CHAPTER VI – FINANCIAL MANAGEMENT
management as follows: ―Financial management is
DEFINITION AND FUNCTIONS OF FINANCE
DEPARTMENT SOURCES OF FINANCE, FINANCING
ORGANIZATION, TYPES OF CAPITAL, ELEMENTS OF
COSTS AND ALLOCATIONS OF INDIRECT
EXPENSES, COST CONTROL, BREAK EVEN
ANALYSIS, BUDGETS AND BUDGETARY CONTROL,
EQUIPMENT REPLACEMENT POLICY, MAKE OR BUY
ANALYSIS, BALANCE SHEET, RATIO ANALYSIS,
PROFIT AND LOSS STATEMENT.
FINANCIAL MANAGEMENT: IT’S DEFINITION,
MEANING AND OBJECTIVES!
DEFINITION:
One needs money to make money. Finance is the life-
blood of business and there must be a continuous flow of
funds in and out of a business enterprise. Money makes
the wheels of business run smoothly. Sound plans,
efficient production system and excellent marketing
network are all hampered in the absence of an adequate
and timely supply of funds.
Sound financial management is as important in business
as production and marketing. A business firm requires
finance to commence its operations, to continue
operations and for expansion or growth. Finance is,
therefore, an important operative function of business.
A large business firm has to raise funds from several
sources and has to utilise those funds in alternative
investment opportunities. In order to ensure the most
judicious utilisation of funds and to provide a reasonable
rate of return on the investment, sound financial policies
and programmes are required. Unwise financing can drive
a business into bankruptcy just as easily as a poor
product, inept marketing or high production costs.
On the other hand, adequate and economical financing
can provide the firm a differential advantage in the market
place. The success of a business enterprise is largely
determined by the way its capital funds are raised, utilised
and disbursed. In the modern money-using economy, the
importance of finance has increased further due to
increasing scale of operations and capital intensive
techniques of production and distribution.
In fact, finance is the bright thread running through all
business activity. It influences and limits the activities of
marketing, production, purchasing and personnel
management. The success of a business is measured
largely in financial terms. The efficient organisation and
administration of the finance function is thus vital to the
successful functioning of every business enterprise.
MEANING OF FINANCIAL MANAGEMENT:
Financial management may be defined as planning,
organising, directing and controlling the financial activities
of an organisation. According to Guthman and Dougal,
financial management means, ―the activity concerned with
the planning, raising, controlling and administering of
funds used in the business.‖ It is concerned with the
procurement and utilisation of funds in the proper manner.
Financial activities deal with not only the procurement and
utilisation of funds but also with the assessing of needs for
funds, raising required finance, capital budgeting,
distribution of surplus, financial controls, etc.
Ezra Solomon has described the nature of financial
properly viewed as an integral part of overall management
rather than as a staff specially concerned with funds
raising operations.
In this broader view, the central issue of financial policy is
the wise use of funds and the central process involved is a
rational matching of the advantage of potential uses
against the cost of alternative potential sources so as to
achieve the broad financial goals which an enterprise sets
for itself.
In addition to raising funds, financial management is
directly concerned with production, marketing and other
functions within an enterprise whenever decisions are
made about the acquisition or distribution of funds.‖
OBJECTIVES OF FINANCIAL MANAGEMENT:
Financial management is one of the functional areas of
business. Therefore, its objectives must be consistent with
the overall objectives of business. The overall objective of
financial management is to provide maximum return to the
owners on their investment in the long- term.
This is known as wealth maximisation. Maximisation of
owners’ wealth is possible when the capital invested
initially increases over a period of time. Wealth
maximisation means maximising the market value of
investment in shares of the company.
Wealth of shareholders = Number of shares held ×Market
price per share.
In order to maximise wealth, financial management
must achieve the following specific objectives:
(a) To ensure availability of sufficient funds at reasonable
cost (liquidity).
(b) To ensure effective utilisation of funds (financial
control).
(c) To ensure safety of funds by creating reserves, re-
investing profits, etc. (minimisation of risk).
(d) To ensure adequate return on investment (profitability).
(e) To generate and build-up surplus for expansion and
growth (growth).
(f) To minimise cost of capital by developing a sound and
economical combination of corporate securities
(economy).
(g) To coordinate the activities of the finance department
with the activities of other departments of the firm
(cooperation).
Profit Maximisation:
Very often maximisation of profits is considered to be the
main objective of financial management. Profitability is an
operational concept that signifies economic efficiency.
Some writers on finance believe that it leads to efficient
allocation of resources and optimum use of capital.
It is said that profit maximisation is a simple and
straightforward objective. It also ensures the survival and
growth of a business firm. But modern authors on financial
management have criticised the goal of profit
maximisation.
Ezra Solomon has raised the following objections
against the profit maximisation objective:
Objections against the Profit Maximisation
Objectives:
(i) The concept is ambiguous or vague. It is amenable to
different interpretations, e.g., long run profits, short run
profits, volume of profits, rate of profit, etc.
(ii) It ignores the timing of returns. It is based on the
assumption of bigger the better and does not take into
account the time value of money. The value of benefits
received today and those received a year later are not the
same.
(iii) It ignores the quality of the expected benefits or the
risk involved in prospective earnings stream. The streams
of benefits may have varying degrees of uncertainty. Two
projects may have same total expected earnings but if the
earnings of one fluctuate less widely than those of the
other it will be less risky and more preferable. More
uncertain or fluctuating the expected earnings, lower is
their quality.
(iv) It does not consider the effect of dividend policy on the
market price of the share. The goal of profit maximisation
implies maximising earnings per share which is not
necessarily the same as maximising market-price share.
According to Solomon, ―to the extent payment of
dividends can affect the market price of ―the stock (or
share), the maximisation of earnings per share will not be
a satisfactory objective by itself.‖
(v) Profit maximisation objective does not take into
consideration the social responsibilities of business. It
ignores the interests of workers, consumers, government
and the public in general. The exclusive attention on profit
maximisation may misguide managers to the point where
they may endanger the survival of the firm by ignoring
research, executive development and other intangible
investments.
Wealth Maximisation:
Prof. Ezra Solomon has advocated wealth maximisation
as the goal of financial decision-making. Wealth
maximisation or net present worth maximisation is defined
as follows: ―The gross present worth of a course of action
is equal to the capitalised value of the flow of future
expected benefits, discounted (or as capitalised) at a rate
which reflects their certainty or uncertainty.
Wealth or net present worth is the difference between
gross present worth and the amount of capital investment
required to achieve the benefits being discussed. Any
financial action which creates wealth or which has a net
present worth above zero is a desirable one and should
be undertaken.
Any financial action which does not meet this test should
be rejected. If two or more desirable courses of action are
mutually exclusive (i.e., if only one can be undertaken),
then the decision should be to do that which creates most
wealth or shows the greatest amount of net present worth.
In short, the operating objective for financial management
is to maximise wealth or net present worth.‖
Wealth maximisation is more operationally viable and
valid criterion because of the following reasons:
(a) It is a precise and unambiguous concept. The wealth
maximisation means maximising the market value of
shares.
(b) It takes into account both the quantity and quality of
the expected steam of future benefits. Adjustments are
made for risk (uncertainty of expected returns) and timing
(time value of money) by discounting the cash flows,
(c) As a decision criterion, wealth maximisation involves a
comparison of value of cost. It is a long-term strategy
emphasising the use of resources to yield economic
values higher than joint values of inputs.
(d) Wealth maximisation is not in conflict with the other
motives like maximisation of sales or market share. It
rather helps in the achievement of these other objectives.
In fact, achievement of wealth maximisation also
maximises the achievement of the other objectives.
Therefore, maximisation of wealth is the operating
objective by which financial decisions should be guided.
The above description reveals that wealth maximisation is
more useful if objective than profit maximisation. It views
profits from the long-term perspective. The true index of
the value of a firm is the market price of its shares as it
reflects the influence of all such factors as earnings per
share, timing of earnings, risk involved, etc.
Thus, the wealth maximisation objective implies that the
objective of financial management should be to maximise
the market price of the company’s shares in the long-term.
It is a true indicator of the company’s progress and the
shareholder’s wealth.
However, ―profit maximisation can be part of a wealth
maximisation strategy. Quite often the two objectives can
be pursued simultaneously but the maximisation of profits
should never be permitted to overshadow the broader
objectives of wealth maximisation.
FUNCTIONS OF FINANCE DEPARTMENT
1st Function – To Prepare the Budget
It is duty of finance department of company to make the
budget before actual providing money to any department.
It will be helpful to fulfill each department with minimum
cost. Finance department can take the past records from
respective department. It will be useful for making better
budget.
2nd Financial Management
In this function finance department gets money from
capital market at very low risk and cost. Finance
department analyzes all the resources of funds and create
a good financial structure of company. In this structure,
finance department analyze whether it will decrease the
overall cost of capital on Average basis or not.
3nd Management of Investments of Company
After making financial structure, finance department
invests debenture holders and shareholders money in
best projects for getting highest return on investment. For
this finance department has to take investment decision.
These investment decisions can be taken with the help of
capital budgeting and investment analysis techniques.
4rd Management of Taxes
Management of taxes is also the function of finance or
finance department. Taxes may be direct or indirect.
Finance department continue watches the amendments
and updates in tax laws and also create good corporate
relation with government by paying return of corporate tax
on the time.
5th Management of Financial Risks
Finance department takes many measures for managing
the financial risks of company. For reducing loss of fund
due to happening liquidity, solvency or financial disaster,
finance department makes a good plan and also takes the
help of debt collectors, insurance companies and other
rating agencies for reducing financial risk.
6th Merge or Acquisition decisions
For creating good brand in the market, financial
department works with marketing department and both
takes the steps of merge and acquisition action. Main aim
of merge or acquisition is to reduce competition and
spread on brand in the market. Finance department
provides the money for takeover any other firm for
estimating its long run return.
Prepare and create financial accounts – such as
Trading, Profit and Loss Account and the Balance Sheet.
Keep and maintain financial records – sales figures and
records of expenditure would be held by the Finance
department and used by other departments also.
Prepare and plan internal financial information – this
would mainly be performed in the case of a budget, which
is a financial plan and can help managers take corrective
action.
Analyse current financial performance – how the firm
has done in trading or expenses would be analysed
primarily using ratio analysis tools.
Pay creditors – Finance Department would ensure that
bills are paid to people the firm owes money to.
Pay employees wages and salaries – running the
payroll system is another important task for Finance to
undertake. Employees have to be paid!
SOURCES OF FINANCE
There are various sources of finance such as equity, debt,
debentures, retained earnings, term loans, working capital
loans, letter of credit, euro issue, venture funding etc.
These sources are useful under different situations. They
are classified based on time period, ownership and
control, and their source of generation.
Sources of finance are the most explored area especially
for the entrepreneurs about to start a new business. It is
perhaps the toughest part of all the efforts. There are
various sources of finance classified based on time
period, ownership and control, and source of generation of
finance.
Having known that there are many alternatives of finance
or capital, a company can choose from. Choosing right
source and right mix of finance is a key challenge for
every finance manager. The process of selecting right
source of finance involves in-depth analysis of each and
every source of finance. For analyzing and comparing the
sources of finance, it is required to understand all
characteristics of the financing sources. There are many
characteristics on the basis of which sources of finance
are classified.
On the basis of time period, sources are classified into
long term, medium term, and short term. Ownership and
control classifies sources of finance into owned capital
and borrowed capital. Internal sources and external
sources are the two sources of generation of capital. All
the sources of capital have different characteristics to suit
different types of requirements. Let’s understand them in a
little depth.
ACCORDING TO TIME-PERIOD:
Sources of financing a business are classified based on
the time period for which the money is required. Time
period are commonly classified into following three:
 Long Term Sources of Finance: Long term
financing means capital requirements for a
period of more than 5 years to 10, 15, 20
years or may be more depending on other
factors. Capital expenditures in fixed assets
like plant and machinery, land and building
etc of a business are funded using long term
sources of finance. Part of working capital
which permanently stays with the business is
also financed with long term sources of
finance. Long term financing sources can be
in form of any of them:
 Share Capital or Equity Shares
 Preference Capital or Preference
Shares
 Retained Earnings or Internal
Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes,
Government, and Commercial Banks
 Venture Funding
 Asset Securitization
 International Financing by way of
Euro Issue, Foreign Currency Loans,
ADR, GDR etc.
 Medium Term Sources of Finance: Medium
term financing means financing for a period
between 3 to 5 years. Medium term financing
is used generally for two reasons. One, when
long term capital is not available for the time
being and second, when deferred revenue
expenditures like advertisements are made
which are to be written off over a period of 3
to 5 years. Medium term financing sources
can in the form of one of them:
 Preference Capital or Preference
Shares
 Debenture / Bonds
 Medium Term Loans from
 Financial
Institutes
 Government, and
 Commercial
Banks
 Lease Finance
 Hire Purchase Finance
 Short Term Sources of Finance: Short term
financing means financing for period of less
than 1 year. Need for short term finance
arises to finance the current assets of a
business like inventory of raw material and
finished goods, debtors, minimum cash and
bank balance etc. Short term financing is also
named as working capital financing. Short
term finances are available in the form of:
  Trade Credit
 Short Term Loans like Working
Capital Loans from Commercial
Banks
 Fixed Deposits for a period of 1 year
or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.
ACCORDING TO OWNERSHIP AND CONTROL:
Sources of finances are classified based on ownership
and control over the business. These two parameters are
an important consideration while selecting a source of
finance for the business. Whenever we bring in capital,
there are two types of costs – one is interest and another
is sharing of ownership and control. Some entrepreneurs
may not like to dilute their ownership rights in the business
and others may believe in sharing the risk.
 Owned Capital: Owned capital is also
referred as equity capital. It is sourced from
promoters of the company or from general
public by issuing new equity shares. Business
is started by the promoters by bringing in the
required capital for startup. Owners capital is
sourced from following sources:
 Equity Capital
 Preference Capital
 Retained Earnings
 Convertible Debentures
 Venture Fund or Private Equity
Further, when the business grows and internal
accruals like profits of the company are not enough to
satisfy financing requirements, the promoters have
choice of selecting ownership capital or non-
ownership capital. This decision is up to the
promoters. Still, to discuss, certain advantages of
equity capital are as follows:
 It is a long term capital which means
it stays permanently with the
business.
 There is no burden of paying interest
or installments like borrowed capital.
So, risk of bankruptcy also reduces.
Businesses in infancy stages prefer
equity capital for this reason.
 Borrowed Capital: Borrowed capital is the
capital arranged from outside sources. These
include the following:
 Financial institutions,
 Commercial banks or
 General public in case of debentures.
In this type of capital, the borrower has a charge on
the assets of the business which means the borrower
would be paid by selling the assets in case of
liquidation. Another feature of borrowed capital is
regular payment of fixed interest and repayment of
capital. Certain advantages of borrowing capital are
as follows:
 There is no dilution in ownership and
control of business.
 Cost of borrowed funds is low since it
is a deductible expense for taxation
purpose which ends up saving on
taxes for the company.

It gives the business a leverage
benefit.
ACCORDING TO SOURCE OF GENERATION:
 Internal Sources: Internal source of capital is
the capital which is generated internally from
the business. Internal sources are as follows:
 Retained profits
 Reduction or controlling of working
capital
 Sale of assets etc.
The internal source has the same characteristics of
owned capital. The best part of the internal sourcing of
capital is that the business grows by itself and does
not depend on outside parties. Disadvantages of both
equity capital and debt capital are not present in this
form of financing. Neither ownership is diluted nor
fixed obligation / bankruptcy risk arises.
 External Sources: External source of finance
is the capital which is generated from outside
the business. Apart from the internal sources
finance, all the sources are external sources
of capital.
Deciding the right source of finance is a crucial business
decision taken by top level finance managers. Wrong
source of finance increase the cost of funds which in turn
would have direct impact on the feasibility of project under
concern. Improper match of type of capital with business
requirements may go against smooth functioning of the
business. For instance, if fixed assets, which derive
benefits after 2 years, are financed through short term
finances will create cash flow mismatch after one year and
the manager will again have to look for finances and pay
the fee for raising capital again.
WHAT IS CAPITAL? MEANING
Different subjects like Book-keeping, organization of
commerce (O.C) and secretarial practice (S.P) in
commerce, economics, etc., indicate different meaning of
the term Capital.
In book-keeping, capital means amount invested by
businessman in the business.
In commerce subjects like O.C and S.P, capital means
finance or company's capital.
But, in economics, capital is that part of wealth which is
used for production.
But here consider meaning of term capital from economic
point of view.
Relations of Capital
The word Capital is related with the following three terms,
viz.,
 Wealth,
 Money, and
 Income.
The relation of capital with wealth, money and income is
explained below:-
1. Relation with Wealth:-
Capital is that part of wealth which is used for production.
So, wealth is a broad concept and capital is a narrowed
concept.
Relation of Capital and Wealth is explained with the help
of following picture.
If a commodity is having features like scarcity, utility,
externality and transferability, it becomes wealth. A motor
car has all above features, so it is a wealth. (As per
picture 'A' in above photo). When wealth is used in
production process, it becomes capital. If that car is used
for taxi (cab) business, it becomes capital. (As per picture
'B' in above photo). Therefore, any commodity as a wealth
becomes the capital if it is used for production.
Thus, all capital is wealth but all wealth is not capital.
2. Relation with Money:-
The relation between Capital and Money is shown in the
following picture.
Normally, capital means investment of money in business.
But in economics money becomes capital only when it is
used to purchase real capital goods like plant, machinery,
etc. When money is used to purchase capital goods, it
becomes Money Capital. Please see the picture given
above.
But money in the hands of consumers to buy consumer
goods or money hoarded doesn't constitute capital. Money
by itself is not a factor of production, but when it acquires
stock of real capital goods, it becomes a factor of
production. For production we need real capital and
money capital but money capital acquires real capital.
3. Relation with Income:-
Capital generates income. So, capital is a source and
income is a result. E.g. refrigerator is a capital for a ice-
cream parlour owner. But, profits which he gets out of his
business is his income.
So, Capital is a FUND concept and Income is a FLOW
concept.
Features of Capital
The characteristics or features of capital are:-
 Man-made Factor : Capital is not a gift of nature.
So it is not a primary or natural factor, it is made
by man in capital goods industry. It is secondary
as well as an artificial factor of production.
 Productive Factor : Capital helps in increasing
level of productivity and speed of production.
 Elastic Supply : Supply of capital depends upon
capital formation process. Capital formation
depends upon savings and investment. By
accelerating capital formation, capital supply can
be increased. But it is a long term process.
 Durable : Capital is not perishable like labour. It
has a long life subject to periodical depreciation.
 Easy Mobility : Movement of capital from one
place to another is easily possible.
 Is a Wealth : Since capital has all features of
wealth viz. utility, scarcity, transferability and
externality, capital is a wealth but wealth doesn't
necessarily become capital.
 Derived demand : As a factor of production,
capital has a derived demand to produce finished
goods which have a direct demand. e.g. demand
for raw cotton is derived from demand for cotton
cloth.
 Round about production : Capital goods doesn't
satisfy our wants directly. But resources should be
diverted towards production of capital goods first.
And thereafter such produced mean can be used
to produce consumer goods having direct
demand.
 Social Cost : Resources have alternative uses.
Either they can be put to production of capital
goods or consumer goods. When resources are
used for producing capital goods, it means society
has sacrificed enjoyment of consumer goods. This
is called social cost.
Types of Capital
The forms, classification or types of capital are:-
 Fixed capital : It refers to durable capital goods
which are used in production again and again till
 they wear out. Machinery, tools, means of
transport, factory building, etc are fixed capital.
Fixed capital does not mean fixed in location.
Since the money invested in such capital goods is
fixed for a long period, it is called Fixed Capital.
 Working capital : Working capital or variable
capital is referred to the single use produced
goods like raw materials. They are used directly
and only once in production. They get converted
into finished goods. Money spend on them is fully
recovered when goods made out of them are sold
in the market.
 Circulating capital : It is referred to the money
capital used in purchasing raw materials. Usually
the term working capital and circulating capital are
used synonymously.
 Sunk capital : Capital goods which have only a
specific use in producing a particular commodity
are called Sunk capital. E.g. A textile weaving
machine can be used only in textile mill. It cannot
be used elsewhere. It is sunk capital.
 Floating capital : Capital goods which are
capable of having some alternative uses are
called floating capital. For e.g. electricity, fuel,
transport vehicles, etc are the floating capital
which can be used anywhere.
 Money capital : Money capital means the money
funds available with the enterprise for purchasing
various types of capital goods, raw material or for
construction of factory building, etc. it is also
called liquid capital. At the beginning the money
capital is required for two purposes one for
acquiring fixed assets i.e. fixed capital goods and
another for purchasing raw materials, payment of
wages and meeting certain current expenses i.e.
working capital.
 Real capital : On the other hand, real capital is
referred to the capital goods other than money
such as machinery, factory buildings, semi-
finished goods, raw materials, transport
equipments, etc.
 Private capital : All the physical assets (other
than land), as well as investments, which bring
income to an individual are called private capital.
 Social capital : All the assets owned by a
community as a whole in the form of non-
commercial assets are called social capital e.g.
roads, public parks, hospitals, etc.
 National capital : Capital owned by the whole
nation is called national capital. It comprises
private as well as public capital. National capital is
that part of national wealth which is employed in
the reproduction of additional wealth.
 International capital : Assets owned by
international organizations like UN, WTO, World
Bank, etc., constitutes an International Capital.
Balance sheet
Balance sheet is a picture of financial position of a
company. Explain
How does balance sheet differ from profit and loss
statement?
 Any business is interested in knowing two facts
 Where does business stand at any
given point of time in financial terms
 What is result of operation carried out
by business in specific time>
 Answer to first question is balance sheet, while
second question is answered by profitability
statement
 These two statements are called as ―Financial
statements
 The financial statements and their accompanying
notes explain company’s financial performance
 Thus health of company can be judged using
these two financial statements
BALANCE SHEET
 Balance sheet as we discussed is a financial
sheet
 It represents status of investment in business at
any given date
 It comprises of list of Assets, Liabilities and capital
funds at a given date
 Thus is short we can say that, balance sheet is a
statement which represents financial position of a
business on a prescribed date. This prescribed
date is a date at which final accounts are
prepared.
 Balance sheet is a summary of entire accounting
records
 All the transactions taking place in an enterprise
are recorded initially in a journal. From journal
these entries are then posted to ledger
 From ledger, balances are then transferred to trial
balance
 Some balances from trial balance are directly
transferred to balance sheet. While other
balances are transferred to profit and loss account
 The overall balance from profit and loss account
is then copied to balance sheet
 Hence we say balance sheet is summary of entire
accounting records
 Balance sheet tells about two major components:
 Assets : Assets tells us about use of
business funds. Assets include fixed
assets, investments, current assets,
loans and advances etc
 Liabilities : Liabilities tells us various
sources from where funds have been
arranged. Laibilities include share
capital, reserves and surplus, secured
and unsecured loan etc
 Format of Balance sheet is prescribed by India
companies act
 Balance sheet of XYZ company as on date
dd/mm/yy can be drafted as
 Liabilities Amount Assets Amount graphic designer to design the look and feel of the kite,
and the development of promotional materials used to
Share Fixed assets advertise the kite. These costs are fixed because they will
capital not change with the number of kites sold.
Reserves Investments The variable costs include the materials used to make
and each kite — special string for $3, the fabric for the body
supples for $6, wooden dowels for $7, a special plastic handle for
$4 — and the labor required to assemble the kite, which
Secured Current amounted to one and a half hours for a worker earning
loans Assets $20 per hour. Therefore, the unit variable costs to make a
Unsecured Loans and single kite is: $50 ($20 in materials and $30 in labor). If
loans Advances she sells the kite for $75, she’ll make a unit margin of $25.
Given the $25 unit margin she’ll receive for each kite sold,
Current Miscellaneous
she will cover her $25,500 in total fixed costs if she sells:
liabilities expenditure
and and losses
provision
Total Total
Using the interactive illustration below, you can enter each
figure and see the output on the right. Put the Revenue
per Unit Sold slider (r) at $75, Variable Cost per Unit Sold
(v) slider at $50, the Fixed Costs (C) slider at $25,500 and
 Sum total of assets side and sum total of liabilities set the actual output at 0.
side should be equal WHAT IS A PROFIT AND LOSS STATEMENT?
 Thus in balance sheet Assets = Liabilities The profit and loss statement is a summary of the financial
OBJECTIVES OF BALANCE SHEET : balance performance of a business over time (monthly, quarterly
sheets given following information or annually is most common). It reflects the past
performance of the business and is the report most often
 Summary of firms assets and liabilities in easy used by small business owners to track how their
readable and understandable form business is performing.
 Information about Firms liquidity position As the name indicates the profit and loss statement (also
 Information about profitability and overall financial known as a statement of financial performance or an
health of business income statement) measures the profit or loss of a
 Information from balance sheet is of interest for business over a specified period. A profit and loss
shareholders bankers, suppliers and top statement summarises the income for a period and
managers subtracts the expenses incurred for the same period to
calculate the profit or loss for the business.
ARE PROFIT AND LOSS STATEMENTS
CURRENT ASSETS AND CURRENT LIABILITIES COMPULSORY?
 Current assets are the assets acquired through Sole traders, partnerships and small proprietary
cash and that can be easily converted bal companies are not required to prepare and lodge a profit
and loss statement with their annual tax return. However,
BREAK EVEN ANALYSIS they are very useful in helping you to objectively
determine the financial performance of your business.
Managers typically use breakeven analysis to set a price
Most accounting software packages will produce a profit
to understand the economic impact of various price- and
and loss statement, but you may need the help of a
sales-volume scenario. Pricing matters. Having the right
bookkeeper or an accountant unless your business is very
price for a product or service can boost profit much faster
small.
than increasing volume. Setting a price is, of course,
complicated but breakeven analysis can help. All public companies and large proprietary companies are
required by lawto prepare a formal financial report that
It’s a simple calculation to determine how many units must
complies with Australian Accounting Standards for each
be sold at a given price to cover one’s fixed costs. You’re
financial year.
typically solving for the Break-Even Volume (BEV).
WHY PREPARE A PROFIT AND LOSS STATEMENT?
Producing regular profit and loss statements (at least
quarterly or monthly) will enable you to:
 answer the question, "How much money am I making, if
To show how this works, let’s take the hypothetical any?"
example of a high-end kite maker. Assume she must incur compare your projected performance with actual
a fixed cost of $25,500 to produce and sell a kite. These performance;
costs might cover the software needed to design the kite compare your performance against industry benchmarks;
and be sure it is sufficiently aerodynamic, the fee paid to a
 use past performance trends to form reasonable forecasts need to buy. Generally, COGS only applies where there is
for the future; a sale of stock or inventory and is the total direct cost of
 show your business growth and financial health over time; getting your products into inventory and ready for sale.
Items included in the COGS will differ from one type of
 detect any problems regarding sales, margins and
business to another.
expenses within a reasonable time so adjustments may
be made to recoup losses or decrease expenses; Retail business:
 provide proof of income if you need a loan or mortgage; COGS includes the cost of buying stock for resale, and
and freight inwards.
 calculate your income and expenses when completing Manufacturer:
and submitting your tax return.  COGS includes the cost of raw materials or parts, and the
Components of a Profit and Loss Statement direct labour costs used to manufacture the product.
Each component influences the determination of net profit, Business selling only services (e.g. accountants or
and are used in the two basic equations. consultants):
A profit and loss statement is based on two basic These usually do not have COGS unless they hire
equations: additional casual or contract labour to provide direct
 Gross profit = sales – cost of goods sold services to clients.
For example, the COGS for a bicycle retailer would
 Net profit = gross profit – expenses
include the costs of the component parts plus the labour
costs used to assemble the bicycle.
Gross profit and net profit is calculated as follows:
Revenue $ 550,000 COST OF GOODS SOLD IS CALCULATED AS
FOLLOWS:
less Cost of good sold (COGS) $ 220,000
Opening inventory
Gross Profit $ 330,000
(cost of inventory at the$ 10,000
beginning of the period)
less Expenses $ 275,000 Inventory purchased (during
plus $ 43,500
the period)
Net Profit (before tax) $ 55,000
Total inventory available
The main components of a profit and loss statement are: Equals $ 53,500
during the period
 Revenue
 Cost of goods sold
Closing inventory (cost of all
 Gross profit less $ 7,000
unsold stock)
 Expenses
Cost of goods sold $ 46,500
 Net profit
Revenue Back to top
Revenue (sales) is the total earned from ordinary Gross profit
business operations. Revenue includes sales of goods Gross profit is the difference between sales and the cost
and services, interest received, dividends, rebates, and of producing or purchasing products or providing services
rent received. before subtracting operating expenses such as wages,
Back to top rent, accounting fees, or electricity. Gross profit reflects
how efficiently labour and materials are used to produce
Cost of goods sold (COGS) goods.
Cost of goods sold (cost of sales) is the cost of Gross profit = sales – cost of goods sold
merchandise sold during the period. COGS includes all
the costs directly related to getting your inventory ready The gross profit margin is one indicator of the financial
for sale such as: health of a business. Larger gross profit margins are
better for business – the higher the percentage, the more
 the purchase price, the business retains of each dollar of sales for other
 import duties, expenses and net profit.
 non-recoverable taxes, Gross Profit Margin % = (Gross Profit ÷ Sales) x 100
 freight inwards, Back to top
 freight insurance, Expenses
 handling, Expenses (overheads, outgoings) are costs incurred for
the purposes of earning income. They include items such
 direct labour, and
as:
 other costs of converting materials into finished goods.
 wages,
COGS vary directly with sales and production; the more
 rent,
items you sell or make, the more stock or components you
 accounting and legal fees,
 electricity, depreciation, and
 interest paid on loans.
Back to top
Net profit
Net Profit (net income; net earning; the bottom line) is
calculated by subtracting expenses from the gross profit,
showing what the business has earned (or lost) in a given
period of time (usually monthly, quarterly, or annually)
after both the cost of goods sold and operating expenses
have been taken into account.
Net Profit = Gross Profit – Expenses
Sole traders
For sole traders, drawings are not an expense and net
profit is calculated before the owner’s benefits are
subtracted, and is the total taxable income of the
business. You pay tax on the entire net profit, regardless
of how much you have taken out for your drawings.
Partners
For partners where no partnership agreement exists, net
profit is allocated according to the proportion specified in
the partnership agreement. Each partner pays tax on the
proportion of their interest of the total net profit, regardless
of how much the partner takes out as drawings.
Companies
For companies, salaries for working directors are treated
as an expense along with other employees’ wages. So,
net profit is what’s left after these salaries have been
subtracted, and it is then available for distribution to
shareholders as dividends.
Service businesses
For a service business, net profit will be the difference
between the income of the business and its expenses,
given there is no gross profit calculation.
Refer to the example profit and loss statement.
RATIO ANALYSIS
 The term ratio implies arithmetical relationship
between two related and inter dependant figures
 When inter dependant figures belong to account in
financial statement it is known as accounting ratio
 Use of accounting ration to analyse financial
statement is known as ratio analysis
 The technique of ratio analysis helps in interpretation
of financial statement
 Ratio may be expressed in either of the following
ways
 Percentage example : Net profit as 10% of sales

rd
Fraction example : Retained earnings 1/3 of share
capital
 Stated comparison between number examples :
current assets as twice as current liabilities
OBJECTIVES OF RATIO ANALYSIS
 Ratio analysis helps in analyzing and interpreting
financial statements
 Ratio analysis gives proper information which can
be used for planning, coordination, control
communication
 Long statement of accounting can be simplified
and summarized systematically using ratio
analysis
IMPORTANCE OF RATIO ANALYSIS
 It simpliefied systematize and summarize long
statement of accounting figures
 Ratio analysis takes care of financial health of firm
 Inter firm and intra firm comparison can be done
for better efficiency
 Accounting ratios for number of years when
compared tells us about change of trade
 Various complex figures in financial statement can
be better understood and analysed by use of ratio
analysis
 Various figures in financial statement are not self
explanatory. It becomes easy to understand when
they are correlated and studied
 Example : gross profit is related with amount of
sales; it becomes easy to understand profitability
if we understand their correlation.
TYPES OF RATIO ANALYSIS
Ratios may be classified under various categories as
follows :
 Liquidity group
 Turnover Group
 Solvency Group
 Profitability Group
 Overall profitability Group
 Miscellaneous group
Various ratios used in accounting are as follows :
 Current Ratio- = current assets/current liabilities
 Liquid ratio or acid test ratio= net sales/fixed
assets
 Fixed assets turnover ratio = net sales/fixed
assets
 Current assets turnover ratio = Net sales/current
assets
 Gross profit ratio = Gross profit/net salesx100
 Net profit ratio = Net profit after taxes / Net
salesx100
 Return on capital employed = Net profit+interest
on long term sources /capital employed
Ratio Analysis:
 Ratio analysis is mainly used as an external
standard, that is, for comparing performance with
the other organisation in the industry. It can also
be effectively used for comparing the performance
 of the firm over time.It is used to exercise cost
control. Ratio is a yard stick which provides a
measure of relationship between the two figures
compared. The ratio may be expressed in
percentage terms as a proportion or as a rate.
 In the ratio analysis, an acceptable ratio is
determined first and then it is compared with
actual performance and the corrective measures
can he resorted. The significant aspect in this
analysis is that the management can take a
greater interest in relative as opposed to absolute
figures.
 A particular ratio can be chosen depending on the
need. It is possible to calculate different ratios
relating to aspects like liquidity, profitability,
capital structure, etc. But for a programme of cost
control and cost reduction, one need to
concentrate only on the operating cost ratios.
 Ratio analysis is used as an instrument of
cost control in two ways:
 (i) Ratios can be used to compare the
performance of a business firm between two
periods. It helps to identify areas which need
immediate attention.
 (ii) Besides, standard ratios are used to compare
actual areas. Standard ratios are averages of the
results achieved by several firms in the same line
of business.
 If these comparisons reveal any significant
differences, the firm can take suitable action to
eliminate the causes responsible for increase in
costs.
 Some of the most commonly used ratios for
cost comparison are listed below:
(i) Net Profits/Sales
(ii) Gross Profits/ Sales
(iii) Net Profits/ Total Assets
(iv) Sales/ Total Assets
(v) Production Costs/Cost of Sales
(vi) Selling Costs/ Costs of Sales
(vii) Administration Cost / Cost of Sales
(viii) Sales/Inventory
(ix) Material Cost/ Production Costs
(x) Labour Cost/ Production Costs
(xi) Overheads/ Production Costs
 Important Techniques of Cost Control:
There are two other techniques which are sometimes
used by firms for cost control and reduction.
These are:
(i) Value Analysis
(ii) Method Study
(i) Value Analysis:
Value analysis is an approach to cost saving that
deals with product design. Here, before buying any
equipment or materials, a study is made as to what
purpose these things serve? Would other lower- cost
design work as well? Is there a cheap material which
can serve the same purpose? So value analysis is a
procedure which specifies the function of products or
components, establishes appropriate costs,
determines the alternatives and evaluates them.
Thus the objective of value analysis is the
identification of such costs in a product that do not in
any manner contribute to its specification or functional
value. Thus, it is the process of reducing the cost
without sacrificing the predetermined standards of
performance. It is a supplementary device in addition
to the conventional cost reduction methods.
Value analysis is closely related to Value Engineering.
It is very helpful in industries where production is done
on a large scale and in such cases even a fraction of
savings in cost would help the firm significantly.
Some examples of savings through value analysis
are:
(i) Discarding tailored products where standard
components can do.
(ii) Dispensing of facilities not required by the
customer.
(iii) Use of newly developed materials in place of
traditional materials.
(iv) To examine the use of alternatives which are
available at a lower price.
(ii) Method Study:
Method Study is a systematic study of work data and
critical evaluation of the existing and proposed ways
of undertaking the work. This technique is known as
work study and organisation and method Work study
helps to investigate all factors which enable the
management to get the work done efficiently and
economically.
The prime objective is to analyse all factors which
affect the performance of a task, to develop and install
work methods which make optimum use of human
and material resources available and to establish
suitable standards by which the performance of the
work can be measured. Method study aims at
analysing and evaluating all those conditions which
influence the performance of a task. It is the creative
aspect of work study.
Cost Control, Reduction and Estimation in Business!
Meaning:
Business firms aim at producing the product at the
minimum cost. It is necessary in order to achieve the goal
of profit maximisation. The success of financial
management is judged by the action of the business
executives in controlling the cost. This has led to the
emergence of cost accounting systems.
Cost control by management means a search for better
and more economical ways of completing each operation.
Cost control is simply the prevention of waste within the
existing environment. This environment is made up of
agreed operating methods for which standards have been
developed.
These standards may be expressed in a variety of ways,
from broad budget levels to detailed standard costs. Cost
control is the procedure whereby actual results are
compared against the standard so that waste can be
measured and appropriate action taken to correct the
activity.
Cost control is defined as the regulation by executive
action of the costs of operating an undertaking. Cost
control aims at achieving the target of sales. Cost control
involves setting standards. The firm is expected to adhere
to the standards.
Deviations of actual performance from the standards are
analysed and reported and corrective actions are taken.
Cost control emphasis is on past and present. Cost
control is applied to things which have standards. It seeks
to attain lowest possible cost under existing conditions.
Cost control is a preventive function.
Aspects of Cost Control:
Cost control involves the following steps and covers
various aspects of management. It has to be brought
in the following manner:
(i) Planning:
Initially a plan or set of targets is established in the form of
budgets, standards or estimates.
(ii) Communication:
The next step is to communicate the plan to those whose
responsibility is to implement the plan.
(iii) Motivation:
After the plan is put into action, evaluation of the
performance starts. Costs are ascertained and information
about achievements is collected and reputed. The fact
that the costs are being reported for evaluating
performance acts as a prompting force.
(iv) Appraisal:
Comparison has to be made with the predetermined
targets and actual performance. Deficiencies are noted
and discussion is started to overcome deficiencies.
(v) Decision-making:
Finally, the reported variances are received. Corrective
actions and remedial measures are taken or the set of
targets is revised, depending upon the administration’s
understanding of the problem.
The management and control of the resources used in
most commercial organisations leaves a great deal to be
desired. Waste is growing at such an enormous rate that it
has spawned a new industry for recycling and extracting
useful materials.
Materials are wasted in a number of ways such as
effluents, breakage, contamination, inefficient storage,
poor workmanship, low quality, pilfering
obsolescence. All these contribute to significantly
increased material costs and all can be controlled by
efficient working methods and effective control.
Advantages of Cost Control:
Cost control has the following advantages:
(i) It helps the firm to improve its profitability and
competitiveness.
(ii) In the absence of cost control, profits may be
drastically reduced despite a large and increasing sales
volume.
(iii) It is indispensable for achieving greater productivity.
(iv) Cost control may also help a firm in reducing its costs
and thus reduce its prices.
(v) If the price of the product is stable and reasonable, it
can maintain higher sales and thus employment of work
force.
Tools of Cost Control:
Control has a regulatory effect. For better performance
and better results certain means of control have been
evolved. These are called control techniques.
Mainly two types of standards are established to
control costs:
(i) External
(ii) Internal
External standards are applied for comparing performance
with other organisations. The external standards are used
for comparing the cost performance with the other firm
take the shape of a set of cost ratios.
Internal standards, on the other hand, are used for the
evaluation of intra firm cost elements like materials,
labour, etc.
The internal standards used for cost control are:
(i) Budgetary control
(ii) Standard costing
(i) Budgetary Control:
Budgetary control is derived from the concept and use of
budgets. A budget is an anticipated financial statement of
revenue and expenses for a specified period. Budgeting
refers to the formulation of plan for given period in
numerical terms. Thus budgetary control is a system
which uses budgets as a means for planning and
controlling entire aspects of organisational activities or
parts thereof.
According to Floyd H. Rowland and William. H. Barr,
―Budgetary control is a tool of management used to plan,
carry out and control the operation of business. As a
further explanation, it establishes predetermined
objectives and provides the basis for measuring
performance against these objectives.‖
George R. Terry has defined budgetary control as ―a
process of comparing the actual results with the
corresponding budget data in order to approve
accomplishments or to remedy differences by either
adjusting the budget estimates or correcting the cause of
difference‖.
and
The above definitions point out that budgeting is an aid to
planning and control.
Features of Budgetary Control:
(i) Budgetary control establishes a plan or target of
performance.
(ii) It tries to measure the outcomes of activities in
quantified terms.
(iii) It tries to focus attention of the management on
deviation between
What is planned and what is being achieved so that
necessary actions can be taken.
Characteristics of Budgetary Control:
Budgetary control leads to maximum utilisation of
resources. It also helps in coordination. Thus budgetary
control can play five important roles in an organisation.
The following are the characteristics of budgetary
control:
(i) Planning:
Budgetary Control forces managers to plan their activities
of the each department of the enterprise. Since budgetary
control is duly concerned with concrete numerical goals, it
does not leave any ambiguity regarding the targets. It
leads to a cautious utilisation of resources since it keeps a
rigid check over activities in the organisation. It also
contributes indirectly to the managerial planning at higher
levels.
(ii) Co-ordination:
Budgetary control system promotes co-operation among
various departments in the organisation. The system
encourages exchange of information among various units
of the organisation. The system promotes balanced
activities in the organisation.
(iii) Recording:
Budgetary control enables to keep up-to-date records of
all activities of the business unit as a whole. A budget can
be defined as a numerical statement expressing the plans,
policies and goals.
(iv) Control:
Budgetary control as a control device is very exact,
accurate and precise. It pinpoints any deviation between
budgeted standards and actual achievement. It also points
out the reasons which may be responsible for deviation
between budget and actual.
(v) Corrective Actions:
Budgetary control ensures corrective actions as the basis
of deviations for better results. It helps in directing,
counselling, guiding and supervising in a co-ordinated
manner so this improves the overall performance of the
business unit.
Advantages of Budgetary Control:
The following are the main advantages of budgetary
control system:
(i) Budgetary control integrates and brings together all
activities of the enterprise right from planning to
controlling.
(ii) Budgetary control provides a yardstick against which
actual results can be compared.
(iii) Budgetary control provides a clear definition of the
objectives and policies of the concern.
(iv) Budgetary control is a useful tool in profit-planning.
(v) Budgetary control helps to eliminate or reduce
unproductive activities and minimising waste.
(vi) Budgetary control makes everyone accountable for his
work, as it defines the responsibility for performances.
(vii) Budgetary control system acts as a basis for internal
audit by providing a method of continuous appraisal of
performance.
Essentials of Budgetary Control System:
The conventional budgeting system gives a picture of
expenditure made in the past. As a business firm
becomes interested in cost reduction and control, the
accounting manager is forced to become less interested in
past history’, and is more interested in the future.
The budget is a plan for the future and as such it is a base
for cost control in the long run. The management may
take up several cost reduction measures but without
budgetary control there can be no long range process.
Most of the managers are of the opinion that budgetary
control requires time and money, but it is effective in
bringing about cost improvement.
Managers should remember that the budgetary control is
only a tool and it does not replace management. Bearing
in mind the limitations of budgetary control, it should be
designed to each job. Budgetary control is not just the tool
of the budget administrator but it is the tool of all.
Budget preparation and administration should be fully
supported by top management. If the top management
encourages, budget will be most effectives.
Budget estimates should be prepared by those executives
who are to be held responsible for performance.
Another method of making budgets effective is to ensure
that all managers participate in budget preparation.
Managers should get quick information whenever actual
performance deviates from forecast performance. This
means that actual progress at each and every stage
should be made known to the manager.
Yet another method of making budget effective is that it
should not cost more to operate than it is worth.
Finally, the standards established should be capable of
being easily translated for measurement.
Limitations of Budgetary Control:
Though budgetary control provides a lot to management
in planning, controlling and coordinating the activities of
an organisation, it is not a fool- proof system. It has its
own limitations. Therefore, managers should be well
aware about these problems so as to take adequate
precautions to minimise the impact.
(i) The main problem in budgetary control comes because
of uncertainty of future. It is a known fact that budgets are
formulated on the assumptions of future happenings in a
certain way.
(ii) The budgetary programme takes a long time to
develop a reasonably good system of budgetary control.
(iii) The role of budgetary control system in planning is
sometimes over emphasised. Any deviation from
budgeted figures is looked upon with contempt. This
inflexibility contributes negatively to the organisational
objectives.
(iv) The effectiveness of the budget depends largely on
the dedication and co-ordination of the top management.
(v) Budgetary control system requires a lot of paper work
which the technical personnel always resent.
(vi) Budgetary control may affect the organisational
morale. Managers may adopt defensive attitude and this
may create many types of problems and conflicts in the
organisation.
Types of Budgets:
Every business unit has a variety of plans such as
production plan, sales plan, financial plan and the like.
When the plans are projected in advance, they are called
budgets.
The budgets may be classified on the following basis:
(i) Coverage of functions: Master Budget and Functional
Budget.
(ii) Nature of activities: Capital Budget and Revenue
Budget.
(iii) Period: Long Term Budget and Short Term Budget.
(iv) Flexibility: Fixed Volume Budget and Flexible
Budget.
(v) Preparation of budget methods: Performance
Budget and Zero-base Budget.
They are explained as under:
(a) Master Budget and Functional Budget:
Master budget is the summary budget which covers all
types of budgets such as sales, production, costs, profit
and appropriation of profit, and major financial ratios. Thus
this is nothing but the targeted profit and loss statement
and balance sheet of the organisation.
The functional budgets have a number of classifications
depending upon the type of functions performed and
budgeting practices adopted by an organisation.
Therefore, there can be budget for each major functions
and sub-function like material budget, production budget,
financial budget, marketing budget, sales budget,
research and development budget, personnel budget and
the like.
(b) Capital Budget and Revenue Budget:
Business activity involves two processes:
(i) Creating of facilities for carrying the business activities;
and (ii) carry out the activities. Budget in respect of the
former is called capital budget and the latter is called
revenue budget.
(c) Fixed and Flexible Budgets:
A fixed budget is prepared for a specific output level and it
has no concern with the changes in the level of activity of
the firm. Fixed budgets are called short period budgets. A
flexible budget is also called variable budget. In the
flexible budget, provision is made for changes in the
production levels of the firm. Flexible budget is adaptable
to changes in operating conditions.
(d) Performance Budget:
A performance budget is an input-output budget or costs
and results budget. It shows costs matching with
operation. The concept of performance budgeting
originated in the USA around 1960s when defense
budgeting led to the thinking of ways and means of linking
outputs to inputs.
Afterwards, this became quite popular in many
government departments outside the United States. Now
it is being used in business and other organisations
besides government departments. It emphasises non-
financial measures of performance which can be related
to financial measures in explaining changes and
deviations from planned performance.
The conventional budget is not effective because the
concerned department does not like expenditure with
performance. The performance aspect is side-tracked in
all government or public sector industries department. It
is, therefore, necessary to have performance budgeting.
In the performance budget each item of expenditure is
related to a specific performance.
Performance budgeting results in the following:
(i) It measures progress towards long term objectives.
(ii) It makes possible more effective performance audit.
(iii) It correlates the financial and physical aspects of every
programme.
(iv) It facilitates better appreciation and review of
organisational activities by top management.
(v) It improves budget formulation, review and decision
making at all levels of the organisation.
(vi) To achieve the most important facet of budgeting, that
is, control of the performance in terms of physical unit and
the related costs.
(vii) It makes possible to find out sufficient performance
measures to represent adequately all important variables
in determining the cost of an activity.
(e) Zero- Base Budgeting:
Zero-Base budgeting was originally developed by the
Texas Instruments of USA in 1971. Subsequently, it was
applied by the State of Georgia in 1973. Since then, it has
been used by a number of states and business
organisations in the U.S.A. and other countries.
The key element in zero-base budgeting is future
objective orientation of past objectives. In the zero-base
budgeting, it is assumed that the budget for the next year
is zero and starts the demand for the project. It requires
each manager to justify his entire budget in detail from
scratch that is zero-base.
The burden of execution shifts on each manager and he
has to justify the demand for money .Such an analysis
indicates which activities are important and which are
unimportant. Unimportant activities are eliminated or
made into productive and profitable. Thus zero-base
budgeting helps in choosing those activities which are
essential and important.
(ii) Standard Costing:
Standard costing is one of the prominently used systems
of cost control. It aims at establishing standards of
performance and target costs which are to be achieved
under a given set up working conditions. It is a pre-
determined cost which determines what each product or
service should cost under certain situation.
Standard costing is defined as the preparation and use of
standard costs, their comparison with actual costs and the
measurement and analysis of variances to their causes
and points of incidence. Standard costs should be
obtained under efficient operations.
It starts with an estimate of what a product should cost
during a future period given reasonable efficiency
Standard costs are established by bringing together
information collected from various sources within the
company.
The degree of success is measured by a comparison of
actual performance and standard performance. For
example, if the standard material input for a unit of
production is Rs. 500 and the actual cost is Rs 475 then
the variance of Rs. (-) 25 is the measure of performance,
which shows that the actual performance is an
improvement over the standard.
This comparison of actual costs with standard cost will
help in fixing responsibility for nonstandard performance
and will focus attention on areas in which cost
improvement should be sought by showing the source of
loss and inefficiency.
Basic Requirements in the Use of Standard Costing:
The basic requirements are the following:
(i) The ability to establish a meaningful standard.
(ii) A system for measuring actual quantities and costs at
the same level as the standard costs and quantities.
(iii) The facilities to calculate variances over time, which
will allow corrective action to be taken.
Advantages of Standard Costing:
Standard costing has the following merits:
(i) It helps in establishing a yardstick with which the
efficiency of performance is measured that helps to
exercise control.
(ii) It provides how the clear goal is to be achieved by
providing incentive and motivation to work.
(iii) It provides the management the basic information to
fix selling price, transfer pricing, etc.
(iv) It facilitates delegation of authority and fixation of
responsibility.
(v) It helps in achieving optimum utilisation of plant
capacity.
(vi) It provides means for cost reduction.
(vii) Variance analysis and reporting is helpful for taking
corrective measures.
Limitations of Standard Costing:
Even though this method confers several benefits,
there are certain difficulties which are listed below:
(i) Application of standard costs is quite difficult in
practice.
(ii) Frequently, standards become rigid over time and do
not keep pace with changes in conditions.
(iii) If the standards are outdated, loose, inaccurate and
unreliable, they are more harmful.
(iv) It standards set are higher than reasonable, they act
as discouraging factor.
(v) When there are random factors, it is difficult to explain
variance properly.
(vi) Standard costing may be found to be unsuitable and
costly in the case of firms dealing in non-standard
products.
(vii) It is difficult to distinguish between controllable and
non-controllable variances.
(viii) Setting the standard costing are highly technical and
mechanical.
Basis of Setting Standard Costs:
Without standards, a company’s management has no way
of knowing its overall performance. The standard costs
are to be established by collecting all information
pertaining to different cost functions. The main basis of
setting standard costs is technical and engineering
aspects. A major issue in standard costing is the
determination of the tightness of standards which may
range from a desire for engineering perfection to very
slack practices.
The other basis of setting standards is:
(i) Time of use—current standard and basic standard
(ii) Performance level—normal, ideal, expected, attainable
standards, etc.
(iii)Price level—ideal, normal, current, basic standard
(iv) Output level—theoretical, practical, normal expected
standards.
(a) Normal Standards:
Normal standards comprise:
(i) Ideal Standards:
The standards represent the maximum level of efficiency,
i.e., using minimum resources to complete the goal
without any loss of time. In control terms, it is essential for
standards to motivate individuals towards their attainment.
It is very difficult to use ideal standards. Ideal standards
are, therefore, more likely to be set for direct material
costs and usage rather than for direct labour or overhead
costs.
(ii) Target Standards:
These are the standards which can be attained during a
future specified budget period. These are a modified
version of ideal standard costs. Hence a certain amount of
waste is permitted.
(b) Basic Standards:
Basic standards are those standards which are set at their
initial level. In fact, basic standards are not very pragmatic
as they emphasize the past instead of the future. Their
effectiveness is very little in situations of change in
production methods, range of products and prices.
(c) Currently attainable Standards:
Currently attainable standard costs are those costs that
should be incurred currently under efficient operating
conditions, but making allowances for normal spoilage,
unavoidable idle time, unavoidable machine breakdown,
set up time, etc. In other words, currently attainable
standards or expected standards are the target standards
minus a realistic allowance for normal or acceptable
waste.
Tolerance Limit:
In reality, it is rare that the costs of the firm will exactly
match the set standards. Management cannot insist that
every time the performance must match the rigid
standards. Limits of these deviations from the set
standards which are called tolerance limits. The deviations
are of two types: Random and significant. Random
deviations are those which arise purely due to chance and
are therefore uncontrollable. Significant deviations are
those that have assignable causes and are therefore
largely subject to control of the management. Cost control
must be based on some measure of importance of these
significant deviations.
MAKE OR BUY ANALYSIS
Introduction
Are you outsourcing enough? This was one of the main
questions asked by management consultants during the
outsourcing boom. Outsourcing was viewed as one of the
best ways of getting things done for a fraction of the
original cost.
Outsourcing is closely related to make or buy decision.
The corporations made decisions on what to make
internally and what to buy from outside in order to
maximize the profit margins.
As a result of this, the organizational functions were
divided into segments and some of those functions were
outsourced to expert companies, who can do the same
job for much less cost.
Make or buy decision is always a valid concept in
business. No organization should attempt to make
something by their own, when they stand the opportunity
to buy the same for much less price.
This is why most of the electronic items manufactured and
software systems developed in the Asia, on behalf of the
organizations in the USA and Europe.
Four Numbers You Should Know
When you are supposed to make a make-or-buy decision,
there are four numbers you need to be aware of. Your
decision will be based on the values of these four
numbers. Let's have a look at the numbers now. They are
quite self-explanatory.
 The volume
 The fixed cost of making
 Per-unit direct cost when making
 Per-unit cost when buying
Now, there are two formulas that use the above numbers.
They are 'Cost to Buy' and 'Cost to Make'. The higher
value loses and the decision maker can go ahead with the
less costly solution.
Cost to Buy (CTB) = Volume x Per-unit cost when buying
Cost to Make (CTM) = Fixed costs + (Per-unit direct cost x
volume)
Reasons for Making
There are number of reasons a company would consider
when it comes to making in-house. Following are a few:
 Cost concerns
 Desire to expand the manufacturing focus
 Need of direct control over the product
 Intellectual property concerns
 Quality control concerns
 Supplier unreliability
 Lack of competent suppliers
 Volume too small to get a supplier attracted
 Reduction of logistic costs (shipping etc.)
 To maintain a backup source
 Political and environment reasons
 Organizational pride
Reasons for Buying
Following are some of the reasons companies may
consider when it comes to buying from a supplier:
 Lack of technical experience
 Supplier's expertise on the technical areas and
the domain
 Cost considerations
 Need of small volume
 Insufficient capacity to produce in-house
 Brand preferences
 Strategic partnerships
The Process
The make or buy decision can be in many scales. If the
decision is small in nature and has less impact on the
business, then even one person can make the decision.
The person can consider the pros and cons between
making and buying and finally arrive at a decision.
When it comes to larger and high impact decisions,
usually organizations follow a standard method to arrive at
a decision. This method can be divided into four main
stages as below.
1. Preparation
 Team creation and appointment of the team
leader
 Identifying the product requirements and analysis
 Team briefing and aspect/area destitution
2. Data Collection
 Collecting information on various aspects of
make-or-buy decision
 Workshops on weightings, ratings, and cost for
both make-or-buy
3. Data Analysis
 Analysis of data gathered
4. Feedback
 Feedback on the decision made
By following the above structured process, the
organization can make an informed decision on make-or-
buy. Although this is a standard process for making the
make-or-buy decision, the organizations can have their
own varieties.
Conclusion
Make-or-buy decision is one of the key techniques for
management practice. Due to the global outsourcing,
make-or-buy decision making has become popular and
frequent.
Since the manufacturing and services industries have
been diversified across the globe, there are a number of
suppliers offering products and services for a fraction of
the original price. This has enhanced the global product
and service markets by giving the consumer the eventual
advantage.
If you make a make-or-buy decision that can create a high
impact, always use a process for doing that. When such a
process is followed, the activities are transparent and the
decisions are made for the best interest of the company.