Unit-IV- Economic Aspects

Methods and Techniques of Costing

Basically, there are two methods of costing (as per CIMA Terminology)
(i) Specific Order Costing (or Job/Terminal Costing) and
(ii) Operation Costing (or Process or Period Costing.)

Specific Order Costing is the category of basic costing methods applicable where the work
consists of separate jobs, batches or contracts each of which is authorised by a specific order
or contract. Job costing, batch costing and contract costing are included in this category.
Operation Costing is the category of basic costing methods applicable where standardized
goods or services result from a sequence of repetitive and more or less continuous operations
or process to which costs are charged before being averaged over units produced during the
period.
1. Job Costing:
Under this method, costs are collected and accumulated for each job, work order or project
separately. Each job can be separately identified; so it becomes essential to analyse the cost
according to each job. A job card is prepared for each job for cost accumulation. This method
is applicable to printers, machine tool manufacturers, foundries and general engineering
workshops.
2. Contract Costing:
When the job is big and spread over long periods of time, the method of contract costing is
used. A separate account is kept for each individual contract. This method is used by builders,
civil engineering contractors, constructional and mechanical engineering firms etc.
3. Batch Costing:
This is an extension of job costing. A batch may represent a number of small orders passed
through the factory in batch. Each hatch is treated as a unit of cost and separately costed. The
cost per unit is determined by dividing the cost of the batch by the number of units produced
in a batch. This method is mainly applied in biscuits manufacture, garments manufacture and
spare parts and components manufacture.
4. Process Costing:
This is suitable for industries where production is continuous, manufacturing is carried on by
distinct and well defined processes, the finished products of one process becomes the raw
material of the subsequent process, different products with or without byproducts are
produced simultaneously at the same process and products produced during a particular
process are exactly identical.
5. One Operation (Unit or Output) Costing:
This is suitable for industries where manufacture is continuous and units are identical. This
method is applied in industries like mines, quarries, oil drilling, breweries, cement works,
brick works etc. In all these industries there is natural or standard unit of cost. For example, a
barrel of beer in breweries, a tonne of coal in collieries, one thousand of bricks in brickworks
etc.
The object of this method is to ascertain the cost per unit of output and the cost of each item
of such cost. Here cost accounts take the form of cost sheets prepared for a definite period.
The cost per unit is determined by dividing the total expenditure incurred during a given
period by the number of units produced during that period.
Types or Techniques of Costing:

Following are the main types or techniques of costing for ascertaining costs:
1. Uniform Costing:
It is the use of same costing principles and/or practices by several undertakings for common
control or comparison of costs.
2. Marginal Costing:
It is the ascertainment of marginal cost by differentiating between fixed and variable cost. It
is used to ascertain the effect of changes in volume or type of output on profit.
3. Standard Costing:
A comparison is made of the actual cost with a pre-arranged standard cost and the cost of any
deviation (called variances) is analysed by causes. This permits management to investigate
the reasons for these variances and to take suitable corrective action.
4. Historical Costing:
It is ascertainment of costs after they have been incurred. It aims at ascertaining costs actually
incurred on work done in the past. It has a limited utility, though comparisons of costs over
different periods may yield good results.
5. Direct Costing:
It is the practice of charging all direct costs, variable and some fixed costs relating to
operations, processes or products leaving all other costs to be written off against profits in
which they arise.
6. Absorption Costing:
It is the practice of charging all costs, both variable and fixed to operations, processes or
products. This differs from marginal costing where fixed costs are excluded.
Any of the methods of costing like unit or output costing, service costing, process costing etc.
can be used under any techniques of costing.
Meaning of Break-Even Chart (BEC):
The Break-Even Chart is a graphical representation between cost, volume and profits. No
doubt it is an important tool which helps to make profit planning. It has been defined
as “a chart which shows the profitability or otherwise of an undertaking at various
levels of activity and as a result indicates the point at which neither profit nor loss is
made.”

Construction of a Break-Even Chart:

A Break-Even Chart is constructed on a graph paper. Activity or volume of production is

plotted on the ‘X’ axis, whereas cost and revenue are plotted on the ‘Y” axis.

In its simplest form, the break-even chart is a graphical representation of costs at various
levels of activity shown on the same chart as the variation of income (or sales, revenue) with
the same variation in activity. The point at which neither profit nor loss is made is known as
the "break-even point" and is represented on the chart below by the intersection of the two
lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also
increase. At low levels of output, Costs are greater than Income. At the point of intersection,
P, costs are exactly equal to income, and hence neither profit nor loss is made.

Method of Preparation:

(a) Draw fixed cost of Rs. 40,000 line parallel to ‘X’ axis. Then plot the variable cost line
over fixed cost level at various level of activity and join the variable cost line with fixed cost
line at zero level of activity which will indicate total cost line—variable cost being over fixed
cost line.
At the same time, ascertain sales value at various activity level and plot them on the graph
paper and then join to zero which line indicates the volume of sales. It is interesting to note
that where the sales line intersects the total cost line, that is known as Break-Even Point.

What is Break-Even Analysis?

 
Break-even analysis is a tool used to calculate the point at which a company's revenues
equal its expenses. This point is known as the Break-Even Point (BEP). It is used to
assess whether a business is likely to be profitable.
 
There are two main types of break-even analysis: Graphical and chart.
 
Graphical break-even analysis is a visual way to calculate the break-even point. This
method uses a graph, which plots total revenue and total cost. The BEP is the point at
which total revenue and total cost intersect.
 
The break-even chart, however, is a table that shows the break-even point in terms of
units sold and currency. This method is more precise than graphical break-even analysis,
but it can be more difficult to understand.
 
Taking note of the graphical method, let us understand the steps you need to take to
conduct your own break-even analysis through PowerPoint.
 

How to Conduct Break-Even Analysis?

 
There are a number of factors you should consider when conducting a break-even analysis.
These are:
 
 Sale price: The price at which a product or service is sold.
 
 Unit cost: The cost of producing one unit of a product or service.
 
 Fixed costs: The costs that remain constant regardless of the level of activity or sales.
Examples include rent, insurance, and salaries.
 
 Variable costs: The costs that vary in relation to the level of activity or sales. Examples
include raw materials and commission.
 
 Break-even point: The point at which revenue equals costs.
 
With these parameters in mind, let us look at the steps that will help you conduct a
graphical analysis.
With these easy steps and a simple line chart, you can create a graph based on your own
data. In this format, the data is quite useful.
 

Applications of Break-Even Analysis

 
There are numerous applications of break-even analysis. This is done by estimating the
fixed and variable costs associated with the business and then calculating the break-even
point. Some common applications include:
 
 Determining the desired sales volume needed to break even
 
 Determining the price of a product or service
 
 Predicting the financial impact of changes in variable costs, fixed costs, and selling price
 
 Assessing the financial viability of a business idea
 
 Understanding how changes in costs or prices will impact profitability
 
Break-even analysis can ensure that the company’s profitability heads North.
 
Advantages of Break-Even Analysis
 
There are several advantages of break-even analysis:
 
First, it can help owners and managers understand the relationship between revenue and
costs. This information can be used to make decisions about pricing, production levels,
and other factors that affect the bottom line.
 
Second, break-even analysis can help owners and managers predict how changes in costs
will affect the break-even point. This information can be used to make decisions about
how to respond to changes in the business environment.
 
Third, break-even analysis can help owners and managers compare the financial
performance of different businesses. This insight can be used to make decisions about
which business to invest in or expand.
 
Finally, break-even analysis can help owners and managers monitor the financial
performance of their business over time.
 
Despite its many advantages, break-even analysis is not without its cons.
 
Disadvantages of Break-Even Analysis
 
One of the main disadvantages of break-even analysis is that it can be quite difficult to
estimate all costs. Hence, the break-even point could be overestimated or underestimated,
leading to losses or missed opportunities.
 
Another downside of break-even analysis is that it only looks at the financials of a product
or project. Factors like customer demand or satisfaction are not accounted for. This can
create a false sense of security among decision-makers who may think that a product is
more successful than it actually is.
 
Finally, break-even analysis can be quite simplistic and does not always provide the most
accurate picture of a business's financial health. This tool is only one part of the decision-
making process and can never be used as the sole criteria to value a business.
 
With such complete knowledge of break-even analysis, let us learn how to best
communicate the analysis and its results across the rank and file of your business.
Conclusion
 
Use our break-even analysis templates to conduct your own analysis. Simply input your
sales price, unit cost, and fixed costs, and the break-even point calculator will do the rest!
 
Sources of capital and hire charges
The most important elements of a clean energy lending program are the
capital source and the capital provider. The capital source provides the
funding to pay for clean energy projects, and the capital provider manages
those funding sources. For example, a bank might use its customers'
deposits as a capital source, but as the capital provider, the bank manages
the investment of that capital.

Capital sources and providers can be from one or a combination of the

following:

 Bonds
 Bank capital
 Credit union capital
 Foundation grants and funds
 Community Reinvestment Act funds
 Federal funds
 State government funds
 Utility system benefit charges and ratepayer funds
 Local government general funds
 Emissions allowance revenues.
BONDS

Bonds consist of many different types of funds that are too numerous to

describe here. Some of the more common types of bonds are tax-exempt
bonds that can fund investments in government facilities or, subject to
many limitations, investments in certain private activities. Those are
known as private activity bonds. 

BANK CAPITAL

Banks can invest their own depository capital in clean energy lending
projects if they feel the return is sufficient, given their understanding of the
risk involved in the investment.

CREDIT UNION CAPITAL

Like banks, credit unions invest their capital in projects for which they feel
the return will justify the risks as they understand them. Credit unions tend
to be smaller than most national banks and are closely tied to particular
communities or constituents. Credit unions may also have less capital to
lend and a smaller network of branches than the larger banks.

FOUNDATION GRANTS AND FUNDS

Community development financial institutions (CDFIs) receive foundation

grants to cover their operations and make loans to businesses, nonprofits,
and homeowners in the community. CDFIs also receive foundation
program-related investment (PRI) funds. Those are funds that foundations
can legally place with CDFIs as an investment with a low interest rate,
typically 2% to 3%.

COMMUNITY REINVESTMENT ACT FUNDS

Commercial financial institutions often meet their regulatory

responsibilities under the federal Community Reinvestment Act by placing
funds at a low interest rate with CDFI lenders. Like PRI funds, these
investments often earn a below-market rate of 2% to 3%. In turn, CDFI
lenders are expected to lend the funds at that same low rate plus a small
interest rate spread that typically ranges from 2% to 3%.
FEDERAL FUNDS

Federal funds, whether from U.S. Department of Energy (DOE) initiatives

such as the State Energy Program or other agencies, can be a source for
loan capital. As long as those funds are used to support qualifying clean
energy investments, they are a flexible funding source with few
restrictions. Another possible federal resource is the funding designated to
support lower income populations, such as the U.S. Department of
Housing and Urban Development's CDFIs, may also be able to access
grants from the U.S. Treasury to provide loan capital to targeted groups.
The 2013 guide to Federal Finance Facilities Available for Energy
Efficiency Upgrades and Clean Energy Deployment provides a review of
many of the federal resources available.

STATE GOVERNMENT FUNDS

Government entities can make loans and have often done so. For instance,
some state energy offices created clean energy lending programs in the late
1980s and early 1990s using allocations of funds through DOE and from
certain legal settlements. Other state financing authorities operate lending
programs using a number of different capital sources. State and local
financing authorities are diverse, but tend to operate in collaboration
(rather than in competition) with private financial institutions. State
financing authorities lend in markets that are not attractive to private
entities, such as loans to cash-strapped nonprofits, or co-lend with private
financial institutions. In some cases, government entities make direct
loans, too. In some cases, state treasurers may be willing to invest a
portion of their capital in energy efficiency lending.

UTILITY SYSTEM BENEFIT FUNDS

Public utility commissions will often require utilities to collect funds from
their bill payers to support clean energy programs, including financing
programs. These funds can provide direct loan capital, credit
enhancements, technical assistance, rebates, and other support for energy
efficiency and renewable energy projects. Utility customer-funded
program spending on energy efficiency alone was almost $5 billion in
2010
LOCAL GOVERNMENT GENERAL FUNDS

Tax revenues can sometimes capitalize on a clean energy or solar energy

loan program. Many jurisdictions, however, are experiencing reduced tax
revenues and budget cuts, which limit their ability to capitalize on loan
programs using their general funds.

EMISSIONS ALLOWANCE REVENUES

States that receive revenues from participating in a cap-and-trade structure

(e.g., the Regional Greenhouse Gas Initiative) can use those funds to seed
clean energy finance programs.

Capital Recovery
There is more than one definition of capital recovery in finance. When someone makes
an investment on a company or an asset, he or she gets a negative return until the whole
amount is returned. The RIO (Return on Initial Investment) made in such cases is called
capital recovery.
There can be other definitions too. For example, capital recovery occurs when a
company sells its machinery and recollects the money invested in them. In broad terms,
capital recovery is the money that is the investment or money gained back from a project.
Capital recovery is applicable to the asset's life span and the recovery period of the
repayment.
Example
Capital Recovery plays an important role while a company decides to buy new
equipment. If the payments generated is higher than the purchase value of the equipment,
if would be profitable for the company. For example, if you buy a printing press for INR
200,000 and expect INR 80,000 each year from it, you'll exceed the value in about 2.5
years. So, it would make sense to buy the equipment.
Note − Capital recovery can be used to decide whether a particular project would be
profitable or not.
Liquidity
Once you decide to sell your assets, you might need to know the exact price of the
equipment and fixed assets of your company. Here, capital recovery calculations play a
vital role because you must know the price of the asset and by when you can recoup the
price of it.
Debt Collection
Companies that recollect the loans, such as business and equipment loans, represent
themselves as capital recovery companies. Their major goal is to recover the loans and
offer this to the lender who originally funded the loan. Debt collection is often done
using the capital recovery formula.
Note − The capital recovery method is used in liquidation and debt collection.
Calculation
We know,
 Present Value = Annuity × Present Value of an Annuity Factor
PV = A × PVFA n.i ------ (1)
Where PVFA n.i represents the value factor of an annuity of INR 1 for n periods and i
rate of interest.
The reciprocal of Present Value Factor is called Capital Recovery Factor and is given
by,
A = p (1/PVFA n.i) ----- (2)
Now, the Present Value of Annuity can be written as,
P = A (1/i - 1/ i(1+i)n) ----- (3)
From equations (2) and (3), we get,
A = p × CRFn.i = p × (i (1+i)n / i (1+i)n -1
= (1/ (1/i - 1/i(1- i)n)
Which gives the capital recovery.
To calculate the capital recovery, we use the formula of the Present Value of Annuity.

Depreciation

In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed

asset in a systematic manner until the value of the asset becomes zero or negligible. An
example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is
the only exception which cannot be depreciated as the value of land appreciates with time.
Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the
fixed asset. This is mandatory under the matching principle as revenues are recorded with
their associated expenses in the accounting period when the asset is in use. This helps in
getting a complete picture of the revenue generation transaction.
Depreciation accounts for decreases in the value of a company’s assets over time. In the
United States, accountants must adhere to generally accepted accounting
principles (GAAP) in calculating and reporting depreciation on financial statements. GAAP
is a set of rules that includes the details, complexities, and legalities of business and
corporate accounting. GAAP guidelines highlight several separate, allowable methods of
depreciation that accounting professionals may use

An example of Depreciation – If a delivery truck is purchased a company with a cost of

Rs. 100,000 and the expected usage of the truck are 5 years, the business might
depreciate the asset under depreciation expense as Rs. 20,000 every year for a period of 5 years.
There three methods commonly used to calculate depreciation. They are:
1. Straight line method
2. Unit of production method
3. Double-declining balance method

Depreciation accounts for decreases in the value of a company’s assets over time. In the

United States, accountants must adhere to generally accepted accounting
principles (GAAP) in calculating and reporting depreciation on financial statements. GAAP
is a set of rules that includes the details, complexities, and legalities of business and
corporate accounting. GAAP guidelines highlight several separate, allowable methods of
depreciation that accounting professionals may use.

Three main inputs are required to calculate depreciation:

1. Useful life – this is the time period over which the organization considers the fixed asset to be
productive. Beyond its useful life, the fixed asset is no longer cost effective to continue the
operation of the asset.
2. Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a
reduced amount. This is known as the salvage value of the asset.
3. The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.

Methods of Depreciation
Straight-Line Depreciation

The straight-line method is the most common and simplest to use. A company estimates an
asset's useful life and salvage value (scrap value) at the end of its life. Depreciation
determined by this method must be expensed in each year of the asset's estimated lifespan.
This is the simplest method of all. It involves simple allocation of an even rate of
depreciation every year over the useful life of the asset. The formula for straight line
depreciation is:
Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset
Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000
and the useful life of the machinery are 10 years and the residual value of the machinery
is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
Thus the
Year Original cost – Residual value Depreciation expense
1 Rs. 80000 Rs. 8000
2 Rs. 80000 Rs. 8000
3 Rs. 80000 Rs. 8000
4 Rs. 80000 Rs. 8000
5 Rs. 80000 Rs. 8000
6 Rs. 80000 Rs. 8000
7 Rs. 80000 Rs. 8000
8 Rs. 80000 Rs. 8000
9 Rs. 80000 Rs. 8000
10 Rs. 80000 Rs. 8000
company can take Rs. 8000 as the depreciation expense every year over the next ten years as
shown in depreciation table below

Sum-of-the-Years' Digits Depreciation

The sum-of-the-years'-digits method (SYD) accelerates depreciation as well but less
aggressively than the declining balance method. Annual depreciation is derived using the
total of the number of years of the asset's useful life. The SYD depreciation equation is more
appropriate than the straight-line calculation if an asset loses value more quickly, or has a
greater production capacity, during its earlier years.
Units of Production Depreciation

The units of production method assigns an equal expense rate to each unit produced. It's
most useful where an asset's value lies in the number of units it produces or in how much it's
used, rather than in its lifespan. The formula determines the expense for the accounting
period multiplied by the number of units produced. This is a two-step process, unlike
straight line method. Here, equal expense rates are assigned to each unit produced. This
assignment makes the method very useful in assembly for production lines. Hence, the
calculation is based on output capability of the asset rather than the number of years.

The steps are:

Step 1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit Depreciation * Units Produced
Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a
useful life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.
Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2
Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800

Declining Balance Depreciation

The declining balance method is a type of accelerated depreciation used to write off
depreciation costs earlier in an asset's life and to minimize tax exposure. With this method,
fixed assets depreciate more so early in life rather than evenly over their entire estimated
useful life.

This method is often used if an asset is expected to lose greater value or have greater utility
in earlier years. It also helps to create a larger realized gain when the asset is sold. Some
companies may use the double-declining balance equation for more aggressive depreciation
and early expense management.

This is one of the two common methods a company uses to account for the expenses of a
fixed asset. This is an accelerated depreciation method. As the name suggests, it counts
expense twice as much as the book value of the asset every year.
The formula is:
Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the
accounting period
Book value = Cost of the asset – accumulated depreciation
Accumulated depreciation is the total depreciation of the fixed asset accumulated up to a
specified time.

Example: On April 1, 2012, company X purchased an equipment for Rs. 100,000. This is
expected to have 5 useful life years. The salvage value is Rs. 14,000. Company X considers
depreciation expense for the nearest whole month. Calculate the depreciation expenses for
2012, 2013, 2014 using declining balance method.

Useful life = 5
Straight line depreciation percent = 1/5 = 0.2 or 20% per year
Depreciation rate = 20% * 2 = 40% per year
Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000
Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000) * 40% * 12/12
= Rs. 16,800
Depreciation table is shown below:

Book value at the Depreciation Book value at the

Year Depreciation rate
beginning Expense end of the year
2012 Rs. 1,00,000 40% Rs. 30000 * (1) Rs. 70000
2013 Rs. 70000 40% Rs. 28,000 * (2) Rs. 42,000
2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200
2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120
2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

Depreciation for 2016 is Rs. 1,120 to keep the book value same as salvage value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should stop).

Budgeting and Standard Costing

Similarities Between Standard Costing and Budgetary Costing

Basis of Standard Costing Budgetary Costing

Difference
Predetermined Standard costs are predetermined Budgetary costs are also estimated
cost costs fixed according to estimates. costs.
Advance cost Standard costs are estimated in Budgetary costs are also estimated
advance and compared to actual in advance and compared to actual
costs. costs.
Both aim at Standard costs are designed Budgetary costing also seeks to
cost control to control costs and improve promote cost control and maximize
efficiency. employee efficiency.
Cost Standard costs are designed well These advanced estimated costs are
comparison in advance and compared to actual compared to actual costs.
costs.
Reporting Standard costs are periodically Budgetary costs are also reported
reported to top management. to management periodically.
Corrective Standard costing lays stress on Budgetary control lays stress on
action identifying adverse variances and identifying adverse variances.
corrective actions are taken.

Differences Between Standard Costing and Budgetary Costing

Basis of Standard Costing Budgetary Costing

Difference
Base Standard costs are predetermined Budgetary costs are based on past
or planned costs. experience.
Technique Standard costs are based on Budgetary costs are based on
technical estimates. historical data and adjusted to the
 future.
Scope The standards are set for elements Budgets are prepared for every
of cost. business activity.
Limited use Standard costs can be used for Budgets are used for men, materials,
estimation or forecasting. and money.
Conditions Standard costs are used in ideal Budgets are made and used in
conditions or situations. diverse conditions and situations.
Per unit Standard costs can be calculated Budgetary costs cannot be
per unit. calculated on a per-unit basis.
Nature Standards are set only Budgets are compiled for
for expenditure. both income and expenditure.
Coverage Standard cost is not Budgetary cost coverage is
comprehensive (i.e., it is limited significantly greater than standard
only to cost operations). cost coverage.
Parts Standard costs cannot be specified The budget can be in parts (only
in parts. the cash budget).

Capital budgeting:
Capital budgeting – the long – term investment decision – is probably the most crucial
financial decision of a firm. It relates to the selection of an assent or investment proposal or
course of action that benefits are likely to be available in future over the lifetime of the
project.

The long-term investment may relate to acquisition of new asset or replacement of old
assets. Whether an asset will be accepted or not will depend upon the relative benefits and
returns associated with it. The measurement of the worth of the investment proposals is,
therefore, a major element in the capital budgeting exercise. The second element of the
capital budgeting decision is the analysis of risk and uncertainty as the benefits from the
investment proposals pertain the future, which is uncertain. They have to be estimated under
various assumptions and thus there is an element of risk involved in the exercise. The return
from the capital budgeting decision should, therefore, be evaluated in relation to the risk
associated with it.

The third and final element is the ascertainment of a certain norm or standard against
which the benefits are to be judged. The norm is known by different names such as cut-off
rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly
expressed in terms of the cost of capital is, thus, another major aspect of the capital;
budgeting decision. In brief, the main elements of the capital budgeting decision are: (i) The
total assets and their composition (ii) The business risk complexion of the firm, and (iii)
concept and measurement of the cost of capital.

Capital Budgeting: Capital budgeting is the process of making investment decision in long-
term assets or courses of action. Capital expenditure incurred today is expected to bring its
benefits over a period of time. These expenditures are related to the acquisition &
improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number
of years. It is the process of deciding whether or not to invest in a particular project, as the
investment possibilities may not be rewarding. The manager has to choose a project, which
gives a rate of return, which is more than the cost of financing the project. For this the
manager has to evaluate the worth of the projects in-terms of cost and benefits. The benefits
are the expected cash inflows from the project, which are discounted against a standard,
generally the cost of capital.

Capital Budgeting Process:

The capital budgeting process involves generation of investment, proposal estimation of cash-
flows for the proposals, evaluation of cash-flows, selection of projects based on acceptance
criterion and finally the continues revaluation of investment after their acceptance the steps
involved in capital budgeting process are as follows.

1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1. Project generation: In the project generation, the company has to identify the proposal to
be undertaken depending upon its future plans of activity. After identification of the
proposals they can be grouped according to the following categories:

a. Replacement of equipment: In this case the existing outdated equipment and

machinery may be replaced by purchasing new and modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the
existing product line by purchasing additional equipment.
c. Diversification: The Company can diversify its product line by way of
producing various products and entering into different markets. For this
purpose, It has to acquire the fixed assets to enable producing new products.
d. Research and Development: Where the company can go for installation of
research and development suing by incurring heavy expenditure with a view to
innovate new methods of production new products etc.,
2. Project evaluation: In involves two steps.

a. Estimation of benefits and costs: These must be measured in terms of cash

flows. Benefits to be received are measured in terms of cash flows. Benefits to
be received are measured in terms of cash in flows, and costs to be incurred
are measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the project.
3. Project selection: There is no standard administrative procedure for approving the
investment decisions. The screening and selection procedure would differ from firm to firm.
Due to lot of importance of capital budgeting decision, the final approval of the project may
generally rest on the top management of the company. However the proposals are scrutinized
at multiple levels. Some times top management may delegate authority to approve certain
types of investment proposals. The top management may do so by limiting the amount of
cash out lay. Prescribing the selection criteria and holding the lower management levels
accountable for the results.

4. Project Execution: In the project execution the top management or the project execution
committee is responsible for effective utilization of funds allocated for the projects. It must
see that the funds are spent in accordance with the appropriation made in the capital
budgeting plan. The funds for the purpose of the project execution must be spent only after
obtaining the approval of the finance controller. Further to have an effective cont. It is
necessary to prepare monthly budget reports to show clearly the total amount appropriated,
amount spent and to amount unspent.

CASH FLOW DIAGRAM

The graphic representation of each monetary value with time is called a cash flow
diagram. The benefits are represented as upward arrows and costs as downward arrows. It is
drawn to convert the time stream of monetary value into an equivalent single number. All
cash flows are combined into an equivalent single lump sum at the end of a period.

An example cash flow diagram is shown below. At the beginning, a large expenditure is
made. Benefits are received thereafter every year. It is to be noted, that all expenditure done
on a project is included as cost. The cost can be fixed or continuous. The fixed cost can be the
initial construction cost where as there are repeated costs for maintenance. In a hydroelectric
power plant, the initial cost shall be the cost of making a dam, various channels, cost of
equipment, cost of acquiring land, cost of approach roads etc. The variable cost (annual) shall
be the cost of repairing, consumables used, wages to workers. There is one more cost, i.e.
periodic replacement of worn out of equipment, It may be carried out six monthly, yearly and
so on. See the cash flow diagram given below Arrows pointing downwards=cost Arrows
pointing upwards= Benefit Constant Benefits Rising Benefits Maintenance cost Periodic
replacement Periodic replacement Initial Construction cost. The benefits start to grow
gradually as the project start their activity and reach a value after which the benefits remain
constant, as indicated in the cash flow diagram.

Cash flow diagram

Cash flow diagrams are required to visualize or represent the income and expenses
over a certain period. The diagram contains a horizontal line with markers at a series of
intervals of time. At particular times, expenses and costs are depicted. Transactions may
include initial investments, maintenance costs, projected savings or earnings resulting from
the project, as well as the salvage and resale value of the equipment at the termination of the
project. These diagrams along with the associated modeling are then used to find out a cash
flow neutrality (break-even point) or to analyze operations and profitability
To show an example of the cash flows diagram, consider the cash flows of a simple business
project that is undertaken by a firm.

Features of a cash flow diagram

 The horizontal axis of the cash flow diagram represents the time.
 The axis is divided into equal periods.
 The period can be in days, months, or years. It is stretched for the entire duration of
the project.
 Cash inflows are represented by the arrows that are pointing in the upward direction.
 Cash outflows are represented by the arrows that are pointing in a downward
direction.
 Initial investments are shown at the beginning of the cash flows diagram - at the
period 0.