a shop building new work to order only, such as an
engine works, these material requisitions for direct material would
originate in the engineering department, though they should pass
through the storekeeper's hands before going to the purchasing
agent in order to check off material on hand. In a shop manufacturing
standardized articles, as knives, watches, etc., a material requisition
would naturally originate in the stores department, which is the
reservoir that feeds the factory, and here also would originate,
always, the requisitions for all indirect and expense material. In a
shop doing all three of these classes of production, therefore, material
requisitions might originate from several sources; and just as it is
necessary to centralize the authority and responsibility of the
purchases based on these material requisitions, so it is absolutely
necessary to fix definitely the authority and responsibility for
originating these requisitions. In a factory that is well managed this
power is limited to responsible men, and the requisitions in many
cases must be countersigned by a higher official as a check on
irregularities.
Where production is fully controlled, the planning department
will, as a matter of routine, issue such information concerning the
material needed as will be necessary both for the stores department
and for the purchasing department in obtaining the proper material
at the proper time. The purchase requisition should specify
accurately the character and amount of the material needed, the
time when it is required, the place where it is to be delivered, the
purpose for which it is to be used, and any other information needed
to identify it fully with its purpose. The requisition should be signed
by the person responsible for its issuance so that any necessary
adjustments may be taken up with him.
Routine of Purchasing:
A full discussion of the problems of purchasing and of the
printed forms and documents used in purchasing is beyond the
scope of this chapter. Only those features which are of general
interest will be noted. If the items called for by the purchase
requisition are not important, the buyer to whom it is referred may
place a purchase order with some reliable vendor with whom a
regular business is conducted. If, however, the amounts involved
are large, he may ask for quotations from a number of vendors. On
the basis of the bids received he will place the order to best
advantage. It is in this connection that good department records are
of great importance, for it is not sufficient that the bidder's price be
right but the buyer must be assured of his reliability in the matter of
meeting delivery dates, quality of material furnished, etc., and past
experience may show that the lowest bidder is not desirable from,
these viewpoints.
The purchase order will necessarily vary widely in form
depending upon the business, but, in general, it should include all
information necessary to make misunderstandings impossible. It
should bear an identifying number, the date of issue, the name of
the vendor to whom it is sent, a full description of the article desired
and the quantity thereof, the date of delivery at the plant, shipping
directions, prices and terms of payment, and the name of the
company making the purchase, with the signature of the purchasing
agent. Quite frequently the purchase order has an acknowledgment
form attached to the purchase order which the vendor signs,
detaches, and mails to the purchasing agent as an acknowledgment
that the order has been received. The buyer usually sends a duplicate
copy of the purchase order to the receiving and inspecting
departments and sometimes to the requisitioner of the material as a
check on accuracy.
Skilful purchasing involves following five principal features,
namely:
1. Price.
2. Quality.
3. Quantity.
4. Time of delivery.
5. Verification of goods purchased.
1. For a given quality and quantity of material the securing of
low prices becomes a commercial matter depending on a knowledge
of the sources of supply, transportation facilities, market conditions,

discounts, and similar considerations that apply to all purchasing.
Price, however, is not always the only factor that must be considered,
for, as will be seen, an effort to obtain low purchase prices may
result in high manufacturing costs, though it is fundamental that
other things being equal, the lowest possible prices should be
obtained.
2. It is obvious that the judgment of the purchasing agent as
regards the quality of materials required increases with his
knowledge of the trades and processes for which he buys. In the
buying of many indirect or expense materials such as oil, waste,
stationery, etc., it is customary in many plants to trust to the judgment
of the purchasing agent. In fact, this is true in many cases of much
of the direct material. But as an ind ustry grows more complex and
the scientific knowledge on which it is based becomes more
important, the purchasing agent must depend more on the expert
in each line for instructions as to the quality of material required. In
electrical construction, for instance, the quality of many materials
is of highest importance, and the characteristics must be carefully
specified to the purchasing agent. Many large companies keep well-
equipped experimental laboratories for determining the best
qualities of material; foundries now buy their iron by chemical
specification; and careful managers specify the character of their
supplies, such as coal and oil. Best results will, therefore, be obtained
when the special buying ability of the purchasing agent is reinforced
by the expert knowledge of the specialist who knows the
characteristics desirable in the material under consideration. Where
necessary, therefore, the purchase requisition should be
accompanied by complete specifications, and the purchasing agent
should be guided strictly by these in making purchases. Any other
method will be found to be wasteful.
3. The temptation to buy large quantities of material is always
strong for two reasons: (1) Lower prices are obtained as the quantity
to be purchased increases, and (2) a large stock on hand ensures
prompt service to the shop and consequent quick deliveries. But
here again the judgment of the purchasing agent should be reinforced
by expert knowledge and advice. There is no money in ordering
several years supply of anyone article, storing it, and thus tying up
considerable capital and losing the interest thereon simply for a
small saving in price. The quantity ordered, therefore, should have
a reasonable relation to the prospective output of the factory. Mr.
Frank Parrish, Supervisor of Inventories of the United States Steel
Corporation, is quoted as estimating inventory carrying charges for
average warehouse stocks as 25 per cent per annum, divided as
follows:
Storage facilities ......................................................... 0.25
Insurance .................................................................... 0.25
Taxes .......................................................................... 0.50
Transportation ............................................................ 0.50
Handling and distribution ........................................... 2.50
Depreciation ............................................................... 5.00
Interest ........................................................................ 6.00
Obsolescence .......................................................... 10.00
25.00
Furthermore, before placing purchase orders for large quantities

of stock, particularly special stock, careful inquiry should be made
as to prospective changes in design that may render such stock
obsolete, an occurrence only too frequent in an industry that is in a
state of development. In large works a great purchasing advantage
can be obtained by standardizing, as far as possible, articles of a
similar character used by different departments, thus decreasing
the variety and increasing the number of each kind purchased.
This principle should be observed from office lead pencils to the
largest common supplies and tools purchased.
4. The time element is a most important one in purchasing. It
is essential that all material for a job arrive so as to be fabricated in
time to avoid delay in assembling the completed product. Yet a
contract might be taken for machines involving the use of tons of
copper, say, and requiring a year for completion, the copper not
being needed till near the end of the construction. Evidently the
purchasing agent, working in connection with a good planning
department, can save considerable money by means of well-
arranged schedules of delivery. The same thing can be accomplished

for material used constantly, such as coal, by making long-term
contracts but with periodic deliveries and payments. In other cases,
again, the purchasing agent is often justified in paying a high price
for a quick delivery if it will save great delay in the factory or secure
a remunerative contract because of early shipment.
5. The verification of purchased goods is usually conducted
by the receiving department which is, in general, a branch of the
stores department and is, therefore, discussed among the problems
of that department.
Market Purchasing:
The routine methods of purchasing, are those in general use
where it is the purpose simply to satisfy the manufacturing needs
at the proper time and at the best prices of the existing market.
There are many cases, however, where it is possible to satisfy these
needs without strict reference to the requirements of the
manufacturing program and, by taking every advantage of market
conditions present and future, make great savings in purchasing.
Such a procedure is called market purchasing. There are three
sources of information from which prices may be forecast: (1) the
many published statements of price movements, (2) special advises
furnished by private statistical bureaus for remuneration, and (3)
whatever statistical data the purchasing department may gather
from its own experiences. A competent purchasing agent should be
able by a careful study of such statistics to forecast the trend of
market prices and thus make advantageous purchasing contracts.
If, for instance, such studies show prices to be low but with an
upward tendency, contracts for material at the low price and
extending some time into the future will be advantageous. Again, if
prices are high with a tendency downward, close buying will be
advisable.
Statistical data presumably reflect changes due to supply and
demand. There are however, other factors that may exert a large
influence upon the policy of purchasing. Labour troubles, congested
conditions in transportation facilities, and many other movements
in the industrial field all tend to affect prices. Furthermore, market
movements in fields other than the one in which the purchasing

agent is directly interested must be kept in mind. Thus, market
movements in basic industries such as steel and copper, the number
of unfilled orders, and the stocks of material on hand in these
industries are indicative of future prices in other lines.
Unemployment and import and export statistics may also be of
service in evaluating future market prices.
In some industries where the manufacturing processes do not
change materially, where the cost of production is small compared
with the cost of the material, and where large quantities of some
basic commodity are used, purchasing is often conducted without
much reference to immediate factory needs. Thus in the textile
industries and in some of those industries which use large quantities
of copper, where the cost of the raw material is a large part of the
total cost, it is often good purchasing policy to buy large quantities
when the market price is low without any reference to the immediate
manufacturing program. Such purchasing is known as speculative
purchasing. Obviously such purchasing cannot be successfully
carried on without a comprehensive knowledge of all market
conditions; and although, no doubt, there are industries in which it
has a proper place, it should be avoided as far as ordinary
manufacturing is concerned. Such methods tie up large amounts of
money and in many forms of production are likely to upset the
manufacturing program and to leave large quantities of unusable
material on hand owing to changes in design or policy.
Purchasing Contracts:
In ordinary commercial purchasing the purchase order and a
written acceptance are considered all that is necessary, it being
assumed that the mutual interests of purchaser and vendor are
sufficient to ensure good faith on both sides. Usually this is true,
though when business declines suddenly, the practice of cancelling
orders is all too common. In very large and important undertakings
dependence is not placed upon the purchase order and its
acceptance, but a written contract is drawn up binding both parties
to the fulfilment of their share of the transaction. Thus the Federal
government contracts for practically all materials, supplies, and
services rendered to it by those doing business with it. In important
contracts the bidder is required to deposit with his bid a certified
check for a specified amount as a guarantee of good faith and
performance. This practice is not uncommon in private practice
where the work is of considerable magnitude.
Many companies that use large quantities of basic materials
such as pig iron, coal, coke, etc., have found it very desirable to
contract for the entire supply of such commodities for a considerable
period of time. Usually the schedule of deliveries of the commodity
is worked out to fit into the manufacturing program and
incorporated into the contract. The advantages of such an
arrangement are that the purchaser obtains reasonable assurance
of a supply of material during the contract period, he is protected
against excessive price fluctuations, and, in general, he is able to
secure low prices because of the large quantities contracted for. The
vendor also enjoys corresponding advantages that ~re obvious.
Frequently it is not possible to fix a flat price for long-term contracts,
and in such cases the price may be fixed with reference to lowest
market quotations or by quotations in some selected periodical.
These contracts are of many kinds varying widely with the
circumstances. It should be noted, however, that these contracts
may not be broken by either party with impunity, and they should,
therefore, be drawn with care so that they are fair and binding and
include all necessary stipulations. In important cases, especially
where the contract fixes penalties for nonperformance, it is advisable
to have legal advice before signing the contract.
Chapter
7
STORES CONTROL
**
Under ideal manufacturing conditions the raw materials would
be used as fast as they arrive at the factory, passing directly through
it, and the finished goods would be shipped to customers as fast as
it was turned out. Such conditions are almost impossible to attain,
though they may be approached in some of the simple continuous
process industries. In most manufacturing companies the raw
materials are used in varying quantities at varying times, and sales
are likewise intermittent and varied. For these reasons, and also
because purchasing and transportation are facilitated by quantity,
provision must be made for storing such quantities of raw material
as will ensure prompt service for these varying demands. Where
sales are varying and goods must be made in advance of sales,
similar provision must be made for caring for finished goods, in
order to ensure prompt delivery to customers. In shops that make
goods to order only, as a shipbuilding company, this last feature
would not be important.
Unworked material is usually known as stores, and the space
where it is housed is known as the storeroom stores department.
The storeroom is, in effect, a reservoir between the incoming materials
and supplies and the factory proper, equalizing the varying supply
and demand. Finished goods ready for shipment is usually called
stock, and the place where it is stored is called a stock room. The
Stores Control 87
stock room is, in effect, a reservoir between the factory and the selling
department equalizing the varying demand of the customers and
the varying output of the shop. In small factories the storeroom and
stock room may be one and under the control of the same official,
but there is a major difference in their functions; and as plants grow
in size, separation becomes almost inevitable.
In order to obtain the advantages of manufacturing a large
number of pieces of one kind it is often necessary to finish large
numbers of parts of machines or other goods and store them,
drawing them out for final assembly in completed goods as the
business requires. In fact, in some companies carrying on semi-
continuous manufacturing, the quantities are so large that it is
necessary to store them between successive operations, especially
if the materials involved are valuable. In many cases, also, the same
part is used in different kinds or sizes of goods that come through
the factory at different times, and repairs and supply parts always
demand a stock of standard finished parts on hand. The storeroom
may, therefore, also act as a reservoir to equalize inequalities in the
manufacturing processes of the company by storing so-called
finished parts, and in some cases a special section of the storeroom
called the finished-parts storeroom is set aside especially for this
purpose. A distinction is sometimes made between finished parts
made by the factory and those purchased. Thus bolts, screws, or
any other element that is purchased and used directly in the goods
are, strictly speaking, finished parts and are sometimes called
purchased finishe~ parts to distinguish them from manufactured
finished parts. The distinction is, however, somewhat academic
and not of practical importance, provided the cost of each goods is
accurately determined. The storeroom may be said, therefore, to
care for following three classes of material:
1. Stores, or raw material that is to be fabricated into goods,
consisting largely, therefore, of direct material.
2. Supplies, or indirect material, such as oil, waste, etc.
3. Finished parts, or goods, fabricated, but not fully assembled.
The stock room in its fully developed form will care only for
finished goods, that is, fully fabricated and ready to be shipped. In
88 Stores Control
large organizations this department comes, naturally, under the

shipping clerk. In such cases the stock room may carry many
finished parts for convenience in supplying repair parts. In smaller
concerns the stock room, storeroom, shipping and receiving rooms
may be under one man and in one room. But as factories grow in
size, these different functions should be separated in the interest of
efficiency.
Storeroom Organization:
The storeroom is usually organized under the superintendent
of planning, and the chief stores clerk is responsible to him. It will
be obvious that since the stores constitute a service function, the
exact manner of this, organization will depend upon the size of the
com pan y. In companies of moderate size a single storeroom centrally
situated will serve all needs, but in a very large company with
many buildings housing diverse activities it is frequently economical
to establish branch storerooms throughout the plant at convenient.
locations. And in large companies with factories separated "
~\geographically it is obvious economy to have storerooms at each
plant even though the purchasing may be centralized.
Storeroom Methods:
The necessity and the advantages of a well-organized storeroom
are not always fully recognized. Managers who would look with
horror upon a financial system that would permit the easy extraction
of small sums of money from the office safe often look complacently
upon storeroom methods that permit the tmauthorized withdrawal
of valuable material from the stores, wastes due to excess material
drawn, and losses due to valuable material unaccounted for, out of
all proportion to their care of the cash in the office till. Managers
who would look most carefully into the tying up of money in
securities permit the investment of large surns in raw material with
little thought as to the relative amount invested, the possibility of
how long it may remain so tied up, or the depreciation that it may
suffer while so invested. Yet material represents value as truly as
the money in the office safe, though this is not always appreciated.
Any saving in material is as effective as a saving on the pay roll.
Money tied up in material is crystallized capital and while in this
Stores Control 89
form is inactive. Clearly, the amount so invested should be carefully
scrutinized, and its total kept as low as proper service of the factory
will allow.
The major business of the storeroom is to anticipate the needs
of the factory in the most effective and economical manner possible.
In order to accomplish this it must fulfil the following functions
perfectly:
1. Issue requisitions on the purchasing department for the
most economical amount of the right kind of material for
delivery at the most advantageous time.
2. Check all material received as to quality and quantity.
3. Store all material in a safe and convenient manner.
4. Issue materials and supplies in the exact amounts needed
and at the exact time requ:ired.
5. Maintain exact records of all receipts and issues and of all
balances on hand.
The work of the stores department is, therefore, closely
connected with that of the purchasing department on the one hand
and with the shop and cost system on the other. In small business
the storeroom and purchasing department are often included in
one department.
Item 1 : The origin of purchase requisitions will vary with the
character of the industry, but usually all requisitions originating
outside the storeroom should be passed upon by the storekeeper so
as to ensure the use of material on hand before ordering more. For
this reason all requisitions are drawn on the storeroom in some
organizations, the storeroom alone requisitioning the purchasing
department.
The problem presented in obtaining material for repair work or
for special work done on order is comparatively simple, since the
quantity and quality are here fairly definite in character, the question
of time, however, being often of great importance. If the work is of
large magnitude and is to extend over a considerable period of time,
a careful planning, by either the engineering department or the
planning department, of the time schedule on which materials
90 Stores Control
should be delivered is almost essential to prevent premature and

over investment of funds. In the case of repairs, on the other hand,
quickness of delivery is usually an essential.
The problem of anticipating the needs of a large.company that
is manufacturing standardized goods of several kinds and many
sizes is a more difficult problem, including as it does the
consideration of the quantity of raw material that should be carried
in all stages of fabrication from raw material to finished goods.
Among the leading considerations that must be given weight in
deciding what stock of goods shall be carried in the several stages
of production the following may be noted:
1. The demand for the particular part or combination of parts.
2. The saving that may be effected by manufacturing in
quantity.
3. The interest on the capital tied up in material in process of
manufacture and in facilities for storing and caring for it.
4. The time required to obtain raw material and to assemble it
into completed goods from various stages of fabrication.
5. The probability of change of design and consequent
depreciation of raw material, finished parts, or completed
goods.
To make the interrelation of these considerations Clearer
consider a hypothetical problem of manufacturing a complete line
of alternating-current transformers. The demand for the smaller
sizes of transformers, or, say, up to 100 kilowatts, is large though
varying; very quick deliveries are essential; the voltages are
moderate; and the design will be assumed to be fairly stable. These
small sizes would be in continuous manufacture, or they would, at
least, be passed through the factory in large lots, finished completely,
and put in stock. To facilitate delivery some stock of these sizes
would also be carried in branch sales offices. Complete sets of special
winding machines and other labour-saving devices Vv ould be
developed so as to take advantage of quantity in reducing shop
costs. Anticipation of the demand for raw material in this case is
comparatively simple, care being necessary only to see that the
supply of any material does not get so low before ordering that
Stores Control 91
production is held up and care exercised, on the other hand, that
the amount ordered is not so excessive as to tie up too much capital
or to run the risk of any of it becoming obsolete through changes in
design. This case represents in a general way the problem of
continuous processes of all kinds.
Now, in general, the demand for a given class of goods lessens
as the size of the unit increases. Transformers from 100 to, say 250-
kilowatt capacity would probably not be in such demand as the
smaller sizes and would not be carried in branch-office stocks.
The demand may also vary with the season. The yearly demand,
nevertheless, is such that they can be economically put through the
shop in large lots, the size of these lots and the proper times for
authorizing their production requiring careful consideration to keep
the investment as low as is consistent with prompt delivery. A good
equipment or special tools might also be warranted for these sizes,
though they may not be in continual use.
Transformers of, say, SOD-kilowatt capacity may present a very
different problem. Here the demand may be so small that it may not
be advisable to put large lots through to completion and stock,
because the interest on the money so tied up would more than equal
the saving made by production in quantity. Yet the time required to
manufacture these larger sizes may be prohibitive from the
standpoint of the salesman, and, therefore, it may be good policy to
make up and stock some of the parts that require the longest time to
produce. Thus the copper coils may be wound and insulated and
carried as finished parts, thus also providing spare parts for repairs.
A limited amount of sheet steel for building up the laminated cores
might also be carried among the finished parts. The cast-iron casings
or any steel or malleable-iron castings that require time to obtain
might be carried in the raw-material supplies, labour being
expended only on such parts as would greatly facilitate delivery
when orders to assemble these sizes were received. The outfit of
special tools for these sizes would also be very limited and carefully
considered.
In the case of still larger sizes not even finished parts of any
kind would be justifiable, and only such raw materials as require a
92 Stores Control
considerable time to obtain would be carried. Thus, certain special
sizes of copper strip might be justified, though usually special
material of any kind should be avoided, if possible, since, if rendered
obsolete for any reason, it depreciates very rapidly and is, in general,
useless for other purposes. No special tools might be justified for
these larger sizes because of the small quantity demanded.
In still larger sizes and perhaps for higher voltages it may be
that not even raw materials should be c'1rried. The more difficult
engineering problems involved, the possibility of changes in design,
the varying requirements to be met in the field would perhaps make
all anticipation of materials hazardous and out of the question. The
problem has passed from the extreme case of the continuous
industry to the other extreme where the goods must be made to
order and material ordered as needed and not anticipated.
The relative sizes assumed above are, of course, hypothetical
but entirely possible. The principles involved are, however,
universal. The question of the quantity and form in which material
shall be carried is not a simple one or one that can, in the general
case, be decided by anyone man. The storekeeper can easily handle
the extreme cases. In the cases that approach continuous production
it is simply a matter of considering the stock bins as hoppers feeding
the factory. Minimum limits can be set to each bin or other storage
that will serve as a warning to order more quantity material.
Maximum limits may be set, based on the sales demands that will
prevent over investment. In the other extreme where work is done to
order, the problem is specific as to quality and quantity and the
important element is the time relation. But between these extremes
the combinations are complex, and an intelligent solution can be
reached only by the joint efforts of the storekeeper, the salesman,
the engineer, the financier, and the tool-maker.
Item 2 : When the vendor ships goods to the purchaser, he
mails the purchaser an invoice, or list of the goods. This invoice is
sent to the receiving department which is usually a part of the stores
department; and when the goods are received, they are checked
against the invoice and purchase order in order to ensure fulfilment
of the purchase order before sending t~e purchased material to the
stores or to fabrication. This checking at the receipt of the material
Stores Control 93
includes the quantity and quality of the shipment, the price, terms,
and freight charges. Any discrepancies are referred to the
purchasing department for adjustment. In many lines of work a
visual checking is sufficient, but again it may be necessary to inspect
the material as to chemical or mechanical characteristics, in which
case an inspection department fitted with laboratory apparatus
may be a necessity.
Item 3 : It is axiomatic that all type of materials should be stored
in places where they will be safe against deterioration or pilfering.
They should also be stored in a convenient and systematic manner
and so that they can be delivered quickly to the shop. In large works
branch storerooms are a necessity, for reasons of both convenience
and economy. If the stores are extensive, a book, plan, or written
record of some kind showing the location of stores is imperative to
guard against the delay and confusion arising from the 1055 of
experienced employees who carry such matters in their heads. The
. same remarks apply to pattern and other storage problems. A
carefully planned systematic way of storing tools, patterns, and
materials of all kinds is an important feature of good management.
A well-developed stores system also necessitates a system of
identifying nomenclature so that the location of all material is easily
found. The physical arrangement of storerooms and the methods of
placing material in bins, racks, etc., will depend upon the character
of the plant.
Item 4 : In former times, when shops and factories were small,
materials and supplies were stored on open shelves and each
workman helped himself to what was wanted. The custom still
prevails in small plants, particularly where the stores are such as
are of no personal value to the workmen or where they consist of
indirect material and form a very small part of the material cost.
There are, no doubt, many cases where it would cost more to employ
a storekeeper than he could save by his watchfulness, but in most
cases it pays to put all stores under a good storekeeper, give him
needed facilities to keep the stores properly, and then hold him
responsible for wastes and losses as far as the stores are concerned.
It is common experience that workmen cannot, in general, be
trusted to draw either direct or indirect material from stores without
94 Stores Control
great waste, both as to the quantity drawn and as to its economical

use. Furthermore, loose methods of issuing materials are always
likely to lead to dishonesty and pilfering. The first method of
checking these difficulties was to put the responsibility on the
foreman. Under this system each foreman is furnished with an order
book and no article can be issued from the storeroom except on the
authority of the foreman's order which describes the material
required, the amount needed, and the order number to which it is to
be charged. Indirect material is ordered in the same way; in many
cases the foreman also notes the order number to which the expense
material is to be charged, this number usually being the order
number on which the workman is, at that time, employed. The
unfairness of such a method of distributing expense material is
obvious. The orders issued by the foremen are taken up by the
storekeeper and are his authority for the issuance of the material
and also the basis of material costs.
The advantages of such a system are its simplicity, flexibility,
and quickness. No delays are experienced in getting the material
from tRe stores to the factory floor. This method responds instantly
to emergencies, either in production or in the shop repairs. There
are many places where it is adequate, particularly where the force
of men is small, the foreman intelligent, and the stores of no value to
the workman personally and where the number of orders issued
daily is small and the accounting consequently easy.
As departments become larger, on the other hand, it is not good
practice to use a busy foreman for this purpose. His time is more
valuable for other purposes, and he will not do it well if he pays the
attention that he should to the more important problems of
production. He may, of course, be given clerical help, but this, again,
is a palliative only, as the system falls down for other reasons. As
shops grow in size, the problem of cost keeping becomes rrlore and
more important and, in most instances, when the problem of
drawing material becomes too great for the foreman, it is high time
to consider better methods of cost keeping.
This leads naturally to the preplanning of work and the use of
the production order. Under these modem methods full bills of
Stores Control 95
material are prepared in the engineering department, in the
planning department if there is one, or by someone in the office of
the superintendent. These bills of material give full information
regarding the quality and quantity of the material and the order
number to which it is to be charged. They are made in multiple, one
copy going to the foreman with the drawings and other directions
for the work and constituting his authority to draw the material.
One goes to the store keeper and constitutes his authority for issuing
the material specified, serving also as the basis of costs.
The accuracy of the method is manifest. If properly operated it
prevents unnecessary drawing of direct material, fixes responsibility
and authority definitely and in such a manner that errors or
irregularities can be instantly attributed to those responsible. Most
important of all, it permits of more accurate costs than are attainable
under the older methods.
The method is not flexible, however, and emergencies must be
cared for by modifications of the plan. Small jobs would cost too
much if passed through a system of this kind. It does not take account
of expense material and supplies. For these reasons it is customary
to give a foreman or other official power to issue emergency
requisitions to care for these special conditions. Thus, in an
emergency repair job brought into the shop on Saturday afternoon
or an imperative repair job on the shop powerhouse on Sunday,
when the machinery of the planning department is not running,
this official would issue the requisitions, subject to the approval of
the proper authorities when the office and storeroom open up again.
Emergency methods must always be provided, in any well-
organized system, to prevent inflexibility destrOying its usefulness.
It is the fear of this inflexibility which often leads superintendents
and foremen charged with the duties of production to oppose new
systems that savor of "red tape" because although they may cure
certain evils, they may do so at the cost of convenience and
~lexibility. This particular defect in all systems deserves careful
....
consideration in installing them, and it is in making modifications
of this kind that the manager shows his true ability in organizing.
Expense materials and supplies such as oil and waste cannot,
of course, be handled on production orders. They may be issued on
96 Stores Control
the foreman's order, but in no case should the foreman assign the
order number to which they are to be charged unless classified
standing order numbers have been provided for this purpose.
Standard supplies, such as oil and waste, are often given out at
assigned times only and in definite quantity to each man. Extra
quantities may be drawn at other times by special order only.
Item 5 : It is obvious that if the stores department is to anticipate
the needs of the factory, it must keep a fairly accurate record of all
material and supplies. If a planning department exists, this need is
accentuated, since skilful planning cannot be carried on without
accurate record of materials on hand. The extent and detail necessary
in such records will, of course, vary greatly with the type of business.
In the case of continuous processes or of manufacturing
approaching a continuous process, where the material for the most
pClrt moves from the storeroom directly through the factory without
interruption, the storeroom bins and racks may be considered as
reservoirs in which the material should never fall below or rise
above certain economical limits that have been fixed by the
considerations already discussed.
Many methods are available for making intelligent use of such
maximum and minimum limits. The simplest is that which may be
called observation of limits. Usually only two limits are set, the
maximum and the minimum, though sometimes a lower or danger
limit is also set for the purpose of indicating that orders for a fresh
supply of material must be rushed. To keep account of the material
a printed form is attached to each bin or rack; and as material is
withdrawn, the storekeeper deducts the amount taken away, thus
keeping a continuous record of what is left. When the amount falls
to the lower limit, an order is placed that will bring the amotmt up
again to the maximum.
Balance-of-stores Ledger:
In more highly developed systems of production, the stores
records are kept by a head storekeeper or his clerical assistant on a
card system or in a loose-leafledger ruled especially for this purpose,
and known as a balance-of-stores ledger the complete control of
production and the accurate prediction of the schedule of productive
Stores Control 97
processes depend to a certain degree on the control of materials.

The required information concerning material is recorded on these
ledger sheets in the following manner. Each ledger sheet records
the transactions in one part or item only.
There are four main vertical divisions, namely, l-Ordered;
2-On Hand; 3-Apportioned; and 4- Available. If entries are
properly made, the sum of divisions 1 and 2, that is, the amounts
ordered and on hand, will always equal the sum of divisions 3 and
4, that is, the amounts apportioned and available, and the
distribution of all stores recorded upon the sheet may be seen at a
glance. To illustrate the procedure let it be assumed that on February
11 there were on hand 1,500, lh- by 4lh-inch bolts. Being on hand
they were also available, and entries to this effect were made in
these columns. The balance of stores shown by the four division
columns was then 0 + 1,500 =0 + 1,500.
On February 12, 600 bolts were apportioned to production order
760. The entries made were as follows: 600 was added to the
Apportioned column, 600 subtracted from the Available column,
and the balance was 0 + 1,500 = 600 + 900. This l>ransaction,
however, brought the available amount below the minimum
allowable quantity as shown at the top of the sheet; consequently
an order was placed for 4,000 bolts, which is also the predetermined
quantity to be ordered. Ordered material is considered as available,
due allowance being made for time of deliveries; hence 4,000 is
added to both column 1 and column 4, making the balance 4,000 +
1,500 = 600 + 4,900.
On February 15, the material issue of production order 760 to
which 600 bolts had been apportioned was presented by the move
man to the stores, and these bolts were issued and this amount
subtracted from both column 2, On Hand, and column 3,
Apportioned. The balance then was 4,000 + 900 = 0 + 4,900.
On February 16, 75 bolts were returned to stores, it having been
found that the material issue of production order 760 was that much
in excess of actual requirements. This number was, therefore, added
to both column 2 and column 4 and the balance then stood 4,000 +
975 = 0 + 4,975.
98 Stores Control
On February 17, the 4,000 bolts that were ordered on February
12 were received. This number was, therefore, deducted from column
1 and added to column 2. The balance on that date was, therefore,
o+ 4,975 = 0 + 4,975.
In column 2 provision is also made for pricing the bolts both for
unit cost and also for total cost. This serves as a memorandum of
the value of the inventory and also provides the information for
evaluating the material issue for the benefit of the cost department,
from time to time the actual quantity on hand is checked by actual
count against the quantity recorded on the ledger. This is indicated
by drawing a vertical line in volume 2 down to the date at which
this checking was performed.
Visual Balance of Stores:
In such companies that manufacture a standardized goods,
where the variety of stores is not very great and the quantities fairly
large, a visual balance of stores may be operated to advantage. In a
N.K. Computer Ltd. actual board is about 15 feet long and 6 feet
high. Through a series of corresponding notches at the top and
bottom of the board, pairs of strings are carried completely around
the board so that they can be moved at will. The right-hand string of
each pair is made up of two parts, one white and one blue, knotted
together, the knot serving as an indicator. The left-hand string of
each pair is made up, also, of two parts, one white and one red,
knotted together in a similar fashion, the knot serving again as an
indicator. These knots will be referred to as the blue knot and the
red knot respectively. Each pair of strings indicates for one part as
follows:
1. The amount of raw material on hand.
2. The amount of finished or partly finished parts in process.
3. The point where raw material should be ordered.
4. The point where new manufacturing orders should be
issued.
5. The amount of raw material on order.
6. The total inventory of finished parts, parts in process, and
raw material in stores for any given machine part.
Stores Control 99
To illustrate the method of operation, consider the pair of strings
on which the blue knot and red knot are indicated. The horizontal
markers 1,2,3,4, and 5 are made of coloured ribbons and are placed
on the board at the desired level as indicated by the scale at the
extreme left. The lower ribbon indicates the danger limit for finished
parts and'is so placed that if, when the blue knot falls to that level,
a new manufacturing order for finished parts is placed with the
factory, these parts would be available by the time the blue knot
reaches zero. It is not advisable, however, to work so closely to the
limit, and, therefore, ribbon 2 is placed somewhat above ribbon 1
and indicates the minimum limit to which the supply of finished
parts should be permitted to fall before placing a new manufacturing
order. The distance between ribbons 1 and 2 represents a cushion
or reserve to provide for emergencies and should never be too large,
as this increases the inventory value, which should be kept as low
as possible, compatible with safety in production.
A certain amount of time must be allowed to the planning
department for issuing manufacturing orders, bills of material, etc.
This time is represented by the distance between ribbons 2 and 3.
There should also be a limit to the number of parts on hand, and
this limit is set by ribbon. 4. The distance between ribbons 4 and 2,
therefore, measures on the scale the size or number of the lot to be
made on new manufacturing orders.
The height of the red knot measures the total inventory of
finished stores, parts in process, and raw material, all in terms of
numbers of finished parts. The distance between the red knot and
the blue knot, therefore, measures the amount of raw material on
hand. The ordering point for new material is indicated by ribbon 5
and is set as far above ribbon 2 as will permit the stores and
purchasing departments to obtain new material by the time it is
needed. By means of auxiliary clips attached to the strings and
coloured marker buttons shown at the left it is possible to visualize
all the conditions shown on the balance-of-stores sheet. Control
boards based upon the Gantt chart that are adaptable to the control
of stores, etc., are now manufactured commercially.
100 Stores Control
Control of the Inventory :

Materials in stores, in process of fabrication, and in the form of
'finished stock are, for the time, crystallized capital and not
infrequently represent a large part of the capital investment.
Although it is essential, therefore, that the material needs of the
company be adequately provided for, it is equally important that
this form of capital investment be kept at a minimum value. Under
older and cruder methods of management this value was known,
with any degree of certainty, but once a year when a visual inventory
was taken of the entire plant; in fact, this method, still prevails in
many plants. In taking such an inventory all assets are evaluated
and all material measured, weighed, or counted, and priced
according to the judgment of those taking the inventory, with a
view to finding the current value of the business. Usually this means
a total suspension of work for several days, and it always makes a
serious interruption of the work, though it does give a good picture
of the state of the business.
It will be clear, however, that if stores have been issued only
upon proper orders and if the balance-of-stores ledger is accurately
kept, it will be a continuous inventory of all material in stores. And
since the cost of all material is also placed upon these ledger sheets,
they also record the cost value of all material in stores. Whether this
value or the present market value or a depreciated value shall be
placed upon such an inventory is a matter of judgment upon the
part of the management. It is customary, where a continuous
inventory of this kind is kept, to check the actual amount in each
bin or rack against the stores ledger whenever an order is placed for
additional material, so that verification of the stores ledger is in
constant progress. Many managers are not satisfied, however, with
such a clerical inventory and, although using it for ordinary
accounting purposes, insist upon a periodic visual inventory. An
analogy is found in banking where book values are always verified
by periodic counting of all assets on hand.
The cost ledger shows at all times the values of all material in
process of fabrication. Finished goods or stock is recorded in a stock
ledger not unlike the stores ledger. The value of all fixed assets such
Stores Control 101
as land, buildings, machinery, etc., is recorded in a plant ledger.

These several ledgers, therefore, if accurately kept, constitute a
complete continuous inventory of the physical assets of the
enterprise. The relation of stores, material in process, stock, and the
three corresponding ledgers in their relation to the main ledger are
shown graphically in Fig. 55, where production is visualized as a
flow from left to right of the diagram. The stores act as a reservoir
between the market for supplies and the factory; the stock room acts
in a similar capacity between the factory and the market for sales.
The stores ledger registers the level of the value of the stores; the
cost ledger registers the accumulated values of materials in process;
and the stock ledger indicates the value of the finished goods on
hand.
It is obvious that the methods, blanks, forms, etc., that may be
used advantageously in storeroom and stock room work will vary
widely with the business and conditions, as indeed they necessarily
must in all business organizations. The methods suggested in the
preceding paragraphs have been included more to explain the
problems met in handling material than to advocate them as the
best for all cases. They are, however, in successful use in many
places.
Although it is essential that the necessary stores shall be on
hand when needed, it is just as essential that no more stores shall
be carried than is necessary. The maximum and minimum quantities
of all materials should, therefore, be determined with care. In many
cases these limits can be set only by experience and careful
observation, and such observation will often result in a great
reduction of inventory.
A number of efforts have been made to determine mathematically
the most economical number of pieces that should be produced at
one time, taking into account probable sales, cost of setting up the
machinery of production, interest upon the investment in stores,
etc. Professor Ralph C. Davis has developed a very complete and
fairly simple solution of the problem as follows:
LetQ = the most economical number of pieces to be
manufactured.
102 Stores Control
A = total cost of preparation for manufacturing, setting up,

etc.
M = rate of manufacturing expressed in pieces per year.
S = rate of consumption by sales per year.
C' unit cost per piece.
I = current rate of interest.
RI = quantity of material necessary to manufacture the lot of
parts.
R = quantity of material in stores when order for new material
should be placed.
R2 = reserve material held in stores for emergency purposes.
R
F = - convenience.
Rl
It should be noted that, in general, R2 = R - RI . If, however, no
reserve is considered necessary, R = RI and ordering would begin
when the material on hand was just sufficient to manufacture a lot
of parts. If, however, material can be obtained quickly and if the
withdrawal of material is gradual so that ordering and receiving of
new material may proceed coincident with the manufacturing of
the same, R may be less than RI and R2 is then a negative quantity.
The value of F, furthermore, will be greater or less than unity
depending upon whether R is greater or less than RI .
Then according to the demonstration of Professor Davis,
Q= fA
V"K'
where K is a constant whose value for different values of F is as
follows:
F K F K
1.25
Stores Control 103
0.50 C'I 1.50

2S
0.75 M+O.5S)C'I 2.00 M +S)(M +2S))C'I

( 2MS ( 2M 2S
1.00 3.00 M +S)(M +4S))C'I

( 2M 2S
To explain the use of the equation, assume that the rate of sales
S = 30,000 per year and that where the machinery of production is
set up, parts can be manufactured at a rate per year of M = 150,000.
Let C' = $20, I = 0.06, A = $1,000, and assume that conditions are
such that no reserve is needed; hence R = Rl and F = 1.0.
Then
K= (M+S)C'I=( 150,000+30,000 !"OxO.6=0.000024

2MS 2 x 150,00 x 30,000 r
Hence
Q=~= 1,000 = 6 455 pieces.

0.000024 '
This would be about 4 months' supply, and it would require
about 2 weeks to produce the lot of goods.
This discussion indicates that for lowest unit cost the quantity
to be manufactured varies as the square root of the preparation
costs. This appears to be corroborated by other similar discussions.
The effect of preparation costs upon unit costs as discussed in Art.
31 and as illustrated in Fig. 4 should be noted. It will be seen that
this influence is very great when the number produced is small,
decreases rapidly as the number is increased, and becomes negligible
when the number produced is very large. It should be noted also in
this regard that in solving the Davis equation the unit cost is
assumed from preceding records. If this cost has been obtained
104 Stores Control
from manufactured quantities not markedly different from the value
of Q, the solution may be considered satisfactory. If, however, this
cost has been obtained from much larger quantities than Q and
particularly if Q should be a moderately small quantity, a rise in
manufacturing costs might result if the quantity represented by Q
was put into production. In other words, the quantities must be
such as to be well away from that portion of the curve (Fig. 4) where
the rate of change of curvature is very great.
The Davis equation is simple and easy for application; and
considering that all such expressions rest partly, at least, upon
certain assumptions, such as the rate of interest, the unit cost of
production, and the yearly rate of sales, it is probably sufficiently
accurate for most cases. Professor F. R. Raymond has developed
fully the theory of economical lot sizes in his book "Quantity and
Economy in Manufacture," and the reader is referred to this volume
for a very exhaustive treatment of the subject.
Economical Use of Material:
The material wasted around a factory may be a serious source
of loss, particularly if the material has high intrinsic value as in the
case of copper and brass. These wastes may be due to many causes.
It is not always possible to specify exactly just how much of a certain
material is needed for a job; and, if a liberal amount is drawn, that
left over after the completion of the job is seldom returned to the
storeroom but collects on and under benches and in out of the way
comers. In certain kinds of work, as in punch-press processes, the
material left after the punched parts are removed is often as great as
or greater than the parts themselves; and if the material is valuable,
care should be taken to recover it. In all cases systematic and
constant effort should be made to collect and store all scrap so as to
recover as much value as possible and also to keep the shop or
factory clean.
In nearly every storeroom will be found old material for which
there is no apparent use. This comes usually from two sources. The
first is over ordering of material for special jobs. Special material is
always a hazardous investment, and care should be taken that no
Stores Control 105
more is ordered than will give the minimum margin of safety. The
second most important cause is a change in design. The engineering
department can save a great amount of money by carefully
considering the question of material. The standardization of parts
and the use of the same part as often as possible keep down the
value of the inventory, and great care should be taken that no change
in design is made that will leave raw material, finished parts, or
completed machines in danger of obsolescence. Obsolete material,
raw or worked, depreciates very rapidly, completed machines often
being worth less than the original cost of the materials of which
they are composed. Before scrapping such material, however, a report
should be sent to the manager, approved by all parties concerned,
giving the inventory value, scrap value, and loss, with the reasons
and responsibility for such loss clearly determined.
The wasteful use of indirect materials and supplies is another
source of great loss, especially in large plants. As before'noted, it is
a difficult problem to specify accurately and supervise intelligently
the drawing of expense material from the stores. The cost-keeping
system, however, that furnishes accurate records of all expense
material is a powerful means of regulating these expenditures. The
purchasing of expense material best suited to the needs of the plant
and its economical handling and use are a fruitful field of study for
the works engineer, and his labour will be greatly expended by
well-kept records of performance.
***
Chapter
CREDIT SYSTEM
**
The term credit may be defined broadly or narrowly. Speaking
broadly, credit is finance made available by one party (lender, seller,
or shareholder / owner) to another (borrower, buyer, corporate or
non-corporate firm). The former may be a pure lender (a financial
institution or a private money-lender), a seller supplying goods
against the buyer's promise of future payment, or a shareholder/
owner of a corporate/non-corporate firm making funds available
to the company viewed as a separate entity.
More generally, the term credit is used narrowly for only debt
finance. In this chapter, we shall also use the term in this sense.
Thus defined, credit is simply the opposite of debt. Debt is the
obligation to make future payments. Credit is the claim to receive
these payments. Both are created in the same act of borrowing and
lending. This act is a special kind of exchange transaction, which
involves future payments. In an exchange transaction, to every sale
there is an equal purchase since, by definition, sale and purchase
are two sides of the same transaction. Similarly, in a credit
transaction, the amount loaned is equal to the amount borrowed
(and the interest paid is equal to the interest received). At any time,
the total volume of debt is equal to the total amount of credit.
Credit is a stock- flow variable. At any point of time there is a
certain amount of credit (of anyone kind or all kinds) outstanding.
Credit System 107
It is a revolving stock. Once a loan is repaid, the amount received
can be advanced to the same party or some other party or parties.
Any increment (decrement) in the stock of credit per period
represents a positive (negative) flow of credit per period.
Credit should be carefully distinguished from money. Even bank
credit is not the same thing as money. Their nature and functions
are not the same. Money is an asset of the holding public. It is a
liability of the banking system (including the RBI) and the
government. However, it is not all the liabilities of the banking system
that are money, but only those that serve as media of exchange,
namely currency and the demand deposits. Bank credit, on the other
hand, is a liability of the borrowing public (or the government) to
banks and an asset of banks. Then, money serves as the commonly
accepted medium of exchange and the unit of account. Bank credit
itself does not serve as bank money. What serves as bank money (in
the narrow sense) is the demand deposit of a bank on which cheques
can be drawn in the settlement of payments. Bank credit only allows
the borrower a claim to such a deposit (or bank money) up to a
certain sanctioned amount, All this will be discussed in sORledetail
separately.
.
Then, bank credit is only one form of credit. In a modem economy,
there exist several other sources of credit as well. Collectively they
constitute the financial system.
In a credit economy, that is economy with borrowing and
lending, each spending unit (whether a household, a company, or
the government) can be placed in anyone of the three categories:
deficit spenders, surplus spenders, and balanced spenders,
according as its total expenditure is greater than, less than, or equal
(owned or internal) receipts, respectively. We shall have several
occasions to use these terms or concepts in the book. The major
function of credit is to relax the constraint of balanced budgets. As
we shall study later, it is through this chief function that the financial
system is able to promote savings, investment, better allocation of
resources and growth in the economy. It is also worth remembering
that if credit is not well managed, it can cause inflation or deflation
and unemployment. It can also lead to malutilisation of resources,
108 Credit System
excessive concentration of income and wealth in a few hands, and

exploitation of the weak and the poor.
What is a Financial System:
A financial system should be distinguished from a payments
system. Earlier we had defined the latter as the set of institutional
arrangements through which purchasing power is transferred from
one transact or in exchange to another. The payments system is,
thus, concerned with payments in cash. The financial system is
much broader than a payments system in that it covers both cash
and credit transactions importantly, the financial system is a set of
institutional arrangements through which financial surpluses (or
commands over real resources) in the economy are mobilised from
surplus units and transferred to deficit spenders. The institutional
arrangements include all conditions and mechanisms governing
the production, distribution, exchange, and holding of financial
assets or instruments of all kinds and the organization as well as
the manner of operation of financial markets and institutions of all
descriptions. In concrete terms, financial assets, financial markets,
and financial mstitutions are the three main constituents of any
financial system.
Financial assets or claims are generally subdivided in the two
heads of primary (or direct) securities and secondary (or indirect)
securities. The former are financial claims against real-sector units.
The examples are bills, bonds, equities, book debts, etc. They are
created by real sector units as ultimate borrowers for raising funds
to finance their deficit spending. The secondary securities are
financial claims issued by financial institutions or intermediaries
against themselves to raise funds from the public. The examples are
such diverse financial assets as the-Reserve Bank currency, bank
deposits, life insurance policies, units, lOBI bonds, etc.
In the present day Indian economy important financial assets
are currency, bank deposits (current, savings, and fixed), post office
savings deposits, life insurance policies provident fund
contributions, bonds (government and corporate bills, hundis,
corporate shares (ordinary and preference), units of the UTI,
company deposits, compulsory deposits, deposits with investment
Credit System 109
companies/trusts, nidhis, chit funds and similar other
organizations. The list is not meant to be exhaustive. Nor is any
asset listed above homogeneous. Thus, currency includes both coins
and paper currency notes, which are further of different
denominations. Ordinary share or bonds of-no two corporations
are identical. Nor are any two insurance policies. The products of
the financial industry are truly heterogeneous. We have already
studied about currency, bank deposits of various kinds and post
office savings deposits in the previous chapter. We shall study more
about other financial assets and various financial institutions and
markets operating in India in later chapters.
In a modem industrial economy a wide variety of financial
institutions, more popularly called financial intermediaries (FIs)
have grown. We shall study about their role and common services
and features in the next pages.
FIs are generally classified under two main heads: (a)
banks and (b) non-banks or non-bank financial intermediaries
CNBFIs). The dichotomous classification shows the special position
banks occupy in a country's financial structure.
Financial Intermediaries:
Financial Intermediaries (FIs) are institutions or companies that
mediate or stand between ultimate lenders and ultimate borrowers
or between those with budget surpluses and those who wish to run
budget deficits. The examples are banks insurance companies, unit
trusts (or mutual funds), investment companies, provident funds,
etc. The central function of all FIs is to collect surpluses (savings) of
other economic units and to lend them on to deficit spenders. Both
the surplus units and the deficit spenders belong to the real sector
of the economy. Their principal economic activity is to buy and sell
productive factors and current out put, whereas the principal
economic activity of financial institutions is the purchase and sale
of financial assets.
We know the distinction between primary securities and
secondary securities. The former are bought by both surplus real-
sector units and FIs. When surplus units buy these securities, they
110 Credit System
are said to provide direct finance to ultimate borrowers. A part of

the total surpluses of surplus units is provided to deficit spenders
in this way. But this is only a part of the story in a modern money-
using system. A large and growing part of the savings of individual
units are now placed in secondary securities and thereby make
them available to ultimate borrowers. The ultimate lenders are still
I
. the surplus units. But they lend to ultimate borrowers indirectly

through FIs and not directly. Therefore, in such cases the finance
given by th~m is called indirect finance.
Thus the FIs are dealers in securities. What they buy are primary
securities, what they sell ere secondary securities. By absorbing
primary securities in their asset portfolios and producing secondary
securities to finance them, they virtually transmute primary
securities into secondary securities. The essence and the success of
financial inter mediation lie In this asset transformation. This is the
alchemy which only the FIs possess,.; They alone are able to produce
securities that are in general far more acceptable to surplus units
than the primary securities produced by deficit spenders. The latter
themselves can not produce financial claims that meet as welUhe
asset preferences (in terms of risk, liquidity, convenience, etc.) of the
wealth-holding public as the secondary securities manufactured
by the FIs. The latter embody innovations in financial technology
whereby disparate asset debt preferences of lenders and borrowers
are reconciled and satisfied to the satisfaction of both the parties.
One simple example of the asset transmutation role of the FIs
will throw further light on it. Consider a farmer who wants a crop
loan against his promissory note supported by .the crop sown in
his field. The local village moneylender has been the traditional
source of finance to him. But an urban, household will not be willing
to lend to the farmer because of high risk and inconvenience
involved. Normally, there will be no point of contact between the
two in the first Instance. It will be different with a bank (or a co-
operative credit society). The bank may be having several such
borrowers among its customers and organizational links and staff
to service such loans. The urban household may be operating a
savings account with this bank and thereby entmsting a part of its
Credit System 111
surpluses to the bank. The bank will be lending a part of the saving~
of the urban household to the farmer. Yet the urban household does
not care so long as it has confidence in the bank's ability to pay
cash on demand. Thus, the secondary security in the form of savings
deposits has enabled the bank to mobiles savings of households
which can be used to lend even to a distant farmer who could not
otherwise borrow directly from an urban household on the strength
of his own promise to pay.
Gains to Lenders and Borrowers :
Talking generally, why do surplus units prefer to lend to FIs
rather than directly to deficit spenders? In other words why do they
prefer secondary securities to primary securities? The major
advantages to ultimate lenders are summed below:
(1) Low Risk : Other things being the same lenders are
interested in Minimising all kinds of risk of capital and interest
loss on loans or financial investments they make. These risks may
arise in the form of risk of default or risk of capital loss on stock
market assets. Such risks on secondary securities are far less than
on primary securities for individual lenders. How FIs are able to
reduce such risks even though they themselves hold primary
securities will be explained later. Besides government regulation of
the organization and working of major FIs helps in reducing risks
of their creditors. Any strengthening of the financial system that
goes to inspire public confidence in it reduces further any
psychological risk suffered by lenders.
(2) Greater Liquidity: FIs offer much greater liquidity on their
secondary securities to their lenders. Consider a few examples.
Demand deposits of banks are perfectly liquid. They can be drawn
upon without notice, Banks allow even time deposits to be drawn
upon subject to certain condition involving only some loss of interest.
They, of course, always stand ready to lend against them. Units of
the UTI can be sold back to it. Savings embodied in life insurance
policies are not equally liquid, but loans can always be arranged
against them from banks or the LIC itself. Primary securities do not
carry any of these features, because primary borrowers need funds
for agreed periods to finance their expenditures. For reasons to be
112 Credit System
explained later. FIs can offer much greater liquidity to their creditors,
and yet lend on a much longer term to their debtors.
(3) Convenience: Secondary securities sold by FIs are easy to
buy, hold, and sell. The information cost and transaction cost
involved are very low. Banks run b:.:anches in all urban areas and
several semi-urban and rural areas. The deposits they sell are
standardised and information about them easily available. So the
choice about bank deposits, life insurance policies. UTI units is not
as difficult as about (say) corporate equIties (primary securities).
Mueh, however, depends on the quality of cpstomer service provided
by the FIs. which in the case of public sector FIs in India is deplorably
poor. This has hampered greatly the growth of financial inter
mediation in the country.
(4) Other Services: Each of the FIs specialises in selling special
kinds of secondary securities and other services associated with
them. Thus, banks specialise in selling deposits with particular
features. In addition, they transfer funds, collect cheques for their
clients, offer safe-deposit vaults and most important of all are the
dominant lender. All these and several other services attract the
public to banks and induce it to hold deposits with them. The UTI
sells units (shares) of a balanced asset portfolio of marketable
corporate securities to the investing public.
The LIC collects long-term savings of the public by selling life
insurance. These other services can be had only when particular
kinds of secondary securities carrying them are bought.
Borrowers also have a preference for Fls due to the following
reasons:
1. Fls have big pools of funds so that big individual demands
for funds can be satisfied only by the FIs.
2. There is much greater certainty of the availability of funds
with the FIs at the all times.
3. The rate of interest charged by the Fls is generally lower
than that charged by other lenders: and
4. Regulated Fls do not fleece small borrowers in
the manner moneylenders do. On the contrary as a matter
Credit System 113
of official policy, banks and other official lending agencies

are required to give small borrowers preferential tr~atment
both in the grant of credit and in the rate of interest charged
by them. The actual implementation of policy leaves much
to be desired.
Economic Basis of Financial Intermediation:
In view of the above the question arises how are the Fls able to
offer better financial facilities both to the lenders and borrowers?
What is the economic basis of their success or of the financial
alchemy whereby they purchase and hold primary securities which
are much riskier and far less liquid than the secondary securities
they sell as their liabilities to the general public and yet earn
handsome profits on their activities? The answer will help us
understand better the source of social gain accruing from
improvements in financial technology.
The true economic basis of financial intermediation lies in the
economies of scale in portfolio management and in the law of large
numbers. This is explained below.
(1) Laws o/Large Numbers: Banks, insurance companies, unit
trusts, and all other FIs operate on the assumption, supported by
statistical law of large numbers, that not all the creditors will put
forward their claims for cash at the same time. Add to this the fact
that if some creditors are withdrawing cash, some others (whether
old or new) are paying in cash. Besides, FIs receive regularly interest
payments on loans and investments made and repayments of loans
due. Fortified by this knowledge, banks keep in cash only a small
fraction of even their demand liabilities and invest or lend the rest*
For the same reason, unit trusts can also afford to keep most of their
funds (liabilities) invested in securities and yet offer to buy back all
the units the unit-holders like to sell at any time. Life insurance
companies also operate on the actuarial fact that a determinable
fraction of lives insured will actually expire in a normal year, so
that they need keep only an estimated fraction of their total life
funds in cash and near cash and the rest of them can be invested on
long-term basis. Thus FIs can afford to manufacture liabilities
1 114 Credit System
(secondary securities) that are far more liquid than the primary
securities they buy as earning assets.
(2) Economies a/Scale in Portfolio Mill. , ~t'l1lellt : The average
size of the asset portfolios of banks, insurance companies and other
organized sector PIs is quite large in value. So these FIs can reap
several economies of scale in portfolio management which improve
significantly their net rates of return from their asset holdings. These
economies accrue in the following main forms:
(a) Reduction of risk through portfolio diversification: Lending/
investing is always risky. It carries risk of default and of capital
loss on marketable assets. One common way of reducing risk is
through pooling of independent risks by placing funds in a
diversified portfolio. There by what the investor may lose in a few
directions may more than make up in other directions. But for
adequate diversification the size of the portfolio must be reasonably
large, otherwise the cost of portfolio management will become
excessively high. An average wealth owner cannot afford the degree
of portfolio diversification and the resulting reduction of risk an
average FI can. Then a large FI can schedule maturities of its loans
to match anticipated outflows and thereby safeguard its liquidity.
(b) Professional Management : The large size of the asset
portfolios to be managed allows FIs to employ professional managers
who are well versed in the complexities of modem finance in
appraising loan proposals in evaluating investment opportunities
in monitoring their loans and investments in analyzing
consequences of market and other developments for the health of
their businesses. Individual wealth owners cannot afford the cost
of professional management and other support staff. They do not in
general have the expertise, time, or even the desire to manage
financial asset portfolios comprising of primary securities.
(c) Indivisibility's and market imperfections: Some loans and
investments are of very large size individually. Average household
wealth owner cannot handle them. In certain cases even FIs have to
come together in consortia, pool their resources and spread their
risks to finance them. The per rupee administration cost of large
loans borne by FIs is quite low.
Credit System 115
In certain cases, such as purchase of treasury bills or placement

of call funds, only sums above a certain minimum amount too large
for an average householder are accepted by the borrower to save
transactions costs. Thus FIs with large asset portfolios can earn
interest ever, on very short-term funds and construct the maturity
structure of their assets as desired. Small asset holders cannot do
so.
(d) Other cost economies: Because of the large volume of business
the fixed C05t of establishment, cost of information and various
transactions costs are lower per unit of transaction to a FI than to
an average household wealth-owner.
FIs and the Economy:
FIs playa very important role in the functioning of a modern
complex economy, in promoting economic development and in the
working of monetary credit policy. This role inheres in the separation
of saving and investment, so characteristic of modern capitalist
economies. In most cases savers are different from Investors. In India
the bulk (75 to 80 par cent of the total) of savings is done by
households. About half of it is invested directly by them in physical
assets but the rest is committed to financial assets. In industrially
developed western economies the proportion of financial investment
of household savings in much higher. Corporate firms and the
government are everywhere net deficit spenders. Financial assets
are the vehicles through WhiC:l the savings of surplus spenders are
mobilised and allocated among deficit spenders. Some part of this
mobilisation allocation is accomplished through primary securities
acquired directly by the savers. But the bulk of financial savings is
handled by the FIs. The more numerous, varied, well organized,
geographically well distributed and efficient the FIs that is the more
developed the financial infrastructure of an economy, in general,
the more economically developed will also be that economy. This is
discussed in the next section.
Functions and Importance of the Financial System:
The financial system helps production capital accumulation
and growth by (i) encouraging savings, (ii) mobilising them, and
116 Credit System
(iii) allocating them among alternative uses and users. Each of these
functions is important and the efficiency of a given financial system
depends on how well it performs each of these functions.
Inducement to Save:
Savers require stores of value to hold their savings in. The
financial system promotes savings by providing a wide array of
financial assets as stores of value, aided by the services of financial
markets and intermediaries of various kinds. For wealth holders,
all this offers ample choice of portfolios with attractive combinations
of income, safety and yield. With financial progress and innovations
in financial technology, the scope of portfolio choice has also
improved. Therefore, it is widely that the savings income ratio is
positively elastic with respect to both financial assets and financial
Institutions. That is, financial progress generally induces larger
savi.tgs out of the same level of real income.
As stores of value, financial assets command certain
advantages over tangible assets (physical capital, inventories of
goods, etc.) : they are convenient to hold or easily storable, more
liquid, that is, more easily encashable, more easily divisible, and
less risky. The pecuniary yield from money is zero. But, as a
generalized means of payment, it gives convenience yield to its
holders and users. Non-money financial assets yield money returns
to their holders. In addition, some of them render other specific
services as well For example, life insurance policies also provide
cover against risk of loss of life over the currency of the policy.
Corporate equities serve as a hedge against inflation.
A very important property of financial assets is that they do not
require regular management of the kind most tangible assets do.
Factories, farms, and shops need to be run by their owners in order
to earn income. Owners of financial assets are completely absolved
of this responsibility, so that they can devote their full time and
energy to whatever other pursuits they like to follow. Owners of
financial assets are only the ultimate (or indirect) owners and not
the immedia te (or direct) owners (except for equity shareholders) of
tangible assets. The latter are the borrowers of funds who are
Credit System 117
responsible for the actual management of tangible assets. They
assume all the risks of production.
Thus financial assets have made possible the separation of
ultimate ownership and management of tangible assets. In the case
of corporations even the immediate owners, the shareholders, do
not run the management. This separation of savings from
management has encouraged savings greatly. With the availability
of financial assets as stores of value, the public can save and hold
its savings in these assets without the necessity of converting these
savings into tangible assets and then managing these assets. On
the other hand, management can be professionalised, that is, the
management of tangible assets can be entrusted to professional
managers (without requiring them to own these assets), which
improves productivity.
Savings are done by households, businesses, and government.
Following the official classification adopted by the Central Statistical
Organization (C50). Government of India, we reclassify savers into
the household sector, domestic private corporate sector and the
public sector. The household sector is defined to comprise
individuals; non-Government non-corporate entities in agriculture,
trade and industry and non-profit making organizations like trusts
and charitable and religious institutions. The public sector
comprises central and state governments, departmental and non-
departmental undertakings, the RBI etc. The domestic private
corporate sector comprises non-government public and private
limited companies (whether financial or non-financial) and co-
operative institutions. Of these three sectors, the dominant saver is
the household sector, followed by the domestic private corporate
sector. The contribution of the public sector to total net domestic
savings is relatively small.
Savings by households are done for several reasons. The motives
to save may be to provide for known future need.s( such as old age,
education and marriage of children, the desire to own property, to
buy high-value consumer durables, or simply to satisfy the urge to
grow wealthy. The motive may also be to build up capacity to meet
better uncertain future needs such as sickness or accident, that is, to
118 Credit System
provide for the rainy day. Household and business savings also
arise due to lack of synchronisation between income stream and
expenditure stream, the latter following the former.
Different kinds of financial assets are required and have come
to be produced to meet diverse needs and preference of differed,
categories of savers. Yet there is vast scope for introducing known
kinds of financial assets not yet available in India such as shares or
deposits of building societies that specialise in giving loan finance
to their members for constructing residential houses, for developing
mortgage market, for innovating with new kinds of financial assets,
and in making available more widely, especially in semi-urban
and rural areas, the financial assets which are already being
produced, such as life insurance and UTI units. For improving
further the financial system's influence on the public's willingness
to save, measures should be taken to reduce the risk of default and
market riskiness of financial assets, to improve their liquidity and
rates of return, and to maintain price stability to avoid real-value
depreciation of monetary financial assets.
It may be noted in passing that not all tangible assets are inferior
to financial assets as passive stores of value. By a passive store of
value we mean something which does not require regular
management as does a farm or a factory. Important examples of
such tangible assets in the Indian context are gold and silver
ornaments or bullion. They are attractive stores of value for the
public. This is especially so during periods of inflation when the
real value of most financial assets (except equity shares) goes down
and gold and silver appreciate in money value along with inflation.
Some time this appreciation is greater than the average rate of
inflation, making these precious metals highly attractive stores of
value. This again emphasis's the importance of price stability.
Mobilisation of Savings:
Financial assets separate the act of saving from the act of real
(physical) investment. Savings are done by millions of individual
households and firms. They may be in large or small amounts, long
term or short term. All these individual savings need to be collected
Credit System 119
or mobilised before they can be spent by deficit spenders. A financial

system is a highly efficient mechanism for mobilising savings. In a
fully monetised economy this is done automatically when, in the
first instance, the public holds its saving~; in the form of money.
However, this is hot the only way of instantaneous mobilisation of
savings. Other financial methods used are deductions at source of
the contributions to provident fund and other savings schemes.
More generally, mobilisation of savings takes place when savers
move into financial assets, whether currency, bank deposits, post
office savings deposits, life insurance policies, bills, bonds, equity
shares, etc.
Financial assets are broadly divisible into two categories: (a)
primary securities; and (b) secondary securities. The former are
securities issued by the ultimate borrowers such as bills, bonds,
equity shares, company deposits, etc., while secondary securities
are securities issued by financial institutions (also called financial
intermediaries) such as banks, insurance companies, etc. When the
public buys primary securities, it makes its surpluses available
directly to deficit spenders. It represents direct mobilisation as well
as allocation of credit, though it is also through the mediation of
financial assets and markets. When the public buys secondary
securities, it entrusts its savings to financial institutions who
allocate it further among competing borrowers. This represents
financial inter-mediation. A part of saving does not go through the
financial system. It is that part which is invested directly by savers
in tangible assets, whether houses, businesses, or precious metals.
For financial planning and control institutionalization of
savings is important, because it is easier to control lending/
investing policies of financial institutions than of millions of direct
lenders or direct investors in physical assets.
Allocation of Rinds:
Another important function of a financial system is to arrange
smooth, efficient, and socially equitable allocation of credit.
Moneylenders and indigenous bankers have been providing finance
to their borrowers since long. But their finance suffers from several
defects. With modern financial development, new financial
120 Credit System
institutions, assets and markets have come to be organized, which
are playing an increasingly important role in the provision of credit.
In the previous sub-section, we have already spoken about direct
purchase of primary se.~urities by the public. Such direct lendings
by the general public have been made possible by the organization
of stock markets and marketable financial assets, such as corporate
bonds and equities. Besides, there are banks, insurance companies,
and other financial institutions. They serve as financial
intermediaries between the ultimate lender and the ultimate
borrower. They mobiles savings of the former by selling their own
liabilities (deposits, insurance policies, etc.) and make these funds
available to deficit spenders at their own risk. So, many savers find
the secondary securities of financial institutions much more
acceptable than the primary securities of all sorts of borrowers.
The allocative role of financial institutions is very important.
Only corporations can go to the stock market for raising funds
through public issue of equity shares and bonds. Even there the
support of financial institutions as buyers of securities is important.
But non-corporate borrowers cannot issue marketable liabilities.
Therefore, they depend on bank finance or private finance. In the
market for funds there Is generally credit rationing. This makes the
availability of credit important to all potential borrowers. Financial
institutions (subject to the policy of the government and the RBI)
determine how institutional finance will get allocated among
various sectors of the economy and among competing borrowers.
In the allocative function of financial institutions lies their main
source of power. By granting easy and cheap credit to particular
companies, they can shift outward the resource constraint of these
firms and make them grow faster. On the other hand, by denying
adequate credit on reasonable terms to other firms, financial
institutions can restrict the growth or even normal working of these
other firms substantially. Thus, the power of credit can be used
highly discriminatory to favour some and to hinder others. Realizing
this early in the day, all important business houses in India had
either started or otherwise controlled individual banks and/or
insurance companies. For the same reason, all major financial
Credit System 121
institutions, called picturesquely as 'commanding heights' of the

economy, have been either nationalised or set up in the public sector
from the very beginning. Thereby the direct control of financial
institutions by business houses has been eliminated. But these
houses do continue to enjoy substantial influence on the actual
credit allocation by these institutions. Organized credit to weaker
sections is still inadequate.
Serving Production, Trade, and Investment:
All the above services of savings promotion, mobilisation, and
allocation are essential for production, capital formation and growth.
Investment obviously requires that there is corresponding amount
of saving. If at individual firm level all investment were to be financed
by Internal savings only, the aggregate rate of investment in the
economy will be pitiably small, because a major portion of savings
Is done by non-investors. What the financial system does is to break
the straight jacket of internal finance (or balanced budget). It places
at the disposal of entrepreneurs resources saved by others. This
enlarges greatly the aggregate rate of investment.
The financial system enlarges greatly the aggregate rate of
savings and their mobilisation by offering savers a wide variety of
financial assets to suit their needs and preferences. There is a
comparable service offered to investors (and producers) to induce
them to absorb the savings the system generates. As borrowers they
are facilitated to produce a wide range of financial liabilities to suit
their needs and preferences. Thus, for example, they can borrow
short term or long terra, issue bills or bonds, ordinary shares, or
preference shares, bonds may be convertible into equity shares, or
not. Then corporate shares are limited liability documents that is
the liability of a shareholder is limited only to the face value of
shares he holds. The sources of funds are also several: open market,
banks, insurance companies, indigenous bankers and
moneylenders, trade credit, etc. All this brings into contact a much
larger number of ultimate borrowers and ultimate lenders than
would be possible otherwise. It bears repetition to say that this
promotes specialisation of the functions of saving and investment.
Those who have the capacity and willingness to save, but not to
122 Credit System
undertake production, may only save and entrust their savings to
others, either directly or indirectly through financial intermediaries.
These other persons may have both the competence and willingness
to organize production but may not have enough resources of their
own to make the required investments. The financial system makes
it possible for them to make use of their entrepreneurial skills by
providing them credit* Apart from encouraging investment, this
makes possible b~tter use of scarce entrepreneurial and technical
skills in the country.
A well developed financial system is able to mobiles and
allocate all kinds of savings, howsoever small or short term. This
helps in the maximum utilisation of savings. It also facilitates flow
of savings throughout the economy and thereby the flow of funds
in directions where returns are presumably highest. This
supposedly helps in the maximization of returns from resources.
Production requires various kinds and amounts of capital
(funds) : long term capital for making fixed investment in physical
plant (land, buildings and machinery); medium term capital for
buying other tools and equipment: and short term working capital
to finance current operations of business. Shortage of any kind of
capital with any firm can hurt badly its productive activity and
growth. The financial system helps firms in raising funds for meeting
its various requirements. Of course, every firm must have some
equity funds of its own to start business. For big projects requiring
large amounts of capital, no single firm or house is usually in a
position to raise all the required finds internally. It has, therefore, to
depend upon outside sources. Even in the case of big corporations,
promoters equity is usually a small proportion of total equity
capital. The rest of the equity capital and all long term debt capital
are raised in the open market by the public issue of shares and
bonds. Thus, a corporation is not only a new for a of business
organization, more importantly, it is a financial innovation which
makes it possible to collect financial surpluses of far-flung surplus
spenders through open-market sale of shares and bonds. Small
firms suffer greatly from the paucity of funds. Their needs for credit
are met inadequately and at very high cost.
Credit System 123
In usual discussions there is a presumption that mobilisation

of surpluses and their allocation among deficit spenders by a
financial system are always to the good of the country as a whole.
This is not necessarily true. The financial system can work to the
detriment of savers in a variety of ways. Public sector monopoly
and official regulation to help in the process. For example, the
deposit rates of banks can be kept artificially low, the deposit rates
of insurance companies can be kept artificially high and their bonus
rates to policy holders deplorably low. On the lending side, too, the
financial system (at least in parts) can be a vehicle of exploitation of
the weak and the expropriator of the small, as has been largely true
of moneylenders credit. Small borrowers can be starved of bank
credit and big borrowers surfeited with it. Excess credit to
government to finance its ever growing deficits is a major source of
inflation and all its ills and inequities. Thus, the equity of financial
system cannot be taken for granted.
Chapter
9
**
KINDS OF CREDIT
Credit is not one homogeneous good or asset. It is of many

kinds. To understand better the nature, scope and complexity of
credit and its problems, we look at the several kinds of credit.
There is no unique method of classifying credit. It can be, and
need to be, classified in more than one method, each way specializing
in only one aspect or dimension of credit. Thus, we classify credit
from five different angles: (a) source, (b) end-use, (c) users, (d) term,
and (v) cost. The problems of credit need to be studied from each of
these angles.
Sources of Credit :
In the present-day Indian economy credit is supplied by a wide
variety of sources. These sources may be conveniently classified as
in Figure 1.
Sources of Credit
I
I I
Institutional Non-institutional
I
I
Banks
I
Non-Banks Moneylenders
I
Open
I I
Sellers
I
(e.g. LlC) and Indigenous Market (Trade
Bankers Credit)
I
RBI Other Banks
I
I I .
Commercial C o-operatlve
Figure 1.
Kinds of Credit 125
Each source can be further subdivided into various sub-classes.
Here, we are presenting only a skeletal picture of them.
The End-uses of Credit:
Real credit is a scarce resource. Therefore, its proper allocation
among competing uses and users is of great importance for the
attainment of whatever social objectives a country sets before itself.
Credit is required and used, less or more, in all spheres of economic
activity. So, we may classify credit by its end-use by way of major
areas of economic activity. This is done schematically in Figure 2.
This provides the basis for the distinction between agricultural
credit, industrial credit, export credit, etc.
The classification in Figure 2 is neither rigorous nor exhaustive.
Its categories are not necessarily mutually exclusive nor their
boundaries well-defined. Yet some such broad classification is
essential for evaluating the prevailing credit arrangements in the
country and for any meaningful credit planning. This is because
the credit needs, their nature and the problems, of organizing credit
supply are likely to differ from one sector to the other, according to
their own structural features.
End-Uses of Credit
Production Consumption
I
Current Production Fixed Investment
Agriculture Industry Construction Trade and others
/
I
II
Cottage Small Large Domestic Foreign
Scale Scale Trade Trade
~
Food
~
Non-Food Expoerts Imports
Figure 2.
126 Kinds of Credit
The above sectors of economic activity can be cross-classified

in a number of ways. One cross-classification adopted by the FBI
for regulating the allocation of bank credit is that between the priority
and non-priority sectors. Another cross-classification is that
between rural urban credit. It is based on the location of economic
activity. The categories of rural credit and urban credit are self-
explanatory.
The end-use classification of credit is particularly important
for evaluating the allocation of credit from a particular source. For
example, this is particularly important in the case of commercial
bank credit as these banks are the lacgest single source of
institutional credit in India. For comprehensiv~ credit planning:
the end-use classification of non-bank institutional credit will also
be important. This knowledge, however, will only be a first step in
credit planning. Bust also develop social criteria for the optimal
allocation of credit know the factors responsible for the prevailing
allocation of credit, identify the difficulties involved in changing
this allocation and the remedial measures necessary for the
realization of the desired allocation of credit.
The Users of Credit :
The classification of credit by its users is not common. But this
(dimension of credit allocation, especially of the allocation of
institutional credit, is of much social Importance. The most important
proclaimed social objective of the rationalisation of major commercial
banks has been to reallocate bank credit in favour of the weaker
sections of the community. This kind of social concern relates to the
users of bank credit and not to the nature of its use.
The Term of Credit :
Yet another dimension of credit is the length of time for which
it is extended. The term of credit is important for both the borrower
and the lender. A borrower needs credit for various uses, some of
which will pay themselves back over a short period and some over
a medium or a long period. For example, the loan taken by a
manufacturer to buy raw materials for his products can normally
be repaid after a short period. The actual time-length will depend
Kinds of Credit 127
upon the time-length of the production-sale cycle, that Is, the time it
takes to manufacture the raw materials into finished products sell
them, and realize the sale proceeds. On the other hand, the credit
taken to install a machine will normally pay itself back over the
expected life of the machine. Suppose this life is 20 years, which is
a long period by common reckoning. Then, the manufacturer will
need long term credit for buying the machine. Similarly, in
agriculture, a farmer needs short-term credit for buying seeds and
fertilizer for a crop and long-term credit for making permanent
improvements on land. The former will pay itself back once the
given crop is harvested and sold, the latter will pay itself back over
a long period so long as the improvement lasts.
From the lenders side, too, the term of credit is important. For
financial institutions that raise funds by issuing their own liabilities
to the public, the determining factor is the nature of t.~eir liabilities:
whether they are short-term liabilities or long-term liabilities. For
example, a commercial bank raises funds by selling deposits of
various kinds to the public. Most of these deposits are short-term
liabilities. Only time deposits of a maturity of more than a year are
medium-term liabilities. Therefore, such a bank generally prefers to
make short-term advances. On the other hand, life Insurance
companies get long-term funds. The Insurance policies which they
sell are, in general, for long periods. Therefore, they can afford to
lend for long periods. They also prefer to do so in order to ensure
steady interest income from their investments and to keep the task
of reinvestment of funds to the minimum. This, task will increase
manifold if insurance companies make only short term investments.
Similar considerations held regarding the expected time-lengths of
the financial surpluses of surplus spenders and the credits expected
by them.
The financial industry is a service industry. It's raison d' etra
lies in servicing the real sector, which is responsible for the
production and distribution of real goods and services. The real
system for its efficient working needs credit of various time-lengths.
The financial system has to see how best it can meet these needs
without endangering either its own health or that of the real system
it is supposed to serve. For this, the financial system devises ways
128 Kinds of Credit
and means whereby short-term funds can be transformed into long-

term funds and vice versa.
We cannot go into the intricacies of all the financial devices for
the aforesaid transformations. But one general point does need to
be made. In financial matters liquidity is very important. In one
sense, it refers to the ability of a debtor to meet his obligations on
time. Almost always, it means his ability to pay cash, when due,
whatever his net worth position. That is, liquidity of a debtor is
different from his solvency. The latter is only concerned with the
question of the net worth of a debtor, whether it is positive or not.
It is possibly that a debtor rna y have positive net worth, but not
all his assets may be perfectly (or even highly) liquid. This brings
us to the second sense in which the term liquidity is used. In this
sense, liquidity is property of an asset. This property refers to the
ease with which an asset can be converted into cash on demand (or
short notice) without loss of value. In short, the liquidity of an asset
refers to the degree of its encashability In this sense, money is
perfectly liquid. Time deposits of banks and short-term marketable
assets are highly liquid. Corporate bonds though liquid, are much
leas so. Hence there arises a need for enchasing imperfectly liquid
assets before payments due can be made. And such needs can
frequently arise for individual units on account of unforeseen
developments.
The financial system provides a mechanism whereby particular
kinds of non-money financial assets (such as bills, bonds, equities,
etc.) can be converted into cash. The system does this through stock
markets where marketable financial assets are bought and sold
openly.
The existence of stock markets (and other financial mechanisms
to be discussed later in the book) allows creditors to make longer-
term loans even when their matching liabilities are of shorter
maturity. For, in time of need, they can tum to the market for meeting
their needs for cash through sale of some of their non-cash assets.
Of course, they run the risk of making capital losses through such
sales. But it is better than being not in a position to meet their
obligations to pay cash to their creditors, or letting the, opportunity
Kinds of Credit 129
of making higher profits by making longer term advances in
vestments slip by. The efficiency and success of a financial
institution depends among other things on how well it can combine
the twin considerations of liquidity and profitability.
Term vise credit is usually divided into three broad classes: (i)
short-term credit, (ii) medium-term credit, and (iii) long-term credit.
Short-terra credit is usually for a year or less. (In agriculture, it goes
even up to 18 months). Medium-term credit is for more than a year,
but less than ten years. Long term credit then is for ten years or
more.
In actual practice, however, borrowers may and do use short
term credit for financing durable investments and long term credit
for meeting working capital needs. For short term credit and long
term credit are not water tight-compartments. They all are liquid
funds that can be used in any manner except that it is not prudent
to finance long term investments by short term credit. But there may
be some delay in the receipt of long term funds. In the meantime,
short term funds may be used for long term investments. Then,
continuous renewals of short-term credit converts it into virtual
long term funds, though the borrower does run the risk of non-
renewal of short-term credit.
Cost of Credit :
The cost of credit is another dimension of credit. It varies over a
wide range for different classes or borrowers and for credit from
different sources. There are no hard and fast r~les for classification
of credit by cost. Following common usage, we may suggest only a
broad three fold classification: (a) cheap, (b) dear, and (c) usurious,
Cheap, dear, and usurious are relative terms. Their numerical
measures in rates per cent per year cannot be specified for all
situations. Two complicating circumstances are specially
noteworthy. One is the premium for any risk of default the other is
the expected rate of inflation. Quoted rates of interest are gross rates
which include provision for both in addition to the pure rate of
interest for the loan. And the provisions for the two llforesaid factors
may vary greatly over time, space, and the circumstances governing
borrowing and lending. Then an element of usury, small or large
130 Kinds of Credit
may also be prese,nt, depending on the relative bargaining strength

of the lender and the borrower.
Thus, several factors will have to be weighed before classifying
a particular rate of interest as representing cheap, dear, or usurious
cost of credit. But such a judgment is essential in any design of
credit policy. Quite often the monetary authorities attempt to achieve
policy goals by influencing the cost of credit through policy tools at
their disposal. So we read about a deliberate cheap money or dear
money policy. More about it later in the book.
Financial Markets:
A financial system operates through financial markets and
institutions. Financial markets deal in financial assets and
instruments of various kinds such as currency, deposits, cheques,
bills, and bonds, etc. In this chapter we describe briefly the main
types of financial markets operating in India.
Analytically, financial markets are very much like markets for
goods and services. As such they have their own demand, supply,
quantities, prices, etc. More important the whole financial system is
loose assemblage of credit markets and institutions of various kinds,
which differ from each other in various says in organization,
functions, size, of individual units on the supply side, geographical
coverage, methods of working, cost of credit, type of credit, etc. Some
parts of the credit system are more closely connected with each
other than others. Within each part of the credit system or within
each credit market, there is, in general, greater competition than
between any two parts or two markets. Thus, credit markets should
not be viewed as constituting one perfectly competitive system,
dispensing one homogeneous good (credit) at one uniform price
(the rate of interest), but a loose structure of markets dealing in
credit of various kinds at widely varying prices and under a wide
variety of organizations. Therefore, to understand well the Indian
financial system, it is essential to know the main features of its
individual parts.
Structure of Financial Markets:
The structure of financial markets can be studied from different
angles, namely, functional, institutional, or sectorial. Accordingly
Kinds of Credit 131
financial markets, institutions and instruments can be classified in
anyone or more of these wa ys. The functional classification is based
on the term of credit, whether the credit supplied is short term or
long term. Accordingly, markets are called money markets or capital
markets. The iilstitutional classification tells us whether the
financial institutions are organized on commercial or cooperative
principles and whether they belong to the organized or unorganized
sector. The sectoral classification Identifies credit arrangements for
various sectors of the economy: agriculture, manufacturing industry,
trade and others.
Various classifications are not intended to be water tight or
mutually exclusive. Their aim is to give a broad idea of the scope of
financial markets, their several dimensions and functions.
Combining the first two bases of study, we give a single functional
cum institutional classification in Figure 2. ,.
Functionally, financial markets are broadly sub-divided under
two heads: money markets and capital markets. The former are
markets in short term funds; the latter in long term funds. We have
interpreted the term money market more broadly to include within
its folds also the notional money market of monetary theory. This
market is co-terminous with the entire economy. The asset it deals
in is money; the demanders are the holders of money (the public)
and the suppliers are the government, the RBI and banks. Money
itself is acquired in the normal process of selling goods, services,
and assets in all markets, as money is the common medium of
exchange (in all monetised transactions). There is no special or
separate market for money like the ones we have for bills, bonds, or
equity shares. In academic discussions of monetary theory and policy
whenever the term money market is used, we mean the market for
mor.ey as explained above. But in business parlance the term money
market is almost always used in the sense of short-term credit
market.
Structurally, the short-term credit market is divisible under two
sectors, organized and unorganized. The organized market
comprises the RBI and banks. It is called organized because its
parts are systematically co-ordinated by the RBI. Non-bank financial
Financial Markets
I I
Money Markets Capital Markets
I (Lond Term Funds)
I I
I
The Money Market Short Term Organizd Unorganized
(National) Credit Markets I I
I I I
Loans from
Organized Unorganized Stock Loans from Moneylenders
I I Market Banks and and others
I I
I I I
Call Bill Bank Hundis Loans
Money Market Loans from
Indigebous Governments Corporate
Bankers, Bonds I
Money-
Treasury Commercial lenders Bonds Equities
Bills Bills and others
Fig'dre 3 : Functional cum Institutional Classification of Financial Markets

Kinds of Credit 133
institutions such as the LIC, the GIC and subsidiaries, the UTI also
operate in this market, but only indirectly through banks and not
directly. Quasi-government bodies and large companies may also
make their short term surplus funds available to the market through
banks.
Besides commercial banks that dominate the organized money
market, there are co-operative banks. They are a part of co-operative
credit institutes that have a three tier structure. At the top there are
state co-operative banks (co-operation being a state subject). At the
district level there are central co-operative banks. At local level there
are primary credit societies and urban co-operative banks. The
whole co-operative credit system is linked with the RBI and is
dependent on it for funds. The RBI deals directly with only state co-
operative banks. For reasons of size, methods of operation, and
dealings with the RBI and commercial banks, only state and central
co-operative banks need be counted into the organized money
markets the rest (co-operative credit societies at local level) are only
loosely linked with it.
The unorganized market is largely made up of indigenous
bankers and moneylenders, professional and non-professional. It
is unorganized because the activities of its parts are not
systematically co-ordinated by the RBI or any other authority. Private
moneylenders operate throughout the length and breadth of the
country but without any link among themselves. Indigenous bankers
are better organized on local basis, as in Bombay and Ahmedabad.
But this kind of organization is also only a loose association.
For the success of monetary and credit policy, the character of
the money market is important. The unorganized sector of the
market is practically insulted from monetary and credit controls. It
is neither subject to reserve requirements, nor capital or investment
requirements. It dependence on the RBI or banks for funds is very
limited. Therefore, it is not affected directly by (say) the policy of
monetary restraint of the economy. The RBI has no control over the
quality and composition of credit in this market either. This works
as an important limitation to the working of monetary policy in
India. But since 1947 the situation is rapidly changing with the fast
134 Kinds of Credit
expansion of banking in the country and the relative shrinkage of

the unorganized sector of the money market.
There are three main components of the organized sector of the
money markets. They are (i) inter-bank call money market (ii) bill
market, and (iii) bank loan market. The unorganized sector also has
its comparable markets. But its call money market is very small and
restricted only to the Gujarati shroffs (one component of indigenous
bankers). The other two markets are quite important. The indigenous
bills are called hundis, and the hundi market is quite active The
indigenous bankers and moneylenders are still the major source of
short term loans for the small borrower.
The main function of the money market is to provide short term
funds to deficit spenders, whether the government or others. It does
this mainly by mobilising short term surpluses of both financial
and non financial units, including state governments, local
governments, and quasi government bodies. Banks do it by'selling,
deposits of various kinds, participation certificates, and bills
discounted. Then, there are treasury bills sold' on tap' by the RBI.
The RBI itself serves as the lender of last resort to the market. Funds
have also to be moved between regions and from one place to another
according to demand. An efficient and well developed system does
it fast and at low cost. Also, it does not allow regional or sectoral
scarcities of funds to emerge. The surpluses in some centers or sectors
get immediately tramferred to others in short supply. Thereby an
even supply of funds and liquidity is maintained throughout the-
economy. For this, banks and other constituents of money market
must have an inter-connected network of branches and offices, rapid
communication and remittance of funds system and well trained
staff.
The real economy may also have a seasonal pattern, giving rise
to seasonal ups and downs in the demand for funds. In the Indian
economy' this kind of seasonality mainly arises from the seasonal
character of agriculture and some agrobased industries (such as
sugar) and their large weight in the overall economy. Thus,
traditionally, the Indian money market has been facing two seasons:
busy season from October to April and slack season from May to
Kinds of Credit 135
September. During the busy season the main (Kharif) crops are
harvested and marketed and sugarcane is crushed. So the demand
for bank credit to traders and sugar manufacturers goes up. During
the slack season this demand for funds goes down. The RBI has
been following a pro-seasonal monetary policy so that any special
stringency of funds does not arise during the busy season which
may hurt legitimate economic activity. For some time past with
increased double cropping of cultivated land, hefty increases in the
output of wheat (a major rabi crop) and autumn rice, growth of
perennial industries and a higher proportion of bank credit going
to manufacturing industries, the previous seasonal ups and downs
in the demand for funds have largely lost their importance. This
trend is likely to gain in strength over time.
The capital market deals in medium term and long term funds.
The importance of such funds for carrying out investment in fixed
capital has already been pointed out in Section 2.3. Like money
market, the capital market also is divisible into two sectors:
organized and unorganized. The organized sector comprises the
stock market the RBI, banks, development banks (such as the
Industrial Development Bank of India), LIC, GIG and subsidiaries
and the UTI. The unorganized sector is mainly made up of
indigenous bankers and money lenders, chit funds, nidhis and
similar other financial institutions, investment companies, finance
companies and hirepurchase companies; and company deposits.
The role of the unorganized sector in the capital market is of very
limited importance.
In the following sections we explain briefly the organization
and functions of important specialized financial markets.
Call Money Market:
This is the most active and sensitive part of the organized money
market. It is centered mainly at Mumbai, Kolkata, and Channai, the
market at Bombay being the most important. It deals in one day
loans (called call loans or call money) which mayor may not be
renewed the next day. The participants are mostly banks. Therefore,
it is also called inter-bank call money market. The borrowing side is
limited exclusively to banks, who are temporarily short of funds.
136 Kinds of Credit
On the lending side, too, there are mostly banks with temporary
excess of cash. As special cases, a few other financial institutions
like the LIe and the uti are also allowed to place on call their short
term funds and earn interest on them. All others have to keep their
funds in term deposits of minimum 15 days with banks in order to
earn interest. For banks are prohibited from paving interest on
deposits made for less than 15 days. Such deposits are treated as
current account deposits. In the past, companies (financial or non-
financial) as well as quasi-government bodies and individuals with
large short term surpluses were allowed to place such funds on call
with banks. Such money from companies and individuals known
as 'house money' used to be an important source of call money for
banks. Finance brokers used to act as intermediaries between
borrowing banks and lending houses. All this has changed now.
From March, 1978 banks have been prohibited from paying
brokerage for arranging call loans for them.
Among banks, the State Bank of India (SBI), because of its
formidable liquid position is always on the lenders' side of the
market. It acts as the lender of intermediate resort, whereas the RBI
as the country's central bank is the lender of last resort The call
advances by the SBI are made against government securities,
whereas call loans by all others are made without security (against
only deposit receipts of the borrowing banks). Since call loans are
made on a 'clean' bast's, the lending banks have to be highly
cautious in adjudging the ability of borrowing banks to repay at
call. Therefore, as borrowers, smaller banks are always at a
disadvantage as compared to larger banks.
The call money market operates through brokers who keep in
constant touch with banks in the city and bring the borrowing and
lending banks together. The main function of the market is to
redistribute the pool of day to day surplus funds of banks among
other banks in temporary deficit of cash. The business of banking is
such that the cash position of banks keeps on changing from hour
to hour. As a result of a day's clearing their closing cash position
may be vastly different from their opening cash position. Some may
end the day with large amount of surplus cash and some with
deficit though banks as a whole may be holding the desired amount
Kinds of Credit 137
of cash. Moreover, to-day's surplus cash banks may turn into

tomorrow's deficit in cash banks. Therefore: there must be an
institutional arrangement for making the surpluses of some banks
available to others in temporary deficit for smooth and efficient
functioning of the banking system. The call money market provides
Just this sort of arrangement. It helps banks economies their cash
and yet improve their liquidity by providing them with the facility
to borrow on call basis. It also signals such banks as are constantly
on only one side (whether borrowing or lending) of the market to
put their house in order. For, either they are over stretching
themselves in making loans and investments or are not doing
enough to buy earning assets.
The call money market is a highly competitive and sensitive
market. It registers very quickly the pressures of demand and supply
for funds operating in the money market. Thus, it acts as possibly
the best available indicator of the liquidity position of the organized
money market. In adjusting its day to day monetary policy, the RBI,
therefore, takes due notice of it. The market experiences some
regular seasonal changes. It is normally tighter during the busy
season (October-April) than during the slack season (May-
September). It is much tighter during the peak of the busy season
(April) before the final dates of quarterly tax payments by firms, end
on the eve of the floatation of government loans.
By its nature the call money rate of interest is highly volatile.
The pressures of excess demand push it up easily and of excess
supply pull it down equally easily. Thus during 2008-09 this rate at
Mumbai fluctuated between the low of 3.5 per cent and the high of
8 per cent per annum, reached on 13 December, 2008. Thereupon,
the Indian Banks Association intervened and fixed a ceiling on it at
15 per cent per annum. Thereafter the ceiling rate has been
progressively lowered. The current ceiling rate is 10 per cent per
annum.
Chapter
10
**
TREASURY BILL MARKET
The treasury bill market is the market that deals in treasury

bills. These bills are short term (91 days) liability of the Government
of India. In theory, these are issued to meet temporary needs for
funds of the government arising from temporary excess of
expenditure over receipts. In practice, they have become a
permanent source of funds, because the amount of treasury bills
outstanding has been continually on the increase. Every year more
new bills are sold than get retired. Then almost every year a part of
treasury bills held by the RBI are funded, that are converted into
long term bonds.
Treasury Bills are of Two Kinds: ad hoc and regular (or
ordinary). Ad hoc means 'for the particular end or cash at hand'.
Thus ad hoc treasury bills are issued for providing investment outlets
to state governments, semi-government departments and foreign
central banks for their temporary surpluses. They are not sold to the
general public (or banks) and are not marketable. However, their
holders, when in need of cash, can get them rediscounted with the
RBI that is sell them back to the RBI. The treasury bills sold directly
to the RBI for its keep, by the government are also ad hoes. The
treasury bills sold to the public or b~nks are regular or ordinary
treasury bills. These are freely marketable. Their buyers are almost
entirely commercial banks.
Treasury Bill Market 139
All treasury bills ad hoc or ordinary are sold by the RBI on

behalf of the central government. Until July 12, 1965 these used to
be sold by tender at weekly auctions. From that date they are made
available 'on tap' throughout the week at a rate of discount fixed by
the RBI. This change was made to make ready supply of bills
available to all investors at all times for investment of their
temporary surpluses and also to mop up larger amounts of such
surpluses for the government. The latter, of course, has been eager
to borrow all the funds offered to it.
Bills (of all types) are bought and sold on 'discounted basis'.
That is the amount of interest due on it is paid in the form of discount
in the price charged for the bill. This price is thus lower than its face
(par) value by the amount of interest due on the bill. Technically
speaking, the price is simply the discounted (or present) value of
the bill and the rate of discount implied (or used) is the treasury bill
rate.When the RBI buys back bills, it is said to rediscount them, that
is, discount them all over again for their remaining lives.
Discounting a bill means purchasing it at its discounted value.
The treasury bill market in India, as compared to such markets
in the U.S.A. and the U.K., is highly undeveloped. There are no
dealers in them outside the RBI who may be willing to buy and sell
any amount of such bills at market. The RBI is the sole dealer in
them. In the U.S.A. and t\le U.K. treasury bills are the most important
money market instrument. These are a very popular forts of holding
short-term surpluses by financial institutions, other corporations
and firms, because these are free from any risk of default are highly
liquid and yield a reasonable rate of return. For the government,
these are a very important form of raising funds. For the central
bank, these are the chief instrument of open market operations.
This is not so in India. The RBI itself is the chief holder of treasury
bills, holding about 93% of such bills outstanding (of the value of
about Rs. 26,000 crores) at the end of March 2009. All other holders
such as commercial banks, state governments, and semi-government
bodies hold them in very small amounts. Non-bank financial
institutions, corporate and non-corporate firms with short-term
surpluses do not invest their surpluses in treasury bills. All this is
140 Treasury Bill Market
because treasury bill (discount) rate in India has been very low-
since July, 1974 it has been kept pegged at the low level of 4.6% per
annum, while, in recent years among short-term rates, the Bank
Rate of the RBI and the call money rate (ceiling) has been 10% per
annum. Business firms with cash credit facility with banks deposit
their short-term surpluses in their cash credit accounts to reduce
their cash credit outstanding and thereby save interest cost at the
prevailing (currently 17.5% per annum) rate of interest. There is
also a reasonably active inter corporate funds market whereby
corporate units with seasonal funds lend them to other companies
at a competitive rate of interest.
The very low treasury bill rate has, no doubt, kept the interest
cost of treasury bill debt to the government very low. But this has
been gained at a huge cost of the economy. First, the low rate has
been maintained by converting the RBI into a passive or captive
holder of these bills, as the RBI has to purchase whatever ad hoes
are sold to it by the government and also rediscount whatever am
punt of these bills are presented to its rediscounting window by
banks and others. This has led to large-scale 'monetiration of
government debt' (that is conversion of such debt into Reserve Bank
money), which among other things, bus been the main source of the
excessive expansion of money supply and so also of inflation in the
economy. Also, due to the low treasury bill rate, the government has
been continuously tempted to use the short-term financial instrument
of treasury bills as a long term source of funds to it, as already
pointed out in the beginning of this section. The low rate has also
kept the treasury bill market undeveloped by not attracting non-
RBT short-term surplus funds in it.
'It has, therefore, been felt for quite some time that the treasury
bill rate should be unfrozen from its artificially low level and made
into a competitively attractive and flexible rate (keeping in view its
special advantages over other short-term financial instruments)
such that it would act as a pace setter for other rates in the money
market, enable banks (and others) to adjust to changes in their short-
term liquidity through the purchase and sale of treasury bills, and
allow the RBI to exercise control over money market operations.
The treasury bills are a short-term instrument and should be used
as such to most only the temporary needs of the government. They
should not be used as a cheap source of long-term funds and cannot
be so used without taking recourse to the RBI in big way, as has
been happening for several years now.
Perhaps as a first step in this direction, the RBI has introduced
182-day treasury bills. The first auction for these new bills was held
in late November 1986. The response from banks was very good,
though the RBI accepted only about 3% of the amount bid at a
discount rate of 8.4% per annum. (The rejected bids must have asked
for a lightly hire rate of discount). The auction system will restore a
degree of flexibility.
Commercial Bill Market:
Like treasury bills, commercial bills also have a market of their
own. The latter bills are issued by firms engaged in business.
Generally, these are of three-month maturity. These are like post-
dated cheques drawn by sellers of goods on the buyers of goods for
value received. An example of typical bill of exchange is given below:
Jaipur, 18 May, 2009
Mr. Kapil,
Three months after date please pay to the undersigned or order
the sum of Rupees Fifty Thousand for value received.
Signed: Vibha
In the above example Vibha is the drawer of the bill and Kapil
is the drawee. The former has sold the latter goods worth Rs. 50,000/
- on three-month credit. The seller may, however, need cash now. So
he draws a bill and sends it to the buyer for acceptance. The latter in
acknowledgement of her responsibility to make payment on take
due date writes 'accepted' on the bill, or arranges to get the bill
accepted on his behalf by his bank. The bank charges acceptance
commission and assumes responsibility of making the payment if
the drawee defaults. Once the bill has been so accepted, it becomes
a marketable instrument. On receipt, the drawer can now sell it in
the market for cash. Again, a bank normally comes into the picture.
The drawer goes to his bank and gets the bill discounted. This
simply means that he sells it for cash to the bank, which pays him
the face value of the bill less collection charges and interest on the
amount for the remaining life of the bill. The rate of in to rest charged
is known as the discount rate on bills. At the time of selling the bill,
the seller (drawer) endorses the bill in favour of the buying bank.
This makes him liable to meet the bill at maturity should the drawee
(or his 'accepting"" bank) fail to do so. Thus, the buying bank is
protected against the risk of default. If need be, this bank can later
sell the bill to source other bank or get it rediscounted with the RBI.
Thus, bills are a very important device for providing short-term
finance to trade and industry. These have a fixed term to maturity
called seance. This usance is reasonably short for banks to invest
their funds in them and reasonably long for the buyers of goods
(drawees of bills) to recover the cost of goods from their resale or
processing and sale. The latter consideration makes bills self-
liquidating. This reduces considerably the risk of default on bills.
Moreover, bills are marketable paper, that is, they can be resold any
number of times in the money market. They also carry competitive'
rate of interest. For all these reasons, banks have a preference for
investment in such bills. In the past, several monetary economists
were of the view that banks should invest wily In bills. This view is
known as the 'real bills doctrine' in the literature. But most
economists have regarded it as an extreme view. One good asset
should not monopolize the show. Also, during periods of business
recession or credit squeeze the expected sales or receipts may not
materialize and drawees may find it difficult to honour their bills.
Thus, the self-liquidating character of bills is a fair-weather friend.
The commercial bills are of various kinds. The bases of
distinction among them are many. One distinction is that between
modern bills of exchange and indigenous bills. What we have
explained above are modem bills. Indigenous bills are called
htmdis. Another distinction is that between inland bills and foreign
(trade) bills. As the name indicates, the former are used to finance
inland trade, the latter to finance foreign trade. It follows that import
bills are used to finance imports and export bills to finance exports.
A third kind of distinction is that between trade bills and finance
bills. The former are also called documentary bills as they carry
with them papers pertaining to genuine trade transactions. As such,
they are also known as genuine (trade] bills. Finance bills, on the
other hand, are'clean' bills. They do not carry any documents of
sale of goods with them, as they do not arise out of any genuine
trade transaction. They are only'accommodation bills' drawn and
accepted as a device for short-term credit. A large proportion of
indigenous bills (hundis) are finance bills. Yet another distinction
is that between drawers, bills and drawees, bills. The same bill may
be of either kind. It all depends on who presents the bill to a bank
for discounting: drawer or drawee. If the former, then the bill is a
drawer's bill, if the latter, then the bill is a drawee's bill. Generally,
the rate of interest charged by banks on the latter kind of bills is
higher than that charged on the former kind of bills This is
presumably because when a drawee comes to a bank for getting the
bill discounted, it shows that he does not have enough credit-
worthiness in the eyes of the bill's drawer.
A distinction is also made between demand (or sight) bills and
time (or usance) bills. The former are payable on demand or
presentation, the latter after a definite time period (of say 30, 60 or
90 days) stipulated in the bill. There is a corresponding distinction
between purchase and discounting of bills. Discounting pertains
to usance bills, purchase to demand or sight bills. Though the
demand bills do not allow any credit to the buyer of goods, there Is
a time lag between the dispatch of goods and their receipt by the
(outstation) buyer, The latter will pay only on receipt of goods. For
the period goods ere in transit or have not been taken delivery of by
the buyer, the seller will be out of funds. Therefore, he may sell the
bill to his banker and get cash.
Purchase of demand documentary bills is freely undertaken by
bankers on behalf of their customers, subject to a maximum limit
granted in each case. Normally, for banks, purchase of bills is an
easier operation than the discount of bills, because in the case of
demand bills, the banker will have possession of documents of title
to goods (such as railway receipt or lorry receipt endorsed in the
name of the bank) until payment of bills, whereas in the case of
usance bills, possession of goods is transferred to the buyer against
his acceptance. But even in the case of demand bills, banks can be
cheated when for example, documentary bills are spurious or
unscrupulous lorry operators deliver the goods to the buyer without
the lorry receipt.
Earlier we had said that in order to make a bill freely marketable,
it must be accepted by a bank or some other institution or house of
good standing. Normally, the bill should have two good signatures:
one that of the drawee and the other that of the accepting bank. This
kind of bank's business is called 'acceptance business, and the
credit implied in it as 'acceptance credit'. Since acceptance of bills
on behalf of one's constituents involves risk of default by drawees,
a bank accepts bills only for those of its customers in whose credit-
worthiness it has confidence and only for the amount it considers
safe. This requires a bank to have full credit information on such
constituents. In the UK there are specialized liras, known as,
,acceptance houses', who do this kind of acceptance business for
commission. In India we do not have such acceptance houses. In
the UK the bill discounting; business is also handled by specialized
firms, known as discount houses. In India the work also is handled
by banks. The bill business, here has not developed so much as to
call for specialized institutions to handle it.
The following factors have been mainly responsible for
impending the growth of a bill market in India:
(i) the prevalence of cash credit system as the main form of
bank lending, and
(ii) the reluctance of the larger buyer in the public and private
sectors to accept the payment discipline involved in the
bill market.
In addition, the lack of uniformity in drawing bills in different
parts of the country; the practice of sales on credit without any
specified time limit, usually undertaken to promote sales; and high
stamp duty on usance (time bills) have also hampered the growth
of bill finance.
Keeping in view the usefulness of bills as instruments of credit
to both business and banks, their self-liquidating character, and
easier regulation of banks bill finance by the RBI, the latter has been
making efforts to encourage the use of bills and develop a bill market
mthe country. It has had only limited success so far. Its main strategy
has been to induce banks to encourage their borrowers to resort
more and more to bill finance. From time to time individual banks
fall short of cash. They meet their needs for cash partly from the call
money market, partly by selling treasury bills to the RBI, and partly
by borrowing from it against government securities. The RBI has
offered to make its refinance available to banks against eligible
commercial bills as well. This has widened the scope for banks'
borrowing from the RBI and acted as a spur for the growth of bill
finance in the country. The main features of two specific bill market
schemes of the RBI are given below.
Old Market Scheme:
The scheme, introduced in January 1952, was a misnomer. It
was designed not to develop a genuine bill market in the country
but to provide further accommodation to banks on top of whatever
borrowing facilities they were already enjoying from the RBI. Under
the scheme, the RBI undertook to give demand loans to eligible
scheduled banks against their promissory notes supported by the
security of bills of their constituents with usance of 90 days or less.
The bill could be genuine trade bills or not. The scheme itself did
not require them to be genuine trade bills. Instead it permitted banks
to manufacture artificially such bills by converting a part of their
advances - whether loans cash credits or overdrafts - into usance
promissory notes maturing within 90 days. The "banks could easily
do so whenever required in concert with their borrowers. Obviously
such a scheme could not be expected to encourage banks or their
borrowers to switch from the easy system of cash credit to the
discipline of bill finance: All that it did was to enlarge further the
loan window of th~BI for banks by permitting them to borrow
even against their ordinary commercial credit after its conversion
into eligible bills. The scope of the "cherne was extended from time
to time by making more banks eligible to borrow under it by reducing
the minimum eligibility value for bills, and by extending it to export
bills with the maximum usance of 180 days.
The scheme had provided for only the lodgement of bills as

security for advances from the FBI and not for their rediscount with
it. Technically speaking, on rediscount the RBI becomes the
purchaser of the bill and the selling bank retains only contingent
liability of the bill, that is liability only in the event of default. Under
the scheme, therefore, the borrowing banks were free to withdraw
I any of the bills lodged and also to replace them by other eligible
bills. The banks were thus enabled to minimize interest charge by
borrowing according to their needs and by remitting spare funds to
reduce their indebtedness to the RBI. To encourage banks to borrow
under the scheme, for some time, the RBI offered loans at a
concessional rate of interest and even met half the cost of stamp
duty incurred by banks in converting demand promissory notes of
their constituents into usance bills.
But the scheme did not stake much of an impact. The amount
borrowed by banks under the scheme remained a small proportion
of the total bank borrowings from the RBI. The villain of the piece
was the dominant cash credit system of bank lending which the
banks borrowers find much more convenient, flexible, and to their
liking. In contrast, bill finance imposes a discipline of making
payments when due and supporting their credit transactions with
genuine trade transactions. The supporting documents are subject
to scrutiny by the RBI and could as well be rejected by it if found
unsatisfactory. Most bank borrowers did not find it acceptable.
New Bill Market Scheme:
Dissatisfied with the old scheme, the RBI introduced a new bill
market scheme in November 1970 with the object of developing a
genuine bill market in India. It has been modified since then from
time to time. We do not go into all the details of the new schema.
Only following two main features of it are specially noteworthy:
(i) The bills covered under the scheme must be genuine trade
bills, i.e. bills which evidence sale and/ on dispatch of goods;
(ii) The RBI rediscounts these bills. That is why it is also (and
more appropriately) called 'Bills Re discounting Scheme'.
In both the above respects the new scheme is an improvement
over the old scheme which covered even improvised usance bills
and did not provide for the rediscounting of even genuine trade
bills by the RBI. The bills were used only as security against advances
to banks. Under the new scheme also the eligible bills should have
maximum usance of 90 days left at the time of rediscount. Banks
can get bills rediscounted with not only the RBI but also the LIe,
GIC and subsldiaries, UTI, and ICICI but not with private persons.
The advantages of a genuine bill market to the banking system
and others are soured up below:
(1) Normally, bills ore self-liquidating and date of repayment
of a bank's advances by way of the discounting/
rediscounting of bills is definite. In contrast, caah credit is
not self-liquidating.
(2) Bills offer greater liquidity to their holders as they can be
shifted to others in the market in case of need for cash.
(3) A well-developed bill market helps greatly in evening out
liquidity throughout the financial system, as those with
short-term surplus funds of whatever duration can invest
them in bills of desired maturities and can always hope to
unload their holdings of bills to others in the market
whenever they need cash. Thus, the short-term surpluses
of some become available through the market to meet the
short-run deficits of others. Thus, the former do not suffer
from the surfeit of liquidity (or cash) and the latter with the
lack of it. In the absence of an active bill market banks in
need of cash have to depend either on the call money market
or on the RBI's loan window.
(4) The commercial bill rate is much higher than the treasury
bill rate. Therefore, commercial banks and other financial
institutions with short-run surpluses to invest find bills
attractive not only for their liquidity but also for their return.
(5) To the borrower, the cost of bill finance is somewhat lower
than that of cash credit because the bills carry the additional
security in the form of acceptor's signature are time-bound
and can be sold in the market.
(6) Extensive use of bills as an instrument of short-term
commercial credit and rediscounting of bills by the RBI
makes the monetary system highly elastic. Whenever the
economy is in need of more cash, banks can get a part of the
bills in their portfolios re discounted with the RBI and there
by increase the supply of money, The process comes in
handy to meet the enhanced needs or busy-season finance.
The seasonal expansion-contraction of money supply also
becomes automatic and obviates the need for policy actions
by the RBI. In the absence of such an automatic mechanism,
the HBI has had to intervene actively in the money market
to meet the busy-season needs for funds of the economy.
We have, however, to remember that this kind of flexibility
is hot an unmixed blessing as it can contribute to excessive
expansions of money supply.
Stock Market:
The stock market deals in long-term securities, both private
and government. It is the most important component of the capital
market. The latter deals in long-term funds of all kinds, whether
raised through open-market securities or through negotiated loans
not resulting in market paper. Open market securities are securities
(or market paper) that are bought and sold openly in the market
(like marketable goods) and can change hands any number of times.
The negotiated loans' have to be negotiated directly (or through a
broker) between the borrower and the lender. They appear only in
the account books of the lenders and the borrowers promissory
notes which are not salable in the market.
The scope and structure of the stock or securities market are
shown in Figure 1.
The stock market comprises several distinct markets in
securities. The most important distinction is that between the market
for corporate securities and the market for government securities.
We shall study them separately in the next two sections. Corporate
securities are instruments for raising long-term corporate capital
from the public. The stock market organisation provides separate
arrangements for the new issues of securities and for buying and
selling of old securities. The former it market is known as the 'new
issues market' and the latter market as the 'secondary market. Both
kinds of markets are essential for servicing corpor'\te borrowers
and investors.
Securities Market
I I
Corporate Securities Govnnment (or giltedged
Securities)
I
I I I
New Secondary Over the Counter
Issues (Old Issues) Market
I I
I I I I
Organized Over the New Secondary
Stock Counter Issues (Old Issues)
Exchange Market
I I
I I I
Bonds Equities Preference
shares
Figure 1. The Structure of Securities Market
New Issues Market:

The major function of the new issues market is to arrange for
the raising of new capital by corporate enter-prises, whether new or
old. This involves attracting new in-vestibule resources into the
corporate sector and their allocation among alternative uses and
users. Both ways the role is very important. How fast the corporate
industrial sector grows depends very much on the inflow of
resources into it, apart from its own internal savings. Equally
important is the movement of sufficient venture capital into new
fields of manufacturing crucial to the balanced growth of industries
in the economy and in new regions for promoting balanced regional
development.
The new issues nay take the form of equity shares, preference
shares or .debentures. The firms raising funds may be new
companies or existing companies planning expansion. The new
companies need not always he entirely new enterprises They may
be private firms already in business, but 'going public' to expand
their capital bases. 'Going public' means becoming public limited
companies to be entitled to raise funds from the general public in
the open market.
For inducing the public to invert their savings in new issues,
the services ofa network of specialized institutions (underwriters
and stockbrokers) is required. The more highly developed and
efficient this network, the greater will be the inflow of savings into
organized industry. Till the establishment of the Industrial Credit
and Investment Corporation of India (lOCI) in 1955, this kind of
underwriting was sorely lacking in India. Instead, a special
institutional arrangement, known as the managing agency system
had grown. Now it has become a thing of the past. We note its main
features for its historical value.
The Managing Agency System was a multi-purpose
arrangement for promoting new enterprises for raising fixed as well
as working capital for them, and for managing them. Managing
agents were individual firms, partnerships, private limited or public
limited companies. They were owned by Europeans as well as Indian
business houses. Daring 1954-55 there were about 4,000 managing
agencies which managed about 5,000 joint stock companies out of
a total of about 30,000 joint stock companies at work in that year.
Most managing agents managed single companies. But big
managing houses managed several companies each. Thus, 17 top
managing agents managed as many as 359 companies. Then, a
majority of big public limited companies were managed by
managing agents. The managing agents used to arrange finance for
new companies from several sources, namely, direct finance from
their own sources, indirect finance from their relatives, friends and
associates, subscriptions, from companies under their control (inter-
company investments), short term bank credit by extending their
guarantees to banks, which quite often were also under, their control.
In the absence of financial institutions specializing in
underwriting of new issues, the managing agents did playa useful
role in promoting new firms and industries. But this was done at
too high a price. The whole system was highly exploitative in which
companies under management were milched to the utmost in
various ways, directly by way of high managing agency

commissions, indirectly as captive buyers from and sellers to other
concerns of their individual managing agent and through inter-
company investments to suit the interests of these managing agents.
It stunted industrial growth of the country, both in terms of the rate
of growth and in terms of industrial composition. Basic industries
and Industries requiring advanced technology and large capital
were shunned and only low-technology traditional industries (like
textiles, sugar) 'Nere developed. It also led to extreme concentration
of industrial wealth in a few large business houses (now called
monopoly houses).
The new institutional arrangements for new corporate issues
in place of the discredited managing agency system started taking
shape with the setting up of the ICICI in 1955. Soon after (1956) the
LIC joined hands. The new system has already attained adulthood
under the leadership of the Industrial Development Bank of India
(IDBI). Apart from the ICICI and the LIC other important participants
in the new issues market are the major term lending institutions
such as the UTI, the IFCI, commercial banks, General Insurance
Corporation (GIG) and its subsidiaries, stock brokers, and
investment trusts. Foreign institutional funds from the World Bank
and its affiliates. International Development Association (IDA) and
International Finance Corporation, are also channeled through the
all India term lending institutions (IDBI, ICICI, and IFCI).
Managing successful floatation of new Issues involves three
distinct services: (i) origination, (ii) underwriting, and (iii)
distribution of new issues. The origination requires careful
investigation of the viability and prospects of new projects. This
involves technical evaluation of a proposal from the technical
manufacturing angle, the availability of technical know how, land,
power, water and essential inputs, location, the competence of the
management, the study of market demand for the product(s),
domestic and foreign, over time, financial estimates of projected
costs and returns, the adequacy and structure of financial
arrangements (promoters, equity, equity from the pUblic, debt-equity
ratio, short-term funds, liquidity ratios, foreign exchange
requirements and availability), gestation lags, etc., and
communication of any deficiencies in the project proposal to the
promoters for remedial measures. All this requires well-trained and
competent staff. A careful scrutiny and approval of a new issue
proposal by well-established financial institutions known for their
competence and integrity improves substantially its acceptability
by the investing public and other financial institutions. This is
specially true of issues of totally new enterprises.
Underwriting means guaranteeing purchase of a stipulated
amount of a new issue at a fixed price. The purchase may be for sale
to the public or for one's own portfolio or for both the purposes. If
the expected sale to the public does not materialize, the underwriter
absorbs the unsold stock in its own portfolio. The underwriter
assumes this risk for commission, known as underwriter's
comI?ission. The company bringing out the new issue agrees to
bear this extra cost of raising funds, because thereby it is assured of
funds and the task of sale of stock to the public or others is passed
on entirely to underwriters. Mostly, underwriting is done by a group
of underwriters, one or more of whom may act as group leaders.
The group (or consortium) underwriting distributes risks of
underwriting among several underwriters and enhances
substantially the capacity of the system to underwrite big issues.
Distribution means sale of stock to the public. The term lending
institutions, the LIe, the UTI and several other financial institutions
usually underwrite new issues as direct investments for their own
portfolios. For them, there is no problem of sale of stock to the public.
But, under the law, a part of the new public issue must be offered to
the general public. This is placed with stockbrokers who have a
system if inviting subscriptions to new issues from the public. In
normal times it is their distributive capacity which determines the
extent of the public participation in new issues. During periods of
stock market boom the demand for new Issues from the public also
goes up. New issues of well-known houses and issues underwritten
by strong institutions generally have a good public response. It is
the placing of the issues of small companies that continues to be the
Achilles' heels of the new issues market. For loosening the grip of
monopoly houses on the industrial economy of the country, it is
necessary that new entrepreneurs are encouraged. For this, special
efforts need be stepped up further for promoting small issues.
There are three main ways of floating new issues: (i) by the
issue of a prospectus to the public, (ii) by private placement, and
(iii) by the rights issue to the existing shareholders. What we have
described above is the first method. The, issue of a public prospectus
giving details about the company, issue, and the underwriters is
the last act in the drama and is an open invitation to the public to
subscribe to the issue. Private placement means that the issue is not
offered to the general public for subscription but is placed privately
with a few big financiers. This saves the company the expenses of
public placement. It is also faster. Rights issue means issue of rights
(invitations) to the existing shareholders of an old corporation to
subscribe to a part or whole of the new issue in a fixed proportion to
their shareholding. Such an issue is always offered at a certain
discount from the going market price of the already trading shares
of the company. The discount is in the nature of a bonus to the
shareholders. Obviously, a rights issue is open only to an existing
public limited corporation, not to a new one. Old corporations also
increase their capitalization (paid-up capital) by deClaring bonus
to their shareholders, which means issue of new shares to them in
a fixed ratio to their shareholding without charging any price from
thE:m. This is a way of converting a part of accumulated reserves
into company's paid-up capital.
Secondary Market in Old Issues:
This market deals in existing securities. Its main function is to
provide liquidity to such securities. Liquidity of an asset means its
easy convertibility into cash at short notice and with minimal loss
of capital value. This liquidity is provided by providing a continuous
market for securities, that is, a market where a security can be bought
or sold at any time during business hours at small transaction cost
and at comparatively small variations from the last quoted price.
This of course, is true of only' active' securities for which there are
always buyers and sellers in the market. 'Activeness' is a property
of individual securities not of the market.
The function of providing liquidity to old stocks is important

both for attracting new finance and in other ways. It encourages
prospective investors to invest in securities, old or new, because
they know that any time they want to get out of them into cash, they
can go to the market and sell them off. In the absence of any
organized 'securities market, this will not be easily feasible. So the
investing public will keep away from securities. Then, the secondary
market provides an opportunity to all concerned to invest in
securities and when they li-ke. This opens a way for continuous
inflow of funds into the market. This is specially important for such
investors who do not want to risk their funds by investing in new
ventures, but are perfectly willing to invest in the securities of on-
going concerns. On the other end, there are venturesome Investors
who invest in new issues in the hope of making capital gains later
when the new concerns have established themselves well. In a sense,
they season new issues and sell them off when the market
acceptability of these issues has improved. With their funds released
from sale of their old holdings, they can move into other new issues
coming into the market. Thus, investment into new issues is
facilitated greatly by the operations of the secondary market.
The new investment is influenced in another way too by what
is happening in the secondary market. The latter acts as an
important indicator of the investment climate in the economy. When
stock prices of existing securities are rising and the volume of trading
activity in the secondary market goes up to new issues also tend to
increase as the new issues market (underwriters, stockbrokers, and
investors) is (are) better prepared and more willing to accept new
issues. This is also a good time for companies to come forward with
new issues. When the secondary market is in doldrums, the new
issues market also languishes. The underwriters are reluctant to
underwrite and stockbrokers reluctant to assume the responsibility
of selling new issues to the public. Then, firms are also advised to
postpone their new issues for better times.
There are two segments of the secondary market: (a) organized
stock exchange, (b) over-the-counter market. The latter deals in such
securities as are not 'listed' on an organized stock exchange. These
are securities of small companies and have only a limited market.

Their prices are determined through direct negotiation between
stock brokers and not Through open bidding as is the case with
listed, securities on a stock exchange. The main action of the stock
market is concentrated on these exchanges. We explain briefly their
organization and functioning.
Stock Exchanges: A stock .exchange is an organization for
orderly buying and selling of 'listed' (approved) existing securities.
The organization includes an association of persons or firms to
regulate and supervise all transactions, rules, regulations and
standard practices to govern all market transactions, authorized
stock brokers, and an exchange floor or hall where stock brokers or
their authorized agents meet during fixed business hours to buy
and sell securities. At present in India there are 11 recognized stock
exchanges in various parts of the country. The one at Bombay is the
leading stock exchange. It leads other exchanges in terms of the
number of securities listed there, the importance of companies
whose stocks are traded there, the average volume of daily business,
and its capacity to absorb big buy and sell orders.
Listed securities are securities that appear on the approved list
of a stock exchange. Approval depends on several considerations,
such as the size of the issue, whether it is widely held by the public
or closely held in a few hands, timely production of annual accounts,
etc. Only listed securities are traded on the floor of the exchange.
Therefore, listing improves marketability of a stock.
An organized stock exchange is an 'auction' type market where
prices of traded stocks are settled by open b bids and offers on the
floor of the exchange. Therefore, it is said that these prices are formed
competitively. To the extent that is so and to the extent buyers and
sellers are well in formed and while bidding prices they take into
consideration all the relevant factors, present and prospective,
concerning not only the particular enterprise and the industry, but
also the general economic and political conditions, the stock prices
will be good measures of the true real worth of enterprises. In the
process, better-run profit-making enterprises will appreciate in real
value as compared to others. In a private-ownership economy (0T"
sector this helps and guides greatly the allocation of new resources
In actual practice nearly all the statements of the previous

paragraph need to be qualified. Competition is not perfect in the
stock market. This market is no leveller of the high and low. Big
investors carry more weight and can influence the market their
way. Already, the weight or big financial institutions such as the
LIC, the UTI, the GIC and subsidiaries has corne to be felt. This meet
not always be to the disadvantage of the small investor. Problems
arise only when there is artificial manipulation of the market or
when the firrnholding of good stocks by j~lStitutions (and promoters)
reduces too much the floating supply of stich stocks in the market.
Then, a slight increase in the demand for such stocks shoots their
prices up. Also small investors are not that well-informed. Nor do
they have the requisite ability to analyse and interpret the myriad of
forces that impinge on stock prices. Therefore, without the leadership
of financial institutions, the prices formed by their transactions
need not be good indicators of the true values of stocks. They are
easily swayed by 'animal spirits'. The result is frequent ups and
downs of stock prices. There is also an excess dose of speculation
present in the market, especially during periods of market booms.
Then, in a planned mixed economy, allocation of resources cannot
be left to the operations of free market forces. A more purposive and
socially informed allocation is needed. This is one of the justifications
of the public sector and the Capital Issues (Control) Act, operating
in the country.
Gilt-edged Market:
The gilt-edged market is the market in government securities or
the securities guaranteed (as to both principal and interest) by the
government. The former include securities of the Government of
India and of the state governments: the latter are securities issued
by local authorities (like city corporations, municipalities, and port
trusts) and autonomous government undertakings like development
banks, state electricity boards, etc. The term gilt-edged means of the
best quality. It has corne to be reserved for government securities as
they do not suffer from the risk of default. Besides, government
securities are highly liquid, as they can be easily sold in the market
at their going market price. The open market operations of the RBI
are also conducted in government securities.
Government securities have become a very important component

of capital market in several countries. In India they have gained
steadily in importance since 1954-55 as the pressure for raising
funds to finance public sector projects under five year plans built
up. The total amount outstanding of the internal government debt
in the form of market loans, special bonds and treasury bills was
about Rs. 76,000 crores at the end of March, 1986. During 1985-86
alone this debt had increased by about Rs. 13,000 crores, while
gross savings of the house-hold sector in the form of financial assets
for the year where estimated at Rs. 25,600 crores. This shows that
the government was able to appropriate for Itself the equivalent of
about 50% such financial savings through the device of treasury
bills and market loans sold to banks and other financial institutions
(over and above direct mobilisation of household financial savings
through post office deposits, 'small savings schemes' and public
provident funds run by the post offices, government provident funds
and' compulsory deposits' from the public).
The gilt-edged market may be divided in two parts: the treasury
bill market and the government bond market. We have already
studied the former, the organization of the latter is explained below.
On the borrower side, the RBI manages entirely the public debt
operations of the central as well as state governments. As such, it is
responsible for all the new Issues of loans. This will be explained
further in later chapter. There is also a large secondary market in
old issues of government loans. It is heavily concentrated in Bombay
with supporting markets in Calcutta, Madras, and Delhi. This
market largely works through a few large stockbrokers who keep in
constant touch with the RBI and other prospective buyers and
sellers. Sometimes financial institutions negotiate directly with ~e
RBI. But this is not very common. The RBI keeps the market informed
through recognized brokers abOl!t its buying and selling prices for
various loans outstanding. It keeps on ready sale securities of
. various maturities to meet the market demand for them. In all this,
the RBI's position is that of a monopolist. There are only brokers or
investors in the market and no dealers or .jobbers (other than the
RBI) who would make a market in government loans by standing
ready to buy and sell any amount of government securities on their

own account. This special feature of India's gilt-edged market
should be carefully understood. It distinguishes this market from
the gilt-edged markets of the USA, the UK and Canada, where the
central bank of the country is not the sole dealer in government
securities as the RBI is in India.
On the demand side, the gilt-edged market is dominated by
financial institutions. Apart from the RBI, the major holders are
commercial banks, insurance companies, provident funds, and trust
funds. These financial intermediaries mobilize savings of the public
and through their investment in government securities transfer these
savings to the government. They constitute what is called the 'captive
market' for government securities, as they are required statutorily
to hold certain minimum proportions of their total liabilities (assets)
in government securities. Therefore, as the total liabilities of these
institutions grow, the demand for government securities also grows.
Besides these financial institutions, local authorities, semi-
government bodies, and non-residents also invest some amounts
in government securities. The demand for these securities from non-
financial companies and individuals is negligible.
Due to the special features of India's gilt-edged market spelled
out above, namely, the monopoly-dealer position of the RBI and the
'captive' nature of the demand for government securities, the prices
of such securities are not formed freely in the market. Instead, they
are very much under the direct control of the RBI. One main reason
for the virtual absence of non-captive buyers from this market Is
that the rate of interest on government bonds has been kept
artificially low - much lower than the rates of interest available on
other financial assets such as fixed deposits with banks and post
offices, with a much shorter maturity of five years and fiscal (income-
tax) concessions, which have bossed up the effective rates of interest
on them for income-tax payers.
The low interest rate policy for government debt was adopted
deliberately to keep the interest cost of market debt to the government
as low as possible. To snake it effective, the RBI, over the years, has
been called upon to take up a sizeable proportion of the new issues
of government loans as high as 64% of the net market borrowing of

the Central Government in 1981-82. This, too, as in the case of
treasury bills, leads to magnetization of debt. (The RBI, then, through
Its open market operations, sells some of these securities to other
financial institutions throughout the year).
In recent years, as a matter of welcome conscious policy, the
coupon rates on central government loans have been progressively
revised upward. For example, the coupon rate on new issues of
long dated securities with 30 year maturity has been raised in
measured annual steps from 8% per annum in 1981-82 to 11.5% per
annum in 2008-09.
***
Chapter
11
tItI
OFFICE MACHINES
Office machines have come a long way since Queen Anne

granted a patent for a writing machine in 1714 and since
Christopher Sholes presented the world with the first practical
typewriter in 1873. Today entrepreneurs are faced with a
bewildering array of machines that have been devised for all types
of operations. Mechanization, coming first to factory processes to
and physical operations in production, has now moved into office
and administrative processes at a pace surpassing its progress in
the factory.
The reasons for accelerated mechanization in management
processes are apparent. The relatively slow beginning left a long
way to go, and at least part of the movement must be regarded as a
catching-up process. Basic changes in the nature of companies and
the operations involved are having profound effects; one indication
is that the white-collar work-force became larger than the blue-collar
workforce for the first time in 1956 and is now rapidly increasing
its lead. By 2009 there will be approximately two white-collar
workers for each blue-collar worker.
Growth in size and complexity of businesses and ever keener
competition are influencing management to look for sharper tools
in physical production and in mental work, such as problem
recognition, analysis, memory, and communication, to achieve
Office Machines 161
understanding. Technological advances in office machines and
related equipment to meet administrative needs are now progressing
with amazing speed. For the past thirty years the office equipment
industry has been one of the leading growth industries.
Developments are now so rapid that managers find it difficult to
keep. abreast of new equipment available. This difficulty is perhaps
best explained by the appearance of a new growth industry -special
service organizations that help users select equipment from the
many different types on the market.
General criteria for design or choice of methods for performing
operations can be summarized under the headings of effectiveness,
economy, and impact on employees. These criteria apply directly to
problems of mechanization in the office. Guides for applying them
to specific problems, such as matching needs and equipment, will
be presented in this chapter. Mechanization in the sense used here
includes all type's of general and special purpose office machines
except those directly related to electronic data processing. This
industry and equipment have become so important and are growing
at such a rate that it will be separately discussed.
Establishing the Need:
A logical beginning to any situation in which purchase of an
office machine is being considered is to question need and selection.
For most office operations need seems almost a foregone conclusion.
But even when a machine is readily available commercially, its
need should never be taken for granted; alternatives should be
considered first.
One alternative is that the work itself could be eliminated,
simplified, rescheduled, or altered to eliminate the necessity for
mechanization. The management of one company was considering
expanding its data processing installation to take care of a heavy
weekly peak load until it discovered that the problem could be
solved without additional equipment by better scheduling and fuller
utilization of present equipment.
Subcontracting is another alternative. What are the possibilities
for subcontracting the work to outside service agencies? A
162 Office Machines
remarkable development of service agencies is now occurring, and

no alert management will overlook the possibility that a service
agency might perform many types of work effectively and
economically.
If the work operations are necessary, is a machine really required,
or could the work be done by simple, non-mechanical means? A
prepared table of values, such as of rates, prices, and products of
numbers commonly multiplied, is an often overlooked alternative
to mechanical devices.
The one situation generally responsible for office mechanization
is fluctuating volume that peaks in cycles. Considerable attention
should be devoted to the question. "ls it possible to even out the
peak loads?" Mechanization geared to peak loads (a necessity for
service and production requirements) results in considerable Idle
or unused machine time and, ultimately, in inefficient and
uneconomical operatiOns.
Making the Selection:
When purchase of a machine is justified, the problem becomes
one of choice Of, in some cases, one of special design. A wide range
of types of machines is available, and technology is continuously
developing new and different types. There are a great many
competitive models in most types; each is likely to provide optional
or special features that should be considered by the buyer. Moreover,
investing in the typical office machine requires considerable money,
and the possibility of obsolescence causes a machine to be an
unstable asset. These considerations suggest the need for objective
study of the proposed purchase of any office machine. An analysis
in three stages usually will be justified, following the sequence
below.
What are the requirements of the operation that may be met
through mechanization? What goals are sought in mechanization
- improved customer service, reduced administrative costs,
facilitation of other internal operations, fewer errors, less
monotonous work for employees, or a solution to the labour shortage?
Then, what specific processes are involved, what are their volume
Office Machines 163
and speed requirements, how highly standardized are they, and
what are future prospects for this operation (it permanent or
temporary, growing or declining)?
Both the precise nature of goals sought and of the specific
processes involved are necessary in establishing the need. If
competitive success in the industry depends heavily upon prompt
service, this consideration may outweigh all others. If the enterprise
is caught in a cost squeeze, getting the work done more economically
may be the dominant consideration. Or the optimum combination
of these and other goals may be sought, with some of major and
some of minor concern.
The nature of the process involved, the capacity and speed
requirements, the degree of standardization. Which will be more
appropriate - special purpose equipment to do only this operation
but do it well, or general purpose equipment that will perform this
and other operations under widely varying conditions? A check
writing machine is a special purpose machine; a desk calculator or
typewriter would come nearer to being general purpose, although
the difference is one of degree - for example, one calculator may be
more versatile than another.
Which machines, among competitive types and makes
available, appear to have the capacity, speed, and special features
needed in the operation? The rapid growth of the office equipment
industry has attracted many competitors, and few, if any, machine
needs do not have a large number of prospective suppliers. Office
machines, like automobiles, are now available in wide varieties of
"horsepower", size, speed, and special features. It is important,
therefore, to ascertain which suppliers have equipment that fits the
needs of an operation; leads are available through advertisements
in trade publications, machines exhibitions, reputable suppliers,
and recommendations by consultants.
Evaluating the available features of a supplier's equipment will
justify close study and comparison; although a supplier may offer a
considerable variety of features, it IS Ii ke\y that his equipment will
excel in certain aspects and be somewhat less satisfactory in Others.
One make of copying machine may produce clearer copies but at
164 Office Machines
higher costs; the buyer must decide which is more important for his
need.
There is also wide variation in speed and capacity. It is usually
possible to find nearly the optimum characteristics if one searches
carefully - so, why pay for a labeling machine capable of affixing
labels to various materials at 12,000 an hour if the need is for labeling
only one type of material and the volume is 12,000 a week?
Or why get the automatic division feature on a desk calculator
unless the operation requires enough of this work to make it
worthwhile? On the other hand, if ther7 is a recurring need to rush
blueprints to distant units of a firm, facsimile reproduction and
transmission may be a wiser approach than a slower and less costly
method of providing the blue prints. As obvious as such precautions
may appear, it is likely that most machine selections are somewhat
less than the best quality currently available for uses intended. And
there is of course the continuing problem of remaining informed on
new developments that might place a choice in an entirely different
light.
Which of the machines that appear to quality for the operation
would offer the best overall ~olution to the specific needs of the
company? In general one might be justified in saying" the simplest,
least expensive machine to do the job," but a set of more specific
questions should usually be considered. With the preceding
discussion as background, a checklist of pertinent questions follows:
1. Is the output of a machine suitable to needs in terms of
accuracy, neatness, and other quality factors?
2. Is speed of service adequate for meeting customer needs or
for facilitating other internal operations that may depend
upon this one?
3. Is cost justified by benefits gained, either in direct dollar
savings or in indirect benefits such as competitive
advantage through prompter service or better infon;nation
for long-range plans? Though it is not an easy undertaking
efforts ordinarily should be made to assess the value of
such intangible benefits as the last mentioned. The
Office Machines 165
alternatives may be a penny-wise, pound-foolish approach

or a tendency to commit the firm to luxuries that may be
impressive but impractical. The large investment involved
in many modem data processing installations makes a
combination of open mindedness and prudence
particularly appropriate in this area.
(a) Does the obsolescence factor warrant special
consideration for the equipment under study? Many
firms have policies requiring that machines of certain
types pay for themselves in a specified number of years
or, perhaps, in one fourth of their useful life. Such
policies have merit considering the current rapid rate
of obsolescence of many machines, but if used, they
should reflect varying rates of obsolescence, and
allowance should be made for intangible benefits such
as those discussed above.
(b) Does the outlook for the operation under study justify
special considerations? Is the need likely to continue,
or may it be uncertain because of the changing nature
or volume of work, the prospect of major overhauling
of systems, or other reasons?
4. Does the equipment offer the necessary flexibility and
adaptability? Consider not only variations in the given
opeJ;ation but other operations that might employ the
equipment as well.
5. Is leasing possible? If so, would leasing be preferable to
purchase? This important alternative will be considered in
a brief, separate section.
6. Could maintenance needs be met effectively and
economically? Key factors in maintenance decisions will
be treated in a separate section.
7. Could the very important problems of employee adjustment
be solved - acceptance of change, adequate ~ply of
potentially able employees, training needs, and reduction
of such problems as drudgery and excessive errors where
present?
166 Office Machines
Before the final choice is made, actual tryout of one or more of

the most likely machines can be vitally beneficial. Arrangements
can usually be made to bring smaller machines to the finn for a
short trial on the work to be processed. Larger equipment often can
be tried out, with a reasonable degree of satisfaction, on the premises
of the supplier.
Purchase versus Lease:
Leasing as a means of financing office equipment is now in
extensive and growing use. Important reasons include the
following:
1. Reduced capital outlay for equipment: Funds may be
limited. Even if this is not the case, more profitable uses of funds
may exist, such as in programs for more aggressive research or
sales promotion involving addition of skilled personnel, or
inventory that can be moved quickly, or general expansion.
2. Up-to-date equipment without permanent commitment of
funds: The obsolescence danger can be minimized for many types
of equipment by leasing recent models, with the opportunity to
retain the equipment or change to newer models when the lease
period expires.
3. Temporary or fill-in needs: Short-tenn needs, for special or
temporary programs and for filling in during peak loads of work
volume, may be met more wisely by leasing than by outright
purchase.
4. Trial use : Suppliers may offer free trial of certain types of
equipment for short periods. For equipment not available for trial,
or for equipment justifying longer and more intensive' trial before
purchase, leasing arrangements are often available.
5. Servicing provided: Leasing arrangements usually provide
for servicing the equipment leased.
Each benefit of leasing has its price, of course. Firms having
heavy, continuing needs for equipment, or having no better
alternatives for use of funds, or lacking the opportunity to lease,
will continue to purchase office equipment. It appears however
that alternative uses of funds are being scrutinized much more
Office Machines 167
closely than in earlier years. Also, accelerated obsolescence is
causing many management's to take a harder look at purchasing
equipment.
When a machine breaks down or fuTh::ti<ms improperly. much
valuable time can be lost, other operations are interrupted, costly
errors occur, and other damages result. Hence, management's may
give almost as much thought to equipment maintenance in some
cases as they do to equipment selection.
Alternative arrangements for the maintenance of office
equipment include the following:
1. Combining rental and maintenance services in lease
agreements (discussed above);
2. Service contracts - either with supplier or with independent
agencies;
3. On call service by supplier or independent agency on
special request; and
4. Providing own maintenance personnel and facilities.
In most companies outside service is ordinarily used. Larger
firms may have the resources to service certain types of office
equipment but are likely to be forced to rely on outside specialists
for most maintenance requirements.
The choice between service contracts or on-call service is
controversial even among firms that make use of both. Service
contracts specify a fixed fee (which may be considered an advantage
by some firms) for providing pre-tentative maintenance through
regular checkups and servicing. They also offer prompt service
when breakdowns occur. However the fees may be considered
expensive, particularly equipment is not heavily utilized. On-call
service may be considered advantageous where:
Equipment utilization is not extremely heavy;
Maintenance service is available on short notice;
Trade-ins of certain equipment (such as typewriters) are
made frequently enough to minimize maintenance
requirements; and
168 Office Machines
Cost comparisons show savings without serious

interruption of normal operations.
Responsibility for Equipment Selection and Maintenance:
Factors considered ir. the above discussion indicate that several
persons or groups normally should participate in office equipment
selection decisions. Equipment selection is an important part of the
overall problem of systems design. Hence, a systems analyst or, in
smaller firms, an office manager who does systems and methods
analysis along with other duties, would have the necessary special
qualifications. They can aid in establishing the need, evaluating
past experiences as revealed by equipment records, insuring
conformance to overall standardization programs, and determining
and evaluating alternative types of equipment available.
Employees who operate the equipment and their supervisors
should of course contribute their ideas regarding equipment. Their
recommendations should be considered and systems requirements
may sometimes require a much broader view. Ideally most decisions
will be made by a team-users, systems analysts, and sometimes cost
analysts.
Valuable outside help can be secured from sales representatives
of equipment suppliers, who have acquired knowledge and
experience in working with other enterprises.
One of the most, notable trends in office equipment and supplies
competition is the provision of more and better systems help, even
to the point of doing much of the basic systems design, training the
user's personnel, and following up at intervals to ensure proper
usage. Particularly striking are the current efforts of computer
manufacturers to design programs (or software) to fit the systems
requirements of certain industries and even individual enterprises
that use their equipment. The need to maintain an objective attitude
toward the offerings and advantages of different suppliers is
important; reputable suppliers attempt (not always with complete
success) to train and supervise their representatives to ensure
- customer satisfaction to a degree where they will recommend other
prospective buyers, and encourage repair business. Trying out the
offerings of two or more suppliers is of obvious value.
Office Machines 169
The services of independent consultants will seldom be required

in office equipment selection, although when advising on complex
systems problems, consultants often strongly influence specific
choices of equipment. Direct assistance with comparative cost
analysis and other dimensions of the problem is available if desired.
And, as mentioned earlier, consultants can conduct an impartial
analysis of needs and equipment available and make specific
recommendations to users.
There is no easy way to classify office equipment. One can list
many types - some having specialized uses and others serving a
variety of operations.
For the sake of continuity we shall relate classes of equipment
to the basic categories of methods by which office operations are
carried out: Assembling;
Processing;
Recording;
Communicating.
The sequence suggested is followed in only a general way.
Virtually all office processes fall into one or more of these categories.
Equipment for Assembling Data:
"Data collecting" may be a more descriptive term for this
category of operations. There are few data collecting machines as
such.
Most ~riginal data come into the enterprise either as oral or
written messages in activities such as purchasing] and sales. Other
data arise from subsequent activities such as production, provision
of manpower, materials and equipment, and accounting. Feedback
data for control purposes are developed continuously from work in
process. All such data may be entered manually or mechanically
on forms, reports, and other documents.
Certain highly promising developments are occurring in source-
data automation. Among these are optical scanning devices,
magnetic ink readers, and voice-to-written message translation.
These devices will be treated in the section on data processing that
170 Office Machines
deals with data acquisition, since they enter directly into processing
sequences.
Equipment for Processing Data:
Data processing involves actually changing data into a more
refined and useful form, either as a part of current operations or
from specific planning or control usage. Machine methods are in
heavy use for processing data. Among principal processing
machines are:
Adding machines;
Calculating machines;
Punched card machines;
Computers.
Equipment for Recording Data:
A broad definition of recording equipment also takes in many
types of machines, including those for initial recording,
reproduction, and retention. Prominent among the recording
machines are:
Typewriters;
Copying machines (for a few copies)
Duplicating machines (for many copies)
Microfilming equipment.
Files and other records storage equipment serve the primary
functions of retention and retrieval; an increasing portion of records
storage is being done in computer storage equipment and
mechanized files.
Forms, reports, and other documents are also important
recording methods. Of course the most basic method for original
entry of data is still handwriting.
Equipment for Communicating Data:
Rapid and significant advances in communications equipment
of many types have been made. Major groupings include:
Mailroom equipment (mailing, addressing, labelling, etc.)
Office Machines 171
Dictating and transaibing equipment;

Intercommunications equipment;
External transmission equipment;
Pneumatic tubes.
Having particular promise is equipment for transmitting data
from machine to machine. This has become so important that data
transmission is treated as a major section in a later chapter,
Most types of equipment mentioned thus far are best understood
and appreciated when considered in relation to the basic processes
with which they are associated. External message transmission
equipment - the teletypewriter, for example - can be appraised most
effectively by considering the general function, processes, and
requirements of communication. For this reason these types of
equipment will be considered in later chapters that deal with basic
categories of office methods and services, the only exceptions to
this approach are certain machines that are general purpose and
do not fall neatly into process categories. These include typewriters;
adding, calculating, and accounting machines; and punched card
machines. These will now be given brief treatment in the following
section. Of special consideration is the fact that basic equipment of
the first three types, while performing primary functions, now
frequently produce by products such as paper tape, magnetic tape,
or punched cards, which serve as input to computers and other
electronic data processing machines.
Detailed descriptions of the many types of equipment available
are neither possible nor appropriate in this book. Moreover, new
and improved models of many types of equipment are appearing at
such a rapid pace that nearly any model pictured or described might
soon be obsolete.
Individuals or companies needing specific description of
available equipment can easily obtain them by :
Communicating directly with suppliers representatives;
Referring to advertisements in trade and professional
Publications;
Attending equipment exhibitions;
172 Office Machines
Following ~p on leads furnished by business associates;

and
Completing equipment advertisement reply cards inserted
in issues of administrative and office management journals.
Typewriters:
Still the most widely used office machine, the modem typewriter
is definitely not what it used to be. The electric typewriter is the
workhorse in most offices. It has undergone continued development
in an effort to improve the quality and efficiency of type-writing.
The popularity of today's electric typewriters arises from their ability
to produce uniform print, cleaner type, more carbon copies, and
greater output with less operator batigue than their ancestors.
Important features of the modem typewriter include:
Self-correcting - typewriter has built-in correcting tape
enabling the typist to correct errors as a normal part of
typing;
Interchangeable typing elements - allows the typist to select
the typing element best suited to the job (for example, with
the IBM Selectric over thirty interchangeable typing
elements are available);
Proportional spacing - enables the typist to at vary the
amount of space between each letter or word in a document;
Ribbon cartridges - provides ease and convenience when
changing ribbons; and
Dual pitch -enables machine to type either ten or twelve
characters per inch.
IBM pioneered the development and marketing of sophisticated
electric typewriters. For example, the IBM Selectric series of electric
typewriters, which has many of the features listed above, also offers
considerable typing versatility, no key jars, ease of cleaning, and
requires less desk space than carriage-return models because only
the rotating head moves back and forth across the typewriter body.
Other important typewriter developments include the memory
typewriter (which permits the storage of typed material within the
Office Machines 173
typewriter); magnetic media typewriters (for example, the IBM
magnetic card and magnetic tape typewriters); and electronic editing
and composing typewriters (which feature memory capabilities and
allow typist to align both margins and set format).
Adding, Calculating, and Accounting Machines:
Standard office equipment for arithmetic operations include
adding, calculating, and accounting machines. Even with
widespread use of high-powered electronic devices, these machines
seem likely to remain as solid standbys in the arsenal of office
machinery. One reason for this is that, although efficient
programming is prevalent today, tasks of an exceptional nature
still arise. Also, many offices are not yet utilizing integrated data
processing (lOP) equipment.
This being true, manufacturers of such standard equipment
and machinery continue to improve it. The speed of these machines
will probably not be increased greatly, but more and more operations
can be performed automatically.
Adding Machines:
Adding machines are limited to addition and subtraction in
most cases. They may be used for multiplication and division, but
their speed and capacity in this work is not as great as other types
of machines. Most adding machines in use today are electric and
employ automatic printing devices that print both the factors and
the results They are available with a choice of a full keyboard or a
ten key arrangement.
Calculating Machines:
Calculating machines have traditionally been used for
multiplication and division, accomplishing these functions by
repetitive, high-speed addition and subtraction. Calculators tend
to be most useful in statistical work in which a large number of
percentages and ratios are determined, and in invoice and payroll
work that requires extensive calculations. The older type calculators
are key-driven machines which operate when a key is depressed
and rotary calculators, which require depression of an activating
bar.
174 Office Machines
In recent years there has been a revolution in the development
of desktop and hand-held electronic calculators. The "new
generation" of electronic calculators that operate on integrated
circuits have gained widespread utilization in most organizations.
The small, hand-held calculator has become a popular consumer
item to millions of Americans. The electronic calculator varies in
capability from performing simple arithmetic functions to very
complex scientific calculations. Although there is considerable
variation in df>sign and capabilities, electronic calculators may offer
such features as:
Programming capability with multiple memory cells;
Printing capability - the units produce "hard" or printed
copy of results;
Pressure sensitive keyboards; and
Visual (digital) displays of results.
The electronic calculator has, in effect, become a small computer.
The machines have the capability to perform complex functions
that only a few years ago required the use of a computer. Since their
introduction several years ago prices for electronic calculators have
decreased substantially while machine capabilities have increased
dramatically.
Accounting Machines:
Accounting machine is a broad classification used to include
bookkeeping, billing, and posting machines. Accounting machines
have several accumulators, or registers, whereby totals from several
classifications of data may be obtained. Accounting machines
perform accounting work ill the literal sense of the word, their basic
purpose being to prepare accounting documents and to total
accumulated sums. The primary factor distinguishing bookkeeping
and accounting machines from other office machines is their ability
to enter descriptive information such as simple numerical codes or
complete alphabetical descriptions. Some of the larger accounting
machines will, for example, type the customer's name together with
a brief description of the sale and the unit cost and then compute
the discount, compute the total amount, pick up the previous
balance, and print the new balance.
Office Machines 175
Typical applications of accounting machines involve accounts

payable, customer billing, and preparing the depositor's ledger and
statement for bank operations.
The previous section dealt with office equipment of both a
general and specific nature for handling routine administrative
work. Reference was made to data processing equipment in several
instances because even routine equipment, such as typewriters,
communication equipment, and accounting machines, is frequently
connected directly to punched Card data processing systems. This
section will deal with unit record systems or what has been called
punched card data processing systems. Electronic data processing
is the subject of the following chapter.
Punched Card:
The common machine language for the unit record system is
the punched card. Joseph Jacquard first conceived the punched
card to control the operations of machines. In 1801 he developed a
system of cards with patterns of punched holes that controlled
weaving looms in producing various patterns of cloth
automatically. The punched card has been used in business record
keeping and simple accounting-oriented problems for over seventy-
five years. Punched card data processing for commercial use was
conceived by Dr. Herman Hollerith, when he developed a system
for processing the 1890 Bureau of Census data. Computation of
1890 census data required only two to three years; it had required
five to seven years to analyze the 1880 census data by manual
methods, and in 1880 the population was 20 per cent smaller.
Once the practical application of the punched card system
proved successful in government census and vital statistics systems,
commercial firms were eager to adopt the equipment and processes
for industrial needs. Some of the early uses were actuarial analysis
by insurance firms and routine paperwork in department stores
and in transportation industries.
The punched card is the key to the unit record system An IBM
stc:ndard punched card. The card measures 7 3/ 8" by 31.4" and is
.007" thick. There are eighty columns on the card from left to right.
Each column is divided into twelve punching rows; ten rows are
176 Office Machines
marked by the digits 0 through 9 the other two rows are in the blank
space immediately above the row of zeros. These zone punches are
called a 12 and an 11 punch or an "x" and "y" punch, respectively.
The punch code devised by Dr. Hollerith in the 1980s is still used
today. Numeric data are represented simply by a digit in the proper
column of the card. Alphabet characters require a two-punch
combination of a zone and a digital punch. For example, an "a" is
represented as a 12 zone and a digit 1 punch - both in the same
column. The zone punch used to represent the letters s through z is
the 0 digit punch. Each of the eighty columns of the card will
accommodate a digit, an alphabet letter, or a special character. The
comer costs on the card help to group ce;tain types of cards used
for specific purposes and to assure that cards will be facing the
proper direction for machine processing.
The design of the punched card provides for basic operations -
field definition and data coding. Field definition is nothing more
than selecting certain columns of the card to be used for fixed data,
such as account number and date, that will appear on each of the
cards. For permanent use, field data can be printed on the face of the
card itself to facilitate manual handling. Coding involves selecting
an alpha or numeric punch or some combination of both to represent
grouped data. For examp1e zip codes now are used to represent
cities, and industrial classification codes are used to represent
business firms with different numbers of employees. The use of a
code permits faster machine handling and reduces the number of
card columns required to record data.
Unit Record Machines:
Unit record machines are recognised as the most economical
means of entry to automatic data processing. However much of the
punched card equipment in the nation is found in installations
that not only do not have a computer system but have no plans for
acquiring one because of the limited size of the company or because
of the prohibitive cost involved.
The significance of punched card machines lies in the common
language provided by the punched card. The punched card is an
important element in the concept of integrated data processing
Office Machines 177
discussed in the following chapters. Once the data is punched in

the cards, the cards can be summarized, sorted, and processed in
an almost unlimited variety of operations as required by
management or by the nature of the operations.
Equipment designed primarily to process punched card data
are the card punch, card verifier, interpreter, sorter, collator,
reproducing punch and accounting or tabulating machines. These
will be discussed briefly in tum, followed by a simple illustration
of a unit record system.
Card punch: This machine is commonly referred to as the key
punch and punches holes in the cards from a keyboard that
resembles a standard typewriter keyboard. The operator reads the
source document and by depressing the proper key, converts the
information into punches on the card. The card punch will, under
semiautomatic programming control, skip or space over
predetermined card columns (fields), duplicate into a succeeding
card the information contained in the preceding card, control the
alpha or numeric shift, and feed, position, and eject cards. An
experienced operator can produce some 8,000 to 10,000 key strokes
an hour.
Card verifier: The card verifier is similar in most respects to the
card punch, but the verifier only senses the punched data. The
operator reads the same source data used with the card punch and
depresses the keys on the keyboard. A difference in what has been
punched in the card and what the verifying operator enters causes
the machine to stop. After a closer inspection, if the punched data
are incorrect, a notch will be cut in the top of the card for visual
reference later in the correction process.
Reproducing punch: This machine is a fast automatic data
punching machine controlled by a wired control panel. The
reproducing punch is capable of gang punching, that is, punching
identical information from a header card into all succeeding cards
and punching a new card from data punched in an original card.
The reproducing punch also receives punch signals from other data
processing rna chines in a "summary punch" operation. Totals of
various classifications can be quickly acquired by processing
178 Office Machines
summary card, punched on the reproducing punch machine as a

by product of other related operations, Mark sense punching is also
performed on the reproducer. Mark sense punching is the automatic
punching of data by means of electrically conducive marks made
on the card with a special pencil. The original data, for example, a
utility meter reading or inventory counts, can be recorded at the
location and then transferred into punched card form by machine
processing.
Interpreter: The interpreter is controlled by a wired panel and
simply translates the punched data into the proper alpha, numeric,
or special character and prints this in a certain position on the
card. Interpreting the punched data is a necessity when the cards
are to be used for permanent file documents and manual reference
is required.
Sorter: The sorter, along with the collator discussed later, is
essential in processing the mass of punched cards. Efficiency and
economy in punched card data processing require reusing the cards
(data) as many times as possible once the data has been recorded
(punched). Current models of sorters will process punched cards at
the rate of 4000 per minute. The machine sorts by reading or sensing
the punch in a selected column and depositing the card in the proper
pocket. There are thirteen pockets on the sorter, one for each digit
from 0 through 9, one for each zone row, and also a reject pocket.
Only one column can be sorted at a time. Sorting machines are also
equipped with selectors, which enable cards to be rejected except
for those that contain a specific punch; these are sorted into the
proper pocket. Actually in this selection process, the sorter simply
suppresses (ignores) all punches except those that will select the
desired cards.
Collator: The collator assumes the prodigious task of filing the
punched cards. The sorter can function as a collator, but the process
is much slower. Collators operate under direction of a wired control
panel and have two card feed pockets and four selection pockets.
Collators can (1) merge two groups of punched cards into one
sequential file according to field or coded data punched in the card,
(2) verify sequence of the cards, and (3) match (verify) the sequence
Office Machines 179
of two groups of punched cards. A typical use of a collator is to
merge new cards into a master file of punched cards.
Tabulating or accounting machine: All the previous machines
and Operations are necessary to record the data and to prepare the
cards for processing on tabulating or accounting machines. These
machines operate from wired control panels and can, at the
discretion of the operator who wires the control panel, perform
routine accounting functions such as listing cards for reports,
selecting cards for listing, and adding and subtracting in several
classes or groups of totals, subtotals, and grand totals. Some
accounting machine models have small storage locators in which
repetitive, information, such as column heading and date of bills,
can be entered only once but will be printed out on command.
Accounting machines are the core of any unit record system, for
here "hard copy" is obtained that will be used internally in the
organization for data such as that on bills mailed to customers.
A Unit Record Data Processing System:
The following example briefly describes how punched cards
are used to prepare bills for a typical telephone company. Several
cards are necessary in this process three permanent cards that are
reused each cycle and several one-time cards, used to enter current
charges or credits. Specifically, there are the following punched
cards:
1. Permanent file card containing customer's telephone
number, name, address, credit rating, and other identifying
information (green);
2. Permanent file card for local service charges, depending
upon type of service, number of telephones, etc. (manila
colour);
3. Permanent file card for yellow page .directory advertising
(orange); and
4. One-time-only cards to enter monthly charges (manila
colour with different coloured stripes); and one card for
each of the following: (a) long distance calls -summary, (b)
fractional month charges or credits, (c) balance from
180 Office Machines
previous bill - debit or credit, (d) inter-zone charges
intrametropolitan area long distance charges.
The basic complement of machines for this operation is five
card or key punches, two card verifiers, one interpreter, one
reproducing punch, one sorter, one collator, and one accounting-
tabulating machine.
The basic document for changes in the permanent data cards is
the service order. This single document authorizes new account
cards and changes to the name and address card, the local service
card, and the directory advertising punched cards.
Each customer account is considered part of a particular control
unit for billing purposes. All billing charges must be balanced
according to these control units; for example, the total local service
charge for a control unit for the previous month's billing is updated
to account for any additions (new customers, upgrading of service)
and for reductions (discounts, moves, downgrading of service) to
obtain a current control unit total of local service charges. A similar
operation occurs for the directory advertising charges. The three
permanent cards - each of a different colour are then merged together
according to telephone number sequence to await final merging
with the one-time charge cards. Up to this point, the card punches,
interpreter, sorter, collator, reproducing punch, and accounting
machine have all been used.
Specially striped coloured cards for one-time only charges are
punched with the telephone number and the amount from
previously prepared statements, which will accompany the
customer's bill. The charges in these cards are then balanced against
previously determined control totals for billing charges; the cards
are then merged with the permanent file cards. All cards are then in
telephone number sequence ready for processing on the accounting
machine. This process results in the customers' bills being printed,
along with control totals for each classification of charges for each
control unit. Once the control unit bills have been prepared and the
total charges balanced, the customers, bills are processed for mailing
and the billing cards prepared for storage until the next cycle. This
requires a selection process with the sorter. The three permanent
Office Machines 181
cards are selected according to their card number (and separated at
the same time), while the one-time-only cards are separated and
destroyed.
In a normal month's operation about 300,000 customers bills
will be prepared requiring a total processing of more than 1,500,000
cards, of which about 100,000-200,000 will be one-time-only cards
used simply to enter a charge on the customer's bill. The customer
billing operation is not simple, but it does save considerable time,
and it results in a reduction of the work force needed for customer
billing. As with most mechanized data processing operations,
however, the total number of employees soon increases because of
the additional work assigned to the unit record equipment.
Of special importance to the development of a common language
for sequential processing of the data on an integrated basis are the
tape punch attachments, which produce punched tape as a by
product of the regular operations. Punched paper tape attachments
or features are quite common on such standard office machines as
typewriters, adding, calculating, and accounting machines. These
features allow a tape to be punched of the essential data generated
from operating the office machine - totals, summaries, or even the
complete data, the punched tape output is compatible with standard
tabulating or electronic data-processing equipment and is a direct
input source for computer systems or for other machines that have
tape-read devices attached and are capable of automatic operation.
These paper punch features allow isolated, small firms to prepare
their basic records in their usual way but also to simultaneously
prepare a punched tape that is processed by service bureaus in
preparing consolidated reports, billing, and similar routine office
reports or summaries.
***
Chapter
12
tItI
PRODUCTION CONTROL
The coordinative mechanisms are general in character and are

applicable, therefore, to a wide range of industry. The particular
combination of these mechanisms which may best serve the purpose
will necessarily vary widely with the characteristics of the company
considered, but usually there is little difficulty in selecting such a
combination as will ensure management control of the several
functions and departments. In certain productive companies,
however, there is, in addition, a much more difficult problem,
namely, that of controlling production so that the required goods
shall be produced in the best and cheapest method, that it shall be
of the required quality, and that it shall be produced at the required
time. Since the work of practically all of the departments of a
manufacturing plant, the arrangement of equipment, and the
personnel of the plant are influenced to a greater or less degree by
this problem, it is desirable to discuss it at some length before
proceeding with detailed discussions of these other departments
and functions. Some typical methods of production control will
first be described, and the possibilities and limitations of their
application to various kinds of companies will then be briefly
discussed.
In a continuous-process industry, where the raw material enters
one end of the factory artdflows through it in a steady stream, the
problem of production control is obviously very simple, since the
Production Control 183
path or route that the material is to follow is fixed by the natural

sequence of processes, and the times of operations are fixed largely
by the capacity of the machines and processes. In an intermittent-
process industry of the special-order type, where products are made
only to customer's orders and where repetition of such orders is
unusual, the case is very different. Here each succeeding part
produced may follow a new path through the shop; the time required
for each operation may not be known; and unlike the continuous-
process industry, the parts do not move automatically from machine
to machine but must be so moved as occasion requires. It will be
clear that unless some supervision is given to the sequence of parts,
congested conditions will arise in the factory, some machines having
more work than they can do and some being under loaded, and as
a consequence the goods will not be produced at the time set for
delivery.
There are, many modifications of these extreme types of
companies. One of the most common and most important of these is
what may be termed the lot-intermittent type. In this type of
manufacturing, standard goods are carried through the factory in
lots in anticipation of sales. The delivery of goods to sales is made
from a store of finished products in the stock room, and the number
of machines or other products in each lot and the frequency with
which manuJacturing orders are placed with the factory are
governed by the quantity of goods on hand and the probable market
demand. If a variety of products is manufactured and if lot-
manufacturing orders for each kind of goods are infrequent, the
conditions approach those of a special-order industry. If, on the
other hand, only a few kinds of goods are manufactured, and if
manufacturing orders for each kind of goods come at regular,
frequent intervals, the conditions approach those of a continuous
industry. In the majority of cases some kind of production control is
required in this form of production as in the case of special-order
work, and this control is usually attempted through a so-called
planning department.
Development of Planning Departments:
The growth of the planning department is of interest. A few
years ago a typical organization of a production department
184 Production Control
consisted of the superintendent, the several foremen, and a few

special officers, such as a storekeeper and timekeeper. The
superintendent received the formal order and instructions for the
work; gave it a number, :etter, or some other distinguishing mark;
and sent each foreman an order instructing him how to proceed
with his part of the work, trusting to natural cooperation among the
foremen to keep the correct sequence of operations so that the
finished goods would be shipped in time. A record was kept of all
time and material expended on the job, and the total cost of the
work recorded, though, in general, detail costs were not obtained.
As the necessity of more detailed costs became greater and the
science of cost keeping grew, the instructions or work orders issued
to the workmen were made more and more in detail for each job. As
works increased in size, it became increasingly difficult for the
foreman and others charged with the production to keep the proper
sequence of operations on a mental and verbal basis; and when one
considers the complexity of the modem shop and the immense
number of small parts passing through even a fair-sized
establishment, the performance of some of these superintendents
and foremen seems marvellous indeed.
The next step in this development was the establishment of
"production departments," so-called, usually directly under the
superintendent, which were intended to relieve the foremen and
others of the burden of keeping the required sequence of operations.
A schedule of performance, more or less complete, was laid out for
each production order by the production manager and an effort
was made to meet this schedule by means of "tracers" or "stock
chasers" as they are sometimes called. These are clerical assistants
to the production manager, usually well informed concerning the
shop and the goods, who follow the work through the shop,
correcting and adjusting conditions and removing difficulties. Under
certain conditions satisfactory results can be obtained in this
manner, and not a few of such departments are now in operation.
Obviously much of the work of such simple production
departments has to do with relieving difficulties after they have.
occurred. True planning, however, aims to prevent difficulties fr.om
occurring, and there has been a constant movement, therefore,
especially in large companies, toward the development of plaRl1ing
departments that can plan productive operations in advance just
as the engineering department plans the structural side of the goods.
Plan!ung of work may be done in one of two ways, namely,
empirically or statistically. Any man highly experienced in a given
line of work can easily plan a desirable sequence of operations for a
given piece of work, basing his predictions on his experience and
judgment, but there will be definite limitations to the accuracy of
his predictions. For instance, if there are several desirable ways of
performing the work, he will not, in general, be able to say which is
the best way unless he or some other equally competent man has
tried them all and recorded his results. Again, he may be able to
assign the approximate time necessary to perform the work or the
tools that are most efficient for the purpose; but, in general, unless
he possesses recorded data bearing on these matters, his empirical
estimates are approximate only, and his predictions useful only
within the range of his experience. Where recorded data are to be
had, however, the basis of prediction is much more sound; and if
such data form a record of high-grade performances, they are
inestimably superior to empirical estimates. The engineering and
drafting department is the finest example of the separation of mental
and manual processes and the prediction of results on the basis of
recorded data. True, a considerable amount of the work of this
department is still empirical and will remain so for many years; yet
the progress that has been made is remarkable and foreshadows
what may be expected to occur in the planning of manufacturing
operations when a sufficient volume of data bearing on capacities
of machines, forms of cutting tools, the times required for operations,
etc., has been collected.
Functional Foremanship:
The first important attempt to solve the problem of production
control was that of the late F. W. Taylor in connection with his plan
of shop management commonly known as functional foremanship.
Since this plan has been the basis of practically all such efforts, its
most important features will be described. Mr. Taylor's typical
organization, as here outlined, is particularly adapted to

metalworking establishments that machine large pieces, but the
principles involved are of almost universal application. Under Mr.
Taylor's system the work now ordinarily performed by the foreman
under the old methods is divided into several parts, or functions,"
H
each performed by a separate functional foreman or functional boss

as Mr. Taylor styles him. Care is taken to separate planning functions
from executive junctions, and all planning is removed, as far as
possible, from the shop to the planning department. The latter then
performs for the constructive side of the industry what the
engineering department has long performed for the designing side
of the work. In fact, the movement to do the planning of all productive
processes in advance and in a separate department is analogous to
the movement that formed the engineering department. It is in strict
accord with the general principles of division of labour and the
separation of mental and manual processes.
In his work at the Bethlehem Steel Company, Mr. Taylor found
the following subdivision and rearrangement of functions
profitable:
In the planning department:
1. The order-of-work or route clerk.
2. The instruction-card clerk.
3. The time and cost clerk.
In the shop:
4. The gang boss.
5. The speed boss.
6. The inspector.
7. The repair boss.
And for the entire works:
8. The shop disciplinarian.
The follOWing is a very brief statement of the duties of these
several bosses as stated by Mr. Taylor:
The order-of-work or route clerk lays out the route that the piece
is to follow through the several shops and the sequence of machines
and men that are to operate upon it in each shop. He prepares the
route sheet and from it he or his assistant makes out the work or
operation orders for each man or machine operating upon it. The
work order must give the order number of the job, the number of the
instruction card 0, or other references that may be needed to identify
it. The order-of-work or route clerk is responsible ror the sequence
of work in the shop, though in some modified applications of Mr.
Taylor's system both a route clerk and an order-of-work clerk are
used, the first laying out the route and schedule and the second
seeing to its operation and enforcement. This division would
naturally come about in a large plant, but even then these two men
must work in close harmony.
The instruction-card clerk fills out the instruction card, which
bears the same relation to the planning department that a drawing
does to the drafting room. It gives all the information regarding the
necessary drawings, jigs, fixtures, etc., and gives the exact sequence
of detail operations that must be followed by each workman. It may
give the number of cuts, the depth of each cut, the speeds and feeds,
and the time that each cut and operation should take. It may also
give full information regarding the piece rate, day rate, or premium
on which the work is to be performed. In certain cases it is clear that
it might include the information listed on the operation card just
described, but usually it is more convenient to use the two cards.
The time and cost cleark prepares for the instruction card the
necessary instructions to the workman for the recording of time
and cost of all work and for securing from the workman the proper
returns for making cost and time records.
The gang boss makes all preparations for getting the work to
the workman, collecting the necessary jigs, drawings, etc., and sees
that the work is properly set in the machine. He relieves the workman
of all preliminary planning as far as placi~g the piece in working
position is concerned.
The work of the speed boss begins after the piece is set in the
machine. He sees that the right tools are used and that the feeds and
speeds are according to instructions. He also instructs the workman
in the best method of doing the work.
The inspector is charged with the duty of seeing that all work is
up to standard in workmanship and finish.
The repair boss has charge of all machines, belts, etc., and sees
that they are kept in good order and repair.
The shop disciplinarian is responsible for discipline and good
order. He is also the peacemaker and assists in adjusting wages. He
represents the disciplinary functions formerly executed by the
foreman.
This rearrangement of duties virtually amounts to replacing all
line organization below the superintendent of production with
functional organization The value of functionalization had, of
course, long been recognized and applied as illustrated in the typical
organization diagrams where such duties as shipping, purchasing,
inspecting, and stores keeping are shown as functional duties. And
these diagrams show that the movement toward functionalization
of duties had long been operative in the upper part of the
organization diagram. Taylor's work, therefore, completed a
movement already well under way and carried functionalization
to the very bottom of the diagram. It should be noted in passing that
functionalized duties, such as engineering, accounting, cost finding,
tool-making, purchasing, etc., make progress in that direction in
proportion to the growth of their scientific background and in
accordance with the general law of division of labour. Taylor's
plan, therefore, is a perfectly logical extension of a movement that
had been gathering force for some time but required vision and
ability to demonstrate by an actual practical example.
A careful consideration of the foregoing will make clear that
there are no new economic principles involved in so-called scientific
management but rather an extension and application of well known
principles. The rearrangement of duties is essentially an application
of division of labour. The combined duties of the foreman and the
workman are separated into component parts, and similar parts
are then reassembled under fu.nctionalized supervisors. The
workman is relieved of all planning in connection with his work
and can, therefore, devote all of his time and energy to actual
production. The actual worker is charged only with the
responsibility of the major factor of prod uction, and all minor factors
are placed in the hands of specialists who guide and assist him
exactly in the same way that engineering design was taken from the
factory floor and centralized in the engineering department many
years ago. And, as in the case of the engineering department, the
functionalizing of these minor factors in an effective manner depends
v~ry greatly upon the accuracy of the fundamental data available
upon which to base these activities. With accurate data on the cutting
of metals and with accurate recorded observations of the time
required to do the operations, Taylor was able to predict where,
when, and how the work was to be performed.
Again, it will be obvious that with such a rearrangement of
duties and such an extension of division of labour an increase in
production might be expected. Such was the case in Taylor's original
experiment. It is self-evident that an operator, whether doing
handwork or operating a machine, will be able to do much more
actual productive work when relieved of all responsibility of
transporting material, finding tools and -fixtures, planning the
sequence of operations, etc. This has been proved too frequently to
admit of argument. It does not follow, however, that an increase of
production through such means will necessarily be accompanied
by lowered costs; in fact, they may be even higher than when the
work is performed by simpler methods. There are several reasons
why this may be so. First, as noted in Art. 51, any extension of
division of labour must be accompanied by some form of
coordinative influence to be successful, and Taylor's functional
foremanship is no exception to this rule. The particular coordinative
measureS that have been devised for this purpose are discussed
fully in succeeding sections. Functional foremanship with its
accompanying coordinative mechanisms is costly and unless the
fillnncial gnin due to increased production exceeds the cost of these
refined methods a loss in profit instead of a gain is incurred. In
other words, the principle of diminishing returns holds true here as
well as elsewhere. A lack of understanding of this important
principle was responsible for not a few financial failures among
those who first tried to apply Taylor's methods to small or medium-
sized plants.
Furthermore, it should be remembered that the major factor in

production usually could be operated at high efficiency only if some
of the minor factors operate at comparatively low efficiency. The
tendency for service departments to be inefficient and the necessity
of stimulating them constantly are too well known to merit
discussion. Necessarily, this tendency is increased in organizations
as refined as that discussed in the foregoing, which again tends.to
accelerate the principle of diminishing returns. Experience has also
shown that efforts to stimulate production by these means, to be
successful, must be accompanied by some form of financial incentive
for the worker. The worker instinctively expects greater pay for
greater output, and all modem plans of administration recognize
this principle. Incentive-wage systems are now very widely used;
and although they vary considerably in their detail methods,
basically they all rest upon the foregoing principle. Naturally, this
principle, while tending to increase production and decrease unit
costs, tends also to increase total labour costs.
Essentials of Planning:
Mr. Taylor's plan of production control has not.been widely
adopted in the exact form that he used at Bethlehem. Many modified
forms of this system are, however, in use, and there is a constant
tendency to adopt many of his control mechanisms in various
combinations to suit the circumstances. The influence of his work
on the problem of planning shop operations in advance of their
actual performance has been very great, and all modem planning
departments are modelled more or less upon his methods.
The planning of industrial operations involves four
considerations, namely, what work shall be done, how the work shall
be done, where the work shall be done, and, lastly, when the work
shall be done. The problem of what work shall be done is one for the
management and the engineering department to solve. It is assumed,
therefore, that the planning department will receive full information
from these sources as to the quantity to be produced; the shipping
directions, if goods are to be shipped directly from production; the
date, if any, on which delivery has been promised; and the necessary
engineering specifications and drawings. The planning department
will then be required to perform one or all of the following functions

depending upon the degree of control required:
1. Issuing all orders that are necessary for production.
2. Routing or laying out the sequence of machines, processes,
and operations that are the most desirable and efficient.
3. Scheduling or assigning to each process and operation the
time that should be required for its completion.
4. Dispatching or starting all operations and processes at the
time set and in the manner in which they have been planned
and ensuring that the materials and tools required are at
hand when needed.
5. Collecting all returns and records of performance that are
necessary for the work of the several <ldministrative
departments or for the production of future performances.
In many instances, the work of the planning department is
confined to the first function, but in progressive shops the last four
are rapidly becoming important and necessary parts of productive
processes. Some remarkable planning departments are now in
operation in which the complete schedule of operations is predicted
not only as to the manner and place of each operation but also as to
the time that is to be consumed. These highly developed planning
departments are connected, of course, most frequently with
industries involving mass production. The planning department
may, and often does, include other functions. A published
description of a factory where so-called scientific management has
been installed lists the following men as under the planning
department: shop engineer, storekeeper, cost clerk, shipping clerk,
receiving clerk, and inspector, as well as several others directly
engaged in planning. In a small companies it not only is feasible
but may be good management to include all these activities under
one department. It is, however, contrary to the elementary principles
of division of labourer, which assigns as few duties as possible to
either a man or a department, these duties being of a similar character
as far as possible. The function of the planning department is the
planning and scheduling of the work; and as factory increase in
size, such dissimilar functions as inspection, cost finding, and
others listed above nalurally tend to become independent
departments functionalized under the factory manager, or as he is
more correctly named productifJn manager. They are in reality more
highly specialized functions that he formerly was expected to
perform himself, and the manner of their formation will depend, to
a large extent, on the size of the works and the character of the men
obtainable for the several positions. On the other hand, there seems
to be no good reason for making the planning department
independent of the factory manager (if there be one), thus making
the head of the planning department a thorn in the side of the
superintendent who is charged with the responsibility for
production. The planning department should be incharge of the
factory manager, and the head of the planning department should
be of the character of an assistant superintendent. When organized
independently, as is sometimes the case, it usually results in much
duplicate work and opens up an opportunity for interdepartmental
bickering.
Issuing Orders :
The degree of detail in which orders are issued to the factory
depends largely upon the degree of refinement needed in compiling
the costs of production. Production is usually initiated by the
general manager's sending the factory manager a production order
which is the authority for the latter to proceed with the work
described in the order. If the work authorized by this order is simple
in character, it may be passed by the factory manager directly to the
planning department as a manufacturing order. If, however, several
machines of different character are authorized by the production
order, the factory manager may, after consultation with the cost
accountant, divide the production order into several manufacturing
orders. The planning department again may subdivide each
manufacturing order into a large number of work orders or operation
orders. Quite frequently a work order is issued for each operation to
be performed, and all production orders, manufacturing orders,
and work orders are identified by number or symbol, as-described
hi Art: so that all instructions issued concerning each part can be
clearly understood and all labour and material used in its
production can be accurately cha-rged against it in the cost system,

a cost sheet being usually opened for each machine or part so ordered
and identified.
When a work order is issued to a workman, instructing him to
proceed with a particular operation, it is accompanied by such
instruction cards, time cards, engineering data, and other
information as are necessary for the work. The planning department
will also issue orders on which material is to be drawn, directing
the moving and transportation of material in process (if such a
system is used), and orders for such tools and equipment as may be
necessary.
Routing:
The demand for a more systematic method of carrying the work
through the shop gave rise to the practice of routing. Routing may
be defined as the selection of paths or routes over which each piece
is to travel in being transformed from raw material into finished
goods. The object of routing is to determine the best and cheapest
sequence of operations and to ensure that this sequence is followed.
It will be noted that routing is automatic in continuous industries,
since the plant itself is laid out with a view to passing the goods
through a fixed, predetermined series of processes. In intermittent
industries, however, there is sometimes a very large number of
sequences that can be followed, though there is usually one series
of operations that is best for any given article. The process is
analogous to selecting the best railroad route from one place to
another.
The economic advantage of routing is based upon division of
labourer. Someone must do this planning, and it demands
deliberation and concentration of mind wqich the busy foreman
cannot always bestow upon the problem. Routing constitutes a
function that can well be separated from others wherever there is
sufficient volume of business to warrant this procedure. Once a
good route has been worked out and recorded, furthermore, it can be
used again for other similar jobs, thus securing the advantages of
recorded data. For this reason routing can often be done to advantage
in the drafting room, the route being recorded on the drawings
themselves. If routing is done in the drafting room, care should be

taken that it is directed by someone who has accurate knowledge of
factory conditions and equipment.
The degree of refinement to which routing may be carried will
vary with the factory and the goods. In some cases it is sufficient to
designate the successive departments through which the piece in
question is to pass, while, again, it may be advantageous to go
further and designate the particular machine and process that is to
be used. It will be obvious that successful routing requires that the
route clerk must have great knowledge of the goods and of the
manufacturing equipment, and he must also have readily available
full knowledge of the capacity and characteristics of every macr.ine
and process. It will be clear also that the engineering department, if
there is one, can be of great aid in intelligent routing.
Assembly Routing:
In complex products such as computer and automobiles the
sequence of operations in assembling is often very important and
is, therefore, carefully planned. The importance of an orderly
procedure in the assembly of such goods will be clear on brief
consideration, for example, of a computer or an automobile. Many
of these complex constructions consist wholly or in part of an
assemblage of unit assemblies or subassemblies, as they are
sometimes called, each one of which is composed of a number of
individual parts. Thus the engine of an automobile is assembled in
the machine as a unit and not built up in place from individual
parts. Obviously there is one best way of assembling these units
and also of assembling them into the completed goods, and this can
be accomplished only by careful routing and standardization of
assembling procedure. Perhaps the best illustration of such
procedure is the progressive assembiy used in assembling certain
automobiles. In such an assembly the frame of the automobile is
attached to one end of a travelling chain or carrier about 600 feet
long and moving about 5 or 6 feet per minute. Along this chain at
fixed intervals workmen or groups of workmen are stationed, each
charged with the duty of attaching an individual part or unit
assembly in its proper place in the machine during the time it moves
past the station. Thus by the time the frame reaches the other end of
the carrier a complete automobile has been assembled upon it. The
sequence of assembly operations is presumably the best that can be
devised, and the several component part;s are routed either directly
from production or from stores, so that they arrive at the proper
place in the chain of events. The assembly of component parts such
as the engine is conducted in a similar manner.
The problem of routing the material through the factory may
have a great influence upon the design of the buildings and the
arrangement of the machines. Even in extreme intermittent-process
industries, such as a shipbuilding plant, great savings can be made
by a logical arrangement of buildings and processes. In such
companies as automobile, computer, rolling-mill, and similar mass-
production plants, economical routing in the design of the factory
is of greatest importance, and in purely continuous-process factories
the arrangement of buildings and processes is almost entirely a
problem in routing.
Scheduling in General: Routing has been defined as the
determination of the proper sequence of a number of operations.
Scheduling is defined as the determination of the time that should
be required to perform each operation and also the time necessary
to perform the entire series, as routed, making allowance for all
factors concerned. The analogy of the railway may again be helpful.
The route shows the passenger the path that he is to pursue in
passing from one point to another. The schedule gives him the time
elements of his progress in passing from place to place. The problem
of routing is, in general, not a difficult one, but the problem of
assigning time elements to productive processes with accuracy is
often very difficult and sometimes necessitates many refined data.
Scheduling, like routing, may be of three degrees of refinement,
namely,
1. Master scheduling, or the assigning of the dates on which
important features of a production are to be completed.
2. Operation scheduling, or the assigning of the total time
required to do a given piece of work with a given machine
or process.
"
3. Detail-operation scheduling, or the assigning of the time

required to do each detail operation of a given job with a
given machine or process.
These degrees of refinement may be visualized more clearly by
considering the construction of a ship, the contract for which calls
for delivery upon a specified date. Beginning at that date and
measuring backward a series of dates may be set fixing the latest
time on which important features of the work must be completed if
the delivery date is to be met. The dates, therefore, for beginning the
trial trip, for the completion of the installation of all machinery, for
the completion of the construction of the boilers and engines, for the
launching of the hull, for the arrival of steel for the boilers and hull,
etc., may be set off as a master schedule for the general guidance of
all concerned in the schedule of events. It will be clear also that a
similar master schedule can be made for each and every large element
entering into the construction of the ship. Thus a series of time
elements may be laid out for all important parts of the engines so
that the base plate or bed, the columns, cylinders, cranks, etc., shall
all arrive at the assembly floor at the proper time and so that the
date of completion of the engine will conform to that set by the
controlling master schedule.
It is an adaptation of the Gantt chart in which horizontal
distances are used to measure times of performance. The important
steps into which the work was analyzed are numbered on the left-
hand side from 1 to 30. The time by weeks is indicated along the top
of the diagram. As in the case of the ship, a controlling date, May 7,
was fixed, on which the building was to be turned over to the owner.
The schedule was then marked back from this date, the time for
each element being so set that if completed on scheduled time the
date of delivery would be met. The heavy horizontal lines indicate
the scheduled time; the heavy broken lines show whether the work
is up to schedule, behind schedule, or ahead of schedule. In column
3 a cross indicates any item that is not up to schedule, and in
column 4 t~e heavy horizontal lines indicate the percetitage of each
item that is completed. When this heavy line extends entirely across
the column, it signifies that this particular item is completed and
needs no further attention. The schedule is brought up to date each
week by a field engineer, and a copy is sent to the main office, thus
permitting the manager of construction to make suggestions or
modify the schedule. Not the least value of such a schedule is the
fact that it records clearly the progress and delays attendant upon
the venture, and this is of great value in estimating future
undertakings.
Consider next a machine part such as one of the eJ1gine
cylinders, which is finished by a series of operations such as boring,
planing, milling, drilling, etc., similar to the list of operations.
Obviously time elements can be assigned to each of these operations
which, if they are fulfilled, will ensure that the cylinder will be
produced at the proper time. This would be operation scheduling.
Sometimes routing and operation scheduling are both listed upon
the same sheet. Such sheets are sometimes called planned-operation
sheets, but such planning is simple operation scheduling and
should be clearly distinguished from detail-operation scheduling,
which is to be described.
Detail-operation scheduling is the assigning of time elements
to each detail operation, which is usually known as an instruction
sheet or instruction card. This is the extreme of refinement in
scheduling; and as will be seen, a considerable amount of data on
the characteristics of the machinery of production and of the time
required to do basic operatiOns must be available in classified form
before such refined prediction of time elements is attempted. These
required data and the methods of securing them are fully discussed
in a succeeding section.
Master Schedules-Control Boards:
The master schedule is based naturally upon the sales orders
or the prospective sales requirements. Such schedules can be made
up intelligently, therefore, only on a clear understanding of such
requirements and the volume of work already in process. General
policies and the necessity of keeping all divisions of the plant
employed as far as possible will, therefore, enter into its compilation.
Usually the making of a master schedule for a single piece of goods,
however complex it may be in itself, is not a difficult matter; but
where many production orders are to be scheduled more or It'S5
simultaneously, the problem may be very difficult. It should be noted

that in purely continuous-process industries routing and scheduling
are automatically performed by the machinery of production, and
the nearer an industry approaches to this type the simpler are the
problems of routing and scheduling.
In a factory manufacturing largely on specific sales orders there
will be jobs like that of the ship described in the preceding article
where there is ample time to meet the delivery date by following the
regular procedure laid down. But it may be that one or more of these
orders may be coincident as to time in their main features; and
unless the master schedule is carefully compiled, congested
conditions, on the one hand, and idle machines, on the other, are
likely to result. Then again, repair jobs or jobs that for other reasons
must be rushed through as quickly as possible may make it necessary
to modify the master schedule so as to prevent congestion and obtain
the desired results. It may be also that the plant produces lines of
goods for stock in antic~pation of sales orders. Orders for such goods
can be issued at such times as will help to keep the schedule
balanced.
The problem of the master schedule in plants that manufacture
entirely for stock is not markedly different. More consideration must
be given, of course, to market conditions and prospective sales, and
questions of general policy are more dominant in compiling the
master schedule. This is particularly true where production in
anticipation of sales ties up a large amount of capital in materials
and labour. The size, sequence, and character of the lots of parts or
complete machines that are scheduled for production must be given
very careful consideration, especially as the schedules for this type
of production must usually be determined months in advance of
completion of the goods.
A master schedule, therefore, should not be considered as a
fixed procedure that admits of no change. Constant minor changes
are usually necessary to accommodate new conditions as they arise,
and sometimes major changes are imperative because of unforeseen
troubles. In many cases the master schedule consists simply of a
limited number of important dates, the problem of directing the
production so that the several parts will be completed at the proper

time being left to the superintendent and foreman to work out as
best they can. The author has witnessed some very extensive and
important contracts carried through to successful completion in
this simple manner. In most advanced modem practice, however, it
is not uncommon to chart all important events for all work on the
master schedule, thus making some form of control board. The Gantt
chart is one of the most effective forms of such graphical schedules.
On this chart, as has been noted, horizontal lines represent time,
and hence a large number of desired events can be scheduled on a
comparatively small space and in a form that makes them easy to
visualize.
On GenU chart the date for starting the several operations, the
amount scheduled per week, and the total amount scheduled to
date are indicated by the key at the right hand of the chart. The
heavy black lines indicate the proportion of work actually completed.
A similar diagram showing the work ahead for various machines
and processes and known as a machineload chart is often very
useful in routing and scheduling.
It will be obvious that the idea on which the Gantt chart is
based is capable of wide application. The most interesting and most
complete application of the principle to control-board methods is
that devised by Major George Babcock for the Franklin Motor
Company. On this board a great degree of flexibility was attained
by movable markers placed upon the horizontal elements that
indicate time. It was, in fact, a mechanical Gantt chart.
At the left-hand side are listed vertically, first the machines in
Department first and below these the machines in next Department.
At the top of the picture, part way down, between the two lists of
machines, and at the bottom of the picture, are identical time scales
showing consecutive time by days divided into 8 hours each. A
traveller, the frame of which is back of the board, carries two white
strings set 8 hours, or one working day, apart. They mark the events
that are scheduled for one day in both departments. Opposite each
machine number there is a metal holder shown clearly on the right-
hand side, into which can be placed paper strips that indicate the
rate at which it is expected the several operations will be performed.
These paper strips are laid off into hourly divisions of the same
length as those in the calendar strips at the top and bottom of the
board. The half hours are indicated by short lines, and every fifth
hour is marked by a longer division line to facilitate calculations.
Each paper slip also carries a record of the identifying symbol, the
number of operations, the manufacturing order number, and the
operation number. Thus, opposite the first 10 x 24 Norton grinder.
The production slip indicates that at the beginning of the fifth hour
on the last working day in January production was started on part
No. x-So The number of parts ordered is 1250; the production order
number is 2626; and the number of the required operation is 20. It is
expected that this work will be completed by the end of the sixth
hour on specific day.
The strings indicate the work that is to be performed on specific
day, provided the schedule has been adhered to and all operations
are up to schedule. All deviations from schedule are reported by the
dispatchers on the machine floors, and the board is corrected by
sliding the slips forward or backward as may be necessary. Small
riders of various colours are clipped over the control slips to indicate
variations in schedule caused by such troubles as breakdown of
machines, lack of material, etc. Some of these clips may be seen on
the picture. The actual control board from which this model was
made is long enough to control three months' work, at the end of
which time the board is reset from the left end. The hourly division
lines are machine printed, and the material for the control slips is
furnished in rolls, the schedule operator simply cutting off the
desired length.
It will be noted that when all of the machines are running, the
board opposite the lists of machines will be completely filled with
control slips. On the model board a considerable amOlmt of machine
idleness is shown, and this is a valuable characteristic of such
control boards, since they show at a glance the degree of activity in
the plant. Again, the total hours of work scheduled for any day is
an index of the number of workmen needed at any time, and this
assists planning in advance for the working force. Thus for specific
day only 62 man-hours of work are scheduled for the first group of
machines, assuming one man to each machine, whereas the total
capacity of the group is 128 man-hours on the same assumption.

The department is therefore working at less than half capacity. It
will be obvious that the general principles are capable of wide
variation. A most interesting variation that has been attempted is to
schedule only the jobs that fall behind or are delayed from one
cause or another. In a plant having, normally, a steady flow of
work, there would be a great saving in scheduling only the
exceptional jobs that are thus out of line, so to speak. This would be
an application of management by exception, to which further
reference is made elsewhere.
Dispatching:
The most important functions in dispatching are
1. The procurement for the workman of all tools and fixtures
necessary for each operation in advance of the time when
they will be needed.
2. Initiating the work by giving the workman all work orders,
instructions, drawings, etc., at the time when work should
begin.
3. Recording the time of starting and completing each
operation.
4. Moving the work after completion to the next operation or
process listed upon the route sheet.
5. Tracing the progress of all production and making
adjustments in the schedule to accommodate necessary
changes.
The work of dispatching may be made clearer by considering
one of the methods in common use for this work. All of these methods
are patterned more or less after Taylor's original plan. An order box
containing not fewer than three compartments is placed near each
workman. The first compartment holds the work order, instruction
card, drawings, etc., for the work in process; the second compartment
contains similar instructions, etc., for the next job for which the
necessary tools, jigs, and fixtures will be collected by the time that
work is to begin upon it. The third compartment may be used to
hold instructions for future work, the sequence of which has not as
yet been determined. In the offices of the planning department is

placed a planning or control board as it is usually named, made up
of sets of compartments that are duplicates of those in the shop,
each compartment containing instructions and orders that are, in
general, duplicates of those in the corresponding compartments at
the machine. When any change is made on the planning board by
moving instruction material from one compartment to another, a
corresponding change is made in the compartments at the machine
so that the planning board always shows the exact amount of work
before each man or machine. The order-of-work clerk keeps fully
informed of the desired dates of delivery, as outlined by the schedule,
and of any changes that may be made in these dates. By means of
the planning board he can control fully the sequence of operations
and make close estimates of the time required to complete work in
process or new work on which such an estimate is desired.
The moving of all material to and from machines and processes
is usually in charge of a centralized transportation service, and the
term move man working under a move order designates the
individual who performs this function. Sometimes this service also
includes the procurement of tools, fixtures, etc., as in the case of Mr.
Taylor's "gang boss," but again there may be a special messenger
service for this purpose operated by the dispatch clerk at the
departmental board. There must also be a special messenger service
for synchronizing the central board and the departmental board,
adjusting difficulties, and tracing job orders that may need special
attention.
***
Chapter
13
TYPICAL PRODUCTION
--
CONTROL PROCEDURE
The complex relations may be made clear by considering a

typical production-control procedure which was devised by
Professor John R. Bangs, of Cornell University, for this special
purpose. In this system all office functions are shown above the
heavy horizontal line and all shop functions are placed below it.
Full lines indicate the paths of orders and instructions moving
downward; dotted lines indicate the paths of records and returns
moving upward. Let it be assumed that a sales order has been
received from the sales department. This order will first be approved
by the credit department under the controller or corresponding
official. If so approved it will pass to the factory manager who will
issue such production orders as may be necessary. In routine work
this is frequently accomplished as indicated in the system, the
approved sales order serving as a production order, copies being
sent to the superintendent of the planning department and to the
engineering department.
The superintendent of planning will now divide the work called
for by the production order into such items as may seem desirable
and will issue a manufacturing order for each item. He will also lay
out the master schedule for the whole work and fix the important
dates of delivery, etc., for each item. All of this information will then
204 Typical Production Control Procedure
be forwarded to the route clerk. The engineering department will
prepare or furnish all drawings, dawning lists specification and
bills of material. The drawings and drawing lists will also identify
each part by number, All of these documents will also be forwarded
to the route clerk.
The route clerk will now layout the route sheet for each machine
part or lot of parts to be produced. Or if a combined route and
schedule sheet is in use, he will prepare those sheets, calling upon
the time-study department for any information that he may need
regarding the total time required for the several operations and with
due regard to the work already scheduled upon the planning board.
He will then forward the route sheets, drawings, specifications, etc.,
to the route-file clerk. .
The route-file clerk will then proceed as follows for each operation
called for upon the planned-operation sheets: First, if material is to
be drawn from stores for the operation, he will inquire of the balance-
of-stores clerk if the required material is on hand. If it is on hand,
the balance-of-stores clerk reserves the necessary amount and
deducts the material so apportioned from available stores. If the
material required is not on hand, the balance-of-stores clerk will
make a requisition upon the purchasing department which will
purchase the material and have it on hand when needed, the entire
transaction being reported back to the route-file clerk. The route-file
clerk will now write all orders for issuing materials from stores of
the necessary move order if the work is to be brought from some
other machine.
He will make out the necessary orders for procuring tools and
equipment and for the identification tags that are to be attached to
the work and move with it; and lastly he will make out the operation
orders and the instructions to the inspector concerning the times
for inspection. For convenience, the operation order, the
identification tag, the move order, etc., that pertam to each operation
may be placed together in an envelope sometimes called a job or
operation envelope, and these with the route sheets, or planned-
operation sheets, the draWings, and other general directions
pertaining to the work scheduled may all be placed in a larger
Typical Production Control Procedure 205
envelope or container known as a route file and forwarded to the
time-study department. Here the instruction-card clerk will furnish
an instruction card for each operation if such a card is to be used,
and the rate-setting clerk will furnish the proper time card,
piecework or bonus card as may be needed, each of these being
placed in the operation envelope to which they belong. The relation
of these several documents to each other may be more clearly
understood which shows these relations completely for a single
manufacturing order and which was devised by Professor John R.
Bangs for this purpose.
The order-of-work clerk has charge of the planning board and
correlates it with the several departmental dispatch boards. When
he receives the route file for a given machine or goods, he retains the
route sheets or planned-operation lists, and he assigns each
operation to be performed to the machine of production center for
which it has been routed, by removing the duplicate work order
and other duplicate documents necessary for complete
identification and control of the operation from the operation
envelope and placing them on the planning board, upon the hooks,
or in the pockets controlling the particular machine to which the
work is assigned. The operation envelope, with its remaining
duplicate contents, is placed in corresponding position upon the
departmental dispatch board controlling the production center or
process to which the work is assigned. He will do this for each
operation for which the route file contains operation envelopes,
placing them so that the work orders are in the sequence called for
by the scheduled time of performance.
Let it be assumed that the first of these machines or processes to
which work has been so assigned and let it be assumed, furthermore,
that there is plenty of work ahead of it so that this particular work
order and its related instructions in the operation envelope are
placed in proper sequence in the upper 01; jobs-ahead pocket of the
planning board. In due process of time the er\.velope will be advanced
to the second or next-job pocket, corresponding changes, of course,
being made upon the departmental dispatch bO<;lrd.
When the work order has been advanced to this position, the
dispatch clerk takes the material-issue order from the operation
envelope, if material is to be drawn from stores, and also the

identification tags that are to be fastened to the work bearing the
identification numbers, etc., and gives them to the move man. The
move man, with this authority, draws the material, tags it, and
moves it to the machine. When this is completed, he signs the
material-issues order and returns it to the stores clerk. The stores
clerk, upon the delivery of the material, corrects his bin-tag records
and forwards the material-issues order to the balance-of-stores clerk,
who corrects his balance-of-stores records, prices the material-issue
order, and forwards it to the cost department where it is charged up
against the cost of the production order. If no material is to be drawn
from stores but is to be moved from some other machine, the same
procedure applies except that in this case the stores are not involved.
The dispatch clerk also issues the equipment orders to the move
man, who, with this as authority, procures all special tools and
appliances and brings them to the machine in advance of the
beginning of operations.
Let it now be assumed that the operator on machine No. 50 has
finished the job in process. He takes his operation order, instruction
card, time card, etc., to the dispatch station and returns them to the
dispatch clerk who stamps the time upon the time card. The dispatch
clerk now takes the duplicate documents pertaining to the work
just completed from the work-in-process pocket and advances the
corresponding documents of the job next in order to that position.
He stamps the time upon the time card in this new set and gives it to
the workman with the work order, instruction card, etc., for the new
operation. The workman then returns to his machine and starts the
new operation for which complete preparation has been made. The
dispatch clerk also issues the new inspection orders to the inspector.
The move man takes the work just completed on machine No. 50 to
the next machine listed upon the route, and returns all tools and
fixtures to the tool storage. The dispatch clerk returns all work
orders, drawings, drawing lists, etc., to the order-of-work clerk, who
checks the completed operation on the planned-operation list and
returns the drawings, instruction cards, etc., to the engineering
department. The time cards are sent to the controller's department,
where they are first checked against the attendance-board record or
time-clock record, depending upon which is in use, and then used

as a basis for the pay roll. They are then forwarded to the cost
department where, with the material issues, they form the basis of
production costs.
In recent years a number of control boards, card index systems,
etc., have appeared, many of which are helpful in production control
and similar problems. It is fitted to carry three sets of control data
for each machine .. It is built in vertical sections so that it can be
extended as desired. It is a mechanical Gantt chart. At the left is the
"visible index" which lists and identifies the items that are to be
controlled. Each indexed item aligns with a double row of small
holes spaced five to the inch. At the top is placed an adjustable
calendar. Vertical lines from top to bottom indicate the dates of the
several items being controlled. At the right of each index pocket a
white string carrying a peg can be stretched horizontally across the
board, the peg holding the string to the desired length. This string
is wound up automatically by a spring inside the board. When
extended it makes a white band across the board. Coloured pegs of
various shape1?and colours may be placed in the adjoining row of
holes to indicate various factors of the control. This board can be
used for many purposes such as inventory control, sales progress,
etc.
Modification and Adaptation:
The foregoing discussion describes a complete plan of
production control based on Taylor's methods and typical of a
number of such plans now in actual use. In this discussion an effort
has been made to define and describe the principal functions in
such a plan and to illustrate the primary documents connected
with each function. Thus the moving of material is defined as a
separate function under the move man, so-called, and the move order
is the fundamental order connected with that function. It will be
obvious, however, that there is an endless number of pOSSible
modifications, abbreviations, and adaptations of these general
principles, and many such are in actual use, the particular
combination of basic functions used and the method of their
combination varying widely with the character of the enterprise
and the degree of control desired. In these modifications and

<\daptations several functions may be performed by one man and
his assistants, and in a similar manner the basic documents may be
combined. An example of such combination is purposely where
both routing and scheduling are listed upon the same sheet. A
combination operation order and bonus time card is not unusual.
A not unusual modification is one where routing and
scheduling are fairly complete but dispatching is left largely to the
foremen with the aid of follow-up men or tracers, as they are often
called, whose sole duty it is to keep track of the several orders and
to assist the foreman in removing any obstacles that may stand in
the way of fulfilling the schedule.
There are two methods of organizing such a force of tracers. In
the first method every manufacturing order is assigned to some one
man and his assistants, who follow the order through production
whether there are delays or not. If delays do occur, the tracers
endeavor to remove the difficulties that delay the schedule, through
conference with foremen and other officials. In large plants a tracer
or group of tracers is visually given charge of a particular class of
production, thus specializing their efforts.
The second method is to tum over to the tracers only those jobs
which are behind their schedule. The source of information on this
point is usually the foreman or the progress report if such a report
is compiled. This method, of course, requires fewer tracers than the
first and is, therefore, cheaper, but it is not so thorough. The choice
of methods will depend somewhat upon circumstances and upon
the degree of refinement in routing and scheduling. If the routing
and scheduling are poorly done, the tracing must be
correspondingly searching if schedules are to be kept. Tracing is
greatly facilitated by conferences among the tracing staff and also
conferences with the foreman and others charged with the problems
of production.
Requirements for Production Control:
It should be noted that the degree of refinement possible in
production control depends upon the degree of refinement with
which route sheets, operation sheets, and instruction cards can be

compiled and upon the degree to which the several departments
are organized to fulfil the predicted performances. In general, good
production control for metalworking establishments requires that
the following information be available in convenient form and that
following specified conditions exist in the plant:
1. Complete detailed drawings and other engineering
information.
2. Complete information regarding special tools, such as jigs
and fixtures, whether existent or to be provided.
3. Complete information on times and costs of previous
performances.
4. Accurate up-to-date information regarding the stores and
finished stock that are to be used,
5. Exact knowledge of the progress of the work in process.
6. Complete tabulated data on power, speeds, and feeds of all
machines.
7. Complete data, as far as can be obtained, on the most effective
forms of cutting tools and the best combinations of speeds,
feeds, and depth of cuts for the metal to be machined.
8. Records of the best performances on similar work with best
combination of tools, feeds, and speeds.
And to ensure the attainment of the performance predicted
on the instruction card, there must be
9. Careful instruction of the workmen by the speed boss or
some similar person.
10. Careful following up and correction of the shop schedule.
11. Careful inspection of all tools and appliances to make sure
that they are up to standard conditions.
12. A financial incentive that will enlist the interest of the
workman.
Brief reflection will show that similar conditions and
requirements apply to other forms of industry, the principles being
capable of wide extension.
Of these requirements several are now fairly well met in many
modern metalworking shops. Thus (1) presupposes a first-class
engineering and designing department; (2) a well-developed
toolroom; (3) a first-class cost system; (4) an accurate continuous-
inventory system, all of which have reached a high state of
development in many plants. The remaining requirements however,
are in a rudimentary stage in many shops, and it may be of
advantage to discuss them briefly. Thus (5) presupposes an accurate
knowledge of the progress of work such as is obtained only by the
dispatching methods.
Data on Machines:
It is evident that before the instruction-card man can intelligently
instruct the workman regarding the size of cuts and feeds and speeds
to be used, very complete data must be compiled bearing on the
cutting power and the speeds and feeds or similar data obtainable
with each machine. This information is not available in many shops
and must be collected. It is also evident that this would be much
simplified if all machines of the same kind were made along
standard lines. At present a machine of given nominal size made
by any given manufacturer is usually very different in its
characteristics from those of rival makers. These new methods of
control will undoubtedly have an effect tending to standardize tools
of all kinds.
Industrial Data-The Art of Cutting Metal:
It would most naturally be supposed that an experienced,
skilled workman would know more than anyone else regarding the
best shapes of cutting tools and most efficient combinations of feeds
and speeds for the work of his particular calling. In simple trades
these or corresponding data may be easily obtained, but, in general,
the information possessed by the mechanic is empirical and based
on inherited practice that is never questioned by him. All trades
and calling abound in practices that are transmitted downward
with almost superstitious exactness and with little or no thought as
to whether a better way can be found. This is very well instanced in
the case of cutting of metals. Here (according to F. W. Taylor) there
are 12 principal variables involved, and it is evident that no man
can carry in his head the best combination for any given case. Actual
experience has shown this to be so and has demonstrated that the
best combination of these variables can be found much more
accurately by mathematical analysis than by the best empirical
knowledge. This problem illustrates the complexity of what may
appear to be simple processes.
A considerable amount of general information on this subject
has been collected from time to time, but the first comprehensive
attempt to solve this problem was that made by F. W. Taylor and
recorded in full in the Transactions of the American Society of
Mechanical Engineers, Vol. 28,1907. Mr. Taylor's experimental work
and the laws that he deduced therefrom were reduced to
mathematical expressions by him and his assistants. The complexity
of the problem will be appreciated when it is considered that no
less than 12 variables are involved. By means of very ingenious
slide rules, however, Carl G. Barth succeeded in making these
expressions usable, and with these slide rules the most efficient
combinations of speeds and feeds are quickly obtainable. These
slide rules are made in several forms and for different machines,
and any extended discussion of them is beyond the limits of this
book; their general characteristics. In this slide rule, the parts A and
B are movable and slide endwise relative to the main body of the
rule and to each other. The upper scale shows the cutting speeds,
and next to it is a scale that indicates the hardness of the material,
in this case steel, by a hardness class number. The lower edge of the
upper slide carries a scale that indicates the feed in inches. The
upper edge of the lower slide carries a scale that indicates the depth
of cut in inches, while the lower edge carries a small scale that
indicates various sizes of tools. Adjoining this scale upon the fixed
part of the rule is another short scale indicating the cutting life" of
U
the tool. As the rule is set it shows that a 3/ 4-inch tool of standard
form will cut well f()r 20 minutes when the depth of cut is 3/16 inch
and the feed 1/16 inch on steel of a hardness number of 13 and a
speed of 60 feet per minute. If the steel is of No. 10 hardness, the
cutting speed may be 80 feet per minute, etc.
Tabulated data on cutting feeds and speeds for various
machines drawn from Taylor's work and elsewhere are to be found
in Kent's "Mechanical Engineers' Hand book" and also in Mark's

"Mechanical Engineers' Handbook." Taylor's work did not cover
all kinds of metals, and it has been very greatly supplemented by
more recent experimental work. There is a vast amount of work to
be done in other industries before similar data will be common In
these other lines of work.
Records of Performance:
What has been said of the average worker's lack of know ledge
of industrial processes is even more true of his lack of exactness as
to the time required to do a given piece of work and of the best
procedure in doing it. Since this item is of importance and requires
a somewhat lengthy discussion it is made the subject of the
succeeding chapter.
Methods of Ensuring Performance:
It is clear that if the standard performances are based on records
somewhat lower even than the best record, they will be beyond the
attainment of many of the less skilled workers. It is clear, also, that
'if the output of the factory is raised to these standard, in general,
one of two courses must be pursued. Either the less skilled men
must be eliminated and their places filled with better men, or they
must be educated and taught how to raise their performance to the
standard. The latter method is, of course, the more humane and in
the long run will be the more effective. H. L. Gantt was the first, the
author believes, to appreciate fully the opportunities of this field,
and his work and writings on this phase of shop management form
a very valuable addition to the literature of general industrial
education.
It is also self-evident that if the planning department is to predict
performances that can be successfully executed, all machines and
tools must be in the first-class condition that the planner must
presume them to be. For this reason the inspection, care, and repair
of all productive apparatus should, if possible, be under one man
whose business it is to see to these matters and nothing else. Such a
man can earn his salary even in a comparatively small shop. Under
such a system many costly delays can be obviated by pre-inspection
and repair, and the same principle applies to apparatus in general.
And last, and by no means least, if the worker is to raise his

output to a standard higher than he has been accustomed to, he
must receive extra compensation for his extra effort. Otherwise he
will not make the effort. It has been noted previously that the worker
is usually skeptical regarding the effect of increased output. It is
useless to point out to him that increased output will tend to help
him because of the ultimate good flowing from abundant
production. The reasoning is usually beyond him, and the only
incentive that will move him is an immediate gain. All efforts to
increase production by the methods described in the foregoing
paragraphs usually are, and in fact must be, operated in connection
with some method of rewarding labour that gives increased
compensation for increased effort.
Collecting and Recording of Data:
The last function of the planning department is the collection
of returns and records of performance. The planning department
does not, of course, collect all the returns. It does, however, record
all times of beginning and completing work and all details of time
expended upon direct production, which form one of the factors in
production costs. All progress reports and all reports as to idle
equipment and spoiled work are compiled in this department. If
special studies of productive operations, such as time study and
motion study, are attempted, they are usually conducted by the
standards department and made available for its use.
Limitations:
The foregoing is a very brief account of the more important
tendencies in the planning of factory operations as they apply
particularly to metalworking plants. It will be obvious that the
principles involved can be and have been applied to other forms of
production where information comparable to that listed in Art. 128
can be obtained. It should be noted that functional foremanship
and similar methods are in no way connected with any particular
form of wage system, nor do the methods discussed in this chapter,
taken singly or collectively, constitute a complete philosophy or
scheme of management that will be best for all cases. The
combination and arrangement that will be best to use will
necessarily, vary with the conditions, and what may be good for
one place would not apply at all in another. These methods,
however, are excellent illustrations of the separation of mental and
manual processes and the use of division of labour and transfer of
skill. The strong coordinative influences necessary for such forms
of organization are found in the instruction card and route card
and the incentive of extra compensation for extra effort. Some very
complete applications of these methods have been made in this
country, though, as yet, few complete accounts of such applications
have appeared.
It should be noted, also, that these methods are, for the most
part, refined extensions of old principles. Some of them are efforts
to apply the scientific method to the measurement of human effort
and aim to do for the field of management what engineering research
has already done for the designing department. How far they can
be considered to be scientific is a debated question. Mr. Taylor and
many of his followers maintain that these methods can be considered
very scientific. Others as strongly insist that the personal equation
enters into these methods so greatly as to "make accurate and
scientific results impossible. Clearly these methods do touch the
human side of industry very closely. Mr. Gilbreth said that they are
closely connected with experience, skill, contentment, training, habit,
fatigue, and other personal matters. A resume of these debated points
of view can be made more intelligently after a consideration of other
industrial problems, and will, therefore, be deferred to a later chapter.
Objection is often made, particularly by managers of the older
type, to the introduction of any such system as described in this
and the preceding chapter on the ground that it adds to the cost of
production. This may often seem to be true, as most of the men
employed in planning and carrying the work through the shop do
not work directly upon the goods. There is no doubt, furthermore,
that a useless and costly system is sometimes installed where the
conditions do not warrant, and in such cases the cost of the goods
is necessarily raised. There is no virtue in system of any kind unless
it is installed intelligently and with a clear idea of the results that it
is desired to obtain.
Usually there is no difficulty in deciding how far it is economical
to go in providing system to collect valuable information, as in cost
systems or in a system for facilitating the transmission and use of
information that will hasten operations and thereby increase the
efficiency of productive processes already existing, but it is not
always easy to decide such questions when they involve the
separation of productive processes into mental and manual
constituents. Functional foremanship, for instance, is based on a
somewhat different reasoning from that underlying a cost system.
A cost system is valuable no matter how large or small the shop
may be, although its characteristics might vary with the size of the
shop. But all extensions of the principle of division of labour that
involve separation of mental and manual processes and transfer of
skill necessarily involve a reduction in the amount of time and
labour actually spent upon the work and an increase in the amount
of planning or indirect labour expended upon it. Whether or not
such a rearrangement of duties will result in netting a greater output
and reduced cost will depend on the quantity to be made and the
character of the work, and it is very easy to over systematize unless
these conditions are fully understood.
This statement is fully borne out by the number of industrial
plants that have introduced quite complete systems of production
control and afterward either have abandoned these systems or have
greatly modified them, retaining only those features which were of
real economic value. It cannot be disputed, however, that these
principles do result in increased output and decreased cost when
properly applied, and the manager who does not use them as far as
the limitations of his case will allow, simply because he does not
believe in system of any kind, is~linding himself to his opportunities.
Management by Exceptions:
In general the aim to visualize and control all details of the
work in hand, and therein lies the danger of over systematization
and possible loss therefrom. The thoughtful manager will therefore
seek togicallimits for his procedure. One of the most effective
methods of limiting managerial system is by the so-called principle
of exceptions, by which the manager concentrates his attention
"solely upon those executive matters which vary from routine plan
or standard." This idea runs like a thread throughout the entire
field of organization, particularly wherever standards of any kind
have been set, deviations from which can be noted and reported.
Thus it is not necessary to report to the general manager all of the
details of the operation of the power plant so long as its performance
is up to standard, whel~as it is highly important to report the
occasional deviation of performance from the standard. If the costs
of all products are not greater than the standard costs that have
been set, it is clearly a waste of the manager's time to go over all of
the cost details. But when costs exceed the expectations, the principle
of exception would naturally be applied through a special cost
report. And so in scheduling work through the plant it may not be
necessary to layout the progress of every shop order but it may be
sufficient to post only those orders which are behind their schedule
or are irregular. Thus in manufacturing that approaches continuous
production or where the production orders are comparatively few
in number and where the execution of each requires a considerable
period of time, it may be necessary to schedule only those which fall
behind thrdugh one cause or another. Mr. C. D. Hart of the Western
Electric Company has thus successfully used the exception principle
in manufacturing telephone cables, employing a modified Gantt
chart.
The principle is of broad application, and the thoughtful
administrator will give it careful consideration in organizing his
procedure. As Mr. F. W. Taylor so truthfully remarked when
discussing this principle:
Under the exception principle, the manager should receive only
condensed, summarized, and invariably comparative reports,
covering, however, all of the elements entering into the ~anagement,
and even these summaries should all be carefully gone over by an
assistant before they reach the manager and have all of the
exceptions to past averages or to the standards pointed out, both
the especially good and especially bad exceptions, thus giving him
in a few minutes a full view of progress that is being made or the
reverse and living him free to consider the broad lines of policy and
to study the character and fitness of important men under him .

Chapter
14
DECISIONMAKING
**
FRAMEWORK FOR EXPORT
OPERATION
In the long run, the basic motivation revolves around the profit
that a company can obtain by getting involved in export business.
Conceptually, profit is the result of simultaneous interaction of a
number of key variables. These are: cost, volume and price. These
variables in tum are influenced by other economic forces. For
example, price is the result of the extent of competition, costs are a
function of the level of the efficiency of the production unit and the
volume depends on the behaviour of the market, viz., whether it is
expanding, stagnant or declining. The interaction process
determining the ultimate profitability is shown in the chart below:
It, therefore, becomes evident that whenever these variables
change, the rate of profitability will also change. For example, a
change in the production and distribution costs in the absence of
any corresponding change in the price will result in a decline in
profitability. Or, costs remaining the same, if prices have to be
t:,equced becauSe of increased competition, the amount of profit will
again record a decline. The same is true of a change in volume in the
absence of an offsetting change in prices.
218 Decision-Making Framework for Export Operation
Interaction Chart
Profit
I
Minus Times
Price Cost Volume
Competition Efficieny Size of Market
The basic decision which a company will have to take when it

decides to embark on export business relates to whether it will
essentially be operating as a domestic company or international
business will form an integral part of the total operations of the
company. For a new-comer most probably the decision will be in
favour of domestic operations and embarking on export business
only when it suits his convenience. In such situations, corporate
decisions will be made primarily on the basis of domestic
considerations. The company may decide to enter into export
contracts only when there is an underutilized capacity. The
company may decide for export business if the relative profitability
from export operations is higher than the corresponding rate from
domestic business. In such a case, there will have to be a trade off
between the total quantity to be sold in the domestic market and the
quantity to be sold in the export markets. Production capacity will
be increased only, when a change in the domestic demand
necessitates an increase in installed capacity.
For a company which looks at the world as its market, it will,
however, take decisions on new investments based on the total
appreciation of the demand for its (company's) products originating
from all the markets. In this situation, international business
becomes as important a decision parameter as domestic
considerations.
Decision-Making Framework for Export Operation 219
The factors which a company will have to take into account
while accepting foreign orders and for the evaluation of their
profitability will vary from one situation to another. Relative
profitability of a series of orders might be different even when prices
quoted are the same. This might happen because of the incidence
on costs as a result of a change in the volume of production in the
short run. The mechanism of evaluation of export orders on corporate
profitability is illustrated below by taking an example.
Example 1 :
Let us consider an Indian export company M/ s ABC Co. Ltd.,
which is manufacturing mango jelly. The production capacity of
the company is 10,000 dozens of bottles per annum. The company
is at the moment manufacturing 9,000 dozens of bottles and its
product is being sold at Rs. 72 per dozen in the domestic market.
The profit and loss statement of the company is given in Table 1.
TABLE 1 : Present Profit and Less Statement of ABC Co.
I. Gross Sales
9,000 doz. @ Rs. 72 per doz. Rs. 6,48,900
II a. Direct production costs
Materials Rs. 2,16,000
Labour Rs. 1,62,000
Consumables Rs.27,OOO
Rs. 4,05,000
If b. Indirect production costs
Indirect labour Rs. 15,000
Other Indirect
expenses Rs. 10,000 RS.25,009
II c. Selling and distribution costs
Selling & distribution costs Rs.45,ooO
Salaries of sales staff Rs.55,OOO
Rs. 1,00,000
II d. Administrative overhead
Staff salaries Rs.36,OOO
Office expenses Rs. 14,000
Rs.50,OOO
II. Total costs Rs. 5,80,000
III. Profit Rs.68,OOO
as % of Gross Sales 10.46
Let us assume that the company has got an export order for
2,000 dozens of bottles. The price to be received is Rs. 66 per dozen
f.o.c>. Mumbai. The company can execute the order by utilizing the
underutilized capacity to the extent of 1,000 dozens of bottles and
also produce the additional 1,000 dozens without increasing its
capacity. The profitability of the export order is calculated in Table
2.
TABLE 2 : Evaluation of the Export Order
Export Order - 2,000 doz. @ Rs. 66 per doz. f.o.b. (Mumbai)
I. Gross Sales Income
2,000 doz. @Rs. 66 Rs. 1,32,000
Less Agency commission
@ 5% on f.o.b. value Rs.6,600
Net Sales Income Rs. 1,25,400
11 a. Cost of Manufacture Marginal Total vari-
cost per unit able costs
Material 2.00 Rs.48,000
Labour 1.50 Rs.36,000
Consumables 0.25 Rs. 6,000
Rs.90,000
II b. Add!. Selling Expenses Rs.2,000
Add!. distribution costs
(from factory to Bombay port) Rs.3,000
Rs. 5,000
II c. Total Additional costs Rs.95,000
III. Additional profit Rs.30,400
as % of gross sales 23.03
It is evident from Table 2 that the profit that can be made by

accepting the export order is of a very high magnitude. This is
essentially due to the fact that, first, the capacity will be fully utilized
and secondly, 10 per cent additional production in excess of the
installed capacity does not result in any cost escalation. It will,
therefore, be advisable for the company to accept this particular
order.
Let us further assume that the overseas party which first gave
the order to the ABC Limited is very much satisfied with the quality
of the product and is willing to increase the volume of the order to
Decision-Making Framework for Export Operation 221
4,000 dozens. The ABC Limited will, therefore, have to recalculate
the profitability of the additional 2,000 dozen order.
It is to be remembered that its capacity utilisation is already
over extended and therefore unless new investment is made, any
increase in production will result in increase in costs in the short
run. Let us assume that this additional 2,000 dozens can be
manufactured by paying overtime to the existing labour force.
Materials will not pose any problem as they are available in the
domestic market at the going market price. Apart from the over
times payment which will be at higher than the normal wage rate,
the company will also need to appoint a man who will exclusively
devote his attention to the execution of the export order. This will be
necessary because the total export business will now constitute a
substantial proportion of the company's sales. There will, therefore,
be an increase in the fixed cost element to the extent of annual
salary to be paid to the new appointee. The 'company will also
need more working capital to finance the production and sale of
this additional amount. Let us assume that company will need
additional working capital to the extent of eight weeks' sales
turnover and it wiII have to pay interest at the rate of 15 per cent on
that amount which it wiII have to procure from the banker. The
effects of all these changes are tabulated in Table 3.
It immediately becomes apparent that even though the price to
be obtained from the first and subsequent orders is the same, the
profitability of the additional order is about 41 per cent of the profit
made in the first order. The management will therefore have to take
a decision as to the advisabili.ty of accepting this additional order,
as the rate of profitability goes down drastically. The management
might also like to consider not only the fact of the additional order
on a short-term basis but on a long-term perspective if it feels that a
stream of such orders wiII be forthcoming in the coming years. In
such an eventuality it wiII have to take a decision as to whether it
would be advisable for the company to increase its production
capacity. This decision can be taken on the basis of the return on
investment caiculated on discounted cash flow basis and also the

return on investment on the same basis as is used for alternative
purposes, if the relative rate of return for increasing the capacity is

better than the alternative opportunities that might be open to the
company, the management may decide to commit further resources
for increasing the installed capacity. The management can approach
the profitability problem in a scientific way.
TABLE 3-Profitability Evaluation of Additi01ral Production
I. Gross Sales Income
2,000 doz. @ Rs. 66 Rs. 1,32,000
Less; Agency com
mission @ 5% on
f.o.b. value Rs.6,600
Net Sales Income Rs. 1,25,400
II. a. Costs of manufacture Marginal Total
Costs per variable
Materials Rs.2.00 Rs.48,000
Labour @ 125% of
basic wage rats Rs. 1.875 Rs.45,000
Consumables Rs. 0.25 Rs. 6,000
Rs.99,OOO
II. b. Addl. selling and
distribution expenses Rs. 5,000
III. Additional fixed
expenses
(One staff member newly
appointed to look after
export sales) annual salarj Rs. 6,000
IV. Total costs Rs. 1,10,000 .
V. Profit Rs. 15,400
VI. Interest on bank
overdraft @ 15% Rs.3,045
VII. Profit after interest charges Rs. 12,355
as % of gross sales 9.36
Logic Chart I
Follow Chart II
No
-.
/ihat are the additional costs 0~1
I What are the total costs of
accepting the order? I products adaptation apart from nor-
mal costs?
Add Add:
- Direct manufacturing costs - Cost of product adaptation
- Indirect manufacturing costs - Direct manufacturing costs
- Distribution costs - Indirect manufacturing costs
-Overhead - Distribution costs
.
-OVerhead
What is the profit margin?

(Net ex-works realisation-total costs)
.
No I Deduct overhead from to-
Is the margin acceptable?
Yes
II s \he co ntnbutlonII
I tal costs
t ~yes acceptable?
Export_
1...--_ I
Export
Logic Chart II
I
What are the cost implications
of increasing capacity?
I
- Additional Investment costs
- Additional fixed costs
- Additional working capital
costs
What is the
Contribution martin
of the present order?
What is the
Break-even volume?
Compare.
Break-even volume
vs
Present and expected orders.
Does the comparison
suggest the acceptance of
Yes - addl financial - No
commitments?
Continue present
Increase capacity and
production volume and
expoert
don't increase production

Chapter
15
ee
PRIVATISATION
Since around 1980, there has been a marked change across the
world towards privatisation. This trend is expected to become so
pronounced in future that it is described as the "wave of the future".
Privatisation means transfer of ownership and/ or management
of an organisation from the public sector to the private sector, it also
means the withdrawal of the State from an economic sector partially
or fully. Privatisation marks a change from dogmatism to
pragmatism and amounts to a reversal of policy.
The trend towards privatisation has been observed in
develo'ped and developing economies; in market-oriented and
socialist, including communist countries; and it cuts across socio-
cultural systems.
In the 1960s, there was a trend towards rationalisation in
Britain. But, since the late 1970s, the trend has been towards
privatisation by selling State owned enterprises (SOEs). Besides the
U .K., countries which have sold or announced the policy of sale of
SOEs in the recent years include Argentina, Bangladesh, Brazil,
Britain, Federal Republic of Germany, France, Italy, Japan, Mexico,
Nigeria, Spain, Thailand and Turkey. A number of other countries,
including India, have deregulated or liberalized the industrial
sector in varying degrees. Countries like China and the U.5.5.R.
now permit private-owned enterprises (POEs) in a number of areas.
226 Privatisation
As Professor Berg rightly remarks, the privatisation response is
in a real sense a reaction to the worldwide growth of government.
The rapidity with which the public sector in many countries
expanded over thelast four decades, roughly in the period from
1960 to 2000, is frequently overlooked. In effect a revolution, a quiet
one, occurred in the shifting of resources into the public sector in
the decade of the 1970s. In the less developed countries and in
many of the poorest countries, the growth of the public sector was
characterised by the growth of the parast,atal sector-State-owned
enterprises. State-owned enterprises now account for 10 to 20 per
cent of GDP in much of the less developed world, and they are
dominant in manufacturing in a great number of countries. What is
true for GDP is also true for capital investment. Parastatal enterprises
are estimated to be responsible for between 20 and 60 per cent of
total investment spending in the less developed world. Regardless
of whether socialist or market-oriented, virtually all countries in
the 1960s and 1970s saw an expansion of the public sector, and in
particular an expansion of state-owned enterprises, across a broad
front.
The performance of SOEs in many countries have, by and large,
been far from satisfactory. They have often put large burdens on
public budgets and external debt. For example, the net deficit of a
sample of SOEs accounted for about 4 per cent of Niger's GDP in
1982. For the seven largest Latin American economies, the combined
deficit of SOEs rose from about 1 per cent of GNP in the mid-1970s,
to about 4 per cent in 1980-82. One study has found that countries
in which SOEs accounted for higher shares of gross domestic
investment generally had lower rates of economic growth.
The heavy financial burden imposed by the SOEs and the
growing public discontent against them due to their inefficiency;
indifferent, irresponsible and sometimes even arrogant attitude and
lack of concern for the customer needs; and corruption, nepotism
and squander associated with their organisation and management
have led to the growing interest in privatisation. As Professor Samuel
Paul points out in country after country, unbridled state expansion
has led to:
Privatisation 227
(i) economic inefficiency in the production activities of the

public sector, with high costs of production, inability to
innovate, and costly delays in delivery of t!le goods
produced;
(ii) ineffectiveness in the provision of goods and services, such
as failure to meet intended objectives, diversion of benefits
to elite groups, and political interference in the management
of enterprises; and
(iii) rapid expansion of the bureaucracy, severely straining the
public budget, causing problems in labour relations within
the public sector, inefficiency in government, and adverse
effects on the whole economy. These problems have led
many governments to undertake programmes of public
sector reform and, pushed by a need to curb public
expenditure, to re-evaluate the possibilities for shifting
publicly managed activities into the private sector.
There are many methods of achieving privatisation. One
important method is Divestiture, or privatisation of ownership,
through the sale of equity. In countries where there are well
functioning capital markets, this entails selling stock to the public.
In industrial countries privatisation has corne mainly through
divestiture of government economic activities. Among the
developing countries, Bangladesh, Chile, Jamaica, Brazil, Peru,
Zaire, Pakistan, the Philippines and Sudan offer examples of
divestiture.
Japan has a century-old history of divestiture. After an initial
attempt to promote industrialization through state ownership, the
Japanese government in the 1880s sold many state firms, including
52 factories, 10 mines and 3 shipyards. Privatisation has assumed
importance in Japan in 1980s too. On the recommendations made
by an administrative reforms committee consisting of experts and
businessmen, Japan has recently made legislation which enables
the privatisation of two of the most lucrative state enterprises,
namely, Nippon Telegraph & Telephone and Japan Tobacco & Salt
Corporation. The objective is to reduce government expenditure
and raise administrative efficiency by withdrawing government
228 Priva tisa tion
presence from areas which can be managed better by private people.
Divestiture became so common in the Western Europe that hardly a
week or month went by without some new evidence of sale of state
enterprise by such Western European countries as France, Italy,
Sweden, the Federal Republic of Germany, and, of course, the
champion industrial company privatizer, Britain.
In the Republic of Korea, the government pioneered the
establishment of basic industries such as oil refining, steel, and
machine tools and then sold them to the private sector once their
profitability was established, using the funds raised to pioneer other
industries. Brazil created a commission for divestitute in 1981 and
Jamica set up a divestiture committee.
There are a large number of cases where privatisation has taken
the form of denationalization or reprivatisation. A considerably
large number of organisation were denationalized in countries like
Chile, Bangladesh and Pakistan.
Another method of privatisation in contracting. Governments
may contract out services they have planned and specified to other
enterprises that produce and deliver them. Franchising -
authorizing the delivery of certain services in designated
geographical areas - is common in utilities and urban transport.
Contracting is common in public works, defense and many
specialized services. Where suppliers compete for contracts and
where there is no loss of economies of scale, contracting is efficient.
But there is scope for corruption in contracting, and long-term
contracts tend to encourage monopolistic behaviour by the private
supplier. Contracts for road construction and maintenance are
common in countries such as Brazi( Colombia, India and Kenya. In
agriculture and urban development in the Philippines and in water
supply in the Ivory Coast, private contracts have played an
important role.
Another option for the government is to withdraw from the
provision of certain goods and services leaving them wholly or
partly to the private sector.
Privatisation may also take the form of privatisation of
management, using leases and management contracts.
Privatisation 229
Government can shed the burden also by liquidation which

can be either formal or informal. Formal liquidation involves the
closure of an enterprise and the sale of its assets. Under informal
liquidation, a firm retains its legal status even though some or all of
its operations may be suspended.
When compared to the industrial countries, the progress of
privatisationhas been slow in the LDCs. As the World Bank points
out, governments confront several obstacles, like those mentioned
below, when they decide to divest SOEs.
(i) Governments usually want to sell the least profitable
enterprises, those that the private sector is not willing to
buy at a price acceptable to the Government.
(ii) Divestiture tends to arouse political opposition from
employees who may lose their jobs; from politicians who
fear short-term unemployment consequences of liquidation
or of cost reduction by private owners; from bureaucrats
who stand to lose patronage; and from those sections of the
public that fear that national assets are being cornered by
foreigners, the rich or a particular ethnic group.
(iii) Relatively undeveloped capital markets sometimes make it
difficult for governments to float shares and for individual
buyers to finance large purchases.
Professor Samuel Paul points out that if privatization is to
succeed, in the sense of raising efficiency or effectiveness in the
production or delivery of goods and services, the following seven
conditions must be met:
First, privatization cannot be sustained unless the political
leadership is committed to it, and unless it reflects a shift in the
preferences of the public arising out of dissatisfaction with the
performance of other alternatives. Privatization has in the past
worked best when a government was' strongly committed to a
change, or w~en a new government vowed to reverse the actions of
its predecessors, a$"has happened in Chile and the United Kingdom.
More recently, some governments that have faced severe economic
crises, with massive budgetary deficits, have turned to privatization
and divestiture as a part of their adjustment strategy.
230 Privatisation
Second, any alternative institutional arrangements chosen

should not stifle competition among suppliers. Replacement of a
government monopoly by a private monopoly may not increase
public welfare - there must be a multipliCity of private suppliers.
This can be a difficult problem where there are few competent
suppliers. Though government may wish to contract out a service,
if there are only one or two qualified contractors, the benefits of
competition are unlikely to follow.
In this context, most developing countries' systems of regulation
need major review and reform. Over regulation of iI).dustry
discourages private initiative; Over regulation of urban land use
and building construction retards urban development; and unduly
low ceilings on the prices of industrial products and utilities, such
as bus transport and electricity, inflate demaRd and depress the
incentives for production.
The third, related, condition is freedom of entry to provide goods
and services. Long-term contracts ;,md franchises limit competition
and consumers' choice. In some services that are capital intensive,
freedom of entry is difficult to achieve. But in others, such as refuse
collection. or health services, the public will be better served by
seve,ral private suppliers competing than by one agency
monopolizing the market through a long-term contract.
Fourth, public services to be provided by the private sector must
be specific or have a measurable outcome. Physical construction or
utility services, for example, can be measured, but most educational
services and police protection are not easy to quantify, even though
their inputs can be measured. Lack of specificity makes it more
difficult to control services provided by the private sector, especially
if the public served is illiterate, unorganized, and unassertive.
Service delivery by non-governmental organizations or local
governments may be more appropriate under these conditions.
Fifth, consumers should be able to link the benefits they receive
from a service to the costs they pay for it, since they will then shop
more wisely for different services. User charges are one way of
establishing this link. The importance of educating consumers and
disseminating information to the public cannot be overemphasized
here.
Privatisation 231.
Sixth, privately provided services should be less susceptible to

fraud than government services if they are to be effective. Services
provided through collective or co-operative action at the community
level are probably the least susceptible to fraud.
Seventh, equity is an important consideration in the delivery of
public services. Broadly speaking, the benefits of privatization can
accrue to the capital owner who supplies the service; to the
consumer, who receives a more efficient service; and to the public at
large, through a reduction in the public sector deficit, and hence in
taxes or the rate of inflation, or both. Privatization will be
counterproductive if the ability of the public to pay, determined by
the prevailing income distribution, becomes the sole guide for the
delivery of services. And, if the benefits of privatization are likely to
be reaped solely by local elite's, expatriate groups, or multinational
corporations, political resistance to reform is likely to increase.
In India, though there were some isolated cases of privatisation,
no clear policy decision on this has been taken so far except some
deregulation's and liberalization's. Soon after Mr. Rajiv Gandhi
assumed Prime Ministership, there was a feeling in some circles
that dogmatism would be replaced by pragmatism. However, in the
context of the search for new political alignments, the situation
appears to be confused and devoid of clear direction. There was a
proposal for involving the private sector in the construction of
highways and bridges but it appears to have been shelved. Although
most political parties and trade unions are against privatization's,
there appears to be a growing public opinion in favour of
privatisation.
The expert planning group in its report on 'civil aviation at the
tum of the century' has recommended partial privatisation of Air-
India and Indian Airlines. It has been felt that conversion of Air
India into a joint stock company with part of its equity capital being
released for public investment would help give it greater commercial
orientation and user sensitivity. There are indeed a number of areas
where partial or full privatisation is advisable.
It was reported that the Kerala Government was toying with
the idea of privatizing some of the prestigious hotels run by the
232 Privatisation
Kerala State Tourism Development Corporation as these hotels had
been making huge losses. Opposition from political parties and
trade unions seems to have shelved this idea.
However, the Government of Karnataka took a bold decision to
dispose of loss-making SOEs. This was made clear by the State's
Minister for Industries, Mr. J.H. Patel, in the Legislative Council on
8th September, 1987, and declared that there was no justification to
run industries manufacturing soaps, detergents, cosmetics, leather
products and such like by incurring heavy losses. Earlier, on March
6,1987, the Chief Minister, Mr. Ramakrishna Hegde, stoutly
defended the move of the government to disin vest its shares in the
public sector and maintained that the state could no longer afford
" to be dogmatic in its approach in this respect. Stating that his faith
in the public sector was thoroughly shaken because of its dismal
performance, he asked: "What is the point in the country investing
over Rs. 55,000 crores in the public sector if there is no matching
return?" The Mahadeshwara Co-operative Sugar Factory in Kollegal
was sold to the Khodays and the state government had resolved to
sell another one, the Vanivilas Sugar Factory, which was also in
very unhealthy condition.
In India, the public sector, both the Central as well as State, has
expanded indiscriminately and it has been extended to non-priority
sectors and sectors where the private sector would perform better.
Populist political appeal and vested interests of politicians and
bureaucrats have contributed to this. State governments have set
up public corporations after corporations to expand the empire of
the political parties and to give berths to political leaders.
The accumulated losses of many SOEs, including some state
transport corporations, are larger than the capital invested in them.
These public sector deficits compel governments to increase taxation
and curtail development expendirnres. There is no justification for
imposing such burden on the public by the state carrying out
activities which the private sector can do more efficiently.
Privatisation of certain sectors and enterprises are, therefore,
necessary to red uce the budgetary burden on the public, t~ make
available more resources for the development activities, to enable
Privatisation 233
the government to concentrate more on the essential government
functions and priority areas and to relieve the consumers from the
indifferent and arrogant attitude of the public sector.
Road transport is an area where privatisation can be easily
carried out in a phased manner. When numerous private parties
can more efficiently operate the road transport, what is the
justification for harassing the passengers and burdening the public
with the losses they incur? There will, of course, be opposition from
political parties and trade unions. A major reason for political
opposition is the 'harvest' that will be lost. It is often said that there
are large kick-backs in the large-scale purchases of the corporations
and huge amounts are collected for appointments to various
positions.
Governments should dispose of SOEs in the non-priority
sectors, particularly the loss mal,<ing ones. It should withdraw from
areas where POEs will be more efficient. The state has no moral
right to impose financial burden on the citizens by having inefficient
enterprises. And it is up to the citizens to bring about a political
reorientation to save themselves from the burden and tyranny of
inefficient state enterprises and bodies. This will happen only when
the common man has realised the 'private motive' behind the public
sector socialism advocated by some people. In the United Kingdom,
where there is a very strong Labour Party which was in power for
long time and where the trade unions are much more well-organized
and stronger than in India, privatisation has gained overwhelming
support. A large number of jobs were transferred from the public
sector to the private sector by privatisation. In the centrally planned
socialist economies like China, the U.S.s.R. and Hungary
privatisation is taking place in the form of individualization of
economic activity, i.e., allowing individuals to own and m~nage
certain forms of economic activity. Further, foreign private firms
have been allowed in several areas of tne iJldustrial sector. It is time
that we in India pondered over the issues: "Should we continue to
be burdened with the loss 9f the state running luxury hotels and
buses and making soaps, deteJ:gents, cosmetics, orea9 and a variety
of other products which can be better done by the I'rivate sector?
234 Privatisation
Don't we have a right to a better alternative to the inefficient state

transport services which harass the customers? Should not the state
concentra te more on the effective discharge of its essential functions
and on dealing with the priority issues than laying its hands on
everything, creating an unwieldy gamut of activities, wasting the
scarce resources and putting more burden on the weary shoulders
of the common man? Besides other benefits, privatisation will help
trim the size of the administrative machinery leading to considerable
savings to the exchequer.
Village, Small and Ancillary Industries
The importance of and the need to promote the development of

the small industries sector have been emphasised by all the
industrial policy resolutions and statements and a number of
protective and promotional measures have been taken accordingly
to ensure their survival and to encourage their growth.
The VSI Sector:
The village and small industries (VSI) sector in India consists
broadly of: (i) traditional cottage and household industries (viz.,
hand loom, khadi and village industries, sericulture, handicrafts
and coir) and (ii) modern small-scale industries including tiny units
and powerlooms. While traditional industries arc generally artisan
based, located mostly in rural and semi-,urban areas, involve lower
levels of investment in machinery and provide largely part-time
employment, modem small"scale units and powerlooms use mostly
power operated appliances and machinery, have some technological
sophistication and are generally located close to or in the urban
areas including large industrial centers. However, as a part of the
industrial dispersal policy and rural industrialization, governments
have been encouring modem small-scale units in rural areas.
There has also been an increase in the variety of products
manufactured by the small-scale sector. They have ventured into
the manufacture of many new and sophisticated items. The small-
scale industries today produce more than 5000 items. Their
contribution has been very notable in important segments of the
Priva tisation 235
electronics industry. Their share in the total production is about 45
per cent in consumer electronics, 75 per cent in instruments and
instrumentation and 45 per cent in computer and allied items.
Importance:
The khadi, village and small-scale industries have a very
important role in the Indian economy characterised by its vast spatial
spread, unemployment and underemployment, rapidly rising
labour force, capital scarcity, numerous market segments and
diverse demand pattern, broad and diverse resource base and
supply, predominance of widely scattered numerous village
settlements, growing modem large industrial sector giving scope
for ancillarisation and so on.
The distinguishing features and major advantages of these
industries, particularly khadi and village industries, are the
following:
(1) In an economy, like India, characterised by abundant labour
supply and the concomitant unemployment and
underemployment and rapidly rising labour force, khadi,
village and small industries assume special significance
because of its high employment potential.
(2) Another important advantage is their ability to provide
employment in the off-season. To a large number of people,
agriculture provides only seasonal employment. Khadi,
cottage and some other village industries provide
employment opportunities during the off-season and help
many households to mitigate their problems during the
off-season.
(3) Khadi, cottage and certain other village industries provide
vast scope for employment of special categories of people
like women, children, old aged, physically handicapped,
etc. It is also an avenue for part-time employment for those
who are employed elsewhere, either full-time or part-time.
(4) Some of these industries provide employment opportunities
within the household premises and some others near the
236 Privatisation
place of residence. The locational advantage of these
industries are, thus, very great.
(5) A major advantage of these industries is that the capital-
output and capital-labour ratios are comparatively very
low. That is, the amount of capital investment required per
unit of employment and the capital investment required
per unit of output are comparatively very low. In other
words, the khadi and village industries in particular and
the small-scale units in general maximize employment and
output for a given amount of capital. This is of particular
importance to a labour-abundant and capital-scarce
economy like India.
(6) Because of the low capital-output ratio and low gestation
period they promote non-inflationary growth.
(7) Khadi and village industries have been found to be of
particular help to the weaker sections of the society. The
participation of scheduled castes, scheduled tribes, women
and other weaker sections of the society in this sector is
significant.
(8) These industries promote economizing of resource
utilisation and conservation of resources. They are expected
to ensure maximum utilisation of locally available raw
materials by adopting easily adaptable techniques. In some
cases, non-conventional raw materials are used thereby
converting waste into wealth.
(9) These industries can develop in almost all areas including
backward, tribal, hilly and inaccessible areas. They are,
thus, helpful in achieving wider spatial dispersal of
industrial activities and thereby reducing the regional
economic imbalances.
(10) They help increase the pace of rural development through
the generation of additional employment opportunities and
income and through its input and output linkages with the
other sectors of the rural economy.
(11) The small indu,stries have acquired more attention in recent
years due to the very less ecological problems they create,
compared to the large industries.
Privatisation 237
(12) As khadi and village industries do not use or use only very
little electric power or oil, they do not cause energy crisis
and foreign exchange crisis.
(13) The fact that the village and small industries account for
abOut" one-third of our total export earnings shows how
important they are to the Indian economy constrained by
shortage of foreign exchange.
Development of VISs under the Five Year Plans:
All our Five Year Plans and Industrial Policy statements have
stressed the need to accelerate the development of village and small
industries to create large-scale employment opportunities, promote
decentralization and dispersal of industries, achieve diffusion of
ownership and prevention of concentration of economic power,
promote entrepreneurship, develop agrobased and ancillary
industries, improve the skills of artisans and quality of their
products, reduce the role of subsidies and to step up the productions
of essential articles and those having potential for exports.
The Government, Central and States, have taken a number of
measures to solve the age-old problems of these industries, such as
lack of credit facilities, outmoded methods and techniques, absence
of organized marketing, unsatisfactory arrangements for the supply
of raw materials and competition from large-scale units.
The Union Government has set up a number of agencies to
foster the development of the VSI. These include the National Small
Industries Corporation, the Small-Scale Industries Board, the Khadi
and Village Industries Commission, the All-India Handicrafts
Board, the All-India Handloom Board, the Coir Borad and the Silk
Borad.
Apart from these, credit facilities are made available to these
industries through a number of institutions. Industrial estates and
rural industrial projects have been set up, and industrial co-
operatives have been organised. State Directorates of Industries and
other agencies are responsible for their development in the States.
Objectives:
The objectives of the development of village and small
industries, as laid down in our five year plans are:
238 Privatisation
(i) to assist in the growth and widespread dispersal of

industries;
(ii) to increase the levels of earnings of artisans;
(iii) to sustain jlnd create avenues of self-employment;
(iv) to ensure regular supply of goods and services through
use of local skills and resources;
(v) to develop entrepreneurship in combination with improved..
methods of production through appropriate training and
package of incentives; and
(vi) to preserve craftsmanship and art heritage of the country.
Promotional Measures
A number of measures have been taken by the governments,
central and state, to protect this sector from the onslaught of the
large sector and to promote its growth. They include the following:
(i) Reservation of Products: Market protection is provided to
the small-scale units by the reservation of items for exclusive
production in the small-scale sector. Over the years there has been
an increase in the number of items so reserved and it stood at 835 at
the end of January 1989.
(ii) Preference in Government Procurement: Preference is given
to the small-scale sector in government procurement. Under this
programme, more than 400 items are reserved for exclusive purchase
from the small-scale sector while a limited number of items (13 in
January 1989) are reserved for purchase upto 75 per cent and a
number ofitems (28 in January 1989) for purchase upto 50 per cent.
(iii) Infrastructurel and Institutional Support: Infrastructurel
and institutional supports are provided though industrial estates,
district industries centres (DICs), Small Industries Service Institute,
Khadi and Village Industries Commission (KVIC) and other
specialised institutions which provide technical assistance, testing
facilities, etc.
(iv) Machinery on Hire Purchase: The National Small Industries
Corporation (NSIC) arranges supply of machines on hire purchase
to small-scale units.
Privatisation 239
(v) Marketing Assistance: Marketing assistance's including

export promotion assistance are provided by instihltions such as
the NSIC, the Small Industries Development Organisation (SIDO),
Handicrafts and Handlooms Export Promotion Corporation, KVIC
etc.
(vi) Financial Assistance: Financial assistance is provided at
concessional terms by commercial banks, state level financial
institutions, etc. In order to step up the flow of assistance to the
small sector and to provide a focal point to coordinate at the apex
level the availability of both financial and non-financial inputs
required for the orderly growth of this sector, the Small Industries
Development Fund (SIDF) was established within the IDBI in 1986.
(vii) Training: Training for existing and potential entrepreneurs
and others associated with the working of the small units are offered
by Entrepreneurship Development Institute of India (EDI!), Technical
Consultancy Organizations (TCOs), financial institutions and
commercial banks, management institutes, NSIC etc.
(viii) Supply of Raw Materials: Arrangements have also been
made for the supply of raw materials, particularly of scarce items,
to the small-scale units.
(ix) Promotion of Ancillarisation: The Industrial policy also
gives importance to ancillarisation. This has been recognised as
one of the objectives of the public sector industry. One of the factors
considered by the government while evaluating application from
the private sector for industrial license is the scope for ancillarisation
by the proposed project
There has been a significant growth of the Small-Scale Sector.
According to the estimates of the Development Commissioner,
Small-Scale Industries (DCSSI), in 2009-2010, there were 15.921akh
small-scale units. Their estimated number was 16,000 in 1950; 36,000
in 1961; 2,38,000 in 1971 and 8 lakhs in 1980. They had provided
employment to over a million people in 2008-2009. (These figures
do not include the khadi and village industries.) In 2009-2010, the
small-scale sector contributed more than 29 per cent of India's export
earnings.
240 Priva tisa tion
Khadi and Village Industries:

Khadi means any cloth '.voven on hand looms in India from
cotton, silk or woollen yarn handspun in India or from mixture of
any two or all such yarns.
Industries coming under the purview of Village Industries are:
(1) Bookkeeping; (2) Cottage Match, manufacture of fireworks and
Agarbath-ies; (3) Cottage Pottery; (4) Cottage Soap; (5) Flaying, curing
and tanning of hides and skins and ancillary industries connected
with the same and cottage leather industry; (6) Ghani Oil; (7)
Handmade paper; (8) Manufacture of cane-gur and khandasari; (9)
Palmgur making and other palm products; (10) Processing,
packaging and marketing of cereals, pulses, spices, condiments,
massalas, etc. (11) Manufacture and use of manure and methane
gas from cowdung and other waste products (such as flesh of dead
animals, night soil, etc.) (12) Lime stone, lime shell and other lime
products; (13) Manufacture of shellac; (14) Collection of forest plants
and fruite; for medicinal purposes; (15) Fruit and vegetable
processing, preservation and canning, including pickles; (16)
Bamboo and cane work; (17) Blacksmithy; (18) Carpentry; (19) Fibber
other than coir; (20) Manufacture of household utensils in
aluminum; (21) Manufacture of Katha; (22) Manufacture of gums
and resins; (23) Manufacture of Lokvastra; (24) Manufacture of Poly
vastra; (25) Processing of maize and ragi.
KVle:
The Khadi and Village Industries Commission (KVIC) is a
statutory organization engaged in the task of promoting and
developing khadi and village industries with a view to creating
employment opportunities in the rural areas and thereby
strengthening the rural economy. It was established in 1957 by an
Act of Parliament. It is an autonomous body which took over from
its predecessor, the All-India Khadi and Village Industries Board,
set up in 1953.
The broad objectives that the KVIC has set before it are:
(i) the social objective of providing employment;
(ii) the economic objective of producing saleable articles; and
Privatisation 241
(iii) the wider objective of creating self-reliance amongst the

people and building up a strong rural community spirit.
The functions of the KVle are generally to plan, organize and
implement programmes for the promotion and development of khadi
and village industries. In particular they include:
(a) training of persons engaged in production of khadi and
village industries;
(b) building up reserve of raw materials and implements and
supplying them to persons engaged in the production of
KVls at economical rates;
(c) to provide for sale and marketing of khadi and products of
village industries and handicrafts;
(d) to encourage and promote research in the technique of
production of khadi and in the development of village
industries, and to provide facilities for study of problems
relating to KVls;
(e) to maintain or assist in the maintenance of institutions for
the devE'lopment of KVls;
(f) to undertake, assist or encourage production of khadi or
development of village industries;
(g) to promote and encourage co-operative efforts among
manufacturers of khadi and persons engaged in village
industries; and
(h) for ensuring the genuineness of and for granting certificates
to producers of or dealers in, khadi or the products of any
village industry.
The KVle have created an organisational base for further
development with 26 State KVI Boards, more than a thousand
registered institutions and about 30,000 industrial co-operatives.
KVle has over 11,000 sales outlets in the country. This is an unique
national organisation in the country which has its roots in the
villages and has wide organisational linkages. Its activities cover
over 1.3 lakh villages in the country. A substantial number of
beneficiaries belong to the scheduled caste and scheduled tribes
242 Privatisation
and inhabitants in hill and border areas. The participation of women

in the activities is also very high, i.e. 45 per cent.
In 2008-2009, the khadi and village industrial units assisted by
the KVle were estimated to have provided employment to nearly 40
lakhs people (26 lakhs in the village industries and 13.7Iakhs in
the khadi industries), compared to less than 16 lakhs in 1956-57
(8.80 lakhs in khadi and 6.781akhs in village industries). The output
of the KVI sector is estimated to have increased from less than Rs. 21
crores (Rs. 8.23 crores of khadi and Rs. 12.72 crores in the village
industries) in 1956-57 to Rs. 1236 crores (Rs. 202 crores in the khadi
sector and Rs. 1,034 crores in the village industries) in 2008-2009.
Employment in the khadi sector appears to have saturated.
Ancillary Industries:
Integration of small and large industries through ancillarisation
is an important feature of industrial development of countries like
U.S.A and Japan. In India, the government policy has been one of
encouraging ancillarisation.
An ancillary unit is one having an investment in plant and
machinery, whether held on ownership basis or by lease or by hire
purchase, not exceeding Rs. 45 lakhs and engaged in the
manufacture of parts, components, sub-assemblies, toolings and
intermediates or the rendering of services of proposing to render,
provided 50 per cent or more of their total production or service as
the case may be is for other units for production of other articles.
Though all industries are not amenable to ancillarisation, there
are a number of industries with scope for considerable
ancillarisation. Large industries may benefit from ancillarisation
in different ways. One benefit of ancillarisation is the realisation of
economies of scale. If the requirement of any item is less than the
economic size of production, it stands to gain by purchasing the
item from an outside unit of economic size. Further, a large company
can relieve itself from the problem of tying up of capital, managerial
time, etc., on minor items which can be efficiently produced by
ancillaries. The society also benefits from the economies of scale
and other efficiencies associated with ancillarisation. As the impact
Privatisation 243
of energy crisis and credit squeeze is comparatively less on small-

scale units, ancillarisation offers further advantages to large units
in an era of power shortage and financial problems.
Ancillarisation and sub-contracting, however, have some
problems also. The parts or components supplied by these units
may not some tim.?s be of satisfactory quality. The small units usually
do not have the resources for carrying out research and development.
Hence, parent units will have to help them to update technology
and enforce strict quality control.
Industrial machinery, agricultural and earth moving machinery;
machine tools; industrial; scientific and mathematical instruments;
locomotives and rolling stock; ships; aircraft's; bicycles; boilers;
steam generating plants; steam engine; automotive parts; turbine;
internal combustion engine; commercial, office and household
equipment; telecommunication equipment; electronics; electrical
equipment; packaging items for use in chemicals; some iron and
steel industry items arc but some fields where there is good scope
for ancillarisation.
The extent of ancillarisation possible in different fields in India
is as high as 60 to 90 per cent in transportation industry; 50 to 75
per cent in communications industry and 30 to 50 per cent in prime
movers and power-based industry. It is 20 to 40 per cent in industrial
machinery and machine tools; 15 to 30 per cent in chemicals and
pharmaceuticals industry; 10 to 30 per cent in consumption and
consumer durable goods industry; and 5 to 10 per cent in basic
industry, such as metals, minerals, cement and petroleum. The
lowest range is 2 to 10 per cent in wood, paper fibers, glass, ceramics,
leather, rubber, etc.'
Drawbacks:
The number of small units have increased remarkably. The role
of this sector in the Indian economy cannot be underestimated.
However, as the Planning Commission observes, some of the
important objectives set for the village and small industries sector
are yet to be fully achieved.
The dispersal of small-scale units far away from the
metropolitan areas and large cities has not taken place to an
244 Privatisation
appreciable extent. Available data indicate that the industrially
developed ,States account for a very large share of the registered
small scale units. Within the developed States, there has been
concentration of units in a areas which are either metropolitan or
large cities or industrial complexes.
Though accurate estimates are not available, industrial sickness
appears to be widespread in the small-scale sector.
A number of promotional measures designed to develop the
VSI sector have not produced the expected results. For example, the
Entrepreneurial Development Programme has not made significant
progress except in a few States like Gujarat in widening the
entrepreneurial base.
Low levels of technology resulting in poor productivity and
inadequate returns continue to characterise the traditional industrial
sector.
It has been pointed out that a number of the registered small-
scale units are bogus; they have been registered to avail the credit
and other facilities offered to this sector. There is deliberate diversion
of resources from the genuine use. Units are delibe~ately made sick
after swindling the credit amount.
Though a number of arguments are put forward in favour of
the VSI sector, in a number of cases the VSI units are promoted and
sustained at a heavy social cost. The enormous subsidies they are
granted, like concessional finance, fiscal incentives, price
preferences, etc., have to be borne by the society.
The earning levels of a large number of people employed in the
VSI sector, especially in the traditional sector, are very low. Unless
productivity in this sector increases, there might not be significant
improvement in the earning levels.
Problems:
Though accurate estimates are not available, industrial sickness
appears to be widespread in the small-scale sector. It has been
estimated that the capacity utilisation in different village and small
industries has been ranging from about 45 to 60 per cent. The major
problems of the small-scale units are the following:
,Privatisation 245
(i) Problem ofInputs: Inadequacy or non-availability of inputs

- of proper quality at reasonable price is important problem facing a
number of units. It is pointed out that the allotments of raw materials
by Slate supply corporations have always been inadequate and are
hardly enough to work thirty to forty per cent of the installed
capacity.
(ii) Financial problems: Many small units face financial crisis.
Though there has been an increase in the flow of institutional credit
to this sector, large part of this has gone to the relatively large units
in this sector. The increased flow of institutional funds in favour of
the decentralized industrial sector has not covered the artisan sector
adequately which continues to depend, for a major part of its capital
requirements, on non-institutional sources, often, at exorbitant rates
of interest.
(iii) Marketingproblems : Marketing is a major problem area for
the small units in general. Small entrepreneurs, generally, do not
have resources and expertise to market their products effectively.
Financial constraints do not permit them to offer attractive credit
terms and the like to the marketing intermediaries. The VSI sector is
in a weak bargaining position so much so that the intermediaries
take advantage of the situation. Though the governments have taken
some steps, marketing arrangements for selling of the products of
the small units are still quite inadequate.
(iv) Competition from the large units: One serious problem faced
by many small units is the severe competition from the large units.
The large units by virtue of their resources, expertise and image,
coupled with quality aspects, are able to dominate the market vis-a-
vis the small units. The small units are thus relegated to a
disadvantageous position.
(v) Competition between small units: Problems arising out of
competition between the small units themselves are not uncommon.
. Many units supplying the same product creates a situation wherein
the large companies purchasing items from the small-scale sector
and the dealers find themselves in a strong bargaining position so
that the small units stand to lose in the bargain.
246 Privatisation
(vi) Obsolete technology and low productivity: Productivity in
the VSI sector is, by and large, not satisfactory. No much progress
could be made in the upgradation of technology particularly in the
traditional sector.
(vii) Institutional constraints: Though a number of measures
have been taken by the Central and State Governments to assist the
VSI sector, they have not come up to the expectations. The small
entrepreneurs have to cross many hurdles to obtain assistance from
them. The District Industries Centers (DICs) have not come up to
the expectations. There are many criticisms about the functioning
of the organizations meant to assist the VSI sector.
In short, as the Planning Commission observes, low levels of
technology resulting in poor productivity and inadequate returns
continue to characterise the village and small industries. Coupled
with this, the problem of obtaining raw materials of desirable quality
at reasonable prices and lack of marketing arrangements for selling
their produce at fair prices have deprived the artisans of a good
part of the earnings which should have accrued to them .

Chapter
16
tIti
INDUSTRIAL SICKNESS
Date available since the late 1970s clearly show that sickness
has been steadily growing in the large, medium and small industries
in India, both in terms of the number of sick companies and the
amount of bank credit blocked up in such companies.
Industrial sickness is a matter of serious national concern
because besides affecting the owners, employees, creditors and
suppliers, it causes wastage of national resources and social unrest.
Definition of Sick Company:
There are different perceptions of the symptoms and
characteristics of industrial sickness. Sickness is a relative concept.
Further, "a given sickness manifests itself in several forms, and at a
point of time these forms may not throw unambiguous or clear-cut
signals. No wonder, then, that sickness is found being understood,
interpreted and measured differently by individuals and even by
institutions" .
"To a layman, a sick company is one which is not healthy. To
an investor, it is one which skips dividends. To an industrialist, it
is a company which is marking losses and tottering on the brink of
closure. To a banker, it is a company which has incurred cash losses
in the previous year and is likely to repeat the performance in the
current and following years". In terms of the definition evolved by
248 Industrial Sickness
the Reserve Bank of India, an industrial company is regarded as

sick if it has incurred cash loss for one year and in the judgement of '
the bank, it is likely 10 continue to incur cash loss in the two
following years and it has imbalance in its financial structure such
as current ratio being less than 1:1 and worsening debt equity ratio.
The Sick Industrial Companies (Special Provisions) Act, 1985,
defines a sick industrial company as an industrial company (being
a company registered for not less than seven years) which has at
the end of any financial year accumulated losses equal to or
exceeding its entire net worth and has also suffered cash losses in
such financial year and the financial year immediately preceding
such financial year. The definition is for the purpose of application
of the Act and it covers only registered companies which have been
in existence for at least seven years.
Common symptoms of industrial sickness include failure to
pay statutory liabilities like Provident Fund and E.S.I, contributions,
failure to pay timely installment of capital and interest on loans
taken from financial institutions and through public deposits,
increas~ in inventories with a large number of slow or non-moving
items, high rate of rejection of goods manufactured, low capacity
utilisation and frequent industrial disputes.
Weak Companies:
According to the Sick Industrial Companies (Special
Provisions) Act, an industrial company is regarded as sick only if it
has, at the end of any financial year, accumulated losses equal to or
exceeding its entire net worth. It is, however, important to detect
sickness at the incipient stage and take necessary remedial measures.
The Reserve Bank has, therefore, ad vised the commercial banks to
take remedial measures in respects companies at the stage of 50 per
cent erosion of their net worth. Such companies are termed as weak
companies to distinguish them from sick industrial companies as
defined in the Sick Industrial Companies Act.
An Industrial company is termed as weak if at the end of any
accounting year it has:
(i) accumulated losses equal to or exceeding 50 per cent of its
peak net worth in the immediately preceding five
accounting years,
Industrial Sickness 249
(ii) a current debt-equity ratio of less than 1:1, and

(iii) suffers a cash loss in the immediately preceding accounting
year. Magnitude
The number of sick companies enjoying bank credit has grown
from 22,366 at the end of December 1979 to 159,938 at the end of
June 2009 and the total bank credit outstanding in respect of them
increased from Rs. 1809 erases to 5737.88 crores representing
increases of 615 percent and 217 per cent respectively. Of the 159938
sick companies at the end of June 2009,1057 were non-55I companies
(as defined in SICA) involving a bank credit of over Rs. 2680 crores
and the remaining were SSI companies.
It may be noted that the statistics of industrial sickness pertain
to companies enjoying bank credit and statistics regarding others
are not available.
Of the 1057 non-SSI sick companies referred to above, viability
studies were completed in respect of 862 companies and about 60
per cent of them were found to be non-viable. Of the 151408 sick
small-scale companies, of which viability studies were done, about
92 per cent were found to be non-viable.
Of the 655 non-SSI weak companies, banks had taken decision
about viability or otherwise of 481 companies and 219 of them were
regarded by banks as non-viable. One is tempted to question the
rationale of classifying those companies which are non-viable as
weak companies rather than sick companies.
The extent of industrial sickness varies by sectors and across
regions. In the category of non-SSI companies, engineering and textile
industries accounted for over 60 per cent of the total credit
outstanding and 47 per cent of the total number of sick companies.
Similarly, weak companies are preponderant in these industries.
Maharashtra and West Bengal account for a substantial share of
the non-SSI sick and weak companies. T~ a large extent, this regional
concentration of sickness corresponds with the historical pattern
of industrialization in India. Further, these regions are cHaracterised
by the presence of industries in textiles, engineering goods and jute
which happen to be the sectors afflicted with industrial sickness
especially in the non-S5I category.
Causes of Sickness:
There are many external and internal factors which can cause
industrial sickness. In many cases, sickness is caused by a
combination of factors.
The Tiwari Committee has culled out, from several published
research works, the following external and internal causes of
sickness:
(A) Internal Causes:
(1) Planning
(a) Technical feasibility
Inadequate technical know-how
Locational disadvantage
Outdated production process
(b) Economic viability High cost of inputs
Break-even point too high
Uneconomic size of project
Under-estimation of financial requirements
Unduly large investment in fixed assets
Over-estimation of demand
(2) Implementation
Cost overruns resultingfrom:
Delays in gelling licenses/sanctions, etc.
Inadequate mobilisation of finance.
(3) Production
(a) Production management
Inappropriate product-mix
Poor quality control
Poor capacity utilisation
High cost of production
Poor inventory management
Inadequate maintenance
Lack of timely and adequate modernisation, etc.
(b) Labour management
Excessively high wage structure
Inefficient handling of labour problems
Excessive manpower
Poor labour productivity
Poor labour relations
(c) Marketing management
Dependence on a single customer / single product
Poor sales realisation
Defective pricing policy
Booking of large orders at fixed prices in an inflationary
market
Weak market organisation
Lack of market feedback and market research
(d) Financial management
Poor resources management
Faulty costing
Liberal dividend policy
General financial in discipline
Deficiency of funds
Siphoning away of funds Over-trading
Unfavourable gearing or keeping adverse debt-equity
ratio
(j) Administrative management
Over centralization
Lack of professionalism
Lack of feedback to management (Management
Information System)
Lack of controls
Lack of timely diversification Excessive expenditure
onR&D
Dividend loyalties (where the same management has
interest in more than one company, cases are known
where promoters of limited companies who also own
private ownership firms tend to look after the interests
of the latter, often at the cost of the former)
Dissension within the management
Incompetent management
Dishonest management
(B) External Causes:
(a) Infrastructurel bottlenecks
Non-availability of/irregular supply of critical raw
materials or other inputs
Chronic power shortage
Transport bottlenecks
(b) Financial bottlenecks
Non-availability of adequate finance
(c) Government controls and policies, etc.
Government price controls
Fiscal duties
Abrupt c~ange in Government policies
Procedural delays on the part of the financial/licensing/
other controlling or regulating authorities (Banks, RBI,
financial institutions, Government departments, licensing
authorities, Monopolies and Restrictive Trade Practices
Board, etc.)
(d) Market constraints Market saturation
Revolutionary technological advances renderihg one's
pwducts obsolete
Industrial Sickn~ss 253
(e) Extraneous factors Natural calamities
Political situation (domestic as well as international)
War
Sympathetic strikes Multiplicity of labour unions
Those tnembers of the Tiwari Committee representing banks
and financial institutions identified the causes of 341 sick companies
in their portfolios as detailed below:
Important causes of sickness Percentage of companies
affected by the cause
1. Management deficiencies/
mismanagement/dissension's 65.1
2. Marketing constraints/competitive market 29.0
3. Shortage of working capital/liquidity constraints 23.8
4. Power cuts 22.6
5. Labour trouble/poor labour relations 22.3
6. Raw materials shortage/non-availability 21.7
7. Plant imbalancelfrequent breakdowns/obsolete
machinery 21.1
8. Del11and recessionlfluctuating demand 16.7
9. Higr cost of production 13.5
10. Under-utilisation of capacity 12.9
.According to the Chambers of Commerce, though it was difficult
to generalise the causes of sickness, one of the reasons could be the
fear on the part of the management to disclose the true state of
affairs of the company lest their goodwill/business reputation be
affected. Other causes attributed by the Chambers to make a
company sick are:
(i) lack of timely modernisation/machinery replacement;
(ii) new industrial location policy;
(iii) non-availability of adequate and timely working capital
credit;
(iv) price control and allied measures;
(v) Infrastructurel bottlenecks;
(vi) deficiencies in the functioning of canalising agencies;
(vii) assessment of banks ignoring the realities of business

fluctuations;
(viii) delay in review of representations by the concerned
agencies;
(ix) recession;
(x) compulsion to pay minimum bonus under Bonus Act;
(xi) deteriorating industrial relations; and
(xii) general managerial deficiency and misfeasance.
Besides, it has also been pointed out that a study by the Tata
Consultancy has shown that underutilisation of capacity in various
segments of the industry is also a factor causing sickness.
We feel that sometimes the attitude of labour, financial
institutions and government which does not allow a company to
take measures, before it becomes sick, to strengthen itself also may
cause sickness. Rehabilitation packages suggested by the BIFR for
several sick companies include such measures as closing down
certain divisions or lines of business, modernisation, rationalisation
and redeployment oflabour force, sale of assets to generate funds,
etc. The pity, however, is that a company which proposes to take
such measures before it becomes sick may have to face opposition
from the trade unions and even from government/government
agencies. And there will be suggestions to take such measures, offer
of concessions and the like after the catastrophe has ushered in.
Further, the swiftness with which the administrative r.lachinery
responds to a grave problem is indicated by the fact that it took
three years to establish the BIFR after the Tiwari Committee
recommended such a measure!
Preventive and Curative Measures:
As the Tiwari Committee observes, "Industrial sickness tends
to cause loss of production very often leading to unemployment/
loss of employment and resulting in blocking of scarce resources of
the banks and financial institutions, besides entailing loss of
substantial revenue to the exchequer. The magnitude and incidence
of industrial sickness are matters of serious concern for the Central
industrial Sickness 255
and State governments, Reserve Bank of India, banks and financial

institutions not merely due to the above factors, but also because
such a trend undermines public confidence in the functioning of
the organized sector with attendant repercussions on the overall
investment climate in the economy of the country". Several measures
have, therefore, been taken by the government and financial
institutions to detect the symptoms of sickness, and to prevent or
cure sickness to the extent possible.
There are some laws which enable the Central Government to
monitor and control the functioning of industrial undertakings and
to deal with the problem of sickness.
The Companies Act, 1956, empowers the government to collect
information from the companies which would enable it to assess
the state of affairs of the companies and to take certain measures to
prevent mismanagement. The Industries (Development and
Regulation) Act, 1951 (lORA), empowers the government to regulate
the management of industrial undertakings, including the take-
over of the management or the undertaking. The Sick Industrial
Companies (Special Provisions) Act, 1985, is a very important law
to deal with industrial sickness.
Government endorsed the recommendation of the Chokshi
Committee regarding amalgamation of sick companies and healthy
companies and amended Section 72 A of the Income Tax Act
relaxing the provision relating to carry forward and set off of
accumulated business loss and unabsorbed depreciation
allowances in case of amalgamation.
In 1981, the government announced certain policy guidelines
to deal with industrial sickness. These guidelines required the
ministries administratively concerned with various industries to
take responsibility for rehabilitation of sick companies. Banks and
financial institutions were required to strengthen the monitoring
arrangement for prevention of sickness.
An important limitation on the ability to tackle sickness arise
from the tact that commercial banks may legitimately consider sick
companies as poor security risks.
Government policy towards the prevention and treatment of

industrial sickness is guided by the following considerations:
On the preventive side, it is considered that closer and more
vigilant involvement of the financial institutions in the companies
with management of doubtful competence of integrity is essential.
Financial institutions have jointly set up a group of professional
directors who are full time employees of the institutions and who
could be nominated on the Board of Directors of companies with
doubtful management and in which the institutions have a
substantial stake. These directors report to the institutions on the
measures that should be taken to prevent sickness. If any such
director comes across features of a company's operation which give
cause to suspect malpractice or gross incompetence, he would report
to the financial institutions for further investigation. The concerned
institution will then report the matter to an inter-institutional group
under the Chairmanship of Industrial Development Bank of India.
If this group comes to the conclusion that the management has
acted in a patently incompetent manner or has indulged in
malpractice, all the institutions and the commercial banks should
take a decision tha t this company or any other company under the
same management will not be extended financial assistance until
the management is changed.
The rehabilitation scheme for a sick company will depend on
the extent of sickness of the company, its future prospects and the
management. Financial institutions have realised that the usual
methods of rehabilitation are not quite adequate for acute cases of
sickness. Such cases may require extraordinary efforts and measures
including leasing out an undertaking, merger and amalgamation,
restructure of capital and liabilities, selling a company on bloc!<
basis, etc. In such cases, the cooperation of all concerned agencies
is of utmost importance and invariably workers are called upon to
extend greater cooperation. I t has been agreed that the lead financial
institution and the lead bank will jointly ensure that a scheme is
prepared within a time limit of 90 days as fixed under the Sick
Industrial Companies (Special Provisions) Act. Some of the State
Governments have also started taking preventive measures by
announcing certain relief's and concessions in advance even for

companies which do not attract the definition of industrial sickness.
The Government has recently specified the economic size of
companies in many industries. This measures is expected to help
check sickness arising out of uneconomic size of industrial
companies.
The RBI has been closely monitoring certain specific industries
where the incidence of sickness is high. Standing Committees have
been set up in the RBI for the jute and sugar industries to consider
the specific problems of these sectors.
Another significant policy initiative has been the introduction
of liberalized margin money scheme for supplementing the efforts
of the State Governments in reducing sickness in the small-scale
sector, in June 1987. Under this scheme, the State Governments are
to make a matching contribution on a 50:50 basis in providing
assistance to sick small-scale companies in their rehabilitation. In
the revised scheme, the maximum quantum of assistance has been
enhanced from Rs. 20,000 to Rs. 50,000 per company.
In the past, the government took over the management of a
number of sick companies under the lORA, with the objective of
reviving them by providing management support and financial
assistance through banks and financial institutions. For instance,
between 1967 and 2009, the management of 80 companies were
taken over. While some these companies were nursed back to health,
a number of others continued to suffer huge losses. The government
felt that it was a mistake to have gone on taking over sick companies
and that the government should not be burdened with the mOlmting
losses of the sick companies.
Now the approach of the government towards rehabilitation of
sick companies is very selective because the government is convinced
that there is no point in throwing away further resources in support
of the companies which are irretrievably sick. Only such companies
which are found to be potentially viable be taken up for formulation
of rehabilitation packages to restore them to health. The package
consists of concessions from banks, financial institutions,
government (Central/State), government agencies, shareholders,
labour, suppliers of goods and services or other creditors, as may be
necessary. A company maybe regarded as viable if it would be ill a
position, after implementing a package of concessions, spread over
a period not exceeding seven years from the commencement of the
package to continue to service its repayment obligations, as agreed
upon, including those forming part of the package, without the
help of any further concessions after the aforesaid period. The
repayment period for restructured debts sho~Ild not exceed 10 years
from the date of implementation of the package.
Sick Industrial Companies Act :
The enactment of the Sick Industrial Companies (Special
Provisions) Act, 1985 (SICA), is an important step taken by the
Central Government to deal with industrial sickness.
It is declared that this Act is for giving effect to the policy of the
State towards securing the principles specified in clauses (b) and
(c) of article 39 of the Constitution. (These clauses say that the State
shall direct its policy towards securing that the ownership and
control of the material resources of the community are so distributed
as best to sub-serve the common gO(ld and that the operation of the
economic system does not result in the concentration of wealth and
means of production to the common detriment).
The Act which extends to the whole of India, applies, in the
first instance, to all the scheduled industries other than the
scheduled industry relating to ship and other vessels drawn by
power. However, the Central Government may, in consultation with
the Reserve Bank of India, apply the provisions of the Act to this
scheduled industry.
The act provided for the establishment of a Board for Industrial
and Financial Reconstruction (BIFR) to exercise jurisdiction and
powers and discharge the functions and duties conferred or imposed
on the Board by or under the Act. Further, the Central Government
is empowered to constitute an Appellate Authority for Industrial
and Financial Reconstruction, consisting of a chairman and not
more than three other members, for hearing appeals against the
orders of the BIFR under the Act.
The BIFR was set up in January 1987 (and has become operative
since May 15, 1987) for determining the preventive, ameliorative,
remedial and other measures which are required to be taken in
respect of sick industrial companies and for expeditious enforcement
of the measures which are required to be taken in respect of sick
industrial companies.
The BIFR has been given wide-ranging powers in respect of
approval of rehabilitation packages for sick industrial companies
including their restructuring and revival. In cases where sickness
is confirmed, BIFR will determine the course of action to be followed
with regard to the company. This course of action may be:
(i) allowing the company time on its own, i.e., as per the scheme
already initiated by the banks / institutions, to make its net
worth positive within a reasonable period;
(ii) having a scheme prepared through the operating agency
in respect of the company; or
(iii) deciding on the winding up of the company.
The scheme under option (ii) above sanctioned by the BIFR has
to be finalized in accordance with a time schedule stipulated in the
Act. The scheme may contain provisions for financial assistance,
merger, sale or lease of a part or whole of the company, suspension
of existing agreements/ contracts etc. The decision of the BIFR is
binding on all concerned. The Act has an overriding effect over all
other laws except FERA and Urban Land (Ceiling and Regulation)
Act. The jurisdiction of civil courts is barred in respect of matters
coming under the purview of BIFR.
It has been made mandatory on the Board of Directors of a sick
industrial company to report sickness of the company to the BIFR.
The BIFR is vested with power to institute the necessary inquiries to
determine whether or not a company is sick.
The BIFR also has powers to appoint a Special Director on the
sick company in case of mismanagement. It also has powers to
debar the company management and all other companies of the
management from any credit facilities from the organized sector for
a period of 10 years.
According to the Act, the management of a company will have

to seek fresh mandate from the shareholders if 50 per cent of the net
worth of the company is eroded.
, It has been claimed by the Government that the BIFR is a major
step for intervening at an early stage and detecting, preventing and
taking remedial measures which need to be taken with respect to
sick companies. It has, however, been pointed out that some of the
provisions of the SICA need to be amended to make the role of BIFR
more effective in dealing with the problems of the sick industries.
Under SICA, rehabilitation measures are initiated at a very late
stage, i.e, at 50 per cent and 100 per cent erosion of net worth.
Companies should be asked to approach the BIFR much before
their net worth is eroded. Further, despite the emphasis on timely
detection of sickness and the adoption of expeditious schemes, the
actual time involved between the reporting of sickness to the Board
and the final implementation of the rehabilitation package is more
than one year. In sickness, time is crucial. Therefore, it is necessary
to reduce the delays in initiating suitable measures for the
rehabilitation of potentially viable sick companies. The time allowed
for the BIFR at various stages needs to be cut short.
The Act does not apply to government companies and those
specifically exempted under the Act. Further, as the Act applies
only to the registered companies, very few, it at all, small-scale and
ancillary sick companies come under the Act.
Financial Institutions and Industrial Sickness:
Financial institutions have to playa very important role in the
prevention of sickness and rehabilitation of potentially viable sick
companies.
In view of the fact that large amount of bank credit was blocked
up in the sick companies, the Reserve Bank had issued, in 1976,
guidelines to the commercial banks so as to identify incipient
sickness. The RBI had also set up a sick companies cell. The cell
serve as a reference point and tries to bring about coordination in
the efforts of banks, financial institutions and Government in solving
the problems of sick companies and issues suitable instructions
and guidelines to banks as and when necessary.
The steps initiated by the commercial banks and other financial
institutions and the government under the Sick Industrial
Companies (Special Provisions) Act are helping in timely detection
of sickness. From time to time, industrial studies have been conducted
by the financial institutions where it has been found that sickness
is afflicting the industrial growth and climate. Inter-institutional
Rehabilitation Meetings (IIRMs) are periodically held under the
auspices of Industrial Reconstruction Bank of India (IRBI) were
sick cases are discussed in detail and detail rehabilitation packages
drawn up, in addition to various policy issues relating to
rehabilitation of sick industrial companies.
As modernisation is one of the important measures to prevent
sickness, financial institutions are extending soft loans for
modernisation of industrial companies. In 1986 the IDBI established
the Textile Modernisation Fund and the IFCI established the Jute
Modernisation Fund. Further, in the same year, the lOBI created the
Small Industries Development Fund (SIDF).
In 1971, the Central Government established the Industrial
Reconstruction Corporation of India (IRCI) with the specific objective
of dealing with the problem of industrial sickness. The IRCI ceased
to exist when the Industrial Reconstruction Bank of India (IRBI)
was established in 1985. The assets and liabilities of the IRCI were
taken over by the IRBI, which has been given statutory status so as
to effectively discharge its function.
It is reported that as a result of the efforts taken by the IRBI
towards prevention of industrial sickness, industrial companies
are now approaching the IRBI for their cases at the incipient stage
of sickness and that they have become aware of the need to correct
the imbalances of long-term and short-term funds, replacement of
balancing equipment and modernisation of obsolete and old plant
and machinery at an early stage so that the cases of rehabilitation
vis-a-vis their financial involvement to set right their industrial
activities becomes less. In addition, the companies are also
approaching IRBI for financial assistance for expansion,
diversification, modernisation etc.
262 Industrial 5ickness
Sick Small-Scale Companies:

At the end ofJune, 2009, nearly 8 per cent of the total number of
small-scale companies enjoying bank credit were found to be sick
and they accounted for nearly 16 per cent of the bank credit to the
small-scale companies.
Reflecting the serious concern over the growing sickness in the
small-scale sector, in February 2009 the Reserve Bank issued to all
scheduled commercial banks guidelines for rehabilitation of small-
scale companies. The separate guidelines regarding sick small-scale
companies have been issued because, although sickness in the large,
medium and small industrial companies exhibit many common
features, any approach to sickness in 551 sector has to reckon with
the relative weakness of such companies to withstand difficulties
as also the distinction between the small-scale companies and tiny
sector companies and companies in the decentralized sector
comprising artisans, village and cottage industries companies. It
has, therefore, been felt that the emphasis of the rehabilitation effort
in the case of 551 companies should be on adequate and intensive
relief measures and their speedy application rather than giving a
long span of time to the companies for rehabilitation.
According to the definition adopted by the guidelines, a 551
company should be considered sick if it has (a) incurred cash loss
in the previous accounting year and is likely to continue to incur
cash loss in the c1,lrrent accounting year and had an erosion on
account of cumulative cash losses to the extent of 50 per cent or
more of its net worth and/ or (b) continuously defaulted in meeting
four consecutive quarterly installments of interest or two half-yearly
installments of principal of term loans and there are persistent
irregularities in the operations of its credit limits with the bank.
While both the conditions (a) and (b) should be satisfied in the case
of large 551 companies, it would suffice if either alternative (a) or (b)
is satisfied in the case of the tiny and decentralized sector companies.
The guidelines point out that it is of utmost importance to take
measures to ensure that sickness is arrested at the incipient stage
itself and the management of the companies financed should be
advised about their primary responsibility to inform the banks if
they face problems which could lead to sickness and to restore the
companies to normal heal tho The bank branch officials, who are in
constant contact with tb.em, should develop mutual confidence
between the bank and the borrowers. The organisational
arrangements at the branch level should also be fully geared for
early detection of sickness and prompt remedial action. Bank/
Financial institutions will have to identify the companies showing
symptoms of sickness by effective monitoring. The Guidelines give
an illustrative list of warning signals of incipient sickness related
to periodical financial data, stock statements, reports on inspection
of factory premises and god owns etc. whi~ serve as a useful guide
to the operating personnel. The branch officials who are familiar
with the day-to-day operations in the borrowal accounts should be
under obligation to identify the early warning signals and initiate
corrective steps promptly. Such steps may include providing timely
financial assistance depending on established need, if it is within
the power of the branch manager, and an early reference to the
controlling office where the relief's required are beyond his delegated
powers. The branch manager should also help the company in
sorting out difficulties which are non-financial in nature and require
assistance from outside agencies like Government departments/
undertaking, Electricity Board etc. He should also keep the term
lending institutions informed about the position of the companies
wherever they are also involved.
The Guidelines emphasis that only those companies which are
considered as potentially viable be taken up for rehabilitation.
According to the Guidelines, a company may be regarded as
potentially viable if it would be in a position, after implementing a
relief package spread over a period not exceeding 5 years from the
commencement of the package from the banks, financial institutions,
Government (Central/State) and other concerned agencies, as may
be necessary to continue to service its repayment obligations as
agreed upon including those foaming part of the package. In the
case of tiny / decentralized sector companies, the period of relief's/
concessions and repayment period of restructured debts will be 2
years and 3 years respectively.
LOC:
The Industrial Reconstruction Bank of India (IRBI) introduced
a Line of Credit~LOC) Scheme for the small-scale sector. Under this
Scheme funds are given to State level institutions designated by the
State Governments at a lower rate of interest.
5IDF:
In May 1986, the IDBI created a Small Industries Development
Fund to provide assistance for development, expansion,
diversification, modernisation and rehabilitation of small-scale,
cottage and village industries and tiny sector companies.
National Equity Fund:
Another important step was the establishment of the National
Equity Fund in 1986-87, with a contribution of Rs. 5 crores each by
the Central Government and the lOBI. Under this scheme,
administered by the lOBI and operated through nationalised banks,
assistance will be provided by way of seed capital, in the form of
soft loans to eligible small and tiny companies with the project cost
not exceeding Rs. 5 lakhs and located in villages or towns with
population not e.xceeding 5 lakhs. New companies, as also the
potentially viable sick companies in the small-scale sector, eligible
for assistance under the Refinance Scheme of lOBI, will get support
out of the Fund. Assistance under the scheme is available upto a
maximum of Rs. 75,000 per project at a nominal service charge of 1
per cent annum. The companies availing this assistance are
required to mobiles cash contribution of 10 per cent of the project
cost.
Modified Definition of Sick 55I Companies:
The RBI has recently issued certain Guidelines. Accordingly:
(i) The definition of sick SSI companies has been modified as
under: .
" A .small-scale industrial company should be considered
as sicl$ if it has, at the end of any accounting year,
accumulated losses equal to or exceeding 50% of its peak
net worth in the immediately preceding five accounting
years."
In the case of tiny/decentralized sector also a company
may be considered as sick if it satisfies the above definition.
However, in the case of such companies, if it is difficult to
get financial particulars, a company may be considered as
sick if it defaults continuously for a period of one year, in
the payment of interest or installments of principal and
there are persistent irregularities in the operation of its credit
limit with the bank.
(ii) In the SSI sector, particularly among the tiny and
decentralized sector as well as those assisted under
schemes like SEEUY, a number of companies, financed by
the banks, are no longer in existence or are not traceable
and/ or have no assets left, etc. It has been decided to treat .
such companies as a category distinct from sick companies
and collect data thereof separately.
(iii) The above definition [vide item (1)) may be adopted for the
purpose of reporting data from the half-year ending
September, 2009, while for the purpose of identifying sick
companies/ formulating nursing programme, banks should
go by this definition with immediate effect. However, cases
of SSI companies identified as sick and already put under
nursing programmes on the basis of the previous definition,
need not be reopened.
***
Chapter
17
It It
SERVICE SECTOR AND MODERN
ENTREPRENEUR
Service facilities like transport, insurance, warehousing, etc.

are required to be arranged for production and marketing of goods.
These could be taken up by producers and traders themselves. But
in that case it would be highly expensive. Hence, separate business
units have been set up to undertake the service activities. Small
scale producers and traders with limited resources cannot arrange
all the service facilities on their own. Large scale producers and
traders also find it more economical to use the service facilities
offered by other organisations.
The need for transport arises to distribute the goods among the
consumers. Warehousing is necessary to preserve the goods to meet
the future demands of consumers. Insurance provides a cover
against several risks of business. The businessman often faces the
shortage of capital for buying materials and holding stocks. This
necessitates the existence of banks and other financial institutions.
Goods produced in bulk need to be put in convenient packages
for easy handling and exchange in the process of distribution. Since
goods and services are produced on a large scale, their availability,
use, quality, etc. must be known to the ultimate consumers.
Information relating to goods available is provided through
advertisements sponsored by producers and traders.
Service Sector and Modem Entrepreneur 267
Classification of Service Facilities:

The service facilities which are of vital importance to both
industry and trade may be classified as follows:
(i) Transport,
(ii) Banking,
(iii) Insurance,
(iv) Warehousing, Packaging, Advertising, Sales Promotion, etc.
Transport Facilities:
Transport refers to the means of physical movement of goods
and passengers. The means of transportation may consist of
roadways, railways, waterways, airways and even pipelines for
oil.
Transport helps in physical distribution of goods produced by
different manufacturers. It removes the hindrance of place. In
economics, it creates place utility for the goods.
Means of Transport :
The means of transport can be classified into following three
main divisions:
(1) Land Transport (Roads and Railways).
(2) Water Transport.
(3) Air Transport.
Means of Transport
I I 1
Land Water Air
I 1 1
1 I 1 1 1 r---1
Roadways Railways Canals Rive Sea Passen Cargo
1 1 gers
1"'1---";'-"""1 1
Vehicular Non Passenger Goods
(Bullock Vehicular Trains Trains
Carts, Ton- (Man,
gas, Auto-
rickshaws,
Cars, Trucks,
Buses)
268 Service Sector and Modem Entrepreneur
Significance of Transport :
Transport gives the physical means which facilitate the
movement of persons, goods and services from on- place to another.
It is an important part of commerce as it helps in removing the
hindrance of distance. As a matter of fact, transportation has
constituted one of the most important activities of man in every
state of civilization. The importance of transient has increased so
much that it is difficult to think of any busmen activity without the
help of means of transport.
Transport plays an important role in the economic, social and
political development of a country. Rapid industrialisation and
exchange of goods and services cannot take place unless sufficient
facilities for transportation are available. It is with the help of means
of transport that raw materials are transported from the place of
their production to the industrial centers where they are converted
into finished products. It is again transportation that facilitates the
movement of goods from the producers to the users. By doing so,
transportation removes the distance problem and creates place
utility. It also creates time utility in the goods and services because
speedy transport minimizes the time of their means of transit.
Transport Leads to Regional Specialisation: A region may
specialise in the production of those goods and services for which
it is most suited. This leads to production of goods and services in
different regions at the lowest possible cost. Transport also plays a
crucial role in price mechanism. It tends to equalize and stabilise the
prices of various commodities by moving the~ from the areas where
they are surplus to those areas where they are in short supply.
Functions of Transport :
Efficient means of transport perform the following important
functions :
(i) Widening of MarKet: Transport helps in widening the
market. With the emergence of improved means of transport, goods
and services can be moved from one place to another at considerably
low expense and with great ease and speed. This stimulates the
producers to produce not only for the local market but also for the
distant markets including the foreign markets. The expansion of
national and international trade has taken place mainly due to
efficient means of transport.
(ii) Mobilisation ofResources : Transport facilitates the mobility
of men, materials and money which are necessary for large scale
production and for having balanced development of various regions
in the country. Now, it is not necessary to start production only
near the source of production or near the market. A business
enterprise can achieve a large number of economies by setting its
business in those areas where there is less concentration of business
units.
(iii) Regional Specialisation: Transport leads to specialisation
on geographical basis. A region need not be self sufficient in all the
matters because of efficient means of transport. It can concentrate
only on the production of those products for which it is most suited
and can depend on transport to get its other requirements fulfilled
from other regions and sell its surplus production to other regions.
(iv) Price Stabilisation: Transport helps in stabilising prices
by facilitating movement of goods from surplus areas to deficit areas
This leads to equalisation of prices in different regions.
(v) Economies of Scale: Transport facilitates the achiever of
various economies of large scale production which lead to cost of
production which is necessary to meet competition in the market.
(vi) Growth of Industries: Transport helps the growth of
industries using perishable goods like fruits, vegetables, and dairy
products by carrying them quickly to various consumers located in
different areas.
(vii) Social Functions: Transport also performs certain functions
for the benefit of the society. It provides employment to people. It
helps in stabilising prices. It assists in removing regional disparities.
It leads towards specialisation on geographical basis.
Transportation is indispensable for the defense of a country. It also
creates a bond of unity among people of various regions in the
country.
Form of Road Transport :
Of all forms of traru;port, road transport has shown the greatest
growth in recent years in our country. Road transport is also used
as a complementary means of transport to other means of transport.
Roads are indispensable links for carrying goods and people to
and from railway stations, ports or aerodromes.
Transportation of goods by road may assume anyone or more
of the following forms:
Transport by human energy: Porters or coolies carry goods
(i)
either on back or on head. This type of transport is generally used
for short distance and in those areas, particularly hills, where
animals, carts and vehicles cannot be used.
(ii) Transport by animals: Pack animals like bullock, camel,
donkey, elephant, horse, mule, shark and yak are frequently used
for carrying goods and passengers. Camel is the only means of
transport in desert areas. Elephant is frequently used fo~
transporting timber. This transport is flexible and can be taken
anywhere to the point of loading and unloading
(iii) Transport by carts: Bullock-carts and horse-carts are used
to carry loads from one place to another.
(iv) Transport by automobiles: In includes motors, trucks and
buses. It has assumed greater significance in modem industry and
commerce because of its greater speed and low cost per kilometer.
Advantages of Road Transport :
The important advantages of road transport are as follows:
1. Road transport is more flexible than any other means of
transport. It provides door-to door service by loading goods
at the cosigner's place of business and unloading them at
the consignee's place of business.
2. For short distances, say up to 300 kilometers, road transport
is cheaper and quicker. The slow movement of road
transport is more than made up by the adoption of direct
and economic routes and by other benefits.
3. Loading and unloading can be done at a less cost, in the
least possible time and at the place of business of the
consignor or the consignee.
4. The requirements of packing are less and even in some
cases, packing is not necessary.
5. Road transport serves those areas also where no other
means of transportation is available.
6. The freight structure is simple to understand. Freight can
be determiner easily.
7. Roads are not to be constructed by the road transport
owners. Usually, they are provided by the Government.
Rich farmers and businessmen can have their own vehicles
for the transportation of their products without any delay.
8. Road transport is indispensable to other modes of transport
because it acts as a feeder service to railways, airways and
waterways.
9. Road transport is very suitable for transporting perishable
and delicate items. There is less risk of Joss, damage or
pilferage because of proper handling and the element of
personal service by the owners of transport enterprises.
Disadvantages of Road Transport :
Road transport has the following major drawbacks :
1. Road transport is not suitable for long distance as it is
costlier and consumes more time as compared to railways.
2. It is less safe in certain respects. The probability of accident
is higher. The goods are liable to damage because of faulty
roads.
3. Its freight charges are not stable in character. These are
generally subject to bargaining. They vary from one operator
to another.
4. It is quite an irregular means of transport as trucks may not
move regularly.
5. It cannot be completely relied upon because of frequent
breakdowns of vehicles and blockages of roads because of
rain, flood, snow and other reasons.
Advantages and disadvantages of Rail Transport :
The provision of railways as a part of the infrastructure of an
economy is vital for industrialisation. In most of the countries,
railways constitute the principal means of transport for carrying

goods and passengers. Rail transport is more reliable than any
other of transport.
Advantages o/Rail Transport: Rail transport has the following
major advantages as compared to other means of transport:
1. It is the most suitable means of transport for carrying heavy
and bulky goods over long distance.
2. It provides regular service as it follows regular schedules .
. So it is more dependable.
3. The freight rates charged by railways are fixed and do not
change frequently.
4. It us bit affected by weather conditions unlike other modes
of transport.
5. It carries goods and passengers with greater speed than
any other means of transport except the air transport.
6. It is flexible in the sense that the number of wagons attached
to a train may be a justed according to the volume of traffic.
7. It is a safe means of transport as it protects the goods from
exposure de to sun, rain or snow, if the goods are carried in
closed wagons.
Disadvantages o/Rail Transport: Rail transport has the
following major demerits:
1. It requires huge capital expenditure for its establishment. It
cannot operate economically in those areas where volume
of traffic is inadequate.
2. It is affected by the problem of terminals. A terminal is the
point where goods have to be loaded or unloaded. It cannot
rum to every customer's door because the track on which a
train moves is fixed. In this sense, rail transport is inflexible.
Since the customer has to take the help of road transport for
carrying goods to and from his godown, it increases the
cost of transport by rail.
3. It is costlier for short distance as compared to road transport
particularly because of terminal costs.
Service Sector and Modern Entrepreneur 273
4. The task of loading, unloading, assembling and shunting

is quite time consuming and it causes delays.
5. The maintenance of the tracks and wagons and efficient
running of trains is very costly.
6. Pilferage, delay and rough handings of goods during
transshipment are not uncommon. Due to this, the railway
administration has to pay every year heavy amounts by
way of compensation.
Rail-Road Competition:
There has been a keen competition between the rail and road
transports in recent years in our country. In some countries, railways
have incurred heavy losses as a result of such competition. Road
transport has an upp~r hand over rail transport because of the
following reasons.
1. Road transport is more flexible as compared to rail
transport. It is capable of providing door-to-door services
to its customers. Goods can be loaded and unloaded in
trucks or other vehicles at the place of their production or
manufacture. Businessmen choose road transport for short
distance because it involves loading and unloading one
time only. In case of rail transport, the businessman has to
bear additional expenses of loading, and unloading because
goods can only be transported at fixed terminals.
2.. It is easier to send goods through road transport companies
than through railways. In case of railways, a large number
of formalities have to be observed both at the time of dispatch
and delivery of goods.
3. Freight rates are higher in case of railways than in case of
roadways particularly for short distances. That is why short
distance traffic is diverted to road transport.
4. There is more risk to goods due to theft, loss or damage of
goods in transit in case of railways because of impersonal
service provided by it. Some businessmen like road
transport due to personal service provided by their
operators.
,..
5. Road transport is more suited for carrying perishable

commodities like vegetables, fruits, milk, etc. Not much
packing is required to transport them through road
transport.
Need for Coordination:

There is a need of a coordinated transport policy so that wasteful
competition between rail and road transport is avoided. If free
competition is allowed, roadways will take away all the short traffic.
It will be more severe when the rail lines and roads run parallel to
each other. Coordination of transport system is necessary to ensure:
" unnecessary
(i) scarce resources are utilized efficiently and
duplication is avoided;
(ii) the transport system is developed according to the pattern
of users' demand; and
(iii) efficient services at lowest possible cost are provided to the
society.
Measure for Coordination:
Coordination between railways and roadways may be achieved
in any of the following ways:
(i) by integration of the two systems of transport;
(ii) by suitable legislative measures prohibiting the wasteful
competition; and
(iii) by nationalising the whole transport system with a view to
achieve a coordinated system of transport.
Committee on Transport Policy and Coordination:
This committee was set up in July, 1959 under the chairmanship
of K.c. Neogi and it submitted its report in 1966. It made the following
recommendation for coordination:
(i) The transport system should be viewed as an integrated
and unified structure and the objective of coordination,
therefore, should be to develop various means of transport
as complementary services to one another.
(ii) For effective coordination of transport programmes and

policies, it is essential to develop adequate machinery,
organisation and instrument. For this the establishment of
National Council for Transport Coordination is necessary.
(iii) A Committee of Ministers should be established at the center
to facilitate coordination of important questions of policy
and to provide guidance to various bodies connected with
it.
(iv) The responsibility for coordination and development of
road transport within the state should devolve on the state
Transport Authority.
(v) A center for Transport Retouch and Training should be
established to stimulate transport research and studies and
to provide necessary training to persons drawn from
Central and State Organizations.
(vi) Road transport should be regulated uniformly throughout
the country and it should stimulate the growth of under-
developed regions. The road researches in the country
should be fully exploited to reduce the cost of construction
and maintenance of roads, and to utilize the indigenous
and local materials.
(vii) The need for collection and proper analysis of various
information's and data relating to various modes of
transport was also emphasised by the committee.
(viii) The chief objective of the national transport policy should
be to fulfil the future transport requirements of the country.
Merits and demerits of Inland Water Transport and Ocean
Transport:
Water transport is one of the oldest form of transport. Though it
is slow, it is the cheapest form of transport. It is very much suitable
for bulky and cheaper goods. Water transport includes (i) inland
water transport, and (ii) ocean transport.
Inland Water Transport : Inland waterways include rivers and
canals. Rivers are the gift of nature which can be used for
transporting goods and passengers. But canals are artificial

waterways. They require huge amount of capital for their
construction and maintenance.
Water transport in India has been very popular because of the
following advantages:
(i) It is the most suitable means of transport for bulky and less
costly goods like coal and timber.
(ii) It is the cheapest means of transport, The cost of
infrastructure is also low as compared to other means of
transport.
Water transport also suffers from many drawbacks which are as
follows:
(i) Rivers and canals can serve only a limited area.
(ii) The construction of canals requires huge capital
expenditure.
(iii) The speed of boats and steamers is very low as compared
to other means of transport. So it cannot be used for quick
delivery. Moreover., boats have very limited capacity.
(iv) Rivers change their course abruptly which may cause
dislocation of traffic.
(v) Inland waterways are not always reliable. During rainy
season, there may be too much disturbance in the water
and during winter season the Water may get frozen. During
summer season the level of water may not be adequate for
navigation.
Ocean Transport: Ocean or sea transport is very important for
the development of foreign trade. It is the only means of cheap
transport between different countries of the world. Though air
transport is also used for connecting different countries, but it is too
expensive and cannot carry bulky goods in large quantities.
Like inland waterways, the ocean transport also suffers from
certain demerits which are as follows:
(i) The speed of ocean transport is very low. So it cannot be
used when the goods are to be sent quickly.
(ii) There are a large number of risks inherent in carrying goods

through sea.
(iii) The distance between places increases as the routes
followed b}' the ships are quite circuitous.
(iv) The waterways may not be navigable due to seasonal
changes.
(v) Sea transport is not suitable for perishable goods as it is
very slow.
Despite these drawbacks, sea transport is widely used for foreign
trade purposes. It is the cheapest mode of'transport. Its operating
cost is the minimum. It does not involve huge capital expenditure
for building the infrastructure as in railways and roadways. The
ships are more spacious than and other means of transport.
Sea transport may be of two types, namely, coastal shipping and
overseas shipping.
Coastal Shipping. It is prevalent in those countries whose
borders touch the sea shore. It is the most suitable mode of transport
for the movement of bulky cargoes like coal. It is the most economic
form of transport for carrying goods from one po::-t on the coast to
another, e.g., for transporting goods from the port of Madras to the
port of Visakhapatnam.
Overseas Shipping. When goods are carried across the high
seas from one country to another, it is termed as overseas transport.
For India, sea routes radiate mainly from the major ports, namely,
Calcutta, Visakhapatnam, Madras, Cochin, Bombay and Kandla.
Types of Cargo Ships:
(a) Liners: Liners are those ships which form part of a 'line'
offering a fairly regular service between certain ports, with
advertised schedules. A liner follows definite routes with fixed
terminals and operates at regular intervals. Whether it receives full
cargo or not, it does not hinder its movement. It is mostly used by
those traders who have to meet the contracts of delivery of goods by
fixed dates. The unit of liners is known as 'fleet'.
(b) Tramps: In case of tramps, the unit is the single ship which
does not follow any specific route and does not sail in accordance
with a particular schedule. It moves whenever and wherever it finds

cargo. Tramps can be chartered by major importers or exporters.
Their freight charges are not fixed and uniform. They are owned
and run by different companies each possessing one or more ships
which have competition among them. But liners are mostly owned
and run by one company.
(c) Tankers: There are ships which are specially designed to
carry crude oil and refined petroleum products. The load is
discharged from the cargo by pipeline.
Air Transport :
Air transport has also entered into freight traffic. Its greatest
advantage is that it has reduced the time and distance barrier to a
great extent. However, air transport is the costliest means of
transport because of high cost of planes, their operation and
maintenance. That is why, it has not gained much business in freight
transport.
Air transport can be classified into regular flights and chartered
or special flights. Regular flights are run by the airlines on scheduled
routes and at scheduled periods. But in case of a chartered flights,
the entire plane is booked for a trip to a particular place. In India,
air transport was nationalised in 1953. Two corporations, namely
Indian Airlines Corporation and Air India International were set
up for running internal and external air services respectively.
Benefits of Air Transport :
Air transport has the following advantages:
1. Its speed is very high. So it is very suitable for perishable
commodities or when time is the most important factor.
2. It is most suitable for less bulky goods of high value, e.g.,
gold, Jewellry.
3. Air transport helps in carrying goods to those areas which
are inaccessible by any other means of transport.
4. Air transport is most suitable when the other means of
transportation are dislocated due to flood, earthquake or
other natural calamities.
5. Air transport can follow the shortest possible route as
no track or road is involved.
Demerits of Air Transport :
Air transport suffers from the following limitations.
(i) The cost of operation of planes is the highest as compared
to other means of transport.
(ii) The freight charges are the highest in air transport.
(iii) It is highly uncertain and unreliable form of transport as it
depends greatly upon the atmospheric conditions. A
scheduled flight may have to be postponed or cancelled
because of bad weather conditions.
(iv) The probability of accident is the highest in case of air
transport.
(v) Air transport is not suitable for carrying bulky goods and
goods of small value.
(vi) Air transport also suffers from the problem of terminals as
in case of rail and water transport.
Suitability of Different Modes of Transport :
1. Road transport is most suitable for carrying goods of
medium bulk and weight over short distances and for
providing point to point service. It is widely used for
transporting perishable commodities like vegetables, fruit,
milk and milk products.
2. Rail transport is the best means of transport for carrying
bulky goods over long distance within the country as its
speed is higher than road and water transport.
3. Water transport is most suitable for bulky goods of low
price which can bear handling and hazards of journey and
when time is not the consideration.
4. Air transport is most suitable for carrying Valuable,
perishable and less bulky articles like gold, jewellery,
medicines and spare parts where speed is the greatest
consideration or where other means of transport cannot
reach the particular place.
Comparison of Different Means of Transport :
In order to choose a particular means of transport out of Road,
Rail, Water and Air, the following factors should be taken into
consideration.
1. Cost: Water transport is the cheapest means of transport
for carrying bulky goods over long distance, particularly when time
is not the essential element. Railways rank second in terms of cost
of service. It is cheaper than road transport for heavy goods and
long distance movement. However, for small consignments which
are to be carried over short distance, road transport is the cheapest.
Air transport is the costliest means of transport because its
operational cost is too high and its capacity is limited.
2. Carrying Capacity: Railways and waterways have larger
carrying capacity than other means of transport. They are also
cheaper when the whole wagon or vessel is booked for sending the
cargo.
3. Speed: In respect of speed, air transport gets the first ranking
while waterways is the slowest means of transport. Road transport
has the merit of being faster than rail transport over short distance
only because loading, unloading, assembling and shunting of
wagons takes much time. However, for long distances rail transport
is faster than road transport.
4. Flexibility o/Service: Water, rail and air transports are not
flexible as they suffer from the problem of terminal. Goods have to
be carried to and from the terminal in case the businessman decides
to use a~ of these means of transport. But road transport is flexible.
It covers the maximum areas of the country and is capable of
providing door-to-door service. It carries goods from one
businessman to another and this requires loading and unloading
only for once. Road transport also acts as a complementary service
to other modes of transport.
5. Regularity 0/ Service: Rail transport is the most regular
service as it follows regular schedules and is generally uninfluenced
by weather conditions. They may have to delay their trips or even
cancel them sometimes. The impact of weather on roadways is
comparatively less as compared to airways.
'f" .
6. Safety: Roads are considered the safest means of transport.

When the articles to be consigned require delicate handling, it is
preferable to use road transport. Rails also provide sufficient safety
to goods. They are less prone to accidents as compared to road
vehicles. Airways and waterways are the most risky modes of
transport.
Merits and demerits of Road Transport and Water Transport:
Road Transport :
1. It provides door to door service with the help of trucks,
animals, carts and trams;
2. Comparatively high speed.
3. It is flexible.
4. It is more dependable as compared to water transport.
5. It is a costlier means of transport.
6. It is available in all parts of a country.
7. Comparatively more safe.
8. Suitable for sending goods and passengers to the interior
parts of the country.
9. Capacity to carry goods is limited.
Water Transport:
1. It does not provide door to door service as it uses river,
canal and sea,
2. Limited speed.
3. It is not flexible
4. It is less dependable.
5. It is a cheaper means of transport.
6. It is available where rivers, canals and sea routes are
available.
7. Comparatively less safe.
8. Suitable only for regions near the rivers, canals and coast.
9. Its capacity is much higher as compared to motor transport.
Advantages and disadvanta~es of Rail Transport :

Rail Transport :
1. Not possible.
2. Comparatively speed.
3. Not flexible because it runs on schedule.
4. It is regular and more dependable.
5. It is generally fit for all seasons.
6. Its capacity to carry good is quite huge.
7. It is more safe.
8. It operates in the public sector.
9. Transport charges are low.
10. Rail is the monopoly of the Government.
11. It is more suitable for long distances and for heavy or bulky
goods.
Road Transport :
1. Is possible.
2. Limited speed over long distances.
3. It is flexible as there is no rigid schedule.
4. It is less dependable as chances of breakdown are higher.
5. It is not fit during rainy season.
6. Its capacity is very limited.
7. It is less safe.
8. It generally operates in the private sector.
9. Transport charges are high.
10. There is competition in case of Road transport.
11. It is more suitable for short distances and light goods .

Chapter
18
COMMERCIAL BANKS
--
A Commercial bank deals in money. It receive deposits from the
public to lend money to those who are in need of it. The rate of
interest charged by the bank on loans and advances is generally
higher than the rate offered on its deposits. Modern banks perform
a number of other services or functions like collection and payment
of bills of exchange, issue of letter of credit, collecting credit
information, safe custody of valuables, etc.
The commercial bank is an institution which carries on the
business of receiving money from customers subject to the obligation
of honouring the cheques drawn by customers to the amount
available on their accounts." Thus, the essential character-sties of a
commercial bank are:
(i) receiving deposits from the public;
(ii) paying against cheques drawn by account-holders;
(iii) collection of drafts and cheques on behalf of the customers.
(iv) lending money to traders. etc.
Function of a Commercial Bank:
The functions of commercial banks may be divided into
following two bread categories:
1 . Primary functions; and
2. Subsidiary functions.
284 Commercial Banks
Functions o/Banks :
(i) Receipt of deposits, and (ii) Lending of money.
(i) Receipt 0/ deposits or borrowing : The first important
function of a commercial bank is borrowing money from the public.
It borrows by attracting deposits of money. The deposits can be
collected in the following forms: (a) Current Accounts, (b) Saving
Deposits, (c) Fixed Deposits, and (d) Miscellaneous deposits like
Cumulative Deposit Scheme, Cash Certificates. Old Age Pension
Plan,etc.
(ii) Lending o/money : The second important function of a bank
is lending. It makes profit by performing this function. It lends money
to merchants and manufacturers for short periods. Now-a-days, it
lends even to consumers and agriculturists. It lends mostly on the
security of easily releasable assists like rice, wheat, cotton, oilseeds,
cloth, gold and Government securities. It makes advances to those
who require them and who can pay back the loan with interest. A
bank makes advances in various ways- cash credits, -overdrafts
and loans.-It also discounts bills of exchange.
2. Subsidiary Functions:
(i) Agency Service, and (ii) General Utility Services.
(i) Agency Services: A commercial bank acts as an agent of its
customers in the following ways:
(a) It collects cheques, drafts and bills of exchange on behalf of
customers.
(b) It collects dividend and interest warrants of customers_
(c) It collects salaries and pensions of customers.
(d) It purchases and sells securities on the instructions of its
customers.
(e) It executes standing orders like payment of rent, electricity
bill, insurance premium, etc.
(f) It acts as a correspondent of its customers and other banks.
(g) It acts as a trustee, executor and attorney.
(ii) General Utility Services: A commercial bank performs the
following general utility services:
(a) Safe custody of valuables like gold, jewellery and important
documents.
Commercial Banks 285
(b) Provision of lockers to customers on hire basis.
(c) Collection and supply of business information.
(d) Purchase and sale of foreign currencies.
(e) Issue of demand drafts to remit money.
(f) Underwriting of capital issues.
Role of Commercial Banks in the Economic Development of a
Country:
A commercial bank performs various functions and services
which have already been discussed in the previous pages. Because
of these services, it has acquired a place of economic significance in
the economy of any country. Its role will be more clear from the
following points:
1. Banks offer attractive rates of interest for our savings. Idle
savings can earn interest if they are deposited with banks.
Banks encourage the habit of thrift among people. They
mobiles the savings of the society. Banks are compared to
rivers, as they collect the small surplus and scattered
savings of the people and make them available for
productive purposes in large sums of finance.
2. Banks give safety and security of the people's savings. It is
dangerous to keep money at home because of the fear of fire
and theft. But it is safe to deposit it with banks.
3. Banks provide the "cheque system" which is a great
convenience for making payments. Bank cheques settle
transactions as Legal Tender Money. Payment by cheques
economises time and trouble.
4. Banks regulate the flow of national savings into various
productive channels. While lending money, they
discriminate between a genuine trader and a speculator
and thus, they discourage the gamblers.
Different types of accounts by which commercial banks attract
deposits from the public:
Commercial Banks borrow money from the public by accepting
deposits in the following accounts:
(i) Current Accounts.
(ii) Savings Accounts.
(iii) Fixed Deposit Account.
(iv) Money at Call and Short Notice.
(v) Miscellaneous Deposits.
1. Current Account: It is also called demand deposit account.
A businessman can open a current account with a bank. Current
accounts generally do not carry any interest as the amount deposited
in these accounts is repayable on demand without any restriction.
The Reserve Bank directive prohibits the payment of interest on
current accounts or on deposits up to 14 days or less except where
prior sanction is obtained. Most of the banks charge incidental
charges on such accounts.
2. Savings Fund Account: Savings deposit account is meant
for individuals who wish to save a little out of their current incomes.
It helps in safeguarding their future and also earns some interest on
their savings. A savings account can be opened with or without
cheque book facility. There are restrictions on the withdrawals from
this account. Savings account holders are also allowed to deposit
cheques, drafts, dividend warrants, etc. which stand in their names
only. For this facility, it is necessary that account holder must be
introduced by a person having a current or saving account with the
same bank.
3. Fixed Deposit Account: The term 'fixed deposit' means
deposit repayable after the expiry of a specified period. Since it is
repayable only after a fixed period of time, which is to be determined
at the time of opening of the account, it is also known as 'Time
deposit'.
Fixed deposits are the most suitable form of raising resources
for a commercial bank. Since they are repayable only after a fixed
period, the banker may employ these funds more profitably by
lending at higher rates of interest and for relatively longer periods.
The rate of interest on fixed deposits depends upon the period of
deposits. The longer the period, the higher is the rate of interest
offered. The power to fix the rates of interest on fixed deposits rests
with the Reserve Bank of India.
4. Recurring Deposit Account: The Recurring Deposit Account
is gaining wide popularity these days. Under this, the depositor is
required to deposit a fixed amount of money every month for a
specific period of time. Each instalment may vary from Rs. 5/- to Rs.
500/- or more per month and the total period of account varies from
12 months to 10 years. After the completion of the specified period,
the customer gets back all his deposits along with the cumulative
interest Secured on them.
5. Miscellaneous Deposits: Banks have introduced several
deposits schemes to-attract deposits from different types of people.
These include pigmi deposit account, cumulative deposit account,
Mini Deposit Scheme, Children Gift Plan and Old Age Pension
Scheme.
Methods of lending money by the commercial banks:
The importants methods of lending by the commercial banks
are:
(1) Overdraft.
(2) Cash Credit.
(3) Loans.
Overdrafts : Under this arrangement, the bank allows its
customer to overdraw his current account so that it shows a debit
balance. Any businessman can enter into this arrangement to tide
over a temporary shortage of funds. The customer can draw this
fund as and when be requires and repay it when it is convenient for
him. The customer is charged interest on the amount actually
overdrawn by him.
Cash Credits: A cash credit is an arrangement under which a
borrower is allowed to withdraw up to a certain limit against the
security of tangible assets. Cash credit is like overdraft arrangement,
but for this purpose a current account does not have to be in
existence. In cash credit, a trader or industrialist or agriculturist
can withdraw amounts within the limits sanctioned for meeting
expenses on current operations. In such cases, interest is paid on
amounts withdrawn.
Loans: In this case, the entire amount is paid to the borrower in
lump-sum. The loan amount may be paid either in cash or
transferred to the current account of the borrower. Interest is charged
on the whole amount of loan. However, loan can be repaid back in
installments.
Types of Modern Banks: Banks may be classified into the
following categories:
(1) Commercial Banks.
(2) Industrial Banks.
(3) Agricultural or Land Development Banks.
(4) Exchange Banks.
(5) Cooperative Banks.
(6) Rural Banks.
(7) Central Bank.
(8) Exim Bank.
(9) NABARD.
1. Commercial Banks: A commercial bank may be defined as
a financial institution which accepts deposits and lends money to
commerce and industry. It also renders a number of other useful
services to the customers and the society. Commercial banks borrow
money from those who have surplus funds and lend to those who
need for commercial and industrial purposes. Thus, they act as
dealers in loan able funds of the society.
Commercial banks receive deposits in the form of fixed deposit,
savings bank account and current account. They grant loans,
generally for short periods, in the form of cash credits, overdrafts
and ordinary loans. They also render a number of services such as
collection of cheques, safe custody of valuables, remittance facilities
and payment of insurance premium, etc.
2. Industrial Banks: Industrial banks provide long-term funds
to industrial enterprises. They perform the following functions: (a)
Provision of long-term loans to industrial organizations for their
expansion and modernisation programmes; (b) Promotion of new
industrial enterprises; (c) Provision of technical guidance in the
management of industries; and (d) Controlling the affairs of the
industrial undertakings by securing representation of their Board
of Directors.
In India, there were no industrial banks till 1947. The Central
Government and the Reserve Bank have taken an active part in
setting up industrial banks in India to finance the capital
requirements of small, medium ar..d large scale industrial units.
They include Industrial Finance Corporation, Small Scale Industries
Corporation, Indu~trial Credit and Investment Corporation and
Industrial Development Bank of India.
3. Agricultural or Land Development Banks: Agricultural
banks provide long-term credit to agriculturists for purchase of tools
and implements and for permanent improvement of larld. In India,
these banks were set up to provide loans to agriculturists on easy
terms against mortgage of land for the purpose of repayment of
loans to village money-lenders and indigenous bankers. These
banks were also known as 'Land Mortgage Banks'. But now the
emphasis has been shifted to provide loans for permanent
improvement of land. That is why they have been renamed as 'Land
Development Banks'. They grant loans to agriculturists which are
repayable by annual installments spread over a number of years
ranging from twenty to thirty years.
4. Exchange Banks: Like other commercial banks, they also
undertake the usual banking business, but they specialise in foreign
exchange transactions. Exchange banks are foreign in origin, i.e.,
they have their head offices located outside India. At present there
are sixteen exchange banks in India and these banks have a hold
on India's foreign trade transactions. Since they specialise in
financing foreign trade, they are called 'foreign exchange banks'.
These banks also render other services incidental to financing such
as acting as referees, collecting and supplying information about
the foreign customers, providing remittance facilities, etc.
The foreign banks have also entered the field of internal trade.
They compete with the Indian commercial banks in attracting
deposits of all kinds, discounting of bills of exchange and making
advances to trade and industry. However, the financing of foreign
trade still remains their field of specialisation. The licensing of these
banks is controlled by the Banking Regulation Act, 1949. The
operations of these banks have been made subject to general control
of the Reserve Bank of India. Regard ing their foreign exchange
transactions, these banks are governed by the Exchange Control
Regulations.
5. Co-operative Banks: Co-operative banks are formed on the
principle of co-operation to extend credit facilities to farmers and
small scale industrial concerns and promote in general the habit of
thrift and self-help among the low and middle income groups of the
society. The distinguishing feature of a co-operative bank is the
absence of profit motive. Co-operative banks are very helpful to
meet the requirements of small farmers, artisans, etc. In India co-
operative banks have been the pioneers in mobilising rural deposits.
Co-operative banking has a three-tier structure. At the top there
is State Co-operative Bank at the state level. This is the apex bank
which governs all the co-operative banks in the State. At the
intermediate level, there are Central Co-operative Banks. There is
generally one central co-operative bank for each district. At the base
of the pyramid there are Primary Credit Societies a t the village level.
Each higher level institution is a federation of those below with
membership and loan operatiOns restricted to the affiliated units.
6. Rural Banks: In India, Regional Rural Banks have been set
up in backward rural areas where the coverage of the commercial
and co-operative bank is poor. The purpose of these banks is to
finance agricultural operations and provide employment to rural
educated youth who possess the requisite orientations to look after
the needs of rural folk.
Regional Rural Banks have been conceived to combine the
strong points of both the co-operative and commercial banks
eliminating the weaknesses of both. The Regional Rural Banks have
been included in the Second Schedule to the Reserve Bank of India
Act and, therefore, they enjoy the same privileges and facilities as
the scheduled banks, including access to the Reserve Bank for
financial accommodation.
7. Central Bank : Central bank of a country is the leading
institution created by law in its money market as it acts as a leader
of the money market. It supervises and regulates the activities of
commercial banks and other financial institutions. In India, this
role is played by the Reserve Bank of India. The Reserve Bank acts as
the bank of the bankers. It manages the issue and circulation of
currency and controls the creation of bank credit in order to ensure
stability in the economy. It supervises, guides and controls the
activities of all other banks in the country to bring them in line with
the policy of the central government.
The important functions of the Reserve Bank of India are as
given below:
(i) to issue currency notes;
(ii) to regulate, control and supervise commercial banks;
(iii) to regulate and control money market;
(iv) to regulate and control the banking business of the country;
(v) to frame policy and regulate and control the loans and
advances;
(vi) to implement the banking and financial policy of the
Government of India;
(vii) to regulate and control the foreign exchange; and (viii) to
publish monetary and financial information.
S. Exim Bank: The Export-Import Bank of India (Exim Bank)
was set up in January, 1982 with its headquarters in Bombay. Apart
from the normal banking functions connected with import arid
export of goods, the Exim Bank performs several other functions.
These include financing of exports from and imports to India,
financing joint ventures in foreign countries and financing the
export and import of machinery and equipment on lease basis. It
also undertakes purchasing, discounting and negotiating of export
bills.
9. NABARD : The National Bank (or Agriculture and Rural
Development (also known as Farm Bank) parted its operations with
effect from
July 15, 1982 as the apex bank for agricultural operations. The
Bank provides by way of refinance to banks all kinds of production
and investment credit to agriculture, small scale industries, artisans,
cottage and village industries, handicrafts and other allied economic
activities.

Chapter
19
INSURANCE
**
Insurance may be defined as a mechanism for giving financial
compensation for the effects of misfortune to a party out of the
accumulated contribution of the parties participating in the scheme.
The insurance scheme is run by an insurance company or
corporation. The insurance corporation brings toget~r a large
number of individuals who are exposed to similar kinds of risks. It
gives them an assurance against loss in consideration of the
insurance premium paid by them. Thus, under insurance, the risk
which would otherwise be borne by one individual is distributed
over a large number of individuals.
Insurance contract is a device by means of which a man can get
himself protected from .uncertain contingencies. In such a contract,
the insurer undertakes to indemnify or make good the. Joss of the
insured caused to him, by the happening of the uncertain event
insured for, to the extent of the sum agreed upon therein.
Insurance is a device by which a loss likely to be caused by an
uncertain event is spread over a large number of persons. The agency
which gives insurance facility is known as 'Insurer' or the insurance
company. The person who gets his property or life insured is known
as 'Insured' or 'Assured'. The agreement or contract, which is put in
writing, is known as a 'Policy'. The consideration in return of which
the insurer undertakes to make good the loss or to give a certain
amount in case of life insurance is known as 'Premium.
Insurance 293
Purpose of Insurance:
The purpose of insurance is to provide financial protection
against loss arising from any risks to which one may be subject. All
types of risks can now be insured against. Circus company can
insure against untoward incidents, a person can insure his life and
his property. A captain of the ship can be insured on a specific
voyage apart from his ordinary life insurance. However, the most
important forms of insurance are ; Life, Fire, Marine and Accident.
Advantages of Insurance:
Insurance confers great benefits on individuals and the society
as a whole. Some of the important advantages of insurance are as
follows:
1. Insurance is a good device of distributing the loss of a few
over a large number of persons. By paying a small premium,
the insured fee is assured that he is provided for any
financial loss that may arise from a specific event. This will
enables him to concentrate on his business.
2. Insurance adds to the credit-worthiness of the insured.
Loans can easily be obtained on the security of life
insurance policy. Life insurance is a means of promoting
thrift and the insured will save by way of insurance
premium.
3. Life insurance is an effective device for making provision
for old age. Life insurance also gives against risk of
premature death. In case of early death, the amount of the
policy is given to dependents of the insured. It he survives
period of insurance, his premium goes on accumulating
and he receives a lump sum amount on the maturity of he
policy.
4. Insurance gives a sense of security and safety. The insured
is relieved of the worries if any loss is sustained arising
from certain contingencies.
5. Insurance premiums represent the savings of the nation
and can well be used for the weaker sections of the society
of the country. Thus, insurance serves the national interest
also.
294 Insurance
6. The scheme of social insurance, like insurance against

sickness, old age, unemployment, accidents, etc., protect
people from many hardships. In the absence of insurance,
financial hardships may compel a man to theft or beggary.
Insurance not only helps stopping these by providing
financial assistance, but also saves the society which might
have to support such people.
Definition of Insurance:
D.S. Hansell has defined insurance "as a social device providing
financial compensation for the effects of misfortune, the payments
being made from the accumulated contributions of all parties
participating in the scheme".
According to W.A. Dinsale, "Insurance is a device for the transfer
of risks of individual entities to an insurer, who agrees, for a
consideration (called the premium) to assume to a specified extent
losses suffered by the insured".
Dictionary of Accounting edited by Prof. N.K. Sharma has
defined in$urance as a form of contract or agreement under which
one party agrees in return of a consideration to pay an agreed
amount of money to another party to make good for a loss, damage
or injury to something of value in which the insured has pecuniary
interest as a result of some uncertain event".
Insurance is a device by which a loss likely to be caused by an
uncertain event is spread over a large number of persons who are
exposed to it and who voluntarily join to insure themselves against
such an event. The agency which helps in entering into this
arrangement is known as 'Insurer' or the insurance company. The
persons who gets his property life insured is known as Insurer /
,Assured'. The agreement or contract, which is put in writing, is
known as a 'Policy'. The consideration in rehlrn of which the insurer
undertakes to make good the loss or to give a certain amount in case
of life insurance is known as 'Premium'.
Difference Between Assurance and Insurance:
The two words were used synonymously at one time, but now
a fine distinction is drawn between them. 'Assurance' is .used in
Insurance 295
those contracts which guarantee the payment of a certain sum on

the happening of a specified event which is bound to happen sooner
or later, e.g., attaining a certain age or death. Thus, life policies
come under assurance. Insurance, on the other hand, contemplates
the granting of agreed compensation on the happening of certain
events stipulated in the contract which are not expected but which
may happen. Thus, insurance refers to those risks which are
contingent in nature as fire, marine or accident.
Types of Insurance Contracts:
The contracts of insurance may be classified into the following
important categories:
(1) Contracts of Indemnity: Under a contract of the insurance,
company promises to indemnity or compensate the insured in case
of any financial loss suffered by him on the happening of the event
stipulated in the contract of insurance. Except the life insurance,
accident insurance and health insurance, all other types of
insurance are contracts of indemnity as they give for the
compensation to the insured for the loss caused to him because of
the event insured against. Marine insurance and fire insurance are
contracts of indemnity.
(2) Life Assurance Contracts : Under the life or personal
assurance contract, the insurer agrees to pay to the assured a
predetermined sum of money on the happening of a certain event.
This includes life, accident and health insurance. Since it is not
possible to measure the loss in terms of money in these cases, the
insurer agrees to pay a fixed amount on the happening of the event
stipulated in the contract. The life insurance contract contains an
element of security and investment both. The dependants or
assignees of the assured get the fixed amount in case of his early
death or the assured himself gets the assured sum together with
bonus after the expiry of the term, if he survives.
Contracts of indemnity can be further sub-classified into the
following categories:
(i) Property Insurance: Property insurance includes all
insurance contracts pertaining to the property of any kind. Marine
296 Insurance
insurance, fire insurance, crop insurance and vehicle insurance
are the examples of property insurance.
(ii) Liability InslIrance : A person liable to a third person under
the provision of certain Acts. For example, Workmen's
Compensation insurance and Third Party insurance involve
liability, on the happening on an accident in the factory and damage
to a third party due to a car accident on the road respectively.
(iii) GlIarantee InslIrance : It is an arrangement whereby the
insurer agrees to indemnity the insured for a fixed amount against
losses arising through dishonesty, fraud or a breach of contract.
Burglary insurance, fidelity insurance, credit insurance and cash
in transit insurance are some of the examples of guarantee insurance.
Principles of Insurance:
Contracts of insurance are based on some fundamental
principles. These principles are: (1) Utmost Good Faith, (2) Insurable
Interest, (3) Indemnity, (4) Subrogation, (5) Causa Proxima, (6)
Mitigation of Loss.
Re-insurance :
The insuring of a risk or a part thereof already undertaken by
one insurer with another insurer is known as re-insurance. Under
reinsurance, the contract is between two insurers. An insurer may
resort to re-insurance either with the object of spreading his risk or
to earn some profit when he is able to get re-insurance at a lower
rate of premium than taken by him. When this is done, the original
insured is known as re-insured and the subsequent insured, as
reinsure.
The contract of re-insurance does not affect the insured who is
not a party to it. Neither the insured has any remedy against the
reinsure. He can only make the original insurer liable for the loss
caused to him under the policy taken out by him. It is the insurer
who can claim compensation from the re-insurer. Suppose, a
shipping company has taken a policy of Rs. 10,00,000 from an
insurance company A. If A thinks the risk beyond its capacity, it
can re-insure for Rs. 5,00,000 with another insurance company B.
In case of total loss, A will pay the shipping company a sum of Rs.
10,00,000 and it will reimburse itself from B a sum of Rs. 5,00,000.
Insurance 297
Re-insurance is applicable to all kinds of insurance because
insurer has an insurable interest in the subject-matter insured to
the extent of the amount insured by him.
Distinction between Re-insurance and Double Insurance:
(i) The contract of re-insurance is entered into by the original
insurer with some re-insurer. There is no private of contract
between the insured and the re-insurer. But in double
insurance, the same insured gets the subject-matter insured
with more than one insurer.
(ii) In re-insurance, the re-insurer is liable to the first insurer.
In double insurance, each insurer is directly liable to the
insured.
(iii) In double insurance, loss will be shared by all the insurers.
In re-insurance, re-insured will claim his part of the loss
proportionate to the rist< insured by him.
(iv) Double insurance in a method of assuring the benefit of
insurance whereas re-insurance is a method of reducing
the risk of insurer.
Essentials of an Insurance Contract :
Following are the essential elements of a contract of insurance:
1. Essentials of a Valid Contract: Insurance is a contract
between two parties. Therefore, it must fulfil all the requirements of
a valid contract like offer and acceptance, competence of parties,
legal object, lawful consideration, etc.
2. Good Faith : A contract of insurance is a contract of
uberrimae fidei i.e., requiring good faith between the parties. The
insured must not conceal anything which is material to the subject-
matter of insurance.
3. Insurable Interest: The insured must have an insurable
interest in the subject-matter of insurance, i.e., life or property insured.
4. Indemnity: All insurance contacts except the life insurance
are the contracts of indemnity. Indemnity means to make good the
losses to the extent of losses caused to the insured.
298 Insurance
5. Subrogation: The insurance company gets all his rights
against the third party with respect to the subject matter insured
after compensating the loss of the insured. The insurance company
will have all the rights which the insured had against the third
party.
Utmost Good Faith:
Insurance contracts are based upon mutual trust and
confidence between the insurer and the insured. These are said to
be uberrimae jidei i.e., of utmost good faith. It is a condition of every
insurance contract that both the parties-the insurer and the
insured-should display the utmost good faith towards each other
in regard to the contract. Each party must reveal to the other party
all information which would influence the other's decision to enter
into the contract, whether such information is requested or not.
Utmost good faith requires each party to tell the other "the truth,
the whole truth and nothing but truth" about the proposed contract.
The insured must also disclose all material facts related to the subject
matter of insurance, even if not asked by the insurer, so that the
insurer may be in a position to estimate accurately the risk that he is
undertaking. The duty of good faith applies equally to the insurer,
who is bound to place at the disposal of the proposer all material
facts he possesses concerning the risk. Bad faith, i.e.,
misrepresentation or failure to reveal material information gives
the aggrieved party the right to regard the contract as void.
It is difficult to define material fact. It will depend upon the
circumstances of each case. A material fact is one which goes to the
root of the insurance contract. In other words, a fact is material if it
would influence the prudent insurer in accepting or declining the
risk or in fixing the conditions of insurance or rate of premium.
Some of the examples of facts which are quite obviously material
to an insurance contract are: Life insurance-a person has a known
lung inflection or a damaged kidney, (b) Fire insurance -a building
has a thatched roof or is being used for manufacturing explosives,
(c) Marine insurance-the ship has unrepaired damage affecting
its handling and (d) Burglary insurance-the premises had been
gurgled before. But it is significant to point out that a person cannot
Insurance 299
be penalised for not revealing facts which he does not know at all
and which he cannot reasonably be expected to know.
(i) Utmost Good Faith: A contract of insurance is a contract of
uberrimae fidei, i.e., requiring good faith between the parties. The
insured must not conceal anything which is material to the subject-
matter of insurance.
Utmost good faith requires each party to tell the other "the truth,
the whole truth and nothing but the truth" about the proposed
contract. The insured must also disclose all material facts related to
the subject-matter of insurance, even if not asked by the insurer, so
that the insurer may be in a position to estimate accurately the risk
that he is undertaking. The duty of good faith applies equally to the
insurer, who is bound to place at the disposal of the proposer all
material facts he possesses concerning the risk.
(ii) Insurable Interest: Insurable interest means some pecuniary
interest in the subject-matter of insurance contract. Hansell has
defined insurable interest as afinancial involvement which is able to be
insured. Existence of insurable interest in the subject-matter of
insurance is a necessary pre-requisite of any insurance contract.
The insured must either own a part or whole of it or he must be in
such a position that injury to it would affect him adversely. For
instance, a man who gets his motor car insured against accident
has an insurable interest in it. If the car is damaged, it would cause
him financial or pecuniary-loss.
A person has insurable interest in the building he owns, a
businessman has insurable interest in his stock, plant and
machinery and building, a person has insurable interest in his own
life. A person can also get the life of a person insured if he has
pecuniary interest. For the purpose of life insurance, interest exists
in the following cases: husband in the life of his wife and wife in
the life of her husband, parents in the life of a child the creditor on
the life of a debtor, an employer in the life of his employees and the-
partners in the lives of one another.
The time at which insurable interest must exist vary according
to the type of insurance. In case of fire and accident insurance, the
insurep must have an insurable interest in the subject-matter insured
300 Insurance
against fire or accident continuously from the time when the policy
is taken out until the time when then the loss occurs.
In case of life insurance, the insurable interest must be present
at the time the policy is taken out but not necessarily at the time
when the claim is made.
In case of marine insurance, insurable interest is required to
exist only at the time of loss, i.e., on the happening of the event
insured against. In short, insurable interest remains in the beginning
of life insurance, in the end of marine insurance and in the beginning
and end of fire insurance.
(iii) Indemnity: All insurance contracts, other than those related
to life, sickness and personal accident, are contracts of indemnity.
A contract of indemnity may be defined as a promise to save another
harmless from the loss caused as a result of a transaction entered
into at the instance of the promisor. Thus, in case of fire and marine
insurance, the insurer will compensate the insured for the loss
caused to him by the damage or destruction of the property insured.
The principle of indemnity is of a great importance in case of
fire and marine insurance. The purpose of this principle is to put
the insured in the same position after the event happened (i.e., loss
to property) in which he was immediately before the event. It should
also be noted that the insurance company agrees to compensate the
insured only to the extent of the loss suffered by him up to the limit
of the amount covered by the policy. The insured is not allowed to
make any profit on the happening of an event.
For example, a ,building is insured against fire for Rs. 10 lack
and a portion of it is burnt down. Suppose, it is estimated that an
expenditure of Rs. 4 lack will restore the building to its original
condition. In this case, the insured will get Rs. 4 lack only and no
more.
(iv) Subrogation: The principle of subrogation applies to all
insurance contracts which are contracts of indemnity. Subrogation
means the right which one person stands in place of another and
avail himself of all the remedies and rights of that other.
Subrogation does not apply to life, accident and sickness
insurance as they are not covered by the principle of indemnity.
Insurance 301
The insurer obtains the rights of the insured after he has settled the
claim of the insured. The rights have to be exercised of the name of
the insured unless the insured abandons the subject-matter and the
insurer accepts it. The insurer is entitled to the benefits out of right
of subrogation only to the extent of the amount he has paid to the
insured as compensation. It is also obvious that if the insured
receives any compensation from any third party for the loss incurred
by him, he holds such amounts as the trustee of the insurer who has
already compensated him for the loss.
(v) Contribution: Like subrogation, the principle of contnbution
also applies to any insurance which is a contract of indemnity.
Thus, it does not apply to life and personal acsident insurance. The
principle of contribution limits the amount chainable from
individual insurers so that the amount payable be each insurer is
determined by his ratable proportion of the loss and set by the sum
insured by him.
The insured is not prevented, from taking out two or more
policies on the same property. But in case of loss, when more than
one policy are in force covering the same interest in the same
property, the insured has no right to recove!' more than the full
amount of his actual loss. However, the insured may get the
compensation in proportion to the amount insured by each. Thus,
if anyone of the insurers has made good the whole loss to the
insured, he is entitled to the ratable contribution from the other
insurers.
(vi) Causa Proxima: Causa proxima is a Latin phrase which
means Proximate cause or cause which, in a natural and unbroken
series of events, is responsible for a loss or damage. According to
this principle, the insurer is liable for loss only when such a loss is
proximately caused by the peril insured against.
If the risk insured is the remote cause of the toss, then the insurer
is not bound to pay compensation. This problem arises when there
is a succession of causes. In such cases, the proximate or the nearest
cause should be taken into account to determine the liability if the
insurer. The insurer is liable to pay if the proximate causes is insured
against. For instance, if the loss is the result of two census, it is
302 Insurance
necessary to look into the nearest cause and not the remote one. If
the nearest cause is insured, the insurer is liable for the loss.
Life Insurance:
In a contract of life insurance, the insurer undertakes to pay a
certain sum of money on the death of the insured or on the expiry of
a fixed period, whichever is earlier. The premium for life insurance
may be paid by the insured either in lump-sum or in installments at
regular intervals- monthly, quarterly, half-yearly, or yearly.
Life insurance furnishes a sense of security. The person whose
life is insured is called the assured. The consideration paid to the
insurer (insurance company) is called the premium. The periodical
payments made by the assured towards the total premium are
known as installments. Usually, non-payment of any installment
of premium brings the insurance contract to an end.
The essential elements of a life insurance contract are as follows:
1. It is based on good faith. The assured must disclose all
material facts about his health whether asked by the insurer
ornot.
2. It is based on insurable interest in the life assured. The
insurable interest must be present at the time of taking-up
the policy.
3. It is not based on the principle of indemnity as there can be
no compensation for the life lost. However, the amount
payable will depend upon the terms of policy.
Kinds of Life Insurance Policies
Important kinds of life insurance policies have been discussed
below:
1. Whole Life Policy: Under this type of policy, the sum insured
is not payable earlier than death of the insured. The premia on such
policies may be payable regularly throughout the whole life of the
assured or they may be payable for a fixed period (say 20 or 30
years) after which the payment of premium ceases. If the premia are
payable throughout life, it is called 'Ordinary Life' policy. If the
premia are payable only for a limited number of years, the policy is
called 'Limited Payment Life Policy'.
Insurance 303
2. Endowment Life Assurance Policy: Under this policy, the
insurer undertakes to pay the assured or his heirs or nominees a
specified sum on the attainment of a particular age or on his death,
whichever is earlier. In case of the death of assured before he attains
the specified age, the sum is payable to his legal heirs or nominees.
The premium for endowment policy is a bit higher than that of
whole life policy.
3. Joint Life Policy: A joint life policy involves the insurance
of two lives simultaneously. The policy money is payable upon the
death of anyone of lives assured and the assured sum will be
payable to the survivor or survivors. The most common example of
joint life policy is that of a policy on the lives of a husband and wife,
payable to the survivor on the death of either of the two.
4. Annuity: An annuity provides for the payment of insured
amount in monthly or annual installments for a certain period. The
fixed periodical payments may continue either until death or for a
specific number of years. Insured in this case is asked to deposit a
lump sum of money in the beginning of the policy. Insured may, at
his option, get the annuities commuted again into a lump sum.
These policies are generally taken with the object of making
provision for old age.
S. With or Without Profit Policy: Holders of with profit
policies get the benefit of bonuses declared out of the profit of the
corporation every two years. Bonuses shall be added to the value of
the with profit policy and shall be paid on the maturity of the policy.
6. Children's Endowment Policy: The policies are taken fox
the purpose of education of children and marriage expenses of
daughters. The insurer agrees to pay a certain sum when the child
attain a certain age. Premium is payable by the person entering into
the contract. But if he dies before the maturity of policy, no further
premium is payable.
Fire Insurance:
Under a fire insurance contract, the insurer undertakes, on
payment of the premium, to payor make good to the insured any
loss or damage by fire which may happen to the property insured
during the period covered by the policy, up to the amount specified
304 Insurance
in the policy. The contract specifies the period during which the
indemnity is to last and also the maximum amount to which the
insurer can be held liable.
Generally, a contract of fire insurance is a contract from year to
year only and the insurance automatically comes to an end after the
expiry of the year. However, the contract can-be renewed before
the expiry of the contract. The premium may be paid either in single
installment (lump sum) or by way of installments. The document
containing the terms and conditions of the contract is known as
'Fire Insurance Policy'.
Characteristics of a Fire Insurance Contract :
Following are the essential features of a contract of fire
insurance:
1. It is a contract of uberrimae fidei, i.e., utmost good faith. Both
the, insured and the insurer must disclose everything which
is in their knowledge and can affect the contract of
insurance. The disclosure by the insured regarding the risks
to his property and regarding the nature of the groperty
must be full and fair.
2. It is a contract of indemnity. The insured is entitled to recover
only the actual amount of loss from the insurer, in the event
of any loss or damage to the subject-matter of insurance.
He cannot be allowed to make profit out of this contract.
The maximum amount of compensation is limited to the
value for which the policy has been taken.
3. The insured must have an insurable interest in the subject
matter of insurance. Insurable interest means some
pecuniary interest in the property to be insured which is
capable of valuation. It must exist both at the time ofinsurance
and at the time loss.
4. The contract of fire insur:ance is subject to the principles of
subrogation and contribution. After the insurance company
compensates the insured for the loss caused to him, the
former is subrogated to the rights of the insured. In case of
several insurance policies, each insurer is liable to
contribute to the amount of compensation to be paid to the
insured.
Insurance 305
5. The insurer is liable to make good the loss only when fire is
the proximate cause of damage or loss. There is generally a
clause in most fire insurance policies by which the insurer
exonerates his liability if the fire is caused by riot, war, and
explosives. In the absence of such a clause, the insurer is
liable to make good the loss caused by fire due to any reason.
6. It is a contract from year to year. It generally comes to an end
after the expiry of the year and may be renewed, after
making payment of the premium within the days of grace.
7. The contract is personal to the insured. It is not assignable
without the consent of the insurer. There is only one
exception to this rule, i.e., where the insurer interest ceases
by will or operation of law. However, the insured may
assign the proceeds of such a policy.
Some of the important fire insurance policies are explained
below:
1. Valued Policy: Valued policies are the exception in fire
insurance. Under valued policy, the value declared in the policy is
the amount the insurer will have to pay to the insured in the event
of a total loss, and the insurer agrees to pay this amount irrespective
of the actual value at the time of loss. The policy is issued only on
artistic work, antiques and similar rare articles whose value cannot
be determined easily. The insured knows in advance the exact
amount of compensation payable to him in case of loss. He need not
prove the value of the insured article at the time of loss.
2. Specific Policy: Under this policy, the insurer undertakes
to make good the Loss by fire up to the amount specified in the
policy. Thus, the value of the property is not taken into account. The
insurer will pay the whole loss to the insured if it does not exceed
the specified amount menti(lned in the policy. Suppose, a building
worth Rs. 20,00,000 is insured against fire for Rs. 10,00,000. If the
damage to the property is Rs. 7,00,000 the insured will get the full
compensation. Even if the loss is Rs. 10,00,000, the insured will get
the full amount. But if the loss is more than Rs. 10,00,000 (i.e., the
amount insured), the insured wlll get Rs. 10,00,000 only. Hence, the
value of property is not relevant in determining the amount of
indemnity in case of a specific policy.
306 Insurance
3. Average Policy: Under a fire insurance policy containing

the 'average clause', the insured is penalised for under-insurance
of the property. In other words, the insurer is liable to pay that
proportion of actual loss as the value of policy bears to the actual
value of the property at the time of loss. The amount of claim is
arrived ~t by dividing the insured sum by the actual value of the
property and then multiplying it by the amount of loss. For example,
a person gets his house insured for Rs. 40,00,000, though its actual
value is Rs. 60,00,000. If a part of the house is damaged in fire and
suppose that the insured suffers a loss of Rs. 30,00,000. The amount
of compensation to be paid by the insurer comes out to Rs. 20,00,00
arrived as follows:
Amount of claim : Insured Amount x Actual Loss

Actual Value of Property
= 40,00,000 x 30 00 000 = Rs. 20 00 000

60,00,000 " , ,
4. Floating Policy: A floating policy is used for mercantile

risks and covering fluctuating stocks held in different lots and
several places under one sum and for one premium. It is taken by
big businessmen whose goods lie in different stations, ports and
warehouses. Since with every transaction of sale or purchase, the
quantities of goods stored at different places may fluctuate, it
becomes difficult for the owner to take a policy for a specific amount.
The best method open to him is to take out a floating policy for all
the goods. Usually, a floating policy contains the 'average clause'
to discourage under-insurance by the insured.
5. Replacement Policy: In such a policy, the insurer has the
right to reinstate or replenish the property destroyed instead of
paying compensation to the insured in cash. The modes of discharge
by the insurer are alternative. If he elects one, he cannot afterwards
shift to other. Thus, if he offers to pay cash compensation, he cannot
subsequently claim to [reinstate and vice versa. Since this policy
allows the policy-holder to obtain new goods for c d, the policy is
also called "New Lamps for Old Policy".
Insurance 307
6. Consequential Loss Policy : When fire breaks out in a

factory, it disrupts production because the factory has to be closed
for repairs. The production suffers and so also profits of the insured.
He has also to meet the fixed expenses such as rent, rates, taxes,
salaries and other expenses as usual. Such considerable loss to the
insured is not covered by the ordinary fire policy, in order to cover
such loss by fire, the "consequential loss policy" or "loss of profits
policy" has been introduced. The loss so suffered is separately
calculated from the loss actually suffered.
Marine Insurance:
Under a contract of marine insurance, the insurer undertakes
to indemnity the insured in the manner and to the extent thereby
agreed, against marine losses. Marine insurance is an arrangement
by which the insurer undertakes to compensate the owner of a ship
or cargo for complete or partial loss at sea.
Among the subject-matters of marine insurance are the ship,
cargo and freight. The insured undertakes to pay a certain sum of
money called the premium in consideration of the insurer's
guarantee to make good the losses arising from certain specific perils
which may include 'perils of the sea' as well as any land risk
incidental to sea voyages.
The contract is embodied in a document known as 'Marine
Policy'. The marine policy must specify the following:
(a) The name of the insured or of some person who affects the
insurance on his behalf.
(b) The name of the insurer.
(c) The subject-matter insured and the risks insured against.
(d) The voyage, orperiod of time, or both, as the case may be.
(e) The sum assured.
(f) The rate or amount of premium.
Subject-matter of Insurance:
The insured may be the owner of the ship, owner of the cargo or
the person interested in the freight. Thus, marine insurance may be
of three types, namely, hull insurance, cargo insurance and freight
insurance.
308 Insurance
(a) Hull Insurance: A vessel is exposed to many dangers or
risks at sea during the voyage. An insurance effected to indemnity
the insured for such losses is known as hull insurance.
(b) Cargo Insurance : The cargo transported by sea is also
subject to manifold risks at the port and during the voyage. The
cargo can be insured to cover against such risks.
(c) freight Insurance: The shipping company has to forego its
right of receiving freight on the cargo, if it does not reach the
destination safely. Freight insurance may be issued to reimburse
the loss of freight to the insured in case the cargo does not reach the
place of destination.
Kinds of Marine Insurance Policies:
The main kinds of marine policies are discussed below:
(i) Voyage Policy: A voyage policy is one by which the subject-
matter is insured on a specified voyage from the port of departure to
the port of destination. Thus, the limits of risk are defined by the
places. The risk which is covered starts from the departure of ship
from the port and it ends when the ship reaches the port of
destination. Voyage policy is suitable for cargo insurance as it covers
the risk during transit.
(ii) Time Policy: Under time policy, the insurance is affected
for a specified period of time irrespective of the number of voyages
made. The ship may pursue any course. The policy would cover all
the risks: from the perils of sea for a stated period of time, say, from
1st August, 1993 to 30th April, 1994. Under the Marine Insurance
Act, a lime pOlicy cannot be for a period exceeding 12 months.
However, the policy may contain a 'continuation clause' providing
that if at the end of the period, the ship is yet at sea, the policy 'will
continue for a reasonable time thereafter till the ship arrives at the
port of destination. This kind of policy is suitable for null insurance.
(iii) Mixed Policy: It combines the characteristics of a time policy
and voyage policy. It insures the subject-matter from and to certain
places between a specified period, e.g., Bombay to New York from
1st December 1993 to 30th November'1994. In other words, it is a
policy which covers the risk during a particular voyage for a
specified period. It is known as 'Time and Voyage Policy' and is
generally issued for ships operating over particular routes.
Insurance 309
(iv) Valued Policy: Under valued policy, the value of the subject-
matter insured is specified on the face of the policy itself. The value
which is agreed upon is called the insured value. It forms the
measure of indemnity in the event of loss. Insured value is not
necessarily the actual value. It includes the following:
(a) Invoice price of goods:
(b) Freight, insurance and other charges; and
(c) Ten to fifteen percent margin to cover expected profits and
other incidental charges.
(v) Unvalued Policy: An unvalued policy does not state the
value of the subject-matter of insurance. In case of loss or damage,
the compensation is ascertained by assessment of loss, subject to
the limit of the sum insured. The value so left undecided is called
'insurable value'. It is ascertained as follows:
(1) As regards the ship, the value includes its cost, provisions
and stores, money advanced for wages and disbursement
to make the ship fit for the voyage plus the charges of
insurance. '
(2) As regards freight, the value includes the gross freight
including the charges of insurance.
(3) As regards cargo, the value is the cost of cargo plus the
expenses of and incidental to shipping and the charges of
insurance.
(vi) Floating Policy: A merchant who is a regular shipper of
goods can take out a 'floating policy' to avoid the botheration and
waste of time involved in taking a new policy for every shipment.
The floating policy stands for the contract of insurance in general
terms and leaves the details to be declared subsequently. Whenever
some" cargo is shipped, the, insured makes a declaration about the
value of shipment ~nd the total value of the policy is reduced by
that amount. With each declaration, the amount of insurance policy
goes on decreasing. When the policy is fully covered, it is said to be
'fully declared' or 'run-off'.
(vii)Block Policy: It is a special type of marine insurance policy.
When goods will be transported by land transport to be further
transported by ship to the place of destination, a single policy, known
as block policy, may be taken to cover all the risks.
Types of l\.1iKine Losses:
310 Insurance
The risks to which vessel, cargo, and freight are exposed during
their shipment by sea are known as marine losses. Marine losses
may be divided into two broad categories: (a) Total loss, and (b)
Partial loss, A total loss may be either total loss or constructive total
loss. A loss other than a total loss is partial loss. That means a
partial loss occurs when the articles are not destroyed totally. Partial
loss may be either particular average loss or general average loss.
Insurance can be taken, to cover either total loss or partial loss or
Actual Total Loss:
Actual total loss occurs in the following circumstances:
(a) When the subject-matter insured is totally destroyed as in
case of sinking of a ship or cargo being absolutely destroyed
by fire.
(b) Where the subject-matter insured is so damaged that .it has
changed its nature and ceases to be a thing of the kind
insured. For instance, sugar dissolved by sea water.
(c) When the insured is irretrievably (which cannot be
recovered) deprived of the possession of the subject-matter
e.g., ship or goods have fallen into the hands of enemy or
pirates.
In the above cases, the insured is entitled to get the full amount
of loss.
Constructive Total Loss:
A constructive total loss occurs when'the subject-matter of
insurance, though not actually destroyed or lost, is justifiably
abandoned because its total loss appears unavoidable or when it is
so damaged that it is commercially impracticable to repair, recover
or restore it to the original position. Commercial impracticability
means that the cost of recovering or repairing the subject-matter
exceeds its repaired value.
For instance a ship has stranded or struck against a rock and is
badly damaged. If the expenses in getting the ship ashore and
repairing it are likely to equal or exceed the repaired value of the
ship, the ship-will be abandoned. Such loss is called a constructive
total loss. Similarly, if a ship is wrecked and cargo can be saved by
removing the goods from the wrecked ship and bringing them to
the port, it-will not be prudent to do so if the cost of removing the
Insurance 311
cargo and carrying it to the port is either equal or more than the
value of the cargo. In this case, the goods will be abandoned and
such loss is known as constructive total loss.
Partial Loss:
A loss which does not either completely destroy or render
worthless the insured property is known as partial loss. Under
marine insurance, when the subject-matter is partially lost or
destroyed, the loss is technically called 'average'. Thus, 'average'
means loss or damage or expenses caused by a loss or damage to a'
ship or its cargo. Partial loss may be either particular average loss
or general average loss.
(i) Particular Average Loss: It is any partial loss or damage or
expense from loss or damage to a ship or part of its cargo which,
results from an accident or from the normal perils of the sea. Such a
loss can be recovered only if it is caused by a peril insured against,
and the loss is accidental. For instance, X's goods lying on board
ship are damaged due to an accident, the loss would be a particular
average loss. If his goods are insured, he can recover the loss from
the insurer. Here the loss is borne where it falls and not suffered for
the benefit of all. However, particular charges are not included in
the particular average loss. Particular charges are those expenses
which are incurred on behalf of the insured for the safety or
preservation of the subject-matter insured.
(ii) General Average Loss: It is any loss or damage which results
from actions taken by the captain or any other officer of the ship to
protect or preserve the ship itself or the passengers and crew, or the
cargo in general. It is an extraordinary loss, dampge or expenditure
reasonably and voluntary incurred for the purpose of preserving
all or any of interests, shift, cargo, or freight. General average loss is
caused directly by a general average act. There is general average
act when any extraordinary sacrifice or expenditure is voluntarily
and reasonably made or incurred in time of peril for purpose of
preserving the property imperiled in the common adventure.
The characteristics of a general average less are as follows:
1. The loss must be caused by a necessity for sacrifice for the
sake of the adventure as a whole.
312 Insurance
2. The sacrifice or expenditure must be extraordinary in
nature and must be made with the object of securing
common safety of the ship and cargo.
Comparative Study of Life, Fire and Marine Insurance:
Basis Life Insurance Fire Insurance Marine Insurance

1. Indeminity or Not based on the Based on the prin- Based on the prin-
Compensation principal of indem- ciple of indemnity ciple of indemnity.
nity. The assured, The insured can The insured can
if he survives or his claim the actual claim the cost of
dependents are market value of the goods destroyed
entitled to the sum property de- by perils of sea
assured. stroyed by fire. plus a reasonable
margin for antici-
pated profits.
2. Insurable Inter- Insurable interest Insurable interest Insurable interest
est must exist at the must exist at the must exist at the
time of taking the time taking the time of actual loss
policy. policy and at the only.
time of actual loss.
3. Period Life assurance is Fire insurance Marine insurance
for a long period policy is generally policy is either for a
ranging from 10 to for on year. voyage or for one
30 years. Whole year.
life policy may also
be taken.
4. Assignment Life assurance Fire insurance Marine insurance
policy can be as- policy can't be as- policy can be as-
signment without signed without the signed without the
the permission of permission of the permission of the
the insurance insurance com- insurance com-
company. pany. pany.
5. Measurement Not measurable. Measurable. Measurable.
of loss
6. Double Insur- Benefit of double or Benefit of double Benefit of doble in-
ance multi insurance is insurance is not al- surance is not al-
allowed. lowed. lowed.
7. Contingency of Risk is inevitable. Risk is contingent Risk is contingent
and uncertain. and uncertain .

Chapter
20
tItI
WAREHOUSING
A warehouse may be defined as a place used for the storage or

accumulation of goods. Warehousing is a necessary business
activity to carryon production and distribution on a large scale.
Warehouses help the businessmen to keep their stocks in safe
custody during dull seasons. They can carryon production
throughout the year and can sell their products whenever there is
effective demand. Thus, warehousing creates time utility.
Importance of Warehousing:
Warehousing has become an indispensable service in these
days. Producers, manufacturers, traders, mercantile agents,
importers and exporters engaged in business have to store their
goods in warehouses. Goods are produced or procured well in
advance of the demand. The are stored m warehouses till they are
actually Mid in the market. Thus, warehousing creates time utility.
In addition, modem warehouses perform certain marketing services
also, such as grading, packaging, labelling, etc.
The need for storage of goods arises due to the following
reasons:
1. Regular Supply: Manufacturers produce the goods in
anticipation of demand; so the goods must be stored to make them
available to the customers whenever needed:
314 Warehousing
2. Stock for Trade: Storage has to be done by the middlemen
because consumers are not interested in storing goods (if they are
easily available in the m~rket) because of limited space and limited
purchasing power.
3. Seasonal Goods: Many of the products are produced
seasonally while the demand for them has to be met all the year
round. For instance, wheat is harvested during April and May, but
it has to stored to meet the demand all through the year.
4. Continuous Production: In order to enable the modern
concerns to produce on a large scale basis, it is necessary to hold
raw material in stores. This will ensure continuous large-scale
production.
5. Quality: Some materials take time before they are ready for
sale. Therefore, in such cases, storing is necessary. In some cases,
goods are stored to improve their quality and value with the passage
of time. Rice, wine, tobacco, etc. are some of such examples.
6. Price Stabilisation: Storage is necessary to regulate the
prices of the products. This is mainly done by the government to
keep the prices within certain limits.
Function of a Modern Warehouse:
A modern warehouse performs the following important
functions :
(i) Time utility: It removes the hindrance of time. It is not
necessary that the timings of production and consumption of goods
coincide with each other. Goods which are not immediately required
can be stored in the warehouses.
(ii) Safety ofgoods: It safeguards the stocks of merchants and
saves them from the urgency of making sales for want of supply of
stored goods.
(iii) Regular supply: It facilitates smooth supply of goods in the
market and removes violent fluctuations in supply.
(vi) Packaging: It provides the facilities of processing, packing,
blending, etc. of due goods for the purpose of sale.
Warehousing 315
(v) Payment of Duties: A bonded warehouse removes the

urgency of paying customs duty. An importer can postpone the
payment of customs duty until he draws goods from the bonded
warehouse.
(vi) Financing: It helps in financing the trade. Warehouse receipt
can be used as collateral security to borrow from the financial
institution.
Types of warehouses:
Warehouses may be classified into following three categories:
(1) Private warehouses,
(2) Public warehouses, and
(3) Bonded warehouses.
(1) Private Warehouses: These warehouses are owned by the
manufacturers (traders) to store the goods manufactured or bought
by them until they are, sold out. Manufacturers generally hold goods
back until the conditions are suitable. Merchants also find it more
convenient to deliver goods directly from their own warehouses.
Big manufacturers and traders generally have their own warehouses
in the rural or suburban areas where space is available at cheaper
fates. :
(2) Public Warehouses: Public warehouses are organized to
give storage facilities to the traders, manufacturers, and
agriculturists in return for a storage charge. Anybody can keep his
goods in the public warehouse by paying the necessary charges.
The owner of a public warehouse stands as an agent of the owner of
goods. He is required to take as much care of goods kept in his
custod y as he would have taken of his own goods.
Public warehouses are licensed by the Government and are
subject to Government regulations in respect of method of operation.
The Government gives encouragement to start public warehouses
in the cooperative sector. Public warehouses provide useful services
to the businessmen. They provide for full safety of the goods. They
provide transport facilities for receiving and shipping the goods.
Traders or manufactures can borrow funds on the security of
316 Warehousing
warehouse receipts. Buyers can be taken to the warehouses to

inspect the guods. The public warehouses also provide certain
services for the sale of the products such as packaging, branding,
etc
(3) Braided Warehouses: Bonded warehouses are located near
the ports and are run under the supervision of the customs
authorities. These may be owned by the dock authorities or private
persons. But m either case, they have to work under the close
supervision of customs authorities.
They provide invaluable services to the importers. An importer
can make use of bonded warehouse facilities by getting permission
of the customs authorities. The goods deposited in such a warehouse
are said to be in bond. The importer can withdraw the goods from
the warehouse in installments by making the proportionate
payment of the import duty. Thus, he need not block his funds
before he requires the goods for consumption or industrial use.
Moreover, the goods stored in a bonded warehouse can be
branded, blended, packed and repacked in the warehouse itself.
The _importer is also allowed to take buyers to the warehouse for the
inspection of goods.
Packaging:
Package means a container, case, wrapper or other receptacle
for packing the goods. Packaging is concerned with designing and
producing of appropriate packages for a product. Packing means
wrapping, filling or crating of goods for the purpose of protection of
goods and their convenient handling. Bulky materials like cotton
and jute are compressed into bales, liquid materials like wine and
squash are placed in bottles and cans. Heavy goods are crated and
fragile goods are placed in boxes or special containers. Packing is
essential for placing various kinds of goods in appropriate
packages. Good packing not only means greater attention of the
customers but also increases the durability of the product.
Another concept which has gained popularity along with
packaging is labelling. Labelling means putting identification
marks on the package. The label is an important feature of a product.
Warehousing 317
It is that part of a product which contains information about the

producer of the product. A label may be a part of a package or may
be a tag attached directly to the product. The label is used to
communicate brand, grade and other information about the product.
Significance of Packaging:
In the present age of consumer oriented marketing, the need for
packaging is felt more than ever before. Thus, packaging has become
one of the essential services of modern marketing. Packaging acts
as a multi-purpose arrangement. It gives protection to goods on its
route from the manufacturer to consumer. It even protects the goods
during its life with the user. Packaged goods are generally more
convenient to handle. Packaging also gives individuality to a
product. It makes it easier to identify a product by looking at its
package.
Packaging facilitates the sale of a product. It acts as a silent
salesman of the manufacturer, particularly at a place where there is
widespread of self-service, automatic vending and other self-
selection methods of retail selling. Sometimes, packages are duly
sealed to ensure products of right quality to consumers. In the
absence of sealing, duplicate products may be distributed to the
consumers by the unscrupulous dealers.
Packaging increases the utility of branding a product. The
brand name and mark can be printed on the packages and it may be
used for advertising the product. The packaged goods also do some
sort of self-advertisement. The package advertising copy lasts as
long a the product is used in its packaged form. The user is every
time exposed to the message on the label whenever he uses the
product. Packaging can also be used for giving information about,
the benefits and uses of the product.
Utitlity of Packaging in modem business:
The functions of packaging in modern business are as follows:
(1) Protection of Goods: This is the basic purpose of packaging.
Packaging protects the goods during its transit from the
manufac~rer to user and its use with the user.
318 Warehousing
(2) Easy Handling: Packaged goods are easy to handle.
Handling instructions can also be mentioned on the package to
ensure safe handling of goods e.g., "GLASS, HANDLE WITH
CARE". Moreover packaging is a must for many of the goods such
as Rice, Ghee, Butter, Acids, etc.
(3) Preventing Loss and Wastage: Packaging is necessary to
prevent evaporation of gaseous articles such as spirit and acid. It is
also necessary for preventing liquids flowing out such as drinks,
oils, fruit, juice, milk, etc.
(4) Maintaining Quality: Some goods are perishable in nature.
In order to maintain their freshness and quality, they have to be
packed in airtight containers.
(5) Preventing Adulteration: Packaging is also necessary to
prevent adulteration of goods by the unscrupulous traders. For
instance, Ghee, Oils, Cheese, etc. need sealed packaging to prevent
any possibility of adulteration.
(6) Publicity to Product: Packaging gives individuality to the
product and this acts as a device of publicity. Manufacturers choose
attractive packages so that the users are able to remember and
identify their products.
(7) Sales Device: Packaging helps in pushing up the sales of a
product. It beautifies the product so as to attract the customers. A
customer may be ready to pay a higher price of a product because
its package is very attractive and reusable. For instance, coffee jars
and pickle jars are reusable. If they are attractive, they will draw the
attention of customers very quickly. Thus, packaging acts as a silent
salesman.
Advertisement:
Advertising is used for communicating some business
information to the present and prospective customers.
Advertisements usually provide information about the advertising
firm, its product, product qualities, place of availability of its
products, etc. An advertisement provides information to the
prospective buyers and helps the producers to inform the
prospective buyers about .their products.
Warehousing 319
Advertising is any paid form of non-personal presentation and

promotion of ideas, goods or services of an identified sponsor. The
message which is presented or disseminated is known as
Iadvertisement'. All activities necessary to prepare the message and
get it to the intended people are part of advertisement'.
I
Characteristics of Advertisement:
The important features of advertising are discussed below:
(i) It is a non-personal form of presentation and promotion of
ideas, goods or services. There is no face-ta-face direct
contact with the customers. It is also described as non-
personal salesmanship.
(ii) It is a paid form of communication. The advertiser has to
pay for the message.
(iii) It is done by a sponsor, usually a producer, dealer or trader.
Functions of Advertising:
Advertising is beneficial not only to the manufacturers, traders,
but also to the consumers and the society. The role of advertising in
a competitive economy will be clear by going through the following
functions it performs:
(i) Advertising promotes the sale of goods and servjces by
informing and persuading the people to buy them.
(ii) Advertising facilitates the introduction of new products in
the market.
(iii) Advertising facilitates production on a large scale because
the advertiser is able to distribute the product on a large
scale.
When production is carried on a large scale, the cost of
production per unit is reduced. The benefit of low Cost
may be transferred to the consumers.
(iv) Advertising helps a business enterprise to communicate
its achievements and its efforts to satisfy the needs of the
society. This builds up the reputation of the advertiser.
320 Warehousing
(v) Advertising educates the people about the availability of
new products and their different uses. It stimulates the
people to adopt new ways of life and increase their standard
of living.
(vi) Advertising provides employment to the people engaged
in designing and disseminating advertisements. It also
generates employment by facilitating production and
consumption on a large scale.
(vii) Advertising sustains the press. Advertisements are an
important source of revenue to the newspapers and
magazines.
Benefits of Advertising to Manufacturers and Traders :
1. Generates Demand: Advertising creates demand for the
products of a company. It helps to build a favourable image of the
product in the minds of customers. It arouses interest and desire to
purchase. ' Brand loyalty is built up through repeated advertising.
This helps in stimulating the demand for the product.
2. Creates Good Image: Advertising helps in creating a good
image of the firm and its products. Consumers are persuaded to
patronise the new products developed by the firm from time to time.
Repeat orders could be secured easily through advertising.
3. Less Cost: Advertising reduces the cost of production by
making large-scale production possible through creation of demand.
The large-scale production reduces the total cost per unit of
production.
4. Easy Distribution: Advertisement creates demands for the
products and simplifies the distribution work of the manufacturer.
Middlemen themselves offer their services and demand lesser
incentives, which reduces the overall cost of distribution.
5. Introduction of New Products : It creates demand for new
products by informing people about the availability and suggesting
them about the use of such goods.
Advantages of Advertising to Consumers and Society:
1. Easy Shopping: Advertising facilitates purchasing by
educating consumers to select correct brands of commodities which
increase their satisfaction.
Warehousing 321
2. Educates Consumers: Advertising educates the consumers
about the new products and their uses. In this process, it introduces
new "ways of life to the people at large and prompts them to give up
their old habits. Advertising thus paves the way to better standards
of liVing.
3. Elimination of Unnecessary Intermediaries: By advertising
his goods, a manufacturer may seek to establish direct contacts
with the consumers. In this process, the number of middlemen whose
profits increase the price and reduce the manufacturer's margin of
profits may be considerably reduced. This will mean large profits
for the manufacturer and cheaper products for the consumers.
4. Good Quality: It ensures good quality ofproducts. Advertising
encourages manufacturers to produce better quality products which
boosts the confidence of the consumers and ensures them availability
of good quality products.
5. Economic Growth: Advertising promotes healthy
competition and provides better quality goods at cheaper rates to
the society. It encourages healthy growth of the business and acts
as a barometer of nation's economic growth.
Media of Advertisement:
There are various advertising media available to the advertiser.
Each medium has its own advantages and disadvantages. So the
advertiser has to choose a medium suitable for the situation. The
selection of a particular medium is determined by the nature of the
goods, the types of customers sought, the marketing conditions and
the cost, the circulation and the life of the medium.
The important media of advertisement are described below:
1. Newspapers: Newspapers are the most common medium
of advertisement. They have certain advantages. They are:
(i) Because of their wide circulation, the advertising message
can be carried to a large number of people at less cost.
(ii) Through newspapers, advertisement can be made at the
right time and to the right place.
322 Warehousing
(iii) Advertising message can be changed daily to suit the needs
of advertisers.
2. Periodicals and Magazines : These provide for higher
quality of printing of advertisement. They are more attractive and
colourful than the newspapers. Selective appeal to specific segments
of the market is possible. For example, magazines of general interest
(Illustrated Weekly. India Today, and Caravan) could be Used for
advertising products of common use, Households goods, garments,
cosmetics could be advertised through fashion magazines like Eve's
Weekly, Film fare, Femina, etc., Magazines like Sports Week, Sports
Star could be used for advertising's port5 goods.
3. Posters: Posters include advertising message printed on
paper, cardboard, cloth, wood or metal and displayed in prominent
localities such as roadsides, railway stations, etc. Posters must be
sufficiently large in size. They must contain each headings in bold
types. They must be impressive. The advertising message must be
short.
4. Radio Advertising: Radio broadcasting is highly suitable
for various consumer goods having a mass appeal such as movies,
electric fans, refrigerators, sewing machines, leather good, travelling
bags, etc. It has a wide appeal and all types of people including
illiterates can be approached easily.
5. Television Advertising: Television makes its appeal through
both the eye and the ear. Products can be demonstrated as well as
explained as in film advertisement. Advertising may take the form
of short commercials and sponsored programmes. T.V. advertising
has greater effectiveness as the message is conveyed at their homes
to the people.
6. Direct Mail Advertising: Direct mail is used to send the
massage directly to the customer. For this purpose, the advertiser
has to maintain a list which can be expanded or contracted by
adding or removing names from the list. But a severe limitation is
posed by the difficulty of getting and maintaining a good mailing
list.
7. Outdoor or Moral Advertising: Outdoor advertising in the
from of posters, bill boards, neon signs, wall writings and handbills
Warehousing 323
is another popular medium of advertising. Posters are pasted on
walls at important public places to convey product messages to the
general public. Slogans on the walls in bold letters are also used for
this purpose. Large sized hoarding or bill boards are fixed at
important street crossings; signboards are displayed on buses,
railway coaches; attractive neon signs are fixed at important
buildings.
Factors relevant for selection of advertisement media:
The following factors influence the selection of media by
any advertiser:
(i) the message to be conveyed and the mode of presentation
(oral, written, etc.);
(ii) the circulation of media,
(iii) the necessity of repetition of advertisement; (iv) the category
of consumers to be reached;
(v) the funqs available for advertisement;
(vi) the media used by competitors.
Sales promotion consists of all promotional activities other than
advertising, personal selling and publicity that stimulat the demand
for products. The basic purpose is to stimulate on the spot buying
by prospective customers through short-term incentives. Incentives
such as samples, price concessions, prize contests are offered to
customers to encourage buying.
The promotional activities are used for the following objects;
(i) Introduce new products.
(ii) Attract new customers.
(iii) Increase sales in slack season.
(iv) Create good public image.
Techniques of Sale Promotion
1. Samples: Many businessmen offer samples of their
products to the selected people in order to popularise their products.
Distribution of samples is popular in case of books, drugs, cosmetics,
perfumes and other similar products.
324 Warehousing
2. Price-off Offer: This tool involves offering a product at a _
price lower than the normal price, e.g. off season discount may be
offered on ceiling fans, coolers and refrigerators.
3. Coupons: A coupon is a certificate that enables the
consumer to a specified saving on the purchase of a product.
Subscription coupon of Reader's Digest entitIes the reader to save
substantially.
4. Contests: A business house may hold contests for increasing
the enthusiasm of salesmen, for securing the support of dealers and
for arousing the interest of consumers. These contests are held either
through radio or through newspapers, magazines, etc.
5. Fairs and Exhibitions: Trade fairs and exhibitions are held
on a local, regional or international basis. Fairs are generally held
regularly, say every year at some centrally situated places which
have historical or religious importance. Both fairs and exhibitions
provide in important means of s promotion. These provide
opportunities to the manufacturer and traders for demonstrating
their products, explaining their special features~ usefulness, etc.

Chapter
21
PRICE DISCRIMINATION AND

--
MODERN ENTREPRENEUR
We know the taxonomy of price discrimination, as well as the

theory underlying the various forms of discrimination. In this
chapter, we wish to look in more detail at the ways in which
companies engage in the various practices of price discrimination.
First of all, we'll look briefly at Machlup's classification of price
discrimination methods. Then we'll turn to a more detailed
examination of traditional price discrimination, looking at movie
theaters, telephone service, air fares, medical services, congressional
information services, and college scholarships. In the next major
section, we'll look at tie-in sales as a method of metering demand
and charging accordingly. Next, we'll discuss multipart pricing by
utilities and movie distributors. Finally, we'll examine the sale of
hardback versus paperback books, different labels on physically
similar items, sale of drugs, and trading stamps.
Classification by Type:
Machlup has propounded a somewhat different set of
discrimination classes: (1) personal, (2) group, and (3) product.
Within each class of discrimination, he gives examples of many
different actual types of discrimination. In Table 1, we recreate some
of Machlup's categories.
326 Price Discrimination and Modem Entrepreneur
Types of Price Discrimination:
Personal discrimination
Size up customer's Income
Customers are charged what the market will bear, depending on how wealthy the customer is.
Presumably wealthier customers have inelastic demands and are charged a higher price
Examples-medical and legal services.
Give in if you must
Secret shaving off list prices is done when necessary to capture a sale.
Haggle every time
Each exchange is a separately negotiated transaction. Examples-bazaars in the Middle
East, open-air markets in Latin America, and many private deals, such as purchases of used
items through the classified sections of newspapers.
Measure the use
Those buyers who use the good or service more intensively are charged more, even if
marginal costs of servicing are the same. Examples-Xerox machine rentals based on the
number of copies made: the increased rental charge exceeds increased maintenance costs;
IBM's rental of machines and sale of computer cards at above marginal cost per card
Group discrimination
Dump the surplus
Sales are priced lower in foreign markets than in domestic markets in order not to depress the
domestic price. Examples-drugs, TV sets, steel, free food for the U.S. Food for Peace
program.
Absorb the freight
Freight is either absorbed or overcharged to customers who are located at varying distances
from the production site.
Kill the rival
Prices are reduced only in markets served by a rival who, it is hoped, will be driven out of
business; otherwise called predatory pricing. Examples-alleged practice of Standard Oil
before 1900 and of American Tobacco.
Promote new customers
New customers are offered lower prices than old customers. The goal is to promote brand
loyalty. Examples-magazine subscriptions.
Divide them by elasticity
Group discrimination exists whenever the group can be classified by occupation, age, or sex.
Examples-children's versus adults' haircuts, student versus non-student rates at cinemas,
professional discounts at motel chains and with national auto rental firms.
Protect the intermediary
Large retail buyers are charged the same price as small retail buyers who buy from wholesalers
even though large retail firms do their own warehousing and distribution. This protects
wholesalers from competition with retailers that might otherwise turn to vertical integration
Favour the big ones
Large buyers are given price reductions that exceed cost savings normally associated with
quantity sales
Price Discrimination and Modem Entrepreneur 327
Product discrimination
Pay for the label
Manufacturers distribute homogeneous products under various brands. Better-known brands
have higher price tags. Examples-clothing, food, paint.
Appeal to the classes
Price differences are greater than differences in marg;nal cost when quality is upgraded.
Examples-hardback versus paperback books, first-class versus tourist-class fares on
airplanes.
Differing Demands:
One specific type of price discrimination in Machlup's
classification involves peak pricing where demand may shift during
peak and off-peak periods. In Figure 1, we show a rising marginal
cost curve and two demand curves, one for off-peak, DD, and the
other for peak, D'D'. We see that marginal cost is low in slack periods
and high during boom periods. It is not clear to what extent an
increase in price from P to P' really is true price discrimination,
because demand may be considered at different times for different
products.
Other Qualifications:
Some of the forms of price discrimination are merely a statement
of the conditions necessary for price discrimination. For example,
under personal discrimination both" size up his income" and "give
in if you must" may be translated into conditions necessary for
identifying differing demand curves and recognizing the non-
infinite elasticity of demand. In other cases, forms under product
discrimination, such as "pay for the label" and "appeal to the
classes," may create differential goods in the eyes of consumers. It
is difficult to separate the differences in price attributable to the
product from those caused by price discrimination.
Methods of Price Discrimination:
Movie Theaters: Most movie theaters in the United States do
not differentiate price on the basis of the seat in which one sits in
the theater. On the other hand, most movie theaters do engage in an
obvious form of price discrimination. There are usually two and
sometimes three or four different prices for the same movie at the
same time. At a minimum, there is a higher price charged to adults
D'
Me
D'
D
Q Q'
,?utput per unit time period
Fig. 1 : Peak pricing
than to children 11 and under. Presumably, the price elasticity of

demand of children for movies is numerically higher than that of
adults. It is basically cost-less to monitor the separation of the two
groups because physical appearance will be roughly sufficient
evidence of age. However, cheating clearly does occur when children
who are 12 or older but look younger get in at the lower price.
Many movie theaters, particularly those around universities,
offer special student prices upon presentation of either a student
1.0. card or a specially obtained student pass issued by the movie
theater or its chain. Again, monitoring of the two groups is relatively
cost-less, although some cheating undoubtedly occurs. Many movie
theaters price-discriminate in favor of senior citizens, presumably
because they have a numerically higher price elasticity of demand.
Upon presentation of proof of age or a special senior citizen pass
similar to a student pass, those people age 65 and over enter the
theater at a lower price than younger adults. We see in Table 11-2 a _
typical example of the varying rate schedule.
Changing Rates by Time of Day: Many movie theaters also

engage in peak-load pricing that may constitute price
discrimination, although more properly this pricing can be viewed
as a means of exploiting unused capacity during off-peak hours.
Movie theaters are rarely filled early in the day. In order to induce
individuals to see a movie at off-peak times, theaters may reduce
their rates to attract customers. We cannot consider this a form of
pure price discrimination because the product being sold is clearly
different. (A movie seen at a 7:30 P.M. showing is not exactly the
same product as the same movie shown at 2:15 P.M.) Most people
prefer movies in the evening, particularly since during the week
fewer individuals have the leisure time available for daytime movie
viewing. Price discrimination may be necessary for industry
survival given film owners' exclusive copyright.
Telephone Services: Various rate schedules are utilized by the
telephone company. In brief, they involve charging higher prices
for business phones than for residential phones and higher prices
for big-city users than for small-town users. In fact, telephone pricing
TABLE 1
Sample Prices for Movies, N.K. Theater, September 2009
Matinee Evening
(2:00-5:00 p.m.) (after 5:00 p.m.)
Children
(under 12) Rs.70.00 Rs. 100.00
Adults Rs. 100.00 Rs. 150.00
Senior citizens RS.75.00 Rs. 100.00
has often followed a "value-of-service" format, attempting to

discriminate on the basis of the value of the service or of the relative
inelasticity of demand of some users. The ability to discriminate
derives directly from the exclusive telephone franchise.
Business versus Residential: Rates Table 2 shows a typical rate
schedule for business and residential phones. It can be argued that,
although the higher price charged businesses is ndt fully reflective
of j~st price discrimination, it may involve 50me price
differentiation. Business people typically are more intensive phone

users and thus they may impose higher marginal costs on the system
than residential users do. If, however, high volume users create
economies of scale, the opposite may be true. This is an empirical
question that would have to be answered by looking at the degree to
which business phone use actually causes the system to reach
capacity sooner. Otherwise, the marginal cost for phone calls by
businesses will be essentially zero.
In principle, peak-load pricing of local telephone calls could
also be utilized. Currently many cities have flat-rate monthly charges,
which essentially make the marginal price zero to the individual
user no matter how many calls are made and no matter how long
they last. Since it has been estimated that the peak cost per three-
minute call is at least five times that of off-peak cost, peak loads
involve relatively high capacity cost to the system. Flat monthly
rates discriminate in favor of users who make frequent calls during
business hours and against users who infrequently make calls or
who frequently make calls after business hours. Even in those cities
where message rates are charged (for example, 50 or 100 per call)
after a certain number of calls, the problem is not completely
eliminated. Such a system of message rates still discriminates
against off-peak callers. It is only when calls are charged by time of
occurrence and by duration that such discrimination against off-
peak calls can be eliminated.
Long- Distance Rates: Long-distance rates typically differ by
time of day and day of week. Again, it is not clear to what extent
such differential pricing is reflective of price discrimination or merely
is similar to movie pricing at different times of the day-a system
that expands the use of unutilized capacity at off-peak periods. We
do know that the price elasticity of demand for telephone services is
numerically quite low for calls during normal hours of business
operations, as Table 3 shows.
Air Fares: Prior to the current era of deregulation, the United
States airline industry was severely regulated by the Civil
Aeronautics Board (CAB). Entry was typically limited to one or two
carriers between most cities. All passenger fares had to get CAB
TABLE 2
N.K. Telephone Monthly Charges, December 2010
One private line, One private line,
one phone three phones
Private residence Rs.300.00 Rs.600.00
Business phone Rs.500.00 Rs. 100.00
approval. Basically, airlines were not allowed to compete on the

basis of fares, at least not in terms of first-class and regular coach
fares. Competition, therefore, took on various forms, including
preferred take-off and landing times and better service in the form
of free champagne, free movies, bigger sandwiches, more hors
d' oeuvres, and so on. Additionally, each airline sought to attract a
larger clientele by lowering prices to special groups that had less
elastic demand elasticity'S than other groups. The price elasticity of
demand is certainly different for an expense account executive than
for a student traveller who is deciding between an airplane flight
and sharing driving expenses to go home for the summer. Given
TABLE 3
Initial Price and Usage Data
Route Period Initial Initial Elasticity
price usage
Intra - day 5 445 -0.1
Chicago evening 5 486 -0.1
night 5 210 -0.1
after midnight 5 10 -0.1
Chicago - day 65 73 -0.15

Peoria evening 50 78 -0.37
night 40 27 -0.36
Chicago - day 140 2570 -0.23
New York evening 100 3873 -0.57
night 70 1940 -0.57
332 Price Discrimination and Modern Entrepreneur
such differing demand elasticity's, much price discrimination
existed in airline travel until recently. When we look at the typical
fare schedule prior to deregulation, we find that the fare structure
fits our ideas about relative price elasticity's of demand. The
difference between a first-class round trip between New York and
Los Angeles and a travel group charter between those same two
points was more than 50 percent. The businessperson paid the full
fare, and the student vacationer, for example, took the steps
necessary to obtain a lower fare. Not all the difference was due to
price discrimination, because clearly the products are different. The
first-class passenger, or even the full-fare coach passenger, need
not reserve in advance or pay in advance, can change reservations
quickly, is almost always guaranteed an available seat, and so on.
Nonetheless, even accounting for differences in quality, it is probably
true that the price per constant unit of quality is higher for the
business traveller than for the student traveller.
Youth Fares: Many airlines have offered youth fares at different
periods. Passengers under a certain age, usually 22, were allowed
to purchase youth fare tickeLs, particularly on flights to Europe.
These tickets were lower than the price that adults had to pay for
full-fare tickets. In the past, however( the youth-fare ticket holder
was not guaranteed a seat on a particular flight. Rather, he or she
had to accept seating on a stand-by basis, that is, arrive at the gate
prior to the plane's departure and stand by until 10 minutes before
flight time. If at that time empty seats were available, then the ticket
was accepted and the youth could board the plane.
This is a form of third-degree price discrimination (although
we are referring to different quality products, because youth fare
tickets involve uncertainty). There is probably a difference in the
relative elasticity of demand of young adults and that of adults and
businesspeople. The demand of young adults is more elastic than
the demand of businesspeople. However, the analysis does not end
there. Young adults have more elastic demand curves because their
time is usually less valuable than that of businesspeople. That is to
say, the opportunity cost of waiting in a stand-by system is less for
most young adults than for businesspeople. The total price of a trip
by aeroplane is the money price of the ticket plus the opportunity
cost of going to the airport, waiting in line, boarding the plane,
sitting in the plane, and so on. Holding the number of hours constant,
the lower the opportunity cost of time is, the greater the percentage
of the total price of airplane travel is accounted for by the money
price. Say that the money price of a plane flight is $85 and that the
total time involved in waiting, boarding the plane, and flying is five
hours. If a young person's opportunity cost is $3 per hour, then the
total price to the young adult for the plane flight is $85 + (5 x $3) =
$100. The money price of the plane flight expressed as a fraction of
the total price is equal to $85/$100, or 85 percent. Thus, for those
with a low opportunity cost, the observed demand curve for air
travel in terms of the money price of the ticket may be more elastic.
Hence, it makes sense to charge a lower price for youths than for
adults. Their relative differences in opportunity cost lead to
differences in the relative money price elasticity's of demand.
Children's Fares: Children under the age of 12 have been eligible
for special fares that in some periods are one-half the adult coach
fare and currently are often two-thirds the adult coach fare. This is
a form of price discrimination because the cost differences to the
airline are nonexistent between the adult and the child. Further, the
opportunity cost of a child is considerably less than that of an adult.
A child occupies a full seat and is given a full meal and the same
service that an adult is given.
Price Discrimination under: Deregulation In many respects,
under the more flexible pricing rules in existence since 1977, more
rather than less price disparities exist. In December 2010, for
example, a typical round trip between Miami and London was as
follows: first class, $2,372; economy (full-fare coach), $856 with 7-
180 day stay and advanced purchase; excursion, $509; budget and
stand-by fares, $197 (one way); and Laker Sky train, $187 (one way).
Again, we are not comparing exactly similar products. First-
class and economy seats are almost always available, so the
purchaser is buying not only the air transportation, but also
flexibility in his or her air travel scheduling. The 7-180 day fares
require a predetermined stay. Advance purchase tickets require a
definite date of departure and return, with a penalty assessed
334 Price Discrimination and Modern Entrepreneur
(usually to full fare) for every change. Stand-by fares require just
tha t-standing by withOllt absolute certainty of boarding on a given
da y. Laker's Sky train fares are often obtained at the expense of long
waits in ticket lines.
Medical Services: Since Kessel's seminal article on price
discrimination in medicine, pricing of medical services has been
used as a classic example of price discrimination. Basically, doctors
have been able to price discriminate in the past, not only because of
restrictions on entry, but also because the American Medical
Association was sometimes able to monitor and punish price cutters
by banning them from hospitals. Physicians are able to charge
different prices to different patients for the same medical services
because individual patients are unable to resell services-separation
of the markets is possible. Local medical associations that operate
under the AMA have been known to impose sanctions on doctors
that engage in price cutting. Further, since the AMA can influence
the number of internships a hospital will receive, this association is
in a position to impose costs on hospitals by restricting the
availability of low-cost interns. Doctors who are members of their
local medical societies are often given preferential treatment in
hiring. Further, doctors who engage in price cutting have been
expelled from local medical societies. On the other hand, where
price cutting could have no appreciable effect on physicians'
incomes, there have been no barriers. For this reason, and because
of the possible savings in income taxes, physicians frequently do
not charge one another for their services and sometimes offer such
professional courtesy to members of other physicians' families.
Charging Price on the Basis of Income: Typically, wealthy
individuals have been charged a higher price than poor people for
similar medical services. There is, of course, some disagreement
about whether poor people have received exactly the same medical
care services, but let us assume for the moment that they have. Given
that the marginal cost of servicing these two groups is the same, the
price differences are indicative of third-degree price discrimination
based on differing price elasticity'S of demand. In essence, we can
apply our analysis given in the previous chapter in Figure 1. Simply
substitute Group I and Group II for patient-group I and patient-
group II. We now ask the question, Why do we expect wealthy
individuals to have less elastic demand for medical services than
poor individuals?
In the first place, the opportunity cost of being sick for a wealthy
person is greater than for a poorer person, which translates into a
higher demand for preventive medicine. Second, the time-cost
analysis example that we presented for youth fares above also
applies to medical services. Time costs, as a percentage of the total
cost of medical care, are directly related to the wealth of an
individual. As wealth increases, that portion of time costs
attributable to to~al cost increases. Thus, any nominal price change
will be a lower percentage change in total price (induding time
costs) for a richer person. For any given change in money price, the
relative change in quantity demanded will be less for the richer
person than for the poorer one. Hence, a rich person's price elasticity
of demand for medical services will be numerically lower. Finally,
because medical services are empirically a normal or superior good,
D1
D1
Q1
Output per unit time period
Fig. 2 : Rich versus poor people's delllatld curve for medical care
higher income groups will demand more of them at each and every
price. Look at Figure 2. Here we show demand curve for medical
services to be 0 10 1 for poor people and 0 20 2 for rich people. At any
price, the price elasticity of demand for medical services will be
numerically less for the rich than for the poor since 0 20 2 intersects
the vertical axis at a higher point than 0 10 1. [Alternatively,
remember that at any price the price elasticity of demand is defined
by the reciprocal of the slope of the demand curve times the quantity
P IQ. Thus, at any price, since 0 20 2 is farther to the right than 0 20 2,
the quantity P IQ will be lower for rich people than for poor people
and, hence, the reciprocal of the slope times that quantity will be
numerically smaller (if the slope is the same). Thus, a smaller
numerical price elasticity of demand exists for rich people.
Congressional Infonnation Service: Information services often
engage in a form of price discrimination based on the affiliation of
the subscriber. We show an example in Figure 3 of the Congressional
Fig. 3 : Sample order form-Congressional information Service:
(] iliO per ~nl if It-e annual N10k 111(1 re:riodical b~Jttl of the
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Ilutihtttolllli Libnrkt for ellliosill, pul""pO'.
fbc:w ~atc~ l~ply onlr to :IIuJeml1: r,ut.1ic. bw and co ...ern- o Pluse wel'ldll\ _ _ '>C*./ of blnJ r-u at SI8, Ihe ~E I
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These ~:ar~~ MC re~r,"el.l fUf ~mllrl c,'I1~'h .. nrl pub!,;.- I,brlrits
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It"ftlt ilHCillllo\ln I' bt:"'cen 5)(10\)0 3nd S15,OOO Our but!s":
Price Discrimination and Modern Entrepreneur 337
Information Service, which is an index to publications of the U.s.

Congress. You will notice that in 1970 there was a basic rate of $320
per year, which applied to all private offices and libraries, all
academic public law or government libraries that have a large
enough budget (in this case an excess of $400,000), all libraries
maintained by foreign governments, and all foreign libraries outside
of the United States except those maintained by the U.S. government.
Rates are lowered if the subscriber is a library with a small budget.
The lowest rate, $80 per year, is given to small colleges and public
libraries whose entire annual book and periodical budget is less
than $30,000. In this case, the product is exactly the same, the cost
of servicing each subscriber is presumably exactly the same, but the
price charged is different.
Other information services such as microfilm copies of
congressional reports have similar pricing structures.
Professional Journals : Professional journals practice price
discrimination in basically the same manner as the Congressional
Information Service. We recreate a series of 1981 price schedules for
the American Economic Review (Table 5) to show that there are
different rates to libraries, students, and other parties. Of course,
some cheating goes on. In order to obtain the student rate, the student
usually has to have a note signed by a professor, a practice that will
discourage some, but not all, from cheating.
College Scholarships and Fees: Each year some eight and one-
half million students go to colleges and universities throughout the
United States. Most, if not all, colleges and universities do not and
perhaps cannot charge different prices to different groups, except
perhaps on the basis of residency in state-financed institutions. It
is possible, nonetheless, for colleges and universities to reduce the
price to those students with numerically higher price elasticity's of
demand by awarding them grants, scholarships, and fellowships.
For example, in many cases, financial aid decisions are made on
the basis of "need." In other words, colleges and universities price
on the basis of wealth. The most financially impoverished
individuals are offered the largest awards, while richer students
get relatively little. We have already pointed out why price elasticity
Table 4: Exhibit 0/2009 Price Schedules

THE AMERICAN ECONOMIC REVIEW including four quarterly numbers, the
Proceedings of the annual meetings, the Directory, and Supplements, is published
by the American Economic Association and is sent to all members six times a
year, in March, May, June, September, and semi-monthly in December.
Dues for 2009, which include a subscription to both the American Economic
Review and the Journal of Economic Literature, are as follows :
$30.00 for regular members with rank of assistant professor or lower, or with
annual income of $14,400 or less;
$36.00 for regular members with rank of associate professor, or with annual
income of $14,400 to $24,000;
$42.00 for regular members with rank of full professor, or with annual income
above $24,000;
$15.00 for junior members (registered students). Certification must be submitted
yearly .
Subscriptions (libraries, institutions, or firms) are $100.00 a year. Only
subscriptions to both publications will be accepted. Single copies of either journal
may be purchased from the Secretary's office, Nashville, Tennessee.
In countries other than the United States, add $5.00 to cover extra postage.
of demand is inversely related to income for medical services. At

least one argument dealing with the fact that education is a normal
or superior good still holds. Thus, it is rational for colleges and
universities to attempt to charge more to wealthier students.
In Figure 4 we show a sample form from the Graduate and
Professional School Financial Aid Service. It is a financial statement
for students applying for financial aid. It collects information about
the student's resources and liabilities, as well as those of the
student's spouse or prospective spouse, in addition to the spouse's
employment history, and financial information about the student's
parents. Presumably, none of this information relates to the
candidate's academic qualification, ability to perform in graduate
school, or ability to succeed. One can surmise that the financial
statement required by colleges and universities giving financial aid
is merely a means of metering price elasticities of demand and
making awards accordingly.
Traditl8 Stamps: In the 1880s, Schuster's Department Store in
Milwaukee, Wisconsin, began to issue stamps to its customers. Since
then, we have seen the proliferation of approximately 250 trading

stamp companies. Forty percent of the market is controlled by S&H
(Sperry & Hutchinson) Green Stamps. Only about 5 percent of S&H
Green Stamps and those of other large trading companies are
unredeemed. Let's now try to answer the question of why stores
give trading stamps.
The full price of the product includes not only the monetary
price, but also the implicit opportunity cost of the time that went
into searching out the product and purchasing it (and the time
needed to consume it) . We can assume that the higher one values
time released from shopping, the less one will engage in seeking
out lower-cost shopping arrangements. In other words, a person
who values time more relative to money income will substitute more
money income in order to save shopping time. That person will use
less time to discover lower prices. Therefore, the person who values
time highly will exhibit a less elastic demand curve in any given
store than the person who does not value time so highly.
Charging More to the Richer Person: Let us assume that there is
a strong correlation between the value of time and the relative wealth
of a person. We are assuming that richer people place a higher
value on time than do poorer people. It follows, therefore, that in a
particular store, a richer person's relative price elasticity of demand
will be less than a poorer person's. Now the retailer is confronted
with two classes of consumers, those with relatively less elastic
demands and those with relatively more elastic demands. The
retailer's problem is to separate these two classes and charge the
richer customers a higher price than the poorer customers. One
way this is done is to offer a rebate only to those customers willing
to incur a time cost to obtain that rebate. The rebate is in the form of
real goods that are obtainable in exchange for blue, green, or gold
trading stamps. However, the person who wants the rebate must
collect the stamps, preserve them, and redeem them at a redemption
station. All of these activities require time. Thus, poorer people,
whom we are assuming can be used as a proxy for the relatively
more elastic demanders, effectively pay a lower price for their food
because they obtain goods when they redeem their trading stamps.
The richer customers, with a relatively less elastic demand, refuse

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the stamps because of the time cost involved. They get no discount
at all. Thus, the gross money price of groceries is the same to both
classes of buyers, but the poor get a rebate equal to the value of the
trading stamps' redemption exchange rate.
Some Implications: If the above trading stamp model is useful,
it presents us with some testable implications. These are:
1. We predict that trading stamps will be used [by a seller]
relatively less often in cases where the total value of a single
purchase is large. In such instances, the receiver of the
stamps from a large purchase incurs a small enough time
cost in redeeming a large quantity of stamps to make the
redemption worthwhile. In other words, not enough
differential time costs are imposed to discourage relatively
low elasticity demanders from collecting the stamps. This
"
implication is consistent with the fact that trading stamps
are used by grocery stores. One does not usually obtain
them when purchasing an automobile or a home.
2. We predict that in cases where the commodity is personal
service, relatively fewer trading stamps will be used. The
differentiation of quality of services rendered is used as a
substitute for the price discounting implicit in the trading
stamp system. This implication is consistent with beauty
shops and barbershops, which do not offer trading stamps.
3. We predict that owner-operated stores will use relatively
fewer trading stamps than stores employing a large number
of sales personnel. In the case of owner-operated stores, the
owner can attempt to figure out relative price elasticities
and alter the service given to the customers accordingly.
Employees, on the other hand, have less incentive and less
authority to figure out customer characteristics and
therefore won't treat customers according to their relative
price elasticities. Therefore, we predict more trading stamp
use in large grocery stores than in small "mom and pop"
stores. This use seems to be consistent with casual
observation.
Multipart Pricising:
Multipart pricing involves charging successively lower prices
for the marginal unit of a commodity as more of the commodity is
purchased. Multipart pricing occurs, for example, in supermarkets
when you are allowed to buy one can for 200 and two cans for 390.
In other words, the first can is 200 and the marginal cost of the
second can is 190. A uniform price of 19.50 is charged to all those
who buy two cans, and so on.
There is a difference between multipart pricing, which is second-
degree price discrimination, and perfect, or first-degree, price
discrimination. Multipart pricing is an imperfect way to extract as
much consumer surplus as possible from each consumer. It is a
way of dealing with broad, discrete intervals between quantities
purchased and charging appropriate revenue-maximizing prices
for each additional unit purchased, without ever selling any unit
belowMC.
We expect to observe second-degree price discrimination, or
multipart pricing, rather than first-degree price discrimination
because of the higher costs of negotiating, monitoring, and enforcing
exchanges for the latter. It is difficult to determine what the actual
price elasticity of demand is for different classes of buyers. It is even
more difficult to prevent the resale of goods by buyers who bought
the product at a lower price to those who would be charged a higher
price if they purchased the product from the monopolist.
Sliding Scales for Public Utilities: It is often asserted that public
utilities engage in price discrimination. It turns out that we can,
indeed, analyze some of their pricing policies in terms of second-
degree price discrimination. Public utilities do use multipart pricing,
or what they callI/declining block pricing."
Consider Figure 5. If the electrical utility wanted to sell the
quantity Q3' it could do so by charging the uniform price of P3. Its
total revenues would be represented by the rectangle OP3CQ3'
However, if the utility engages in multipart pricing, or second-degree
price discrimination, it might charge P 2 for the first QI of kilowatts
sold per month. It could charge P2 for kilowatts sold between 2, and
Q2' and then finally it could charge P3 for kilowatts sold between Q2
and Q3' The revenues it would receive would be the sum of the
rectangle of OP1AQ1 plus Q 1DBQ2 plus Q2ECQ3' or OP1DBECQ3'
The sum of these three rectangles exceeds the rectangle given by
uniform pricing of P3 times the quantity sold, Q3' (Moreover,
P,
I
~ _________ LID__ _
1 I
I IE
P3 ---------f----:----
1 1
1 1
1 1
I 1
I 1
I I
I I
1 : d
o 0,
Rate of consumption (kilowatts per months)
Fig. 5 : Declining block pricing. Public utilities often use declining block
pricing in which separate "blocks" of electricity can be purchased at
declining prices. If the electric utitlity charges a uniform price of P 3, its
revenues will beOP3CQ3' If, however, it charges a price ofP l for the first
Q1 kilowatts used and then P2 for the next "block" used up to quantity Q2
and then price P3 for the next "block" up to Q3' its total revenues will
equal OP lAQ l + Q l DBQ2 + Q2EC03 = OP1ADBECQ3'
multipart pricing yields more revenue than charging the weighted

average price.)
Declining block pricing. Public utilities often use declining block
pricing in which separate "blocks" of electricity can be purchased
at declining prices. If the electric utility charges a uniform price of
P3t its revenues will be OP 3CQ3' If, however, it charges a price of PI
for the first 0, kilowatts used and then P2 for the next "block" used
up to quantity O 2 and then price P3 for the next "block" up to 0 3, its

total revenues will equal OP1AQ + QIDBQ 2 +Q2EC03=
OPIADBECQ3.Some Differences in Cost Not all the differences in
electricity prices on the sliding scale constitute price discrimination.
There are some differences in cost. Industrial customers consume
power at higher voltage and on a more predictable basis. Also,
there is usually a smaller connection cost. Basically, however,
declining block pricing is a form of price discrimination. The reason
that industrial users receive a lower price is because they have
more elastic demand. Their options are greater than residential
users' options are. If electricity reaches a high enough price, they
can generate it themselves. Also, particularly for electric-intensive
firms, users can decide to build a plant in a different location where
electricity prices are lower. Since electricity prices constitute a larger
fraction of their total operating budget, and the cost of alternative
sources is relatively lower than that for individual households,
industrial users are more pricesensitive to electricity costs than
residential users are.
Metering Demand and Tie-in Sales:

One industrial practice that has been associated with price
discrimination involves tying contracts, or tie-in sales. A typical
tie-in contractual arrangement requires that a buyer can either
purchase or lease one product from the seller only on the condition
that the buyer also agrees to purchase something else called the
"tied good." Tie-in arrangements are normally illegal under section
3 of the Clayton Act if the effect "may be to substantially lessen
competition or tend to create a monopoly in any line of commerce."
However, the courts' usual understanding of tie-in arrangements
and monopoly power has often been misguided. Under most
circumstances, it is impossible to extend monopoly power by a tie-
in agreement. Consider the following example. Xerox has a
monopoly in the sale and lease of Xerox machines. It does not have
a monopoly, however, in the sale of the paper used in the machines.
Suppose the XYZ firm rents the Xerox machines and purchases
1000 sheets of paper a month. The competitive price for the paper is
$100. Now assume that the total value to the user of the Xerox
machine (including the use of the paper) is $900. If Xerox required
the tie-in arrangement whereby the rental of the machine was
contingent upon purchase of the paper from Xerox, it could charge
any combination for one month's rental and paper as long as it
equaled $900. Thus, it could charge a competitive price for the paper
of $100 plus $800 rental, or it could charge $600 rental and $300 for
the 1000 sheets of paper. In all cases, Xerox would end up with the
same profit. An $800 or other high rental fee, however, would
preclude use by customers with low total demands for the machine.
Basically, if Xerox truly has monopoly power in the copying
machine market and there is pure competition in the paper market,
the supposed extension of Xerox's monopoly into the paper market
will not alter its profits. The tie-in between the Xerox rental and the
paper cannot be construed to extend Xerox's monopoly power. What
is important here is looking at the combined price of the rental plus
the paper to yield the price paid per constant quality unit of services,
since the machine cannot be used without the paper. The same
would be true if we analyzed a company that had monopoly power
in selling cameras and decided to tie-in the film. .
Tying Arrangement as a Means of Metering Demand- The
IBM Case" : Intema tional Business Machines Corporation has been
the leader in the computer field since that industry began. For many
years, IBM would only rent its computing and tabulating ntachines
to users; it would not sell them. The rental agreement was generally
expressed as a fee per shift per unit time period (one month, for
example). Until the 1950s, IBM required that the users buy tabulating
cards only from IBM. If the machines broke down and IBM's
technicians found that the renting firms were using someone else's
cards, IBM imposed a penalty by charging for repairs. This was the
method the company used to police its requirement that no one
else's cards be purchased.
We may not immediately understand why IBM required that
its own cards be purchased and why it policed such an agreement.
However, if we think of IBM in terms of a monopolist, then we
arrive at a prediction from a price-discriminating monopoly model
that is consistent with past IBM-pricing practices. We know from

the theory in Chapter 10 that higher profits can be obtained by price
discrimination; however, it is necessary to have information on the
different price elasticities of demand for different classes of users.
One way that IBM could approximate its users' consumer surplus
was by intensity of use-those who used their machines more
presumably had a relatively higher total consumer's surplus for
computing services. One of the ways to monitor intensity of use is
by knowing the number of tabulating cards used. That is exactly
why IBM required that only its cards be used. The cards provided
an index of use intensity and, hence, the size of consumer's surplus.
This argument would make little sense if IBM had not charged
those who used more cards a higher price per unit of computing
services than those who used fewer cards. The company did just
that; it charged a price for cards that was in excess of their marginal
cost. Its price per unit of computing services was effectively higher
to those with the lower elasticity of demand, that is, those who used
more cards. IBM chose this method of price discrimination rather
than charging a higher rental fee to different users. Perhaps this
latter pricing technique was deemed too overt a form of price
discrimination and was, therefore, subject to antitrust prosecution.
In addition, higher rental fees would require ex ante determination
of high and low demanders.
Nonetheless, various antitrust actions against IBM have resulted
in the discontinuation of this particular pricing practice. Under
Justice Department pressure, IBM agreed to" cease and desist" its
dual practice of only renting hardware and of requiring the purchase
of its own cards.
United Shoe Machinery: Another case of price discrimination
using tie-in sales as a metering device involved United Shoe
Machinery. Prior to 1956, the company was convicted under the
Sherman Act and its tie-in practices were forbidden. Customers of
United Shoe Machinery Corporation (shoe manufacturers) had been
required to use only United Shoe Machinery if they wanted to use
any equipment made by that company. Actually, there were seven
separate types of tie-ins. The most mentioned one involved the
requirement that the lessees of United Shoe Machinery heel

applicators were required to buy United Shoe Machinery staples.
We can use the same analysis presented above for IBM and
IBM cards. If we assume that total consumer's surplus is directly
related to intensity of use, which can be measured by the number of
staples used per unit time period, then United Shoe Machinery was
able to meter demand. As long as it charged above marginal cost for
the staples, it was able to effectively charge a higher machine price
to low demanders than that charged to relatively high demanders.
Cable TV Equipment: A cable TV system receives signals at
one large antenna and then feeds them to subscriber households,
usually by a network of underground wires. The first cable TV firm
was started in 1951. It began by servicing remote small towns. By
the early 1960s, cable had spread to larger towns and the industry
was booming. The first firm in that industry was Jerrold Electronics.
From the onset, Jerrold required all subscribers to install the entire
Jerrold system plus purchase a five-year service contract. In other
words, subscribers were not allowed to use non-Jerrold parts
between the cable line and the TV set. This tie-in between the cable
and the television set provided a way of metering demand.
Presumably, the greater the number of television sets in the home,
the more intensive the demand and thus the lower the price elasticity
of demand. Provided that Jerrold charged above marginal cost for
the connecting devices, it was practicing a form of price
discrimination. Eventually, the Antitrust Division sued Jerrold for
anticompetitive practices. In 1961, the courts declared that Jerrold
could no longer require tie-ins.
Other Reasons for Tie-in Sales: There are numerous other
reasons why firms might engage in tie-in sales. We will discuss
these other reasons in more detail in Chapter 12. Briefly, though,
tie-in sales are used to avoid price controls, to take advantage of
economies of scale, to protect goodwill by preventing cheating on
brand names, to capture some consumer surplus, to reallocate risk
bearing, and to create a barrier of entry because of increased capital
requirements.
A Variation on Tie-in Sales-Block Booking:

One variation of tie-in sales that allows for price discrimination
without overtly engaging in that practice is block booking. Block
booking is an arrangement under which purchasers are forced to
buy all of a firm's output each period or get none of it. In other
words, block booking involves an all-or-none arrangement not
dissimilar to the example we used in Chapter 10 concerning the
purchase of diamonds at an option of all at the stated price or none
at all.
In the famous Loew's case in 1962, the issue of block booking
came up.14 Six distributors were charged with violating section 1
of the Sherman Act. They made the sale of one or more feature films
to television stations conditional on the purchase of other films. In
order to get The Treasure of Sierra Madre, Casablanca, and several
other winners, a Washington television station, WTOP, also had to
purchase such grates as Gorilla Man and Tear gas Squad.
In ruling on the case, the court found that the distributor's
market power resulted from the copyright on the tied goods. The
court further explained that given this monopoly power, the
distributors had economic leverage sufficient to induce their
customers to take the tied good along with the tying good. Speaking
for the Supreme Court, Justice Goldberg considered each copyrighted
film block a unique product, and thus block booking, according to
Goldberg, had adverse effects on competition. Stations were forced
to buy unwanted films and therefore denied access to films marketed
by other distributors.
As with the IBM case, it is certainly not clear that the courts
were correct in their interpretation. How could the tying arrangement
allow the distributors to increase their monopoly power? The court
was saying, in effect, that the block of movies was worth more than
the value of each movie added together. Consider a simple example.
Paramount Pictures has two movies, Winner and Dog. Clearly, they
have a monopoly on these two movies because they own the
copyright. The value of Winner to a prospective movie house is
nebulous if the movie theater won't take the block. If both movies
must be purchased, what does it matter to Paramount if it charges
$500 for Dog or $600 for Winner, or $1,100, for Dog and $0 for Winner,
or any combination? The most it can obtain is the maximum value
of the block to the movie house.
Stigler has suggested that block booking, a form of tie-in sale,
may be inspired by the desire to price-discriminate.
A Numerical Example: In order to see how block booking allows
for price discrimination, we will use a simple numerical example
involving two movies that were indeed block booked by the
distributor-Star Wars and The Other Side of Midnight (henceforth
called Midnight). There are two theaters, X and Y. The maximum
prices they will pay per week for the films are as follows:
$12,000 = PXstar Wurs $ 8,000 = pYstar Wars
$ 3,000 = pXMidnight $ 4,000 = pYMidnight

Therefore, we know that cinema X will pay more for Star Wars
than cinema Y will, but will pay less for Midnight than cinema Y.
Consider the possibility of the distributor's simply selling each
movie separately at a uniform price. He or she will have to charge
the minimum price or $8,000 per week for Star Wars and $3,000 for
Midnight. Thus, total revenues will equal 2 x $8,000 plus 2 x $3,000,
or $22,000.
Now consider the possibility of block booking. The.distributor
will charge a uniform price to both theaters, but they have to take
both films. The maximum block-book price will equal the lowest
combined valuation of each firm for the two films taken together
times 2, or $12,000 x 2 = $24,000. Thus, with block booking the firm
can capture $2,000 more a week in revenues, which translates into
$2,000 higher profits assuming no additional reproduction costs in
the block-book case. Also assumed is no reduction"in the summed
maximum values for the two movies due to the theater owners having
their choice reduced under the block-booking arrangement.
Note that in order for block booking to result in price
discrimination and higher profits, the relative value of the films
must be different for different theaters. Also note that price
discrimination arises only in the context of the implicit prices paid
350 Price Discrimination and Modem Entfepreneur
for each individual film. For example, from the $12,000 fee we know
that cinema Y, with a higher demand for Midnight, is paying $4,000
for the rental of that film. This amount is $1,000 more than the
maximum amount cinema X would pay for Midnight.
Different Goods:
One common way of engaging in price discrimination involves
selling physically different goods at prices that are not reflective of
differences in marginal cost. In this section, we'll look at two
examples: the sale of books and the sale of retail items with different
labels.
Different Book Editions: Hardbacks are sold at a higher price
than paperbacks. The difference in price does not, however, reflect
simply a difference in production cost. On an industry average for
trade books, the price of a hardback is only $5 to $8 more than the
price of a paperback. In Table 6 we list a number of best sellers,
giving their hardback price and their paperback price. Part of the
difference in price reflects economies of scale in the mass production
and perhaps in the distribution of paperbacks. Further, paperbacks
are often associated with a lower risk because they may be
established best sellers. Undoubtedly, though, a large part of the
difference is due to price discrimination. Those who want to read
best sellers as soon as they come out presumably have a numerically
lower price elasticity of demand than all other readers. They end
up paying the higher price for a hardback. Those who can wait for
the soft back to appear presumably have a numerically higher price
TableS
Price o/Hardback and Paperback Best Sellers, Fall 2010
Price
Title Hardback Paperback
Smiley's People $10.95 $3.50
Donahue 10.95 2.95
Portraits 11.95 3.50
Ordinary People 7.95 2.75
The Complete Scarsdale
Medical Diet 7.95 2.95
elasticity of demand. The increased price for the hardback does not
dissuade large numbers of best seller readers, whereas the reduction
in price to paperback readers increases quantity demanded greatly
Total profits will rise.
Library Editions: Price discrimination in book sales was clearly
being practiced with so-called library editions. Library editions were
specially bound books that presumably would last longer. The
differences in price between the library edition and the regular
hardback edition, however, were never equal to the differences in
cost; the price difference was considerably greater than the cost
difference.
Different Labels for the Same Product : Sometimes
manufacturers will sell goods of similar grade and quality at
different prices. In such cases, the major difference between the
products arises from a brand name or label. In 1966, the Supreme
Court ruled that Borden's practice of selling homogeneous canned
evaporated milk at different prices, that is, charging a higher price
for cans sold with the Borden label than for the cans to which other
firms applied their own brand names, was price discrimination.
Chapter
22
LEADERSHIP IN MODERN
--
ENTREPRENEUR
In any economical aggregate some people are bound to be more

active than others. There is a differentiation of roles in economical
groupings that gives a structure and function that, while it may not
always be the same, emerges from the situation. While it may be an
oversimplification to state that in groups there are people who turn
out to be leaders and others who turn out to be followers, for this
chapter it serves a satisfactory beginning. It is virtually impossible
to discuss behaviour, especially economical behaviour, without
including something about the process and nature of leadership.
There are few, if any of us who remain unaffected by the activities of
leaders-assembly line workers have their foreman, college
professors have their dean, Indians have their chiefs, and all of us
as citizens have a president.
What is leadership? Attempts to define leadership or describe
a leader have been many and varied. In the past some reviewers
have focused on outstanding personal characteristics and have
defined leadership around those personal traits. Others, recognizing
the complexity of the economical situation in which we all operate,
have taken into account the many economical variables that are
present and interacting. Definitions of leadership depend, then, on
Leadership in Modern Entrepreneur 353
the focus of attention. Interest in the influence process might develop

the definition of a leader as one who either influences others or who
causes the group to reach certain objectives. Attending to leadership
as a selection process might define the phenomenon as the result of
sociometric choices. A simpler representation of an accomplished
fact would characte~'ize the leader as an individual in a specified
office, while a more arbitrary characterization depicts a leader as
one who engages in "leadership behaviour".
A further identification system is one that concentrates on
certain descriptive functions of a leader. The symbolic leader has
prestige but no power, the administrative leader" gets things done,"
while the expert or the theorist stands out because of his special
qualifications. The charismatic leader has power on a supernatural
or mystical-emotional basis.
Some attempt may be made, however, to focus this diversity of
information toward a shorter verbal definition of leadership based
on a unitary conceptual framework. The concept of role, for example,
is one that may be useful in a description of leadership. In this
view, leadership, quite simply, is a role that is occupied by a person.
Defining leadership in this way identifies a leader as a member of a
group where he is assigned a certain status by that group and
engages in the behaviour that is associated with the position he
oc.cupies.
Leadership also has been viewed basically as an influence
process. A leader may be defined as that person who stands out in
influencing the activities of a group in setting goals and making
progress toward achieving those goals. It should be recognized
that we usually assign to the category of leaders those whose
influence on the group is outstanding. This is important because
each member of a group exerts some influence on another; leadership
is more a matter of degree than anything else.
This definition distinguishes between actual leaders and the
formally designated leaders who may have very little influence on
the group. This is the same distinction that Kimball Young makes
when he distinguishes between "leadership" and "headship." The
latter category includes those who are placed in the position by
354 Leadership in Modem Entrepreneur
virtue of authority or historical accident and who have little control

over circumstances. Sometimes the activity of an individual
operating under formal or legal authorities is called supervision to
distinguish between it and actual leadership. Supervision is most
often used in an industrial setting but it need not be limited to
organizations of that type. There is also no real reason why we
should call a supervisor at the higher organizational level an
executive except that the latter term has by now acquired certain
positive connotations that give it certain emotional motivational
value. Supervision, as used here, should include the exercise of
formal or legal authority at all levels in the organization; the notion
still persists, however, that supervision consists of rather "low-
level" activities while the executive is concerned with more exacting
duties.
In this chapter leadership will refer to the wide range of influence
processes that occur in group interaction. Headship or supervision
are aspects of this broad economical phenomena or leadership.
These variants may differ from true leadership, but since those
invested with formal authority often have, to some extent at least,
the power to influence by virtue of their position, this is still
leadership. And so it will be discussed.
General Approaches to Study:
Leadership is a topic that has fascinated people down through
history, sometimes to the virtual exclusion of all related areas of
human behaviour. It seems that we are vitally concerned (especially
in Western society) with the question of "who's who" and "who's
in charge."
There are many general ways of approaching the study of
leadership. From the past we can identify a basic dichotomy arising
from an analysis of leaders. The most common conceptualization
has been to focus on a single leader apd his characteristics. In ancient
Greece and Rome, Herodotus, Tacitus, and other historians.
concentrated on outstanding men as ~ontributing significantly to:
the stream of events. More recently, Thomas Carlyle remains the
chief proponent of the" great man" theory, the notion that men
make the times. Others have followed in the same or similar
channels; even most of those who have taken psychological

approaches to this problem area have concentrated on the clinical
histories of great men or, somewhat the same, basically, have tried
to determine if there have been any traits that have been peculiar to
leaders or that have been present in them more frequently than in
others. The results of such endeavors have been disappointing,
regardless of the scientific level of the approach.
The other main approach to the study of leadership starts with
a framework representing the converse of the "great man" theory,
namely, that the times make the man. This view has been called the
"situational" or the "sociological" view of leadership and history.
Under this organization of thinking, the researchers look to the
group instead of concentrating on the leader, seemingly an
incongruous way of approaching leadership until we realize that
the situational theory (at least in its newer forms) calls for a closer
look at interactions between individuals in the group (a casual way
of showing the validity of this way of thinking might be to answer
the question, "What does it take to be a leader?" With the not too
facetious response-"followers"). Extending the situational view
to encompass large aggregates would explain events in a fashion
like 'the temper of the times"-such factors as inflation, frustration,
the personality structure common in the German family, and the
search for a father image were responsible for the rise of Hitler. If
not he, someone like him would have fitted into the pattern which
permitted an authoritarian individual to come to the fore.
The focus here is, of course, on the interrelationships between
the members of the group under study. It is conceivable that the
importance of particular traits varies from one leadership situation
to another. If this were so, it could be that the results of the approach
concentrating on the characteristics or traits of a single individual
would nut explain leadership completely.
Traits:
The concentration on personal traits or characteristics has
occupied the attention of a significant number of researchers in the
past, and the interest, in one way or another, continues to the present
day. The measurement of the abilities of individuals who are classed
as "leaders" and a comparison made with others represents, at
least partly, a trend in study that is influenced by the" great man"
approach.
Physical Factors: It is not surprising that physical factors such
as height and weight should have been studied; the interest shown
in this aspect down through the years is evidenced by the folklore
and stereotypes existing in our day-to-day contacts. The main
stereotype has the leader as a tall man. Gilmer tells of the three
windows in the wall surrounding a construction site. The lowest
was labelled "Junior Superintendent," a higher one" Assistant
Superintendent," and -the highest window, "General
Superintendent." References in common speech such as "being head
and shoulders above the crowd" contribute further to the stereotype.
In his extensive survey of leadership studies, Stogdill
determined that nine found leaders taller, two found them shorter,
while one other suggested that the type of leadership activity is the
important feature. Similarly equivocal findings appear for weight,
physique, and health.
Mental Ability: Historically, even more interest has been
maintained in studies of the relationship between intelligence and
leadership. Most shldies agree that, in this respect, leaders are
superior to non-leaders. Certainly, if the group functions in a
problem-solving situation and any activity which contributes to
that problem solving is seen as desirable, those who can contribute
come~o the fore more easily.
A study of college leaders indicated that they scored higher on

the American Council on Education Psychological Examination, a
well-established test of scholastic ability, than did non-leaders on
the campus. In a study in the United States Army, Gibb found that
officer candidates were clearly superior to a general army sample;
99 percent of those selected were above the general population mean.
There may be upper limits, however, though these point to the
situation more than to the attributes. For instance, Holling-worth
found that 30 I.Q. points was the maximum tolerable spread between
the leaders and the led; otherwise the relationship either does not
take hold or maintain itself.
Leadership in Modem Entrepreneur 357
Verbal Ability: Stogdill's survey found that fluency in verbal

communication was a factor to be considered in identifying
characteristics of leadership. It might be intuitively stated that the
ability to talk, particularly where the task is a verbal one, would be
an important variable in leadership. This has since been supported
in the jury studies of Strodtbeck et al. where it was noted, inter alia,
that those who participated more in the discussions were more
influential and when they spoke up at the beginning, were most
often chosen as foremen.
Personalit-:I Traits: Leadership and self-confidence have been
found to be related in most cases, though not all. Drake (1944)
reported a high correlation between these factors. Richardson and
Hanawalt similarly found higher scores on the Bemreuter self-
confidence scale among leaders than among those who did not
display leadership behaviour. In a finding that is representative of
the variation in results of studies in this area, Hunter and Jordan
(1939) did not find a difference in their college group. They did
find, however, that there was a difference between leaders and non-
leaders on the Dominance Scale of that same personality measure.
It seems that leaders may be more dominant in economical
situations, all although here, as with intelligence, there may be outer
limits in a situation with respect to acceptability by others in the
group. Too much dominance may lead to rejection. For instance,
Jennings found that dominant and aggressive leaders were rejected
by the group, although the result may have been partly the result of
the special circumstances; the group was made up of girls in a
closed community, sent there under court order.
Leaders may be more perceptive of ability and personality
differences in themselves and others. In an industrial situation,
Fiedler found that effective supel'visors were ,better able to
differentiate between their best and poorest workers than were the
less effective supervisors. Such individuals are more psychologically
distant from the other members of the group they lead.
The area of introversion-extroversion has received a great deal
of attention generally. Apart from the popular and misleading
approaches to this factor (the categories are not discrete and may be
situationally related), there seems to be little evidence that

extroversion and leadership are related. A review of studies on this
factor by Mann confirms the well-known earlier review by Stogdill
in stating the lack of relationship.
Evaluation of the Trait Approach: While some information
about traits in leadership has been gained from the many studies
that have been made, there still remains a lack of substantial
agreement in the results, particularly when the studies have focused
on characteristics in specific situations. The most significant
outcome from this approach may be the inability to generalize the
findings from one situation to another.
Presentation of the findings in capsule form might be made by
reiterating the results of the well-known survey by Stogdill, one
which is still useful though some time has elapsed since it was
made. Stogdill surveyed studies of personal factors involved in
leadership and found that leaders were higher in self-confidence,
intellectual adaptability, and verbal facility. In age, height, weight,
and dominance the picture was not as clear though there was some
superiority here as well. The above, Stogdill found. represented
only fair agreement between investigators; there were too many
departures from the main findings.
A further complicating factor concerns the limitations placed
on our thinking by a concept of a single and unitary leader. Even
casual observation (though it is backed up by substantial evidence)
demonstrates the fallacy of the notion, the leader. At least some
groups function with more than one person emerging as a dominant
figure, a situation that shows a good deal of fluctuation with time
and place.
It seems clear that while there is no such thing as a "general
leadership trait" or any trait that seems to be necessary in all
situations, there may be generality or transfer of characteristics from
one situation to another. As might be expected, the more alike the
situations, the more the composition of leadership remained the
same. Even more, Katz et al. found generality across different tasks,
but many of the traits in their studies were of a general kind, those
which pointed to leader behaviour in economical situations rather
than to specific personality traits.
Cartwright and Zander express a trend to the study of behaviour
as the result of deficiencies in the trait approach. They put the focus
on the interactional aspects. "Leadership is viewed as the
performance of those acts which help the group achieve its preferred
outcomes. Such acts may be termed grou? functions." Gibb may
have set the stage best for us in his statement that "a person does
not become a leader by virtue of his possession of anyone particular
pattern of personality traits, but the pattern of personal
characteristics of the leader must bear some relevant relationship to
the present characteristics, activities, and goals of the group of which
he is leader." The need to focus on the situation and the part
individuals play in it emerges clearly from most studies.
Roles and Functions:
One of the more precise approaches to the situational approach
to leadership is that which focuses on roles as more descriptive of
the basis of leadership. Some researchers even define leadership as
"a role which an individual occupies at a given time in a given
group" Gouldner. Using the concept of roles not only moves the
observer away from traits and the difficulty that individual traits
may not carry over from one specific situation to another, it also
recognizes that even a description of a situation or the statement of
a role being occupied is insufficient to encompass all the complexity
of economical situations that take place. A "leader" plays more
than one role or his behaviour serves many purposes. In addition,
different individuals may emerge at different times to provide for
more or less influential models or to channel the activities of others
in those specific situations.
One of the most extensive classifications of leadership roles
has been shaped by Benne and Sheats in which they list 27 different
roles. These various roles can be grouped into three general
categories: (1) group task-definition and solution of problems, (2)
group building and maintenance, and (3) individual roles-
satisfaction of individual needs. These are all considered by the
authors to be in the general description of" group required roles."
Another description of leadership patterns is that given by Krech
et al. in discussing the many functions of the position. They place
360 Leadership in Modern Entrepreneur
the various descriptive classifications into two main categories-

those which are primary functions and those which are merely
accessory. The primary functions are those considered essential to
leadership, while the accessory functions may be assumed by the
leader or assigned to him by the group by virtue of his position. All
the various functions can be woven into a practical situation,
especially in an on-going complex and dynamic economical
situation. We might be able to see a little of each type to one extent or
another. More complexity may emerge when the functions of a leader
that are accessory in some situations may become primary in others.
A religious leader, for instance, may act as exemplar or symbol, and
these may be very primary in this particular setting.
A more conceptual and integrative view of roles in leadership
is part of what Schutz calls his Fundamental Interpersonal Relations
Orientation (FIRO) theory. In this formulation there are three
fundamental interpersonal needs-inclusion, control, and affection.
Inclusion is contact or interaction with people or things; control is
power over economical environment, while affection is economical
closeness. An individual functions at an optimal level when all
three areas are functioning in a proper relationship. The focus is on
the individual ego and its development by integrating outer reality;
leadership is viewed as functioning in the same way in that the
leader operates to integrate the needs of the group with reality. The
Table 1. ClaSSification of Member Roles
A. Group Task Roles
1. Initiator-contributor
2. Information seeker
3. Opinion seeker
4. Information giver
5. Opinion giver
6. Elaborator
7. Coordinator
8. Orienter
9. Evaluator-critic
10. Energizer
II. Procedural technician
12. Recorder
B. Group Building and Maintenance Roles
I. Encourager
2. Harmonizer
3. Compromiser
4. Gatekeeper and expediter
5. Standard setter or ego ideal
6. Group-observer and commentator
7. Follower
C. Individ ual Roles
1. Aggressor
2. Blocker
3. Recognition seeker
4. Self-confessor
5. Playboy
6. Dominator
7. Help seeker
8. Special interest pleader
function of the leader is to complete any of the process of integration
that the group does not perform.
Other studies of leadership patterns of behaviour have used
statistical methods to determine the specific factors that are
important and independent dimensions of leadership behaviour.
In one such approach using the technique of factor analysis, the
researchers found that a high percentage of the differences in leader
behaviour could be accounted for by two dimensions.
"Consideration." was that behaviour designed to motivate and
provide satis-factions for members as harmony was being
maintained in the group. "Initiating and directing" behaviour
Table 2. Primary and Accessory Functions of the Leader

Eight Primary Functions of the Leader Six Accessory Functions of the Leader
1. Executive 1. Exemplar
2. Planner 2. Symbol of the group
3. Policy maker 3. Substitute fo'r individual responsibility
4, Expert 4. Ideologist
5. External group representative 5. Father figure
6, Controller of internal relations 6. Scapegoat
7. Purveyor of rewards and
punishments
8. Arbitrator and mediator
coordinated goal-directed activities Leadership behaviour on the

"consideration" factor stresses participation in planning an
acceptance of suggestions from members and, in general, is oriented
toward member satisfactions. Leadership behaviour under the
"initiating and directing" dimension includes definite indications
by the leader of his attitudes and role in the work task and the
nature and level of performance he believes is called for by the
members in the work situation.
Leadership Styles:
In a classic description of the climate developed by leaders,
White and Lippitt (1960) describe three types of styles they believe
emerged from their research studies. In several experiments they
systematically varied the leadership climate in which groups of
ten-year-old boys worked pursuing their hobbies. Three leadership
styles were postulated and produced-the authoritarian,
democratic, and laissez-faire. In the authoritarian style the leader
developed all of the policy and most of the procedures. Not much
went on in the group without the knowledge or personal direction
of the leader himself. Under the democratic procedure, group
activities were pursued after the establishment of policy through
initial group discussion and decision making. Participation of
members of the group was encouraged; there was, however, a need
for the leader to act as a guide or controller of the discussion. The
laissez-faire climate allowed opportunity for an extensive range of
behaviour, often at cross-purposes, in that complete freedom for
individual and subsequent group activity was promoted.
This set of studies included the highly relevant question of
performance of groups operating under the three types of leadership
styles. The researchers noted that output of work was at high levels
much earlier in the authoritarian climate than under the democratic
atmosphere. The authoritarian approach presumably allowed better
coordination of activities to provide the initial high level of
performance. In the long run, however, the output under democratic
situations closely approached the levels reached under the
authoritarian style of leadership. A finer analysis of performance
over the entire period revealed a most significant fact. Performance
under the authoritarian approach varied considerably with the
presence of the leader. When the leader was absent, performance
decreased significantly while it was maintained at regular levels
when he was present. Under the democratic climate, it made no
difference whether the leader was present or not; performance of
the group was fairly even, whether the group was on its own or not.
The group operating under laissez-faire arrangements was
characterized by the uncoordinated horseplay that contributed little
to effective performance. Output was consistently very low in this
group.
Performance of the group represented only one of the two major
aspects considered in this series. The authors considered the
resulting emotional responses and the feeling tone of the group to
be fully as important as the quantitative measure of performance.
The authoritarian climate generated a lot of hostility in the
individuals comprising the group. This hostility was not directed
at the leader, of course, nor was there much venting of these feelings
through aggression toward fellow members. Aggression was
dirct ted primarily toward members of other groups or other
outsiders. An inventory of feelings after the experiment indicatd
lower levels of satisfaction of performance under the authoritariAn
discipline. Hostility and aggression was low in the groups operating
under democratic atmosphere; individuals reported feeling more
satisfied throughout the democratic sessions and aggression toward
others was at a minimal level. The laissez-faire group did not provide
much satisfaction either, in spite of the fact that individual and
group freedom in activity was almost unbounded.
It must be noted at this point, however, that the above represent
general findings; there was some variation on an individual basis.
Not all subjects, for instance, were content with the democratic
approach nor did all function most effectively in that climate. The
fact that some individuals apparently feel a need for a highly
structured situation and do not do well without it is one of the
significant factors t? be taken into account in the evaluation of this
classic study.
Other cautionary statements need to be made as well, since this
set of studies has served as a focal point for countless discussions
of leadership and the factors associated with it. There even may be
some temptation to generalize results as far away as the international
scene in order to promote ideological positions, at least partly, on
the basis of studies such as this one. However valid these results
may be, it must be remembered that the subjects consisted of a group
of ten-year-old boys in an experimental situation. It seems likely,
however, that the results can transfer to other organizational <>ettings
such as industrial work groups. For instance, a study by Baumgartel
(1957) assessed the leadership style of directors of 20 research
laboratories. The directors were divided almost evenly between the
classic three styles of leadership. Scientists in the laboratory were
then asked to discuss the leadership climate conducted by the
director. The directive style (authoritarian) provided the lowest
ratings of satisfaction or orientation toward research and creativity.
The participatory climate (democratic) engendered greater
satisfaction on the part of the scientists who seemed to enjoy the
opportunity to contribute to the development of original work. In
the same way, Pelz found that scientific researchers in a large
government organization performed better under a democratic
approach that allowed them to make their own decisions in a climate
that was neither strongly directive nor completely without any
guidelines.
It may be misleading, however, to suggest that an authoritarian
climate necessarily leads to a condition where a superior lacks
concern for the welfare of the subordinates. Blau and Scott (1962, p.
163) found that supervisors who commanded the loyalty of their
subordinates wer~able to promote productivity even if they were
authoritarian in approach. Stanton also found that an authoritarian
approach need not limit concern for employees. He compared two
companies, one authoritarian and the other democratic, and found
that supervisors did not differ in their attitudes toward consideration
of the welfare of employees.
Other ways of characterizing leadership styles exist, of course.
Knicker- bocker, for instance, identifies four climates: (1) force, (2)
paternalism, (3) bargain, and (4) mutual means. Force is the direct
use of restrictive control while paternalism is characterized
primarily by loyalty of followers in a warm and cohesive setting.
Bargaining involves an exchange in which certain satisfactions are
gained by leaders and followers alike. Mutual means represent a
fusion of individual and group goals and activities or, at least,
attempts made in that direction.
Perception of Leadership:
As has already been noted with frequency in earlier chapters,
much of human behaviour is determined not as much by what is
"out there" as it is by what happens to the material when it gets
inside the human processing system. The perception of the situation
is usually much more important in determining behaviour than is
the objective reality of that situation. The attitudes and views of
individuals involved in all phases of group activity are important
to note; this is true as well in discussions of leadership.
If an individual serves as a leader of a group, it is quite probable
that he is perceived by the members of the group as belonging to the
grou p and sharing with other members the characteristic attitudes
and values of that group. It is not likely that he would function
effectively as a leader otherwise. This factor was stated very early
by Brown as "membership-character" in the group. At the same
time, the members probably have certain expectations, from the very
minute behaviour patterns, perhaps, to the general image the leader
366 Leadership in Modern Entrepreneur
may radiate within the group and outside it. He will probably require
those skills that are judged to be critical for the task at hand and,
even more, will need to excel other members of the group in this
respect. Yet, as we have seen above from Holling-warth's study, the
leader cannot be too far ahead of the group, particularly in intellectual
ability.
The values and norms of the group will influence that group's
expectations vi how the leader should behave. Blau, for instance,
noted that superiors in a governmental organization slipped into a
directive form of leadership behaviour and subordinates became
submissive very readily. All this happened despite clear-cut attempts
by the supervisors to develop a more equalitarian leadership
climate. It was obvious that all members basically insisted that
individuals follow the roles prescribed by the ideologies of the group
in its functioning in the bureaucratic structure of the organization
to which they belonged.
College professors, too, may have their expectations of the
behaviour of department heads or deans. Some campus climates
may foster a directive approach by academic superiors, although it
is quite likely that present trends in academe are away from a
directive approach as an increasing number of academicians expect
more equalitarian procedures to prevail. In this climate the dean is
merely Primus inter pares.
Many observers of the business and industrial scene have
suggested that the kind of leadership expected among American
businessmen is that which we have labelled autocratic or
authoritarian. Individuals who are aggressive and forceful are,
under this set of expectations, ones who are originally selected to
come to the fore as captains of industry.
Perceptions of oneself and others are reinforced, particularly if
one is well placed, by the tendency to see that an existing situation
has something that is "proper" and also to believe that one possesses
the traits or requirements for the position one holds. Porter (1958)
found managers seeing themselves as decision makers with
independence of thought and high degree of initiative, while line
workers perceived of themselves in a way that reinforced a general
image of follower ship with less independence of action. And, since
the two aspects of human functioning mesh together neatly,
perceptions and behaviour were closely related. Bowers, in noting
a similarity in patterns of behaviour between supervisors close
together in the organizational hierarchy, indicated some reasons
for the similarity. Either the lower level supervisors imitate the
behaviour of their superiors because this is where the payoff comes,
or all supervisors have a tendency to think alike because only those
who do are promoted by their superiors. There is, of course, an
organizational tendency to perpetuate the organization in the way
the individuals found it and to select other members of the
organization that are like the existing members of the group.
Followers:
It might be expected, in view of the important place of motivation
in human behaviour, that understanding of leadership behaviour
couldn't be complete unless some knowledge is gained of the "why"
of "leading." The same holds true of "following" as well. What
needs is served in the specialized interaction involved in leadership
and follower ship is an important aspect of motivation. A simple
answer to the question of why people act as they do in the group
situation can be based easily on the general model of motivation
sketched earlier in Chapter 8. We might state simply that certain
needs are present in individuals and that they engage in some
behaviour that will be goal directed. Upon reaching that goal, the
needs are satisfied. In the economical context this implies that some
needs are satisfied for people in a leadership role, while other needs
may be stronger for those who playa less active or less influential
role in the group activity.
It has been stated earlier in this chapter, somewhat facetiously,
that what it took to make a leader was followers. Aside from the
obvious fact that leadership cannot exist without a group, a study
of the characteristics of followers and the conditions under which
they follow is of importance, not only to an understanding of the
dynamics of their behaviour, but also for the need to study followers
in order to gain a better understanding of the leaders themselves. In
the emphasis on leaders and their characteristics, the nature of
follower-ship has been ignored. Consequently, all too little exists in
the research literature.
One such study by Sanford surveyed a sample of individuals
in Philadelphia. After using a scale to differentiate between
authoritarian" and "equalitarian" personalities, the researcher
II
asked the subjects in each of the two categories questions that would
elicit their views of Franklin D. Roosevelt and what made him a
good or poor leader. The responses were categorized into four
classes-whether there was an emphasis on functioning as a
democratic leader, an emphasis on material dependency (the gaining
of material benefits), a stressing of power or strength and, finally,
an emphasis on personal warmth or concern for humanity generally.
In a comparison of the two groups, equalitarians more often
emphasized the function of democratic leader and almost all of the
responses focusing on personal warmth also were given by
equalitarians. The emphases on material dependency were made
by authoritarians. It might be expected that the authoritarians would
emphasize strength of power more than the other group.
Interestingly enough, however, there was no significant difference
between the two groups with respect to their concentration on the
factor of power as being important in their evaluation of the leader.
The study indicates that the response to a leader may be either
positive or negative on the part of followers, but the reasons for the
reactions can differ according to the personality characteristics of
the followers. This has important implications for leadership and
its development.
Hay thorn et al. used the same scale to measure the personality
dimension of authoritarianism and set up experimental groups
composed of leaders and followers on both dimensions. Ratings
were made after a series of experimental tests. As might be expected,
authoritarian leaders were rated as less oriented to others and more
autocratic. Authoritarian followers were also rated in the same way
in comparison to equalitarian followers. In groups led by
equalitarians there was more opportunity for various members,
authoritarian or equalitarian, to participate in the activities of the
group and to exercise some influence. In groups with equalitarian
leaders, the followers were more secure and conflict among
individuals seemed to be reduced.
There may be a tendency, especially because of our casual
references to people as leaders or followers, to believe that there are
consistent and real differences in personality or other traits between
the two types we have established. This is reinforced by following
the trait approach toward leadership behaviour. That some caution
needs to be exercised might be recognized from the fact that
conditions and circumstances differ and, therefore, differing group
requirements may call for various individuals to exercise leadership
behaviour at various times. Not only is the concept of one individual
(the leader) dominant in all situations to be avoided, the hard and
fast distinctions between leaders and followers should be carefully
stated.
There may even be a high relationship between leadership and
follower-ship roles. In a study of choice behaviour in leadership
situations, Hollander evaluated sociometric choices of a group of
naval aviation cadets. The cadets were told that they were to assume
that a critical and stressful mission were facing them. They were
asked to choose those fellow cadets whom they would most or least
like to have as a leader of the group; then each was asked to choose
those he would most or least like to have in his group if he were the
leader. Finally, each cadet was asked to list his best friends. There
was an extremely high relationship between the lists of leaders and
followers that each cadet chose. The same people were chosen as
both leaders and followers, while friendship choices were quite
different. The much lower correlation's with friendship indicated
that, while friends were chosen at times, this was not the same as
an evaluation on other bases and tends to indicate that individuals
will select other members of the group, whether as leaders or
followers, on attributes that are considered to be important for the
task at hand. This would 'confirm casual observation of events like
choosing up sides for games in the primary neighborhood group.
Friends seem to get chosen for one's group, but the skillful players
get chosen first.
Formal Structure and Behaviour:
The nature and extent of the organizational hierarchy playa
significant role in the emergence and maintenance of leadership.
By virtue of one's placement in the group and its channels of
communication, opportunities to exhibit leadership behaviour
appear to a greater or lesser degree.
A position wherein an individual transmits all orders of a
superior to those below and passes information upward to that
superior represents a locus of power, whether the job description
formally specifies or recognizes this or not. Whisler (1960) studied
the "assistant to" personnel in several organizations and found
them particularly influential where top officers were being rotated
frequently. The reliance on the subordinate in these circumstances
is readily understandable. (Whisler also found that the success of
the assistant was related more to how closely he resembled the boss
in economical, educational, ethnic, and political background than
to specific job performance.) The reliance on others may be, as Miner
and Culver state, a mark of the greater feeling of helplessness on the
part of the executive in his meeting of complex job demands.
Communication patterns in a group may, as the result of
previous success become perpetuated so that these patterns remain
one of the main determinants of the leadership function (Klein,
1956). Concomitantly, power, authority, and status are reinforced
by the simple fact of positioning in the communication chain or net.
Klein also found that centrality in the communication structure
was important for two reasons. There is greater access to information
in the central position, and this alone may provide influence and
control. In addition, the occupant of the central slot is more visible
and apt to be more in demand.
Further, since "nothing succeeds like success," the very fact
that one has had an opportunity to practice leadership skills or at
least engage in "leadership behaviour" gives him a later advantage
over those who have been deprived of a chance to do so. Michels
notes further that the exercise of leadership activity contributes to
the motivational structure of the individual. The reinforcement
makes him more likely to act similarly in the future. This is, of course,
consistent with all our information on learning. Parsons, Bales,
and Shils found that the status of leaders can carryover to a new
task. Success with one task enhances the status of the person who
contributes to the successful completion of that task and makes it

more likely that the contributor transfers his status to some new
situation.
In management circles some of the most frequently occurring
questions with respect to the organizational hierarchy and the
impact on leadership has to do with the concept of span of control.
Span of control refers to the number of subordinates directly
responsible to the superior. Much of the activity in this limited area
revolves around the fixing on a specific number in the span of control
on the assumption that the time and abilities of single individuals
impose certain constraints on their functioning with subordinates.
Since the superior and all subordinates are not interacting
constantly, this assumption may not be warranted. However this
may be, the search for the" magic number" continues. Entwisle and
Walton report a span of five as being the median number in their
survey of two different types of organizations. They found that the
presidents of small business companies and the presidents of
colleges or universities had, on the average, a staff of five people
reporting directly to them. They also indicate that, as the size of the
organization increases, the number in the span of control is also
likely to increase.
It might be sufficient to say at this point that no set figure exists
with respect to the number of subordinates a manager ought to
have. Much depends on the internal conditions in the organization,
the type of task, the extent to which interaction is necessary for the
completion of the task, the abilities or capacities of the subordinates,
the communication channels, and virtually any other condition
that affects the functioning of the leader and the organization.
Leadership in Change Situations:
Since change is one of the more ubiquitous features of human
behaviour it should occasion no surprise that change must be
considered in the light of its impact on leadership. Change affects
individuals and groups and, therefore, leaders as well. Changes in
leadership may come about as the result of changes in group
functioning induced by either internal conditions or by those arising
from the external factors. Even groups that look fairly stable or appear
to be in or close to equilibrium undergo change induced by both
internal and external factqrs.
All of the forces generating conflict in groups and organizations
have their implications for leaders. Attitudes of individuals toward
the organization or the leader may be such that friction exists.
Competition among subgroups for scarce resources or a lack of
identification with group goals can upset the equilibrium far beyond
the ability of the leader to reestablish it. Changes can also occur
within the group as people come and go, and the membership of the
organization changes.
Forces from outside the group playa role as well. Input from
the environment, can alter leadership behaviour in many ways.
Attacks or threats from the external situation can result in a change
of leadership or leadership techniques to counter the external
threats. Some external attacks may provide, however, an occasion
for group unity rather than act as a divisive force in the group or
organization. A change in technology, for instance, may force an
industrial organization to reevaluate its position and go so far as to
change not only its leadership but its entire structure. The challenge
arising on this basis may force other companies out of business if
they cannot adapt their functioning to the levels or procedures
required.
The challenge implicit in change is even more pertinent for the
individual in a leadership situation. Since his role usually calls for
more activity than is expected of others in the group, some positive
steps are required in most situations. As he is the prime influencer
of group action, the effectiveness of the leader in dealing with the
conditions of change assumes utmost importance.
There seems to be little doubt that personality factors more than
abilities or knowledge are responsible for most of the turnover in
organizations, particularly industrial ones. Success of managers,
in the eyes of many corporate executives, is traceable to those same
factors and, more specifically, to the ability to evaluate economical
situations or delegate some of the responsibility in the task. The
unsuccessful executives were less perceptive of their own attributes
and those of others with whom they worked.
Another characteristic of successful leaders may be their

avoidance of conforming behaviour, although this may be limited
to individuals higher up in the hierarchy (nonconformity at lower
levels is not often tolerated). The researchers found that the
executives who scored higher on a measure of conformity were
rated lower by their superiors on a measure of performance in their
jobs.
Effective leadership is also, according to Selznick, responsible
leadership. The main task of the leader is to set goals, or determine
what has to be done in order to achieve what must be. "Leadership
is irresponsible when it fails to set goals and therefore lets the
institution drift. ... In addition to sheer drift stemming from the
failure to set institutional goals, opportunism also reflects an
excessive response to outside pressures. To be sure, leaders must
take account of the environment, adapting to its limitations as well
as to its opportunities, but we must beware of institutional surrender
made in the name of organizational survival. There is a difference
between a university president who takes account of a state
legislature or strong pressure groups and one who permits these
forces to determine university policy".
But even responsible leadership often is not enough to meet the
most challenging situations an organization will face, Selznick
adds. What is called for in addition to responsibility is creative
leadership, a concern for constructive change in all facets of
organizational functioning.
***
Chapter
23
ORGANISATION OF FOREIGN
--
TRADE BY MODERN
ENTREPRENEUR
Foreign or international trade means trade between citizens of

different countries or between the countries themselves. Foreign
trade can be bilateral or multilateral. It is bilateral when it is between
any two nations. It is multilateral when each country buys and
sells with whatever other country it wishes.
The important feature of foreign trade is that one country sells
goods or services to, or purchases goods and services from, another
country, where goods or services of a country are sold in a foreign
country, it is said to be engaged in export trade. Where it buys
goods or services from one or more foreign countries, it is said to be
engaged in import trade.
There is a third kind of foreign trade, known as entrepot trade.
In entrepot trade, goods are impo.rted into a country not with the
object of use within the country but for re-export to some other
country.
Growth of Foreign Trade:
The earliest trade between countries took place when they were
able to supply one anoth!,!r with goods which they were unable to
produce for themselves. But if foreign trade had only followed this,
Organisation of Foreign Trade by Modem Entrepreneur 375
it would not have cached its present proportions. The real reason
for its tremendous growth is that countries now-days import many
things which they could produce themselves, in the same way that
individuals purchase many things they could make for themselves.
Division of labour and specialisation, followed by exchange,
result in a greater output of everything and this same thing applies
to foreign trade as well.
The principle underlying foreign trade is that a country should
specialise in the production of those things for which it has the
greatest advantage over others.
Breaking the barriers: Foreign trade recognizes no traditional
national boundaries. It is freely carried on even between nations
which are poles apart in many respects. Even if any two countries
have adopted different political and economic systems, this does
not have much effect on trade between them.
Take the U.S.A. and U.S.s.R., for example. One is a firm believer
in free economy. The other advocates State control over everything.
Neither of them misses any opportunity to criticise the other's role
in various international developments. But when it comes to trade
between them, they give the impression as if they never had any
political or ideological differences.
What does this show? One, the satisfaction of human wants is
given top priority by all nations. Two, that modem methods of
production have introduced a sharp division of labour so that each
country now produces only those goods which it can most profitably
produce; and what it does not produce, it conveniently gets from
other countries. Lastly, that developments in the field of transport
and communications have made nonsense of the traditional
national boundaries.
The net result of all this is that today no country can boast of
being self-sufficient in all respects. Practically every country is
dependent on one or more countries for one thing or another.
Advantages of Foreign Trade:
If foreign trade has been able to break geographical and even
ideological barriers, it is because of the following advantages offered
byit:
376 Organisation of Foreign Trade by Modern Entrepreneur
(1) Mutual give and take: Because of foreign trade, each country
can avail of the goods that it does not produce itself. Likewise, a
country with surplus of certain foods can make it available to a
country of countries the:, t need it.
(2) Specialisation and efficiency in production: Foreign trade
enables a country to concentrate on production of only such goods
that it can most efficiently and economically produce. This results
in reduction or costs and increase in profits for it.
(3) Increase in total world production: Because each country
produces only such goods as it can produce at the lowest possible
cost and sell' at the maximum possible profit, it is able to avoid
wastage of its productive resources. All factors of production can
thus be used to their maximum capacity.
This results in increase in total world production which would
be an impossibility in case each country had been required to
produce everything needed by it irrespective] of whether or not it
was profitable for it to do so.
(4) Higher standards of living: There are not many countries
which have resources to produce everything they require. As such,
if each country were to produce everything it needed, it would not
be able to do it economically as a result of which standards of living
of its people would remain low. Because under foreign trade it is
possible to obtain all kinds of goods from abroad, a country can
assure better standards of living for its people.
(5) Optimum use ofnatural and human resources: Foreign trade
enables a country to make best use of its natural and human
resources. Take Japan, for example, It is best equipped for
manufacturing industrial goods. For a large part of its requirements
of foodstuffs and raw materials, it depends on other countries. If
there had been no-foreign trade, it would also have to produce its
requirements of foodstuffs and raw materials a task for which either
it does not have proper resources or, even where it does, it cannot
make optimum use thereof.
This way, not only the country concerned but all those who
could benefit from its specialisation in the production of certain
goods would stand to lose.
(6) Difficulty ofnwvement of resources : Foreign trade makes it

possible for each country to attain fullest and most profitable
utilisation of its productive resources. Were there no foreign trade,
these resources would remain unutilized or under-utilized. Even iL
would not be p08sible to shift such resources to a country which
could use them profitably because while capital and labour are
normally shy of leaving their homeland, in the case of land such
movement is physically impossible.
(7) Equalisation of prices between countries: Foreign trade
serves to equalize prices in all the tradiJ;lg countries. without it, a
country having appropriate resources to produce a particular
commodity in abundance would face a situation of glut and such
commodity would fetch a low price when sold internally. As against
this, in a country lacking in resources to produce such a commodity,
it would be in short supply and this would make it very expensive
there.
With foreign trade, the supply of such goods in the first country
is reduced (through exports) so that its price goes up and the
producers are enabled to get fair return on their produce. In the
second country the supply of such commodity is increased (through
imports) so that its price in that country is lowered.
Thus, the prices of internationally traded goods tend to be the
same everywhere, the slight difference between them being due to
transport costs.
(8) Miscellaneous advantages : Besides gains from
specialisation and exchange, foreign trade also offers several other
advantages. For example, it enables induction of latest technology,
new ideas, social changes and liberal attitudes.
Problems of Foreign Trade:

Even though both in volume and value foreign trade has
achieved an enormous success, it has still a long way to go. Some of
the problems of foreign trade are as under:
(1) Obstacles in free movement of goods: Full advantages of
foreign trade can be availed only when there are no obstacles in the
378 Organisation of Foreign Trade by Modem Entrepreneur
movement of commodities between countries. Such obstacles may

be of two types: natural and man-made. Natural obstacles, such as
long distances and high transportation costs, can be easily got over.
But what can not be so easily got over are man-made obstacles,
such as, customs barriers raised by govern~,ents to restrict or
prohibit free flow of trade between countries.
(2) Monopolistic competition : Foreign trade can produce
benefits only under conditions of perfect competition i.e., where a
country is free to buy or sell in any country it likes. Then only total
output can be maximized, costs and prices can be minimized and
maximum consumer welfare ensured.
But in practical life, we have conditions of monopolistic
competition where a few economically advanced nations with their
powerful multinational companies have neatly divided the world
market among themselves.
(3) Dissimilar economies of scale: Trade between any two
nations can flourish only when they have similar internal and
external economies of scale. It is only by attaining economies of
scale in a particular line that a country may secure enough cost
advantage to neutralize high labour and transport costs, In reality,
however, only economically advanced countries can achieve such
levels of economies so that the world market -has come to be
monopolistically dominated.
(4) Language barriers: Each country has its own language
and also often its own script. This creates problems of
communication between countries.
(5) Independent currency system: Each country has its own
independent currency system and this creates problems in regard
to payments as between nations.
(6) Greater exposure to risks: People tmdertaking foreign trade
transactions are separated by long geographical distances, This
creates problems of transportation of goods from one country to
another. Yet another problem is that goods transported from one
country to, another are subject to several risks because they remain
in transit for long periods.
(7) Blocking of capital for Ions periods: because there is a long

interval between the time when the goods are dispatched and when
the same are received and paid for by the foreign importer, the
exporter has to invest a large capital in his business to provide for
slow turnover.
(8) Other problems: In the absence of direct contact between
the seller and the buyer, it becomes a difficult task for the seller to
inquire into the credit worthiness of the buyer and for the buyer to
inquire into the reliability of the seller.
This is not all. Foreign trade transactions entail preparation
of a large number of documents and compliance wi th several legal
and customs formalities.
How Orders are Received from Abroad:
Selling goods in foreign countries is not an easy job. It is rarely
that a foreign customer would send in his order to an Indian
manufacturer or exporter without any effort on the letter's part.
There has to be continuous, systematic nurturing of the export
market for local goods.
First of all, the manufacturer Qr exporter should study the
markets from where he hopes to receive orders for his goods. He
should gather information as to population, standards of living,
customs duties and other relevant regulations in those markets.
Then, he should obtain details as to the nature of demand in
those markets, the extent of demand at different price levels, any
other factors likely to affect demand, such as, economic, social, or
religious, and the degree of competition to be faced there.
Likewise, if dealers in those markets have any special preference
for a particular kind of packing or dispatch of roods, it should also
be carefully noted.
It is only after undertaking such detailed study into the
functioning of various foreign markets that a local manufacturer or
exporter can hope to establish a foothold there.
To convert such foothold into a stronghold, the manufacturer
or exporter would have to do a number of things, important among
which are as follows;
1. Advertising: Advertisements in newspapers and

magazines having international circulation should be liberally
given. Special preference should be given to those newspapers and
magazines which are widely read in the countries to which goods
are proposed to be exported.
2. Personal visit: A representative of the business may
personally visit such markets to establish contacts with dealers
there. Needless to say that relations established in this way pay
richer dividends than those borne of correspondence or other
indirect means.
3. Advertising letters and leaflets : Letters and leaflets
introducing the manufacturer or exporter to dealers in foreign
markets may also be sent.
4. Visits to buyers from foreign firms. Representatives of
foreign firms visiting the country may also be contracted to explore
the possibilities of exporting goods to their respective countries.
5. Salesmen: Though appointing salesmen to visit foreign
markets from time to time is a costly proposition, it helps a lot in
promoting exports. But care should be taken to ensure that such
salesmen possess good knowledge of the countries to be visited by
them and that they are armed with sufficient publicity material,
such as, samples, literature, etc.
6. Agents or foreign representatives: These can prove to be a
good source of information about their respective markets. Goods
can be sent to agents or representatives on consignment basis and
they may be paid commission on sales effected by them in their
respective countries.
7. Foreign branches: In casethe manufacturer or exporter is
resourceful enough to afford it, he can set up branch offices in foreign
countries. But this should be done only when there is already a
good market in those countries for the goods produced by the
manufacturer or exporter.
S. Middlemen: Establishment of foreign branches or
appointment of agents or representatives in foreign countries cannot
be done by all manufacturers or exporters for the simple reason that
Organisation of Foreign Trade by Modern Entrepreneur 381
this costs money. For medium or small-scale firms, middlemen can

prove to be of great help. These middlemen assist in establishing
business relationships between exporters and importers for a small
fee or commission. Such middlemen can be classified as under;
(a) Export agents: They operate in the exporting country. They
buy goods in their country from different manufacturers and
dispatch these to their principals in importing countries.
(b) Import agents: They are appointed to obtain supplies from
abroad for importers, i.e., their principals. They operate in the
importing country but maintain establishments in various countries
from which goods are imported. They are paid on a commission
basis.
(c) Indent houses: Also known as Indent Firms, these can be
found at every important port town. They combine the functions of
export and import agents. They buy floods in local markets for their
foreign principals and arrange to dispatch these to them. Similarly,
they also tea buy goods in foreign markets for ~eir local principals
and arrange for their import. They are also said on a commission
basis.
(d) Forwarding agents: They specialise in the collection of goods
from the premises of the sender and pass them on to the main carrier
which is to take these to their destination.
(e) Clearing agents: They specialise in attending to the
formalities at the Customs while taking delivery of the imported
goods at the port and then forwarding them to the importer's place
of business.
Types of Foreign Trade Transactions:
Foreign trade transactions may take various forms. These
depend on the type of contract that is entered into between the
parties concerned. Based, on this, foreign trade transactions may
be classified as follows:
(1) Direct business : When importer or exporter does not make
use of the services offered by middlemen and enters the foreign
market all on his own, he is said to be engaged in direct foreign
trade business.
But an importer or exporter will do so only when he has the
necessary capital or credit to finance shipments to, or from, overseas
parties. Also, it will depend on the degree of specialisation
possessed by the person concerned in this field.
(2) Consignment business: In co~signment business, goods
may be exported either in response to definite orders or a whole
cargo may be consigned to a foreign agent or representative with
instructions to sell either at a fixed price or for the best price he can
obtain there. An agent or representative receives and sells the goods
on behalf of his principal. For the services rendered by hire he is
, paid commission on sales. From, time to time, the agent submits
particulars of the sales made by him and remits the proceeds after
deducting his commission and expenses.
(3) Merchant shippers: They supply their foreign customers
with goods which they themselves purchase from different local
manufacturers. They operate their business at their own risk.
(4) Indent houses : Indent firms are like other middlemen
operating between exporters and importers. They maintain their
offices at every important port town, like Bombay, Calcutta, Madras
etc. For the s~rvices rendered by them, they charge commission from
the importer on whose behalf they buy goods from foreign
businessmen and get them shipped here. Indent houses perform
many useful functions for importers, some of which are as follows:
(i) They assist importers in getting over the intricate problems
involved in importing goods from foreign countries.
(ii) Through their agents in foreign countries, they ensure that
the goods shipped jn response to importers orders are of
the right quality and standard.
(iii) They help in sorting out complaints and grievances of
importers in respect of goods received from foreign dealers.
(iv) Since indent houses command good reputation, their client
importers can cash on it and get credit facilities from banks
and other financial institutions.
(v) They keep importers informed of any change in tastes and
fashions in the- foreign markets.
(vi) They help importers in obtaining favourable terms from
foreign dealers.
Need for Government Control:
The need to have a favourable balance of trade and payments
has made it obligatory for the government to regulate foreign trade.
This is as it should be. Because, in the long run, a nation may stand
to lose if it imports more than it exports. Considering the scarcity of
foreign exchange resources, no country can manage its economy
well if the payments for its imports exceed its export earnings.
Likewise, imports cannot be allowed to pose a threat to local
production units. If anything, imports need to be so organized that
they provide an impetus to production within the country. And of
course, import of inessential goods needs always to be curbed.
If governmental action is necessary to control imports, it is no
less so for the regulation of exports. Exports cannot be allowed for
the fun of it. For example, it would serve no purpose to allow exports
of goods which are in short supply in the country. Then, there is
always a need to use the precious export earnings for the good of
the nation. Further, conscious efforts need to be made to channalise
our exports to countries whose currencies are difficult to obtain.
Last, but not least, exporters have to be so organized that they help
production within the country.
How control is exercised:
Control over exports and imports is exercised as per the
provisions of the Imports and Exports Control Act, as amended
from time to time.
Accordingly, commodities included in Schedule I to the Exports
Control Order, 1962, cannot be exported without an export license.
As for commodities which are included in the O.G.L. (Open General
License) List, these can be exported without any export license if
their export is not regulated by any other law. For example, exports
of tea are regulated by the Tea Board under the Tea Act and those of
coffee by the Coffee Board, under the Coffee Act.
Similarly, imports are also subject to governmental control and
importers are not free to import anything they want, they have to
384 ,Organisation of Foreign Trade by Modem Entrepreneur
apply for import licenses to the Controller of Imports and Exports
who grants their, such licenses within the framework of the existing
import policy of the government. Commodities which are in short
supply in the country are allowed to be imported without any import
license. Such commodities are specified from time to time in the
Import Trade Control Orders. The list that contains these
commodities is known as the O.G.L. List. Commodities not placed
on this list can be imported only under an import license.
For grant of Export and Import licenses, applicants are divided
into three categories, i.e.,
(i) Established Exporters or Importers.
(ii) Newcomers.
(iii) Producers or Manufacturers.
Exchange Control: Besides control over import and export of
goods, the government also exercise control over the foreign
exchange involved in it.
For example, an exporter of goods to foreign countries, except
Nepal, Tibet and Bhutan, must furnish to the Collector of Customs
(or any other authority specified by the Reserve Bank of India) a
declaration that he will surrender the foreign exchange representing
the full value of the exported goods, to the Reserve Bank of India
within the prescribed period.
Similarly, foreign currency required to be paid in case of import
of goods is released after proper scrutiny by the government or the
Reserve Bank of India. Such foreign exchange is not directly released
to importers.
***
Chapter
24
tItI
IMPORT DECISIONS BY
MODERN ENTREPRENEUR
Basically in every transaction two parties are involved i.e., the

seller and the buyer. One offers the goods and services and the
other who accepts, pays for them. On the face of it, the operation
appears to be simple. It is simple in the case of local transaction
when the buyer goes to the seller and pays for the goods purchased.
In international trade things are not so simple except where the
foreign customers comes to the seller and does the whole job of
taking goods to his country. The seller has to send goods to foreign
countries by rail, steamer and air. Shipping companies or other
carriers of goods have to be approached; customs and banking
formalities have to be complied with; every care has to be taken that
the goods reach the destination in safe and square condition;
payment has to be obtained from the overseas buyer to the satisfaction
of the Reserve Bank of India; and a number of other steps have to be
taken which make international trade somewhat complicated.
Overseas market is not merely an extension of domestic market.
Apart from the basic principles of sound business in domestic as
well as foreign market, selling abroad needs specialized knowledge
regarding certain matters such as detailed market surveys, shipping,
marine insurance, customs and foreign exchange formalities etc.
386 Import Decisions by Modem Entrepreneur
Various techniques of export marketing which an exporter must

know are dealt with in the paras to follow.
Knowing the Goods:
Detailed information regarding the goods intended to be
exported is a must for every exporter. The exporter should study
where the goods are produced, are they available for export, what
are factors governing their production, what are the prices obtained
in India and abroad, what is the tendency of the prices to fluctuate,
what is the pattern of trade in regard to the goods, what are the
probable markets, changing tastes and consumer preferences, what
are present sources of supply, are there any difficulties in storage,
preservation and transportation, and last but not the least, what
are the relevant regulations and import duties in force in buyer's
country. Information regarding matters stated above can be obtained
from Export Promotion Councilor Goods Board concerned or the
Director General of Commercial Intelligence and Statistics or the
Export Promotion Officers posted at various important cities of the
country. The functions of these agencies are fully dealt with in
separate chapter.
In case the exporter himself is the manufacturer of the goods
intended to be exported, he should, in addition to the matters
mentioned above, have a clear cut idea of uniqueness of his product,
maintenance of a consistent standard of quality to meet the needs of
foreign customers, enough production capacity, supply of service
or maintenance, if required, adaptability of the product to differing
foreign) needs and tastes, sales literatures, handling instructions
or service manual printed in a foreign language or languages, cost
of shipping etc.
Assessing the Competition:
Overseas markets are highly competitive and, therefore, it is
necessary for every exporter to assess degree of competition. For
assessing degree of competition, he should have a clear idea about
the competitors, their products, prices, marketing techniques, terms
of business etc. so as to enable himself to offer a product to foreign
buyer with a bargaining edge in order to capture the foreign market.
Import Decisions by Modem Entrepreneur 387
Once the competition is assessed, exporter should know his

position regarding: '
(a) the approximate price at which product can be offered;
(b) the terms of credit etc. to be offered;
(c) the packaging, transportation, storage and distribution
methods to be adopted; and
(d) the marketing support to be offered in the term of publicity
literature, visual publicity advertisement, gifts, etc.,
depending on the product.
Market Intelligence:
Marketing is more a science based on precision and
methodology rather than on mere experience and intuition. In the
absence of actual inquiries from the foreign buyers potential exporter
has to explore market potentialities for his goods and locate foreign
buyers. The task of finding markets and buyers is done either by
seeking the help of market research already conducted by different
agencies and institutions specializing in the field or by conducting
fresh market surveys where no such survey reports are available.
As a preliminary step for locating foreign markets, the potential
exporter should examine the export statistics put out by India as
well as other countries over a few years, talk with experienced
exporters, make good use of the trade association, chambers of
commerce, association of trade and industry or export association,
if any, contact foreign or international departments of the
commercial banks, examine trade directories from various countries
or study foreign telephone directories. Alternatively, expert help
may also be sought from the government export promotion
agencies. However, for the convenience of potential exporters,
different sources along with names of publications published by
them and periodicity there of from where a preliminary idea of
products in demand and places where they are in demand can be
had are listed in Appendix I.
However, if survey reports or lists are not available, the potential
exporter should have survey conducted through his own
388 Import Decisions by Modern Entrepreneur
organisation or though a specialized agency. In this connection, he
may contact the Indian Institute of Foreign Trade which is engaged
in market research abroad and which coordinates the markets
survey programmes undertaken in the interest of export promotion.
For conducting such surveys, the Government of India provides
assistance through the Market Development Fund.
In investigating sales prospects for a product in a particular
market, following information is to be gathered and assessed:
Basic Factors:
(i) Area of the country, climate, distances between main
centers, and other geographical factors that may influence
the demand for the product.
(ii) Size, age distribution, and concentration of population.
(iii) Level of income, distribution of income and what sectors of
the population might use the product.
(iv) Natural resources (limited, potentially rich); importance of
agricultural or other products in earning income.
(v) Extent and stage of industrial development, plans for
further development; amount of foreign investment coming
in.
(vi) Present economic situation, trade balance, credit standing
availability of foreign exchange.
Access to Market:
(i) Import restrictions, such as licensing or quotas.
(ii) Rates of customs duties and whether goods from the
country receive preferential treatment.
(iii) Method of calculating the value of goods for duty purposes.
(iv) Marking and labelling regulation: need for health
certificates for animal, plant and fisheries products; testing
procedures for pharmaceuticals etc.
(v) Convertibility of currency, any currency controls, controls
on remittances.
(vi) Added value or other Internal taxes.
Import Decisions by Modern Entrepreneur 389
(vii) Bilaleral trade or barter agreements that favour imports
from particular sources.
Marketpotential:
(i) Current and potential demand for product.
(ii) Domestic production of product or one closely related to it.
Major producers and location, investment plans, etc.
(iii) Statistics on imports of the products by volume, value and
country of origin. Are these increasing or decreasing?
(iv) Dominant price and quality ranges of imported and
domestic product; range with the largest current and
potential sales.
(v) Prices at the importer, wholesale and retail levels.
(vi) Control of market by traditional suppliers, acceptability of
new products.
Market Requirement:
(i) System of measurement used, imperial, metric etc.
(ii) Preferred basis for price quotations: CIF, FOB, C&F., etc.
(iii) Terms of credit considered normal: letter of credit, sight
draft, etc. If credit is necessary, what are the standard terms?
(iv) Preferences in styling, quality, etc., because of national
characteristics or interests as they differ widely from those
in the exporter's country.
(v) Need to conform to certain standards such as electrical
standards, and the procedure for approval; also grading
. system, if any.
(vi) Need for special packaging because of climate, shipping
conditions, government regulations, or local tastes and
prejudices.
Distribution:
(i) The normal importer of the product, whether manufacturer,
commission agent, merchant, stocking distributor or other.
Commissions expected in each instance.
(ii) Normal distribution pattern.
(iii) Should one firm have the exclusive agency for the whole
market or should a number of representatives in various
locations be preferable?
(iv) Do importers normally carry large stocks to supply the trade
or!re frequent small shipments common?
(v) Will the representative expect advertising support?
Sales Promotion:
(i) What media are available for advertising the product e.g.
newspaper, trade magazines, radio, television, cinema etc.
(ii) What is the cost of advel'tising space or the in the media
best suited to advertising this product?
(iii) Are there any suitable trade fairs or exhibitions in the area
and what is the cost of participating in them?
For successful completion of market surveys and for having a
I continuous knowledge of the ever-changing situation in foreign
markets., an uninterrupted flow of information, intelligence and
statistics on a meaningful basis would be required. This information
can also by obtained from trade representatives of Government of
India in different countries.
This market research tells that markets to avoid are those in
which the chances of success are negligible. In general, a market
should be avoided if :
(a) the product is not likely to appeal the customers taste there;
(b) the product needs more adaptation than the demand
warrants or more than what can be really afforded on this
point;
(c) import restrictions and/or high tariff in effect reduce or
eliminate the demand;
(d) shipping cost will be too high;
(e) too much money will have to be spent on pulling out the
sales literature and catal9gues in other language or
languages;
(f) offering service and maintaining a stock of spare parts will
not be easy.
Another method of establishing contacts with the foreign buyers

is to visit foreign markets. Visits to foreign markets can be undertaken
either as a member of trade delegations sponsored by different
agencies or individually. However, this is costly method and a
prospective exporter intending to visit foreign countries is required
to know quite a few things about the general socio-economic and
political set-up of the countries which he intends to visit, the price
structure, banking and shipping facilities, import-export and
exchange control regulations, customs regulations, foreign exchange
requirements of the proposed visit etc. The Director of Commercial
Publicity has brought out a few booklets containing such
information on some countries. The Engineering Export Promotion
Council, Calcutta has also brought out a few similar publications.
If an exporter wants to know something more about the country,
which he intends to visit he is advised to write direct to the
commercial representative posted in the country concerned.
Still another way to find a market is to exhibit the product in
one or more trade fairs. This the exporter can do either on his own
or in a section of the fair taken over by the Government. At a trade
fair, exhibiting can study the reaction to his product, compare it
with the products of his competitors from other countries, make
contract with possible agents or customers. Even attending a trade
fair only as a visitor can be useful in granting contracts.
What has been discussed above relates to finding of new
markets as distinguished from maintaining existing markets. Export
organizations have to be management minded market oriented with
programme flexibility adapting with changing world treating
packaging, advertising and public relations as an integral part of
marketing plan, keeping in close touch with distribution channels
and changes thpreto and putting marketing operations into these
new emerging pattern of distribution and providing for other sales
service ensuring that the company's warranty obligations are' met.
Selecting Channels of Distribution:
In exporters own cotmtry, there are two types of channels
(a) Direct channels including own export organisation
subsidiary export company or allied export selling company.
Though having own export department is economical and

effective, decision with regard to it depends upon financial
and managerial resources at the disposal of the concern.
(b) Second type of channels include confirming houses,
merchants exporters, export houses-and group selling.
The confirming house acts as a broker between the buyer in one
country and the seller in the other. India's trade in individual items
is generally carried out through this method. Merchants exporters
specialise in acting as merchants for business in overseas market.
The export merchants generally purchase goods from local concerns
and sell them abroad in their own account. Thus the supplier is
paid promptly in local currency and relieved of the work relating to
expensive overseas surveys and visit, shipping and packing details,
legal formalities and international risks etc. However, the supplier
loses control over prices, places where he wants to sell and even the
manner in which he wants to sell. Moreover, commission paid to
the merchants exporters adds to the cost of product making the
product lmcompetitive in the highly competitive overseas mark~ts.
Export houses imply concerns engaged in international
business. Export houses have a number of departments each as
financial department, billing and invoicing department, cables,
mail and shipping department. These houses generally buy goods
on cash from the local manufacturers and extent credit to foreign
buyers. They often perform their own freight forwarding services
and through bulk exports economies in ocean freight. Goods are
also exported by export houses on mutually satisfactory terms.
In group selling technique which is not prevalent in India, a
few small firms producing non-competitive but complementary
products join the group by pc Jling the resources and co-operate in
one or more than one field vf marketing information, market
research, sales promotion, joint channels of distribution abroad etc.
Theoretically, this is a very economical and effective method of
selling abroad. But subject to co-operation among different units
this method depends upon availability of trained and experienced
>:..
personnel in the field of export trade.
Import Decisions by Modern Entrepreneur 393
In case, the potential exporter decides to sell directly in foreign
market, he can have a much closer contact, control over local
customers and be far more in command of the market. In the country
of import the exporter has to select channels of distribution.
Channels of distribution of goods in foreign countries mainly
include commission agents, wholesalers and retailers.
The foreign commission agent obtains order on behalf of the
exporter and sends them to the exporter who arranges shipment to
the actual purchaser. The foreign commission agents are of vital
importance for handling goods like machinery's, equipment's, etc.,
which are manufactured against order only. There are agents who
carry stocks for a product on behalf of the exporter on consignment
basis. An exporter avails of all the agents importing facilities and
his position to push sales. But this is a risky method as the agent
may lack both the ability and staff to distribute the products to the
best advantage.
Foreign wholesalers or importers who often buy and sell on
their own account, specialise in imported goods and can develop
sales of almost any product. For developing sales of any products,
wholesalers abroad insist upon sole importing rights in their
respective territories. Before entering into any agreement with foreign
wholesalers to this effect and matters relating to territory, kinds
and description of goods, price and terms, commissions and other
remuneration, mode of payment, method of packing and marketing,
the method and agency for Inspection before shipment, agency for
settlement of disputes including arbitration arrangements, other
duties and responsibilities etc., the exporter should satisfy himself
that wholesalers abroad ace merchants of repute with high market
standing in their respective territories. "-
Goods which lend themselves to wide consumer appeal can be
handled through foreign retailers, thus eliminating commission,
otherwise payable to wholesalers. This method is particularly
suitablE in dealing with large departmental stores or super bazars
which import large quantities.
Starting Correspondence:
It is not that the buyer buys the goods. But it is that he has been
sold the goods. Good and effective correspondence is a key to start
394 Import Decisions by Modem Entrepreneu r
successful export trade. Before starting to write a letter, the potentia I
exporter should give due consideration to the paper to be used i.e.,
the letter head is attractive enough, it shows company's name,
address, telephone number, cable address or telex number, city,
province or state or the equivalent and country. The idea is that the
prospective customer before reading the letter should feel that the
exporter is well established and well managed.
The first and foremost ingredient of good letter is politeness.
Politeness includes not only the manner of writing and form of
address, but its language also. Letters should be written in the
language of the man to whom the letter is written or in language
widely used in business, e.g. English, French, Spanish, German or
Italian or on its cwn language thus avoiding possible
misunderstanding. The most satisfactory procedure is to write in
customer's language for which services of a translator can be
avoided of, if required. For this, export promotion agencies, trade
associations, chambers of commerce and the language departments
of the universities can assist in putting in touch with a good
translator. However, if the exporter intends to try correspondence
in any of the commercial languages internationally used, the
following publication would prove useful:
(i) Export Import Correspondence in English, German, French,
Spanish published by Gower Press Ltd., London.
(ii) La Correspondence due Commerce International Buroter,
S.A. Madrid (Spain). It is a comprehensive guide to
commercial correspondence in aforesaid five languages.
(iii) Bilingual Guide to Business and Professional
Correspondence (English & French) published by Pergama
Press Oxford (U.K.).
Second foremost rule is be precise while writing to on agent or
prospective importer abroad. While replying an agent, instead of
sending hire a form letter with a sheet tom out of catalogue, he
should be told something about the firm and its standing, the major
uses of the product and the types of firms to which it is already
selling. In case the letter is destined for the potential buyer, he should,
be told whether the exporter is selling through agencies or direct,
his export prices, usual credit letters and in what foreign market he
is already selling.
The exporter should also be precise a& to product as well as
price. If F.O.B. price is'quoted, approximate cost of shipping should
also be given enabling correspondent to know Just about how much
the product will cost to him.
Third rule is to be prompt. It means write letter even when the
exporter has no definite news to give or when no business will
result. It also includes acknowledging an order at once, especially
if it will take time to fill it. Besides, letters should be dispatched air
mail and should be fully stamped Cable telex and telephone can
also be employed for urgent business.
Last but not the least, rule is to be persistent which also means
that every inquiry about the product and every request for more
information should be followed up.
Answering Trade Enquiries and Sending Quotations:
Once contact between exporter end importer has been
established the potential exporter may expect to receive trade
inquiries from abroad. The first and foremost thing that he should
take P'lrticular care to do is to reply promptly and courteously to
these inquiries.
Trade inquiries often relate to the price at which the exporter
can deliver the goods at the port of the destination. However, while
quoting the price, the prospective exporter should also forward to
the prospective buyer a copy of the standard contract form, if any,
which the trade community to which he belongs has evolved. In the
absence of standard conb;act form, the exporter should send various
details of his terms and conditions as forming part of the quota tion
to be sent by him to the prospective buyers. The terms and conditions
of sale should specify the following:
(i) The price to be charged;
(ii) The quantity and specification of the goods;
(iii) The method of packing and marking;
(iv) The place and date of delivery;,
(v) The method and agency for inspection before shipment;
(vi) The commission and discounts, if any; (vii) The tine and
method of payment;
(viii) The responsibilities and rights of the parties; and
(ix) The agency for settlement of disputes, including arbitration
arrangements.
It is also advantageous to send along with the quotation and
the terms a Performa invoice as in some countries the importer may
have to produce license. In such cases it would be advisable to have
the Performa invoice countersigned by a Chamber of Commerce or
association to which the exporter belongs.
Ensuring Buyer's Credit Worthiness:
Before entering into actual contract with foreign buyer, the
prospective exporter should ensure himself regarding the credit
worthiness of the prospective buyer. Reference regarding the buyer's
credit worthiness can be obtained from one or more of the following
sources:
(i) Exchange Banks,
(ii) Director of Commercial Intelligence and Statistics, Calcutta.
(iii) Export Credit & Guarantee Corporation of India.
(iv) Firms dealing with importer.
(v) India's GovemmentTrade Representatives abroad.
(vi) Other sources such as Chambers of Commerce, Trade &
Industrial Associations.
Knowing Foreign Government Regulations and Trade
Agreements:
In order to be in a position to prepare or arrange for the
preparation of shipping document correctly, the exporters are
supposed to know foreign government regulations relating to certain
matters such as consular invoice, import licensing, protection of
trademark patent and copyright etc. In this connection, the exporters
are advised to consult" A Hand Book of Import Regulations" which
details out trade regulations in 79 countries. This Book is published
by the Engineering Export Promotion Council. Further details may
be ascertained from any Chamber of Commerce or Export Promotion
COlIDcil functioning in India or from Consular representative of the
country concerned.
The exporter should also be fully conversant with trade
agreements, payment agreements and General Agreements on Tariff
and Trade. Some of there are briefly discussed below.
General Agreement on Tariff and Trade: The member countries
to GAIT share about 80% of the world trade. The objective of the
agreement is to lay down a common code of conduct in international
trade, to provide machinery for lowering the rates of tariff to obviate
frequent changes in the' rates and to provide facilities for regular
consultation on trade problems and disputes. International Trade
center which acts as a Secretariat of the GATT provides assistance
to developing countries with commercial intelligence, market
surveys for their products and similar activities.
Generalized Scheme of Preferences: As a result of decisions
reached at the UNCTAD various advanced countries have agreed
to preferential rates of tariff for imports from developing countries.
This is known as "Generalized Scheme of Preferences" details of
which can be had from Export Promotion Council concerned.
European Economic Community: soils countries of Europe have
formed the organisation 'European Economic Community which
is also known as the European Common Market, the main objectives
being:
(1) Full economic union of the member countries, which allows
for the free movement of labour, capital and services within
the member countries and harmonized economic, financial,
fiscal and social policies.
(2) A common external tariff for the member countries
applicable to trade outside the area and a customs union of
the member countries which is to be formed by the gradual
elimination of customs duties and quotas.
The E.E.C. has also an Associate Agreement with various
African countries for preferential entry of the goods of all these
countries into S.E.C. market and also for financial help .

Chapter
25
BILATERAL TRADE AND RUPEE

--
PAYMENT AGREEMENTS
India has entered into Rupee Payment agreement with some

European countries which are Soviet Union, Czechoslovakia,
Yugoslavia, Rumania, Hungry, Democratic Republic of German,
Bulgaria, South Korea and Poland. Under these agreements all
payments on both sides should be made in rupee only and all
contracts concluded on that basis.
India has also entered into bilateral trade agreements with many
countries of the world. The important objectives of the bilateral trade
and payment agreements are:
(i) Opening up of direct trade contract with centrally planned
economies;
(ii) Obtaining capital goods and industrial raw materials
without additional drafts on foreign exchange resources of
.convertible currency;
(iii) Stabilising the prices of traditional exports;
(iv) Utilizing imports for automatic expansion of exports;
(v) Reducing the dependence on traditional export market;
(vi) Opening up of markets for non- traditional products.
Bilateral Trade and Rupee Payment Agreements 399
The Directorate of Exhibitions & Commercial Publicity in the
Ministry of Commerce has published a book titled "India's Trade
Agreements with other Countries" which gives condense of the
trade agreements entered into by India with countries.
Costing and Calculating Price:
Export pricing has a great role to play in effecting the buyer's
decision to buy in highly competitive international trade market.
Every effort, therefore should be made to keep the cost as low as
possible. Economy in export pricing is possible if the following
broad features are kept in mind:
(i) Economic procurement and utilisation of materials of right
quality.
(ii) Time scheduling for orders and Inventory control.
(iii) Choosing appropriate techniques of production and
pressurizing sequence to minimize wastage and to ensure
optimum quality.
(iv) Making due provisions for spare tools and accessories to
avoid time loss due to break downs ..
(v) Taking advantage of locational economies offered by Free
Trade Zones; and
(vi) Fuller utilisation of capacity with the help of multiple shifts
to reduce overhead costs.
Many factors creep into while calculating export price for the
goods. Export being a national necessity Government grants
concession and assistance in various matters so as to make the
product competitive In overseas market. Therefore, while calculating
export price following matters should also be taken into
consideration:
(i) Fiscal incentives, like special tax concession for production
of export goods, drawback of duty.
(ii) Financial assistance like cash subsidy to off set competition
in foreign markets.
(iii) Special incentive schemes like import replenishment
licenses; end
400 Bilateral Trade and Rupee Payment Agreements
(iv) General incentives like providing institutional
arrangements for export promotion and training in exports,
rewarding export performance etc.
Price is quoted in various terms which are explained below:
Ex Works (or Ex-factory, Ex-Mill, Ex plantation, Ex Warehouse):
In Ex works contract, the seller places the goods at the disposal
of the buyer at the time specified in the contract. The delivery of the
goods is taken by the buyer at the seller premises and all the risks
and expenses thereafter are borne by the buyer. Ex-works price
usually means the price of the goods plus packing. In certain cases,
it may not include packing charges. While quoting ex-works price,
it is necessary to specify whether packing charges are included or
not. Where ex-works price includes packing charges, it is quoted as
'Ex-works packing included' and where it does not include packing
charges, it should be quoted as 'Ex-works packing extra'.
Ex-works contract is usually used for sale of plantation goods
such as coffee, tea, cocoa.
F.O.B. (Free on Board) :
Free on Board price includes ex-works price, packing charges,
inland transportation cost, warfare and porterage, customs dues,
export duties, and cost of checking operations like checking of
quality, measure, weight or quantity, if any.
In an f.o.b. Contract, the responsibility and liability of the seller
does not end until the goods nave actually passed the ships rail. In
an F.o.b, contract, seller must-
(1) Deliver the goods on board the vessel named by the buyer
at the named port of shipment, in the manner customer at
that port, and on the date or within the stipulated period.
(2) Provide at his expense for the customary preparation and
packing suitable to the nature of the goods and to their
carriage by sea.
(3) Bear all costs payable on or for the goods until they have
effectively passed ships rail at the port of shipment.
(4) Give the buyer (at his own expense) such notice of shipment
of the goods as may enable him to insure them.
(5) Provide at his expense the customary clean" document in
/I
proof of delivery of goods board the vessel. A clean" /I
document means that the bill of lading (or mate's receipt)

does not bear any superimposed clause stating that either
the goods or the packaging are defective in some way.
(6) Bear the costs of checking operations (such as checking the
quality, measure, weight or quantity) necessary for the
purpose of loading the goods on board at the port of
shipment.
(7) Bear the cost of all dues and taxes payable on the goods for
the purpose of loading them on board.
(8) Bear all risks of the goods until such time as they shall
have effectively passed ships rail.
(9) Provide the buyer at Ms request and expenses, with the
certificate of origin and the consular invoice; and
(to) Render the buyer, at the latter's request, risk and expense,
every assistance in obtaining a bill of lading and other
documents, other than in (9) above, issued in the country of
shipment and/ or of origin and which the buyer may require
to import the goods into the country of destination (and
where necessary for their passage in transit through another
country).
In tum under an F.O.B. contract, the buyer must:
(1) At his own expense, charter a vessel or reserve the necessary
space on board a vessel and give the seller due notice of the
name, loading berth of and delivery dates to the vessel.
(2) Bear all costs and risks of the goods from the time when
they shall have passed the ship's rail effectively at the named
port of shipment and pay the price as provided In the
contract.
(3) Bear any additional costs incurred because the vessel he
names has failed to arrive on t~le stipulated date or by the
end of the period specified or was unable to take the goods

or closed for cargo earlier than the stipulated date or the
end of the period specified and all the risks of the goods
from the date of expiration of the period specified. This is
provided, however, that the goods were duly appropriated
to the contract, i.e., is clearly set aside or otherwise identified
as the contract goods.
(4) Should be fail to name vessel in time, or if he has reserved
to himself a period within which to take delivery of the
goods and/or the right to choose the port of shipment,
should he fail to rive detailed instructions in time, he shall
bear all the additional costs incurred because of such failure
and all the risks of the goods from the date of expiration of
period stipulated for delivery provided, however, that the
goods shall have been duly appropriated to the contract.
(5) Pay any costs and charges for obtaining a bill of lading, if
incurred, under article (10) above.
(6) Pay all costs and charges incurred in obtaining the
documents mentioned in article (9) and (10) above
including the cost of certificate of origin and consular
documents.
F.A.S. (Free Alongside Ship):
Free Alongside Ship price includes all costs incurred in
delivering the goods alongside the vessel at the port of export or
other place named, but does not include charges for loading the
goods on board the vessel. Nor does nit include ocean freight charges
and marine insurance premium. Under a F.A.S. Contract the exporter
is required to deliver the goods within the specified period; produce
clean dock or ship receipt; shoulder the responsibility for any loss
or damage incurred or caused before the goods are delivered
alongside the vessel; or the dock; and assist the buyer for documents
issued in his own country.
C. & F. (Cost & Freight):
Cost and Freight price covers F.O.B. value of the goods plus
freight charge of transporting goods to the port of destination. The
C. & F. price is quoted where COlmtries want that buyers must insure
the goods in their own countries so as to encourage local insurance
companies. In such type of contract, the buyer is responsible for
taking out the marine insurance, as opposed to the C.I.F. contract
where the seller must obtain an insurance policy that covers the
c.1.F. price plus 10 per cent. If the seller is willing to assume the risk
of the exchange rate fluctuating between the time that the contract
is accepted and the date of payment the terms are C.I.F. & C.C.I.F. &
C. means that the commission charged by the middleman is
included in !he price and also the interest charges that accumulate
in indent transactions.
C.I.F. (Cost Insurance and Freight) :
This type of contract includes F.O.B. price plus cost of ocean
freight and marine insurance up to the port of destination. In C.LF.
quotation care must be taken to state the name of the port to which
the goods are intended to be shipped. However, if the C.LF. contract
is applicable all over the world, the quotation should be C.I.F. Main
Port.
Under the C.LF. contract and also C & F contract the risk of the
goods is transferred to the buyer once they have been loaded on
board the ship. But he seller has to pay the expense of transportation
for the goods up to the port of destination. The exporter often prefers
these terms because he can channel all his exports through the
freight forwarder of his choice to the port of export and ship by the
vessel that he se~ects. For the importer, these terms mean fewer
responsibilities, because (there is a suitable clause in the contract),
it is the exporter who has to gamble on fluctuations in the freight
and insurance rates.
However, it may be pointed out that when the quotation is
C.I.F., exporter has to ensure the goods from were house to
warehouse and if the quotation is C & F, he should see to it that the
buyer has insured the goods from the warehouse. But to be on safer
side exporter should insure goods from his warehouse to the ship,
this will be sufficient if the goods are exported against Letter of
Credit. If the goods are exported against "Documents on Acceptance"
or "Documents on Payment" the exporter is advised to take out an
insurance policy from warehouse even if the contract is C & P.
The seller while quoting a price should ensure that in contracts
'~f sale these terms are clearly defined and that both he and customer
understand them. Moreover units of weights and measurement used
in a contract should also be clearly stated as these differ from country
to country. An English ton, for example (sometimes called a long
ton) is 2240 pounds, a metric ton is 1204.62 pounds, an American
or short ton is 2000 pounds and a Spanish ton is 2271.64 pounds. A
hundred weights are 112 pounds in Britain but 100 pounds in
America. In this connection, reference is made to a useful book titled
World Weights and Measures published by the U. N. Department
of Economic and Social Affairs in New York.

Chapter
26
tItI
EXPORT TRADE
Once an export order is received from the foreign customer, the

receipt of the same should be confirmed'and the customer should
be given an opportunity to check that every fact recorded meets
with his satisfaction. This is done by presenting the customer with
the confirmation in the form of a contract. He is invited to signify
his assent by signing the foot note to the contract. There is no hard
and fast rule as to terms to be contained in an export contract.
However, the contract should contain details in respect of goods,
quantity, price, delivery period of delivery/shipment, packing,
terms of payment, licenses, insurance, marking instructions,
documentary requirements, commission, etc.
Obtaining Export License:
Goods specified in schedule I of the Export (Control) Order
1%8 can only be exported under a valid export license. While
obtaining a license for that purpose certain formalities have to be
complied.
Finance and Credit in Export Trade:
From a banker's point of view, there is difference between credit
and finance. Credit means the agreement of a seller of merchandise
to accept payment from the buyer. after a stipulated period after
shipment or actual delivery. Financing on the other hand means
406 Export Trade
the provision of financial assistance either to the seller or to the

buyer by an outside source such as a bank for a period during
which the goods are in transit and any additional period that may
be arranged to cover special circumstances. Methods of obtaining
and institutions extending financial and credit facilities are dealt
with in separate chapter.
Preparing Goods for Dispatch:
As soon as the exporter communicates his acceptance of the
orders, immediate steps should be taken for the manufacture of the
goods, if they are not already in stock, according to the specification
and/ or samples.
If the exporter is not a manufacturer, he should have either
certain standing arrangements with a manufacturer for supplying
the goods or established relations with a manufacturer which would
enable him to enter into individual contracts with such manufacturer
for supplying the goods which he contracted to export.
In case the transaction relates to unmanufactured goods, the
exporter should normally have a purchasing organisation to collect
the produce at different convenient centers. This organisation
should be geared to the task of collecting the material contracted for
in time. Without the backing of an effective collecting organisation,
it may not be safe to enter into large contracts for supply of goods
which have to be collected over large areas.
In the case of an exporter who is himself a manufacturer of the
goods the problem is of a different nature. He has to arrange for the
necessary raw materials for production and packing and to lay
down a tide schedule for the manufacturing process. Most of the
indigenous raw materials would be available in the normal course,
but same of them are in short supply, Arrangements for prompt
supplies of selected indigenous raw materials (such as iron and
steel, aluminium, plastics and chemical raw materials, sugar etc.) to
manufacturing units producing goods for export have been made
under a scheme of 'Green From Allotment'. Once the arrangements
for obtaining raw materials are completed, manufacture should be
taken in hand and the factory manager should be given particulars
of:
Export Trade 407
(a) Specifications;
(b) Quality;
(c) Packing specifications;
(d) Marking specifications;
(e) Name and Address of the Consignee;
(f) Port of shipment;
(g) Port of destination;
(h) Name and Address of shipment;
(i) Terms of payment;
G) Shipping instructions.
Contracting Shipping Companies:
As soon as the order is placed and the steps for preparation of
goods for dispatch are taken, the exporter should contact the
shipping companies, which have sailing's for the port to which
goods have to be sent. The shipping companies have usually their
agents who accept the cargo on their behalf end similarly there are
clearing and forwarding agents who work for exporter on
commission basis. A complete list of important shipping clearing
agents and freight brokers at major towns is given in Appendix III.
Since an exporter has to apply for space in the ship, he can get
necessary information about sailing from the Daily Shipping
Intelligence. It is better. If a freight broker is employed for the purpose.
The freight broker does not charge anything in the matter of keeping
informed as to when a ship is sailing and form which port. On an
application for applying space in ship, the shipping company issues
a shipping order if the space applied is accepted.
There are following two kinds of acceptance:
(1) Shipping Advice. (2) Shipping Order to Dead Freight.
In the case of former, the shipping company is not bound to
accept the cargo. It is only an intimation to the party that the goods
may be tendered on the ship - these mayor may not be accer>ted. In
the case of the latter, the shipping company binds itself to accept
the cargo ansi on its failure it can be sued for loss or damages.
408 Export Trade
The original shipping order is handed over to the party and a
copy thereof is sent to the commanding office of the ship where the
commanding officer is instructed by the shipping company to receive
the goods on board as per details given in shipping order.
In case of any difficulty regarding availability of shipping space,
the exporter may approach the Director of Shipping Freight
Investigation Bureau through concerned export promotion council.
Where the difficulty relates to anamalous freight rates, applications
can be made by Association or Chambers of Commerce only and
not by individual exporters. However, the individual exporter may
make application directly to the regional authorities under advice
to Freight Investigation Bureau and Export Promotion Council.
Packaging and Packing:
Though the primary objective of packing and packaging is safe
delivery of a goods to the final consumer, packing differs from
packaging. Packaging refers to the container in which the product
reaches the ultimate consumer whereas packing refers to external
containers used for the safe transportation.
Since the word packaging is used to describe the protection of
goods destined for a consumer, the form of packaging is important
as a means of helping to sell the goods in question. Therefore while
packaging the goods, it should be kept in mind that packaging
serves the purposes of protecting the production, attracting the
product facilities utilisation of the product and economizing the
expense in reaching the product to ultimate consumer. In order to
achieve these objectives of packaging, there are some other aspects
of packaging such as size of the packaging, shape of the package,
material for the package, making of the package, package closure,
design of the package etc. which should never be lost sight of Good
packing is important not only from the view point of safe
transportation of the goods to the overseas buyer, but also from the
view point of covering insurance. Moreover, if the goods are not
properly packed the shipping company may refuse to accept the
goods for shipment.
There is no hard and fast rule as to packing of the goods.
However, it may be stated that packing should be carried cut strictly
Export Trade 409
in accordance with the instructions received from the foreign buyer.
If no instructions are received, packing should be of the recognised
customary standards for that particular country or should be in
accordance with certain specifications laid down by the shipping
companies for highly dangerous goods. For example, the Indian
Standards Institution has prescribed packing standards for certain
items. Apart from this, 'British Standard Packing Code' published
by British Standard Institutions and Exporters Encyclopedia
published in U .5.A. give detailed packing instructions.
Besides packing standards, there are following points regarding
good packing, which should be always kept in mind:
Firstly, the packing should be durable as the goods meant for
export have to undergo severe hazards in transit, and they are to be
loaded and unloaded at various stages. In order to make the packing
durable so as to stand enough handling and hazards of rough
weather, extreme heat, excessive moisture, vermin and theft, etc.,
strong and durable containers should be used. Of what material
the container should be made of depends upon the product in
question. For example, liquids in bulk are normally shipped in
drums; consumer products are packed in wooden cases or some
form of fabrate cartons are used; capital equipment is protected by
some kind of material and paint, and for delicate goods special
forms of cushioned packing may be used.
In addition to several methods discussed above for protecting a
product against dampness and erosions during voyage plastic films
in the market and asphalt coated paper can also be used. Moreover,
in order to protect the product from bumping, rubbing or tossing
because of rough weather
at sea or because of vibration -within an aircraft straw can be
used in addition to slacking strength outside. In this connection it
is important to note that packages containing straw cannot be sent
to many overseas countries unless a certificate of health is produced
from the health authorities.
Secondly, the size of the case should be minimum as marine
freight is frequently charged according to the space occupied. Thus,
410 Export Trade
the packing should be efficient and also economical because the

packing charges form a part of the cost of the product in question.
The exporter should also keep a record of the goods packed in
each case in order to enable the buyer to check easily that he has
received all the items in all the cases sent to him. For this packing
note or content note may be prepared for each separate case and a
packing list may be prepared of consolidated statements of contents
for a number of cases.
Marking the Goods:

The major object of marking of export packages is to identify the
cargo. Normally, ships carry a large number of consignments
belonging to various exporters. If there were not adequate
identification marks for goods, it would be really difficult to identify
the consignment of each exporter Marking is also essential for
facilitating the inspection of goods by the Customs authorities and
the quick and effective delivery of the goods at the destination by
the railway and shipping authorities.
The marking should include shipping marks of consignee, port
of destination, gross, net and fare weight and cubic measurements,
country of origin and any other special marks requested by the
buyer. In the absence of specific instruction from the buyer, the
exporter can choose his own symbol. The port of destination should
be given below in the symbol whereas the name of the country of
origin should be given as one of the symbol as many countries may
insist on this Below the name of the port of destination, number of
each individual container of a particular lot should be given and
below the number of individual container, gross weight, net weight
and the cubic measurement etc. should be given. In addition such
other marking as are reqred under the regulations of the country
of destination should alBo be made.
The International Cargo Handling Coordination Association
has set out for the use of exporters and carriers a number of
recommendations for the marking of goods carried by ocean going
vessels. Many of these are equally useful for the marking of goods
Export Trade 411
being forwarded by other firms of transport. Important rules of good

marking procedure are as follows:
(1) The marks should appear in a certain order. Essential data
should be placed in oblong frames with lines 1.5
Centimeters thick, and subsidiary information should be
placed in another type of frame.
(2) Declarations on large packages should be placed on two
contiguous sides and for consignments bound together on
a pallet also on the top. Handling instructions should be
placed on all four sides. Scalier packages such as goods in
sacks should be marked on two opposite sides.
(3) Lettering should be at least 7.5 Centimeters high for
essential data, and at least 3.5 Centimeters for subsidiary
data. If the package is too small for such lettering, other
sizes may be used but in the same ratio. The size of the
symbols should only be in proportion to the size of the
package of other markings.
(4) Only fast dyes should be used for lettering. Essential data
should be on black and subsidiary data in a less
conspicuous colour. Red and orange lettering should be
reserved for dangerous goods only. For foods packed in
sacks, only harmless dyes should be employed, and the
dye should not come through the packhlg in such a way as
to effect the goods.
(5) Stick or labels should only be used on individual packages
or parcels and all the old labels should be removed.
(6) Marking should be made by a stencil or by branding or by
pencil or brush without a stencil. If stencils are used, care
should be taken that the letters and figures are perfectly
legible to prevent confusion.
(7) The surface to be marked should be smooth and clean. If
packages are to be branded, they can be marked before this
is done; the hoops should not, however, cover the markings.
(8) The figures should indicate the total number of packages
making up the consignment and the consecutive number
412 Export Trade
of the individual packages. For example 1520/15/1
identifies the first package of a total number of 15 and 1520/
15/15 the last one.
(9) The name of the ship and the bill of lading number should
be shown when this is possible.
The exporter should also keep in view that some countries such
as Argentine, Chile, Spain and Philippines, the United Arab
Republic, the United States and Uruguay require that all products
imported into them bear a mark of origin. Countries like Australia
and France require a compulsory mark on a fairly large number of
products whereas some others like Finladd require it only on a few
products. Countries like Czechoslovakia and Jamica have no
regulations covering such, marks.
Quality Control and Pre-shipment Inspection:
Supply of quality goods is must for penetrating into
international markets, winning new markets and consolidating the
position in existing markets. In a bid to avoid complaints from
overseas buyers about the quality of the goods exported from India
and with a view to promoting exports on a long term and permanent
basis, the Government of India has launched a comprehensive
programme of quality control and preshipment inspection under
the Exports (Quality Control and Inspection) Act, 1963.
The Act empowers the Government to :
(a) notify goods which shall be subject to quality control or
inspection or both prior to export;
(b) specify the type of quality control or inspection which shall
be applied to a notified goods;
(c) establish, adopt or recognize one or more standard
specification to a notified goods;
(d) prohibit the export in the course of international trade of a
notified goods unless it is accompanied by a certificate
issued under Section 7 that the goods satisfies the condition
rela ting to quality control or inspection or it has affixed or
applied to it a mark or seal recognised by the Central
Export Trade 413
Government as indicating that it conforms to the standard

specification applicable to it under sub clause (c).
No consignment of a goods so nof..fied can be exported under
the Act unless accompanied by a certiHcate on the article of package
carries a mark indicnting that it conforms to the recognised
specifications. These certificates are issued by the inspection
agencies duly authorized for that purpose by the Government.
Applications for inspection should be made in the prescribed
form giving the details of the shipment to the inspection agency.
Following documents should also accompany the duly filled
application form :
(a) Commercial invoice giving evidence of the f.o.b. value of
export consignment.
(b) A crossed cheque for the amount of inspection fee.
(c) A copy of the export contract.
Certificate of inspection is issued by the agency on the
completion of the preshipment inspection at the exporter's factory
or warehouse, by the inspector deputed by the inspection agency.
The certificate has to be presented by the exporter to the Export
Department and Customs House at the tine of seeking customs
clearance of export cargo.
The Act has provided for the establishment of the Export
Inspection Council to advise the Government in regard to the
measures to be taken for quality control and preshipment inspection
and the exportable goods, such as standard specifications to be
recognised details of quality control and inspection and methods
and other related matters.
There also exist arrangements in Export Inspection Council for
voluntary preshipment inspection for goods not so for covered by
compulsory quality control and pre-shipment inspection details
regarding which may be obtained from Export Inspection Council
of India (Ministry of Commerce), Government of India, World Trade
Center, 14-1B, Ezra Street, Kolkata-l.
Goods carrying 1.5.1, mark can be exported without lmdergoing
the formalities of preshipment inspection unless the exporter wants
414 Export Trade
goods of specifications other than those laid down by 1.5.1, or insist

on having the goods inspected.
Shipping the G.9ods :
Goods can be exported to foreign markets by post, air or sea.
Shipping by Post:
Subject to the provisions of imports & export control regulations.
Foreign Exchange Regulations Act exports can be effected by post.
Trade samples of value not exceeding Rs. 50 can be sent by post
without any formal approval; samples of value more than Rs. 50
and up to Rs. 270 can be sent on production of a certificate from an
authorized dealer in foreign exchange to the effect that there is no
involvement of foreign exchange. Samples whose value exceed Rs.
270 can be sent on grant of waiver of exchange formalities by the
Reserve Bank of India,
Parcels containing trade samples or trade goods meant for
permissible destination can be booked at any post office in India.
Parcels for trade samples should be accompanied by (a) customs
declaration form in quadruplicate one copy having been pasted on
the parcels for goods of which value does not exceed Rs. 50; (b)
dispatch note; (c) certificate from any authorized dealer in foreign
exchange to the effect that the articles are being supplied free of
charge and that no transaction in foreign exchange is involved and
the documents to accompany parcels of trade goods are (a) PP form
in triplicate with copy duly countersigned by bank; (b) export license
if applicable; (c) Form D in quadruplicate for goods entitled to
customs, drawback; (d) AR form in duplicate for goods entitled to
excess rebate; and (e) VP leOD form in triplicate.
Shipping by Air:
Air exportation is increasingly used for export of certain types
of goods which are perishable, seasonal, or high in cost but low in
bulk, shipping by air is advantageous in many ways. Firstly, lesser
packing charges are involved as there would be less handling of
goods in transit. Secondly, there is likely to be less risk of pilferage
and damage. Lastly, shipping by air ensures faster delivery of goods
Export Trade 415
which in turn leads to quicker payments resulting in lower stock
and quicker turnover.
Where the goods are exported by air, the proof of shipment is
known as Air Consignment Note and is :.n lieu of bill of lading
which is obtained in case of export by sea.
Shipping by Sea:
Shipping by sea is one of the most traditional forms of exporting
goods to overseas markets. First step for shipping the goods by sea
is to make necessary transportation arrangements for movement of
goods from the place of its manufacture to the port and from the
port to the port of delivery. At this stage, the exporter is advised to
avail the facility or concessional reduced rates of freight. Once the
goods have reached the port, the exporter has to arrange for off
loading of goods from the wagons, storing them until the steamer is
ready to take the cargo and arrange for their actual loading into
steamer.
Actual loading of cargo is done either through port
commissioner's shed Vessels called 'Jetty' or in the 'Mid stream
called Over side Loading. In the former case goods are loaded in the
shed vessel. They are rent to the Port Commissioner's Jetty from
where they are loaded and .taken care of the men of the port
commissioner. An exporter has to pay the following charges to the
Port Commissioner before the goods are sent to the shed, (i) Shipping
charges; (ii) Unloading charges; (iii) River dues; (iv) Fixed toll; (v)
Rents, if any; (vi) Renewal charges; if any; (vii) Shunting charges.
In the case of Over side Loading, the cargo has to be taken by
boards for loading. In such case the exporter has direct touch with
the ship without the Port Commissioner's formalities and therefore,
has not to bear loading and unloading charges. However, he has to
pay (i) :River dues; (ii) Surcharge; (iii) Fixed toll; and {iv) Rent. He
has aJso to pay boat charges quantum of which depends on the
amount of cargo and the rate fixed between hire and fhe boatman.
On payment of landing charges, the exporter gets a smail slip
called land,ing slip. The goods are sent to the Port Commissioner's
Shed, the exporter will have to use either a lorry of a caFt. Therefore,
416 Export Trade
he has to prepare an export cart/lorry ticket giving the name of the
ship, shed number, shipper mark, on packages, quantity and
description. The exporter has also to send along with the lorry ticket
a form called Dock Challan giving the details about the 'consignee's
name and address, vessel's napte, port of destination, exporter's
name, marks and number of packages as shown in the shipping
bill, gross weight, in metric tonnes, port charges payable and other
details as may be required. In case the loading is done in mid stream
the Boat Note containing the details stated above should be
prepared.
The dock challan has to be presented in the Ports
commissioner's collection office where the clerk calculates and
checks the Port Commissioner's shipping charges to be deposited
with the cash clerk. Thereafter, documents are checked end registered
by the Gats Wardener and entry of Cargo into dock permitted. The
dock challan and cart ticket are accepted by the export shad writer
who registers the dock challan for sending it to Customs Preventive
Officer for endorsement and mean while issues unloading slip form
lorry after checking its condition. The Super Cargo arranges for
unloading cargo from lorry. The Customs Preventive Officer
examines and checks the contents, weight etc. of the goods and if in
order allows shipment and the Dock Challan is finally signed by
the Customs Division at Officer and released by the Port
Commissioner Writer in shed, I\hen the supper cargo takes over the
control of the cargo for shipment-
The cargo is thereafter loaded in the ship and mates receipt
written up and after being signed by the Vessel's Chief Officer
delivered to the Port Commissioner or the shipper direct In case of
over side shipment. The mate receipt is submitted to the steamer
agent along with typed bill of lading comprising requisite number
of negotiable and not negotiable copies for calculation of ocean
freight based on the measurement, weight of the consignment. After
the freight Is paid, the bill of lading duly signed and stamped are
returned to the shipper or his agent where the freight is payable at
destination, an endorsement to that effect is made by the steamer
agent on the face of the bill of lading itself. All the negotiable copies
Export Trade 417
of the bill of lading are called a full set". The full set of clean or
H
board bill of lading Is distinct from claused bill of lading which

bears adverse endorsement like 'one case damaged' packed in old
gunny bags' should be presented to the Bank along with other
shipping documents for negotiation.
Marine Insurance:
In order to shield the cargo from various hazards of fire, storm,
collusion, theft, leakage, explosions, spoilage etc., necessary
arrangements should be made for insurance of cargo.
For getting the cargo insured the shipper should contact
insurance underwriter and fill full particulars in Declaration Form
supplied by the company. Particulars requires to be filled in,
interalia; include following:
(a) name of the party, which effects insurance or on whose
behalf insurance is effected.
(b) whether payment on account of claim is desired in any
foreign currency;
(c) name of the steamer and voyage;
(d) whether strike, riots and civil commotion risks to be
included;
(e) description of goods and their packing details;
(f) details of risk to be covered i.e., whether it iifree of particular
average or with particular average, cOlllPrehensive or all
risks and inland transit.
Customs Clearance:
Before the goods are loaded on board the ship, they are examined
by the customs authorities who are required to see that the goods
sent out are permissible for export and all the relevant formalities
have been gone through and the law of the land has been complied
with. The Shipping Bill along with the following document has to
be presented to the customs authorities:
(a) Commercial invoice.
(b) Packing list along with packing specifications.
418 Export Trade
(c) Contract with the overseas buyer.

(d) Copy of letter of credit, if any.
(e) G.R.-l Ports.
(f) Certificate of quality or grading, if required.
Shipping bill is prepared by the exporter. There are three forms
of the shipping bill available with the customs authorities. One is
for goods on yellow paper known as dutiable shipping bill on which
there is export duty and other is for goods on white paper known as
free shipping bill on which there is no export duty. Third is green
paper known as draw back shipping bill for claiming customs draw
back against goods exported.
Shipping bill contains particulars of the goods exported and
other particulars such as name of the vessel, master or agent, flag,
port at which goods are to be discharged, country and final
destination, exporter and his address. There are also details about
the package and the goods such as numbers and description of the
goods, quantity details about each case, f.o.b. price, real value as
defined in the Customs Act, 1962, total number of packages, their
total weight and value etc. The shipping bill has also columns on
right hand side for Port Commissioner Stamp and for Customs House
Stamp. The Port Commissioner stamp is affixed as soon as the receipt
for lading charges is shown to officials will put his stamp when the
Appraiser has satisfied himself about the f.o.b. and the real value of
the goods. He would also satisfy himself that the floods are
accompanied by the license or endorsement, if acquired.
In case of export, where there is no export duty to be paid or to
be claimed back, pink colour shipping bill should be used where -
the goods are exported by air. Where the goods are to be exported by
sea white colour-shipping bill is prescribed for the goods and yellow
colour-shipping bill for dutiable goods. Green colour shipping bills
are to be used in case of drawback shipping bills irrespective
whether the shipment is by air or sea.
Where the goods are shipped under drawback, an endorsement
has to be made whether the shipment is being made under schedule
1 or schedule II and whether any drawback rate under schedule II
Export Trade 419
has already been fixed or the export is made under provision for
drawback.
The Customs authorities scrutinise the shipping bills along
with requisite documents and if, prima facie, satisfied passes the
shipping bill for export subject to the physical examination being
done by the dock or air transit staff of the customs for which the
shipping bill passed by the export department has to be presented
to the cargo supervisor of the steamship company of the shed
manager who is the port official at the shed of the ship for permission
to bring in the cargo for export.
For physical examination of the cargo, the shipping bill after
having been passed by the Appraising Department of the Customs
should be presented to the preventive officer in charge of the shed
or section for 'let ships' remark. It is only after the shipping bill is
endorsed with the 'let ship' remark, that the goods can be taken on
board the ship by Cargo Supervisor of the ship, who makes necessary
arrangements for loading the goods on the ship by the port trust
labour and makes receipt issued by the Chief Officer of the ship
acknowledging that the goods have been received by him on board
the ship to be ultimately delivered by the port trusts, the exporter or
his agent after satisfying that they have received their dues*
The exporter or his agent should then present the mate's receipt
along with freight payment certificate and the freight amount unless
the freight is payable at the destination to the steamer agent for
issue of negotiable and non-negotiable copies of bills of landing.
Where the goods are exported under drawback of duty, the
goods should be first presented for examination and Identification
to the dock staff of customs. Thereafter the shipping bill being
presented to the export department of Customs for possession and
allowing shipment.
Clearance of Excisable Goods:
The excisable goods can be exported outside India either under
claim for rebate of excise duty or in bond. The difference between
the two procedures is that In the case of former, the duty is first paid
and refund is claimed after exportation, and in the later case, the
420 Export Trade
goods are allowed to be exported without payment of duty, on

execution of a bond with sufficient surety, security in the prescribed
bond, and under such conditions as the collector of Central Excise
approves, for a sum at least equivalent to the duty chargeable to the
goods in question. All manufacturer exporters, and merchant
exporters exporting excisable goods under bond should maintain a
Running Bond Account in the prescribed form. Exporters while
maintaining the Running Bond Account should also make entries
in respect of clearance from the factories situated in other
collectorates. While opening the Running Bond Account, the
exporters will start their account by entering therein all consignment
which have been cleared from the factory or the place of manufacture
for export and for which export has been not so far taken place.
After these entries are made the current clearance for export should
be entered in the order of clearance.
For removal of excisable goods, the exporter should submit the
original copy of gate pass (GP-l in case of removal of goods under
claim for rebate and GP-2 in case of removal under bond) along
with five copies of AR-4A form to the Range Superintendent of
Central Excise. The Range Superintendent after verifying the fact
that the duty has been paid, certifies the fact of payment of duty on
all the copies and returns the original and duplicate copies to the
exporter. Triplicate copy of the form is sent to the Maritime Collector
for Central Excise at the port of shipment quadruplicate to the Chief
Accounts Officer and triplicate retained for record. However, if the
exporter desires that the goods should be inspected at the factory
and package sealed, he should apply in Form AR-4 (in
I quadruplicate). At the time of presentation of the AR-4/ AR-4A to
the Range Superintendent/ Inspector for Clearance .of excisable
goods, the exporter will present his Running Bond Account for the
verification of the entries by Range Staff. This requirement should
be followed in case of goods cleared from factories in Bombay Central
Excise Collectorate. The value to be filled in AR-4/ AR-4A Forms is
the assessable value of goods approved by the excise authorities for
similar / same goods for home consumption Hence, it is different
from the Lo.b. value to be shown in the invoice/shipping bill.
Export Trade 421
The original and duplicate copies of AR-4/ 4A form are than
presented by the exporter to the customs at the port of shipment
along with other shipping documents. The Customs House after
necessary scrutiny and appraisement of value and assessment of
duty, it any, grant permission to export and stamp shipping bill
number on the forms. These forms along-with Gate Pass and
consignment are presented to the Dock Examiner/Appraiser of
Customs who conducts physical examination and identifies the
packaged with marks and numbers given in Form AR-4/ AR-4A.
These forms and other documents are then presented to Preventive
Officer, who certifies the fact of shipment with references to Mate
Receipt on the original and duplicate copies of AR 4/ 4A forms. The
original copy is forwarded to the Preventive Department of Customs
and duplicate copy is handed over to the exporter's agent. The
Preventive Department after registering particulars of the forms in
register forwards the original copy to the Martime Collectors, who
collect the AR-4/ AK-4A received from Preventive Department with
the triplicate copy received earlier from the Range Superintendent
and enters necessary particulars in refund register. He also allows
provisional credit in the running bond account for the amount of
the duty for the goods certified to have been exported and
communicate the amount of such provisional credit to the exporter
and Range Superintendent.
The export should then make an application in form C in
triplicate (original copy duly signed on a revenue stamp of 20 paise)
to the Maritime Collector of Central Excise at the port of shipment
accompanied by the following documents.
(a) Duplicate copy of the AR-4/ AR-4A form bearing the
certificate of shipment of the Customs Preventive Officer.
In this connection, exporter should complete the following
certificate at the bank of the form.
"I hereby certify that the goods have not been relented or
intended to be relanded at any port in India".
(b) Non-negotiable copy of the bill of lading giving details of
the Central Excise numbers of the consignment.
(c) Original copy of the Gate Pass.
422 Export Trade
If the claim is found in order and a rebate Is held to be admissible,

the Assistant Collector of Central Excise accords his sanction and
signs the refund order on all the three copies of the application. The
duplicate copy of the AR-4/ AR-4A and original and duplicate copy
of the application form bearing the refund order are sent to Chief
Accounts Officer for arranging payment to the exporter, who is
intimated by the Chief Accounts Officer to collect the cheque of that
the amount Is credited to his account.
Exchange Control Formalities:
Whenever goods are sent outside the country, there is an
obligation on part of the exporter to satisfy the Reserve Bank of
India that he has received payment from the overseas buyer. The
government does not allow any exporter to export for no
consideration. And if he does not get the money from the overseas
buyer, he subjects himself to prosecution for violating the foreign
exchange regulations.
Exchange control applies to all exporters irrespective of whether
the items exported are in the restricted category of trade or not.
Exchange control requires all the exporters.
(a) to make a declaration on the prescribed form to the Collector
of Customs that foreign exchange representing the full export value
of goods has been or will be disposed of in a manner and within the
period specified by the Reserve Bank;
(b) to negotiate all shipping documents, including those
relating to sales on consignment basis, through the authorized
dealers; and
(c) to receive payment by an approved method.
The declaration is not required in the case of trade samples
supplied free of payment, personal effects of travellers,
transshipment of cargo, goods exported under orders of Government
authorities and parcels dispatched by post or air freight provided
the contents of the parcel are less than Rs. 50 in value and the
export does not involve any transaction in foreign exchange.
Every person, firm or company engaged in export business in
India should obtain a code number from the Reserve Bank.
Export Trade 423
Applications for this purpose should be made by the Head/

Principal Office of the exporters in the prescribed form CNX in
duplicate to the Reserve Bank of India within whose jurisdiction
(See Appendix VII) the Head/Principal Office of the applicant is
situated. The Reserve Bank returns to the exporter the duplicate of
the form with the branches in India should invariably cite the code
number so allotted by the Reserve Bank in G.R.I./E.P./P.P./V.P./
G.O.D. forms used for declaration of exports.
Exporters have to make a declaration on the appropriate
exchange control form (completed in duplicate or triplicate as the
case may be) the original copy of which has to be submitted to the
Customs authorities at the time of shipment. The particulars to be
furnished in the form comprise the invoice value of shipment, the
type of goods, the method by and the currency in which payment is
to be received and the name of the authorized dealer through which
documents are to be negotiated. The prescribed forms of declaration
are as follows.
Form G.R.I. :
Form G.R.l. is for general use for declaring exports to all countries
(other than Pakistan and Afghanistan) to which the exchange control
procedure applies and where payment is to be received by one of
the prescribed methods in a permitted currency.
This form is to be completed in triplicate. All the three copies of
G.R.I./EP forms, duly supported by the relevant documents, should
be submitted to the Customs at the time of shipment by sea or air.
The Customs authorities will, after necessary scrutiny, retain the
originals of those forms for transmission to the Reserve Bank and
return the duplicate and triplicate copies duly authenticated to the
concerned exporters for submission to the Reserve Bank through
an authorized dealer.
The authorized dealer, after verifying the particulars given in
the form forwards the second copy of the G.R. form to the Reserve
Bank of India. On the other hand, the Customs authorities, after
passing the Shipping Bill, will sent the original G.R. Form to the
Exchange Control Department of the Reserve Bank of India.
424 Export Trade
Similarly, the authorized dealer after realisation of payment will

make endorsement on the third copy of the G.R.I, and forward it to
Exchange Control Department of the Reserve Bank of India. The
Exchange Control Department will verify the original G.R. form
and if satisfied will close the concerned file.
Occasionally, the exporters draw clean bills on foreign parties
covering shipments to be made later. In all such cases the G.R.
forms have to be completed twice, first, when the bills are drawn
and again, when the shipments are effected. At the first stage, the
exporters are required to complete the first and second copies of the
G.R. forms which are to be sent to the Reserve Bank by the authorized
dealer after negotiation with a note to the effect that shipment is
being made at a later date. The third copy of the form duly certified
is to be sent to the Reserve Bank after realisation of payment against
the bills. When the shipment is actually effected, a fresh set of G.R.
forms is to be completed by the exporter, the first copy of which is to
be submitted to the Customs, along with the relative Shipping Bill,
the remaining copies are to be sent to the Reserve Bank through the
authorized dealer who negotiated the original clean bill.
In cases where exporters follow the practice of drawing bills of
only a percentage of the invoice value, the balance being payable
after arrival of the goods at destination, they are required to give an
undertaking to the negotiating bank that the balance of proceeds
will be surrendered within the prescribed time limit from the date of
shipment and endorsement to this effect is to be made on the second
copy of the G.R. form by the authorized dealer concerned before
forwarding it to the Reserve Bank. The third copy is to be submitted
by him to the Reserve Bank only after full payment has been received.
FormG.R.3:
This form is to be filled in by exporters who under special
arrangements entered into with the Reserve Bank are permitted to
retain the proceeds of their exports (excluding those to Pakistan)
with their agents or branches abroad (excepting those in Pakistan)
for financing their imports from those countries into India or to
make other types of approved payment there.
Export Trade 425
This form is also to be completed in triplicate. The first copy is
for submission to the Customs authorities at the time of shipment.
The second and third copies are to be dealt with by the exporter in
accordance with the advice of Reserve Bank.
FormE.P.:
This form, is for declaring shipments to Pakistan and
Afghanistan only and is similar in nature to form G.R.I.
FormE.P.I:
This form similar to form G. R. 3, is for the use of exporters to
Afghanistan who have been authorized by the Reserve Bank to
retain the proceeds of their exports to that country and to utilize
them to finance their imports from Afghanistan or for other
purposes.
FormP.P.:
Exports to all countries by parcel posts, except when on "value
payable" or "cash on delivery" basis, should be declared on P.P.
forms. The procedure in respect of declaration on P.P. forms is
similar to that for G.R. and E.P. form except that the authorized
dealer has to countersign the original copy of the P.P. forms (after
satisfying himself that the parcel has been valued and sealed by the
Customs authorities where it contains jewellery or precious stones)
before it is presented to the postal authorities. In cases where
exporters are unable to get the P.P. form countersigned by the
authorized dealers, owing to reasons such as absence of banking
facilities in the country of destination of parcels, the Reserve Bank
will, on application, countersign the P.P. forms, provided
satisfactory guarantee is furnished by the applicants for the
realisation of the proceeds. Export of goods by postal packet or
airfreight of less than Rs. 50 in value can be made without a
declaration as to the realisation of proceeds.
Form V.P./C.O.D. :
Exports to all countries by parcel post under arrangement to
realise the proceeds through postal channels "value payable" or
"cash on delivery" basis should be declared on V.P./C.O.D. forms.
426 Export Trade
Exporters of films have to declare on G.R.I/E.P./P.P. forms only

where films are exported on outright sale basis. When exports of
films are on a rental basis, they should obtain a waiver of the G.R.I/
B.P./P.P. form from the Bank.
Moreover, exports on a consignment basis have to be declared
on G.R. or E.P. form as the case may be. The procedure for completing
the declaration forms is the same as for exports against firms sale
contract except that the third copy of the form should be accompanied
by account of sales.
Further, when a portion of a s~ipment already filed with the
Customs is short-shipped, the exporter has to give notice of the
short-shipment to the Customs authorities on the prescribed forms
in duplicate. After verifying that the goods were actually short-
shipped, the Customs authorities will forward to the Reserve Bank
the duplicate copy of the notice duly certified as correct.
Time Limit for Realisation of Exchange Proceeds:
The period prescribed for the realisation of foreign exchange
proceeds of export is six months, except in the case of exports to
Pakistan and Afghanistan for which the period is three months. As
a rule, exporters are required to adhere strictly to the prescribed
time limit for the delivery of export proceeds to the authorized dealer.
Where the proceeds are not received within the time specified, the
authorized dealer has to take up the matter with exporter and ask
him to deliver the proceeds within 21 days. If the exporter fails to do
so, the matter is reported to the Reserve-Bank stating the reasons for
delay. The exporter has to apply to the Reserve Bank for the extension
of time limit for delivery of the export proceeds in case where be has
not been able to realise the proceeds for reasons beyond his control.
The Bank may grant an extension of time if the circumstances appear
to warrant it. In cases where the Bank does not consider it necessary
to grant extension, it may instruct the person entitled to sell the
goods, arrange for their sale and obtain payment in an approved
manner.
Alternatively, the Bank may order that the goods be assigned to
Government of India or to a person specified on its "behalf. Failure
Export Trade 427
to comply with any general or special directions given by the Reserve

Bank will render the exporter liable to penalties prescribed in the
Foreign Exchange Regulation Act, 1973.
Exports under Deferred Credit Arrangement:
As regards exports under deferred credit arrangements where
the exporter is eligible to obtain export credit from an authorized
bank under the export credit refinances scheme for a period of over
six months and up to five years, restrictions regarding the time limit
as stated above may be relaxed by the Bank and extended up to a
maximum period of five years from the date of shipment depending
on the type of goods exported. For this purpose, an exporter is
required to submit to the Bank, through his banker, an application
in the prescribed form in triplicate asking Reserve for the extension.
Gift Parcels:
Gift parcels as well as other exports which do not involve any
transaction in foreign exchange are permitted, without compliance
withG.R./E.P./P.P.form procedure provided the exports are made
by parcel post or air freight and the authorized dealer is satisfied
that the contents of the parcel are less than Rs. 270 in value. In all
other cases, prior permission of the Bank is necessary for sending
gift parcels.
In December 1973 the Reserve Bank of India introduced Buyers'
Credit Scheme under which the Bank in participation with the
eligible Banks in India grants credits directly to foreign buyers in
connection with export of capital goods from India. The Scheme is
intended to enable Indian exporters (including export houses) in
the private and public sectors to export capital goods. The exporters
obligation is to fulfil the commercial terms of the contract and once
this is done, they are paid for their exports out of the credits on a
non-recourse basis. While no maximum limit for such credits is
stipulated, applications are normally considered only in respect of
high value contracts viz. those of the value of Rs. 1 crore and above.
The buyer is required to have a stake in transaction by way of
advance / down payment.
In July 1975, the Reserve Bank announced a simplified
procedure for exports on deferred payment basis, including post-
428 Export Trade
facto exchange control clearance by the (R.B.I.) and insurance cover
by the Export Credit and Cuarantee Corporation.
The new procedure, which grants a general permission to
exporters, will apply only to cases where (1) the value does not
exceed Rs. 50 lakhs; (2) the credit period does not exceed five years
for specified types of goods; and (3) finance from the Industrial
Development Bank of India (1.0.B.I.) is not required.
The general permission enables exporters to make offers abroad
and to enter into negotiations for export of goods or submit tenders
provided certain minimum conditions laid down in this regard are
satisfied. The permission also enables exporters to enter into
contracts provided the contract terms conform to the minimum
conditions. The RBI has also granted general permission for issuing
bid bonds and performance guarantees.
Applications are, however, required to be made to the R.B.!, for
post-facto exchange control clearance, and to the E.CC.C for
insurance cover, within 15 days after the signing of the contract.
The procedure in respect of cases not covered by the general
permission has been streamlined by making the IDBI the focal point
for grant of approvals.
Under the revised procedure, the exporters before they make
offers or submit tenders, should submit applications in a composite
form to the IDBI through their bankers. The applications will be
processed by a working group consisting of the IDBI, RBI and ECCC
:E;xporters and their bankers will be associated with the discussions
wherever necessary and package clearance for the offer or bid will
be granted by the IDBI.
Once such clearance is given, the exporters can enter into
contracts in the event they succeed in their bids, subject only to the
provision that they will furnish copies of the contracts together
with complete information in the prescribed form to the IDBI, RBI
and ECCC for post-facto approval and grant of financial assistance.
Approved Methods of ~ayment :
The methods by which payment for exports to various countries
may be received are set out as below:
Export Trade 429
Description of territories Prescribed methods of payment
(a) Convertible Account Countries (a) Payment in the currency of any
(i) Austria Belgium- territory in this sub-group.
Luxembourg
Canada
Denmark (including
Faroe Islands)
French France Area (France and

its non- metropolitan Area)
Italy
Japan
Netherlands Monetary Area
(Netherlands and its non-
meteropolitan Area)
Norway
Sweden
Switzerland and Liechtenstein
The United State of America and
any territory under the soverighty
of the U.S.A. West Germany.
(b) Bilateral Account Countries (b) Payment in sterling from an

Bulgaria external account as defined in the
Czechoslovakia U.K. Exchange Control
German Democratic Republic Regulations.
(East Germany)
Hungary
Northy Korea
Poland
Rumania
U.S.S.R.
Yugoslavia
(c) Sterling Area Countries (c)

(Scheduled Territories) (a) Payment in sterling or any sterling
(See paragraph 2, Section II) of area currency other than Indian
Exchange Control Manual, (Sixth rupee from the account of a
Edition) 1971 resident in any country in this
group other than India.
(c) Payment in rupees from the
account of a bank in any country
in this group other than India
Special Arrangements:
(ii) Notwithstanding the general directions given above
regarding the methods of payment special arrangements in respect
430 Export Trade
of exports of certain specified goods to Afghanistan. Sudan and

U.A.R. as well as those financed under the credits extended by the
Government of India to foreign Governments, as set out below,
should be followed:
(a) Afghanistan: Under the -terms of Indo-Afghan Trade
Agreement, which Is renewed from time to time, the value of exports
of certain specified goods to Afghanistan is set off against the value
of goods imported from that country under the supervision of the
Reserve Bank and the Import Trade Control authorities. Payments
for such exports may also be received.
(1) In any convertible currency, provided a letter of credit has
been opened in favour of the exporter; or
(2) in purpose from the account of a bank in Afghanistan.
(b) Sudan: Payment for exports of specified goods under the
Indo-Sudan Trade Agreement should be received from the special
account maintained in sterling by the State Bank of India Bombay,
with the Bank of Sudan.
(c) U.A.R.: Payment for exports of specified goods under the
Indo-U.A.R. Trade Agreement should be received from the non-
convertible rupee account styled "Special Account - U.A.R."
maintained by the Central Bank of Egypt, Cairo, with the State Bank
of India, Bombay.
(d) Government Credits : Exports of some goods are also
arranged under lines of credit offered by the Government of India to
Government of certain foreign countries. Payment for exports
financed under such GovernmenHo-Government credits should
be received strictly in accordance with the procedure advised to
authorized dealers in this regard by the Reserve Bank. Prior
Approval:
(iii) Financing of exports in a manner other than the methods
stated above requires the permission of the Reserve Bank. While
referring applications to the Reserve Bank in terms of this sub-
paragraph, the reasons why financing is not being done in one of
the approved methods should be explained where possible. In cases
where foreign currency payment is proposed to be received against
Export Trade 431
exports to a Bilateral Account country, it should be indicated

whether such pay Inent has been voluntarily offered by the overseas
importer. As far as possible, suitable documentary evidence in
original should be forwarded with the application.
Getting Paid in Export Trade:

Means of getting paid in export trade include (i) letter of credit,
and (ii) bill of exchange which may be payable either on sight or
after expiry of a period stipulated in the bill itself. A brief discussion
of these modes is given below.
A letter of credit is an instrument issued by a bank on behalf of
and for the account of the buyer of the goods whereby the bank
undertakes that the bill of exchange of the seller, drawn on the
buyer, or on the issuing bank or on another bank designa ted in the
instrument, will be duly honoured by acceptance or payment as the
case may be provided the exporter complies with the terms and
conditions of contract as indicated in the letter of credit. Thus, by
means of a letter of credit, promise to pay made by the importer is
substituted by the promise to pay made by his bank. Various types
of letter of credit are dealt with separately.
The second method of getting payment is by means of
documentary bill of exchange, also called "Draft", drawn on the
importer by the exporter. When the drawer, i.e., exporter expects the
drawee, i.e., the importer to make payment immediately the draft is
presented to him, this draft is called a "Sight Draft" or in said to be
"drawn at first sight" or "on demand" or" on presentation". When
the draft is drawn, for payment at any later date than presentation
it is called a "usance draft or usance bill" or "terra draft".
In the case of sight draft, the exporter through his bank in India,
sends draft and other shipping documents to the importer's bank.
The importer's bank notifies the importer to this effect and hands
over shipping documents to him.only when the latter has paid for
the draft. That is why this form of payment is also called" documents
against Payment".
In the case of usance draft, the exporter draws a draft on the
buyer stipulating the period after expiry of which the latter must
432 Export Trade
pay the amount of the draft. The draft along with other shipping
documents is sent to the importer's bank which hands over shipping
documents to the importer only when the draft has been accepted
by the importer. When a draft has been accepted, the bank abroad
notifies the exporter that his draft has been accepted. The bank also
notifies the date of acceptance. On realisation of the money after
expiry of period stipulated in the draft itself, the foreign bank, which
holds the draft as an agent of the exporter, remits the proceeds to
the exporter after deducting its own charges. The exporter can also
"avail himself of the facility of discounting usance draft with his
bank. This form of receiving payment is called "Documents against
Acceptance".
Eliminating Exchange Risk:
Whenever an exporter has drawn a bill of exchange especially
a usance bill of exchange under which he has to receive payment in
foreign currency at some future date, he runs a risk that the value of
that foreign currency in terms of the domestic currency might decline
by the tine he actually receives the remittance in question. The best
thing for the exporter to avoid such risk will be to agree to a certain
rate with his bank which would make the payment in rupees after
converting remittance received from abroad in foreign currency into
rupee according to the rate agreed upon.
***

H.S. Kumawat-Modern Entrepreneur and Entrepreneurship - Theory, Process and Practice

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H.S. Kumawat-Modern Entrepreneur and Entrepreneurship - Theory, Process and Practice

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MODERN ENTREPRENEUR

First Published - 2009

All rights reserved. No part of this book may be reproduced in any

Printed at: Jaipur

The book has been written to meet the requirements of the

Every business organisation big or small has to invest huge

(i) How much money is needed for the capital expenditure in

where PWF = _1_ is known as present worth factor.

i.e. 5000 = P[l + 5 (0.05)} = P [1.251

Example 4 : A person wants to have Rs. 10,000 in his account

where n is the year at which the value is to be calculated and N is

Obsolescence: Loss in the intrinsic value of an asset due to its

METHODS FOR COMPARING

In plax;ming any production strategy one very often faces a

cases payments can fluctuate with a known seasonal

Present value Approach:

Hence the company should select machine A.

Present value of future income

Present value of annual income

Present value index provide some valuable information about

Solution: Here P = Rs. 50,000

Present value of future income

Since PVI < 1, the project is not to be recommended for

Example 3 : A company is considering to purchase a new

Recommend the grinder to be purchased when the minimum

(i) Present Value of Total Cost for X

+ 5600 (PY\. f-12/o-five years)

Cost Case (ii) With annual expenditure, there is also annual

Annual value of net total income

Annual value of Net income =R (CRF- t%-r years)

Net Annual Total Cost =Annual Capital Cost +Annual expenditure

Example 7: If N.K. Ltd. wishes to have a minimum rate of return

= 8000 (0.9091 ) + 8000 (0.8264) + 1 0000 (0.751 3)

. Solution: Here we are given CAP and CAPS.So we should use

The annual income projected over 15 years

where I investment in Rs.

P b k . d Amount Invested 40,000 8

Case (ii) In the case of uneven cash-inflows, we calculate

Average ammia cash inflor - Annual depreciation

Now average investment can be calculated by any of the

25000 = 12500 25000 = 2500 500 = 0.04

Thus the ranking of the proposals are C, B, D, E and A.

Machine A = 80,000 + 60,000 + 40,000 = Rs. 60,000

Hence from (19)

rate of return for A = 60,000 -33333 = 0.53

rate of return for B = 63300 - 33333 =0.60

present value factor = Investment = 12000 =3.0

The pay-back period for each project can be calculated in the

Annual Cashi in flow - Depreciation 100

Pr' C = 25,000-9807.50 xl00=31%

The rate of return is same for Project Band C being 31 %. Any of

Present value of future income

= 6000 x 4.1925 = 0.80

= 20000 x 4.8696 =0.99

= 25000 x 4.1925 = 1.07

= 4000 x 4.6755 =0.69

The problem of replacement is an everyday phenomena. It is

(iv) Working conditions: Causing unsafety to workers and

and Jong(t) dt, when t is continuous.

Thus the total cost incurred on the item in some period n is

When should the machine be replaced?

Cumulative value of (2)

5 1000 4000 2500 8500 13500 2700