Part B: Entrepreneurship Development

Unit-4 : Business Finance & Accounting

4.1 Cost of Project

Cost of project is the aggregate of costs estimated to be incurred on

various heads for bringing the project into existence. Establishing the
cost of project constitutes a critical step in project planning, on the
basis of which means of finance is worked out.

The cost of project usually comprises the following items:

(a) Land and site development,

(b) Factory building,

(c) Plant and machinery,

(d) Escalation and contingencies,

(e) Other fixed assets or miscellaneous fixed assets,

(f) Technical know-how fees,

(g) Interest during construction,

(h) Preliminary and pre-operative expenses, and

(i) Margin money for working capital.

4.1.1 Sources of Finance:

For implementation of the project, it is required to raise finance from

various sources of finance. After consideration of various aspects
attached to different sources of finance, the scheme of finance will be
determined.

The scheme of means of finance will generally consist of

raising of amounts from the following:

(a) Equity share capital.

i. Promoters, and

ii. Public.

(b) Term loans from all India or state level financial institutions.

(c) Debentures.

(d) Unsecured loans.

i. Promoters, and

ii. Others.

(e) Others.

A hypothetical scheme of cost of project and means of finance is given

below:

Illustration 1:

A well-known company is setting up a project with a total project cost

of Rs. 16 crore.

Its cost of project and means of finance are given below:

Margin Money:

The banks and financial institutions maintain a margin while

financing the project cost by asking the borrower to bring a certain
amount say 20% of the cost of project cost as margin money to
safeguard from the changes in the value of assets that are being
financed and provided as a security. The quantum of margin money
depends on the creditworthiness of the borrower and the nature of
security provided to the institution.

The margin money will be brought by the promoters in project

financing. Margin money is one of the important factors which are
evaluated by financial institutions while considering the project for
financial assistance. The margin money required for working capital
of the project will be provided in the project cost. In working capital
financing, the working capital margin money is to be brought as per
the guidelines prescribed by RBI.

The elements of cost of project are divided into tangible

assets and non-tangible assets to find out the margin
money as illustrated below:

Illustration 2:

A well-known company is setting up a project with a total project cost

of Rs. 100 lakhs.

The details of its project cost are given below:

Tangible assets are those which are physically present and whose cost
can be allocated to either of the above heads. Serial(a) to serial(g)
constitute the tangible assets. It is only the escalation and
contingencies, which is estimated and may give rise to some scope of
error while evaluating margin money.

Interest during construction period pertaining to the interest which

the project is required to bear during the implementation of the
project. This payment is allowed to be capitalised and is distributed
on pro rata basis to the various elements of the cost of the project as
mentioned at serial (a) to (f).

Technical know-how fees are also required to be capitalised and the

normal choice of capitalising it is to be made to the head of ‘plant and
machinery’.

In the above scheme tangible assets constitute 80% of the cost of

project and the non-tangible items constitute 20% of the cost of
project.

Normally the financial institutions do not finance the non-tangible

assets, and it is to be financed by the promoter/borrowing concern.

The tangible assets will be financed between 70% to 85% of the value
of each item of asset.
Suppose if the financial institution maintains the 2: 1 debt-
equity ratio, then percentage of margin money is calculated
by applying the following formula:

Tangible Assets = Rs. 80 lakhs

Term Loan = RS. 66 Lakhs

Suppose, if the financial institution may like to keep margin of 25%

on tangible assets, in such case promoters contribution is calculated
as shown below:

Tangible assets 80% Non-tangible assets 20%

Therefore, it is advisable that while planning the project financing,

the norms of margin money should be kept in mind to establish a
suitable debt-equity ratio and promoters contribution.

Promoters Contribution:

An entrepreneur who promotes the project will also participate in the

scheme of finance of the project. The extent of promoter’s
participation is considered as sign of interest the promoters show in
the project. When the bank/financial institution is asked to
participate in the scheme of finance, they would ask the promoters to
bring a certain portion, normally between 25 to 50% of the project
cost into the equity share capital of the company.

A part of the contribution can be arranged by the promoters from

outside sources like arranging investment in capital from friends and
relatives. For eligibility of financing, the financial institutions will
stipulate minimum promoters contribution which is to be arranged
by the promoter. The financial institutions always press for the
slightly higher participation in the project.

This is to ensure a long and continued involvement of the promoter

in the project. Promoters contribution indicates the extent of their
involvement in the project in terms of their own financial stake. The
promoters contribution will be provided in the form of subscribing to
equity and preference shares issued by the company, unsecured
loans, seed capital assistance, venture capital assistance, internal
accrual of funds.

Social Cost Benefit Analysis:

‘Social cost’ is a sacrifice or detriment to society. Whether economic,

internal or external, social costs are the sacrifices of the society for
which the business firm is responsible like air-pollution, water
pollution, deficiency due to bankruptcy, depletion and destruction of
animal resource, soil erosion, deforestation, impairment of human
factor of production, monopoly and social losses, production of
dangerous products and explosives, deterioration in the law and
order conditions in the industrial estates etc. ‘Social benefit’ is a
compensation made to the society in the form of increase in per
capita income, employment opportunities, etc.

Social cost benefit analysis (SCBA) is a systematic evaluation of an

organization’s social performance as distinguished from its economic
performance. It is concerned with the possible influences on the
social quality of life instead of economic quality of life. It analyses all
such activities which have a social or macro impact.

The development of an economy not only depends on the quantum

of investment but also on the rational and prudent allocation of
resources among various competing projects.

The technique is most popular for making socially viable decisions of

selection or rejection of projects is based on an analysis of social costs
and social benefits of projects. In other words, social cost-benefit
analysis is an important technique of comparing economic
alternatives.

It is used to determine, (a) which alternative or choice is socially

viable (or most suitable) and (b) which alternative is the optimal or
the best solution. The need for SCBA arises due to the reason that the
criterion used to measure commercial profitability that guides the
capital budgeting in the private sector may not be an appropriate
criteria for public or social investment decisions.
Private investors are more interested in minimizing the private costs
and therefore, take into account only those elements which directly
affect, their private gain i.e., private expenses and private benefits.
Both the private benefits and private expenses are valued at
prevailing market prices. But the existence of externalities in benefits
and expenses introduces bias in market-price based investment
decisions.

The total benefits expected from a project to the society are composed
of the private benefits (internal profit or returns) accruing to owner
of the project plus the external benefits (also known as externalities
or spill overs). Thus social benefits or returns equals to internal
benefits to the owner plus the external benefits to the society as
whole.

SCBA is a systematic evaluation of an organization’s social

performance as distinguished from its possible inferences on the
social quality of life instead of economic quality of life. It analyses all
such activities which have a social or macro impact.

The development of an economy not only depends on the quantum

of investment but also on the rational and prudent allocation of
resources. The technique is most popular for making socially viable
decisions of selection or rejection of projects based on an analysis of
social cost and social benefits of projects.

As an aid to planning, evolution and decision making, the cost-

benefit analysis is a scientific quantitative appraisal of a project to
determine whether the total social benefits of the project justify the
total social cost. United Nations Industrial Development
Organization (UNIDO) and Organization of Economic Cooperation
and Development (OECD) have extensively conducted studies on
SCBA.

Indicators of Social Desirability of a Project:

A project is also assessed from the social angle in addition to

assessment of its commercial viability.
The following social desirability factors will be considered
in accepts or reject decisions of a project.

1. Employment Potential:

The employment potential of a project is looked into. A project with

high employment potential is considered highly desirable.

2. Foreign Exchange Earnings:

A project with potential to earn foreign exchange to the country or an

import substitution project which saves the country’s foreign
exchange reserves is highly desirable.

3. Social Cost-Benefit Analysis:

A project with net benefits to the society over the costs to the society
is preferred.

4. Capital-Output Ratio:

If the value of expected output in relation to the capital employed is

high, the project is given priority over the others.

5. Value Added per Unit of Capital:

The amount invested in the project should generate the value

addition to the capital employed by earning surplus profits which can
be used for further capital investments to contribute development of
the national economy.
4.1.2 ASSESSMENT OF WORKING CAPITAL
Any enterprise whether industrial, trading or other acquires two
types of assets to run its business as has already been emphasised
time and again. It requires fixed assets which are necessary for
carrying on the production/business such as land and buildings,
plant and machinery, furniture and fixtures etc. For a going concern
these assets are of permanent nature and are not to be sold. The other
types of assets required for day to day working of a unit are known as
current assets which are floating in nature and keep changing during
the course of business. It is these 'current assets' which are generally
referred to as 'working capital'. We are by now already aware of the
short-term nature of these assets which are classified as current
assets. It may be noted here that there may not be any fixed ratio
between the fixed assets and floating assets for different projects as
their requirement would differ depending upon the nature of project.
Big industrial projects may require substantial investment in fixed
assets and also large investment for working capital. The trading
units may not require heavy investment in fixed assets while they
may be carrying huge stocks in trade. The service units may hardly
require any working capital and all investment may be blocked in
creation of fixed assets.
A set financing pattern is evolved to meet the requirement of a unit
for acquisition of fixed assets and current assets. Fixed assets are to
be financed by owned funds and long-term liabilities raised by a unit
while current assets are partly financed by long-term liabilities and
partly by current liabilities and other short-term loans arranged by
the unit from the bank. The balance sheet of a unit under such
dispensation may be represented as in next page.
The total current assets with the firm may be taken as gross working
capital whereas the net working capital with the unit may be
calculated as under:

Net Working Capital = Current Assets - Current Liabilities

(NWC) (GWC) (including bank borrowings)
This net working capital is also sometimes referred to as 'liquid
surplus' with the firm and has been margin available for working
capital requirements of the unit. Financing of working capital has
been the exclusive domain of commercial banks while they also grant
term loans for creation of fixed assets either on their own or in
consortium with State level/All India financial institutions. The
financial institutions are also now considering sanction of working
capital loans.

The current assets in the example given in the earlier paragraph are
financed asunder:

Current Assets = Current liabilities + Working capital limits

from banks + Margin from long-term liabilities

This is the normal pattern of financing of current assets. However, a

few units may be having a negative net working capital as shown
below :

It is evident from diagram 2 that current liabilities are more than

current assets and a part of short-term funds (current liabilities) have
been diverted to finance fixed assets. Not only that the unit is not able
to provide any margin for working capital from its long-term sources,
but it is showing a net working capital deficit represented by the
bracketed area in the diagram. This situation may not be considered
as satisfactory and the unit is experiencing liquidity problems and
has a current ratio of less than one. It may also be stated here that a
large liquid surplus may also not reveal a very encouraging position,
as it would mean idle funds or a lower turnover in working capital. It
should, therefore, be the endeavour of every concern to ensure
optimum utilisation of all the resources at its command and have just
adequate liquid surplus.
The assessment of working capital may involve two aspects as under
• The level of current assets required to be held by any unit which is
adequate for its day to day functioning, and
• The mode of financing of these current assets.

The value of inventory as given in the balance sheet is the position as

on a particular day on which the balance sheet is drawn and may not
be the actual average requirement of the unit. We will have to,
therefore, evaluate the actual consumption pattern to arrive at a
correct decision.
OPERATING CYCLE CONCEPT

The day to day business operations of a concern of any nature and,

size involves many successive steps and final working results would
depend on the effective combination of all these steps. The steps in
general may include.:

 Acquisition and storage of raw material and other stores and

spares required for manufacture of any product.
 Actual production process when the raw material is subjected
to different processes to bring it to final shape of finished goods.
 Storage of finished goods awaiting sales.
 Sales of finished goods and realisations of sale proceeds.

All these steps put together form an operating cycle which can also
be represented diagrammatically as under :
Realisation Cash Raw Material Stores & Spares

Bills Receivable/Sundry Debtors Semi-Finished Goods

Sales Finished Goods

We start from cash to buy raw material etc. and after completing all
the steps end up with the cash. The intervening period required for
completion of this entire process is the 'Operating Cycle'. The
operating cycle may thus be defined as the intervening period from
the time the goods or services enter the business till their realisation
in cash. The study of this operating cycle is obviously very important
as the actual requirement of the unit may be limited to the funds
required to complete an operating cycle and the simplest formula for
the working capital requirement may be represented as under:
Total operating expenses expecting during the year
Total working capital requirement = -----------------------------------------------------------
No. of operating cycles in a year

This system of calculation of working capital requirement is not in

vogue as it only helps to assess the total requirement of a unit
whereas the banks granting working capital limits would be
interested in proper classification of its various components. The
concept of operating cycle, however, throws light on various
components of working capital required for the unit and these
components may be classified as under:
  Raw material stores and spares consumed in the production
process. The unit must have some stocks of these items for
uninterrupted production.
 Manufacturing expenses such as wages, power and fuel etc. to
be incurred during the process of manufacture.
 Stocks of work-in-process/semi finished goods maintained by
the unit to complete an operating cycle.
 Stocks of finished goods awaiting sale. All the finished goods
may not be immediately sold.
 Administrative and selling expenses during this process.
 Bills receivable/debtors for credit sales.

All or some of these components in varying proportions are required

for any business.

CONCEPT OF MARGIN

Margin in relation to working capital has two concepts which need to

be clearly understood. The one concept of providing margin by way
of liquid surplus i.e. from long-term liabilities has already been
explained. It must be clear by now that current assets shall partly be
financed by capital & long-term liabilities for any going concern. This
gains importance while fixing overall limits of working capital by the
bank.

The other concept of margin as applicable to working capital limits is

related to the value of security charged to the bank as cover for these
limits. Financial accommodation up to 100% of the value of goods
would not be granted by the banks and they would fix a certain
margin on the value of security which must be provided by the
borrower and the balance amount will be financed by the bank. The
percentage of margin fixed on any security is dependent on its nature.
FORMAT FOR ASSESSMENT OF WORKING CAPITAL
In good old days when the banks were mainly adopting security-
oriented approach in lending, no emphasis whatsoever was placed on
assessment of limits as the credit decision was mainly based on the
security available to cover the advance. The concept of assessment of
working capital gained currency in early seventies and Reserve Bank
of India proposed a scientific method for this purpose. A format that
would be utilised for assessment of working capital was also
prescribed. Various other formats and techniques for assessment
have since been developed for different kinds of projects, the earlier
format nevertheless is still in vogue and is made use of in all such
cases where a specific method has not been prescribed. The proforma
as prescribed by Reserve Bank of India is reproduced below :
Assessment of Working Capital Requirements
………. Months raw material requirements Rs.
………. Weeks’/months' consumable stores and spares Rs.
………. Weeks’ stocks in process at any one time Rs.
(average period of processing value of raw material content in
stock-in process and manufacturing expenses for the period of
processing to be indicated)
………. Months’ finished goods at cost Rs.
………. Weeks’/months’ receivables representing credit sales Rs.
One months' manufacturing and administrative expenses Rs.
________________
Total working capital requirement
Less
Credit available on purchases and advance payments received Rs.
Working capital in business or liquid surplus Rs.
________________
Net working capital requirements Rs. (A)
______________
 Permissible Limits
Raw materials Rs.
Less Margin Rs. Rs.
Stock-in-process Rs.
Less Margin Rs. Rs.
Finished goods Rs.
Less: Margin Rs. Rs.
Receivables representing supplies to Govt. Rs.
Less Margin Rs. Rs.
Receivables representing supplies to sundry parties Rs.
Less Margin Rs. Rs.
_________________
Total limits Rs. (B)
__________________

Net working capital requirements (A) Rs.

Permissible limits (B) Rs.
Deficit, if any (A-B) Rs.

It must, however, be noted that assessment of working capital is

always done for future period, while the financial statements reveal
the financial position of a concern as it was at some point of time in
the past. If the calculations are based on the basis of the financial
statements as on some previous date, the results derived may not be
workable. Furthermore the newly established units may not provide
any financial statements for the past period. The working capital is
always to be assessed on tile basis of projections for the next year.
The first most important point, therefore, is to make as accurate
projections as possible for the next year. The projections submitted
to the bank are very critically examined in relation to past
performance of the unit, if any, future prospects and market for the
ultimate product production capacity of the unit and general rate of
inflation expected during the year. The projections given for the next
year are, therefore, to be supported by convincing logic to stand
scrutiny in the hands of the banker.

We shall now make an attempt to define various components of

working capital as taken in the format and explain the most
acceptable principles involved in calculating them for overall
assessment of working capital.

I . …………………. months’ raw material requirements :

Every production unit will be required to maintain a minimum level

of raw material in stock to ensure continuous production. The level
of stock may differ from unit to unit and inter alia depends on nature
of the raw material, its availability with particular emphasis on lead
time involved in procuring it, price level, consumption pattern etc.
From the past records, it is possible to find out the average stocking
period of raw material with the following formula :

Average stock of raw material

Average stocking period in months = -----------------------------------------------------
Average monthly consumption of raw material during the year

where

Opening stock of raw material+ Closing stock of raw material

Average stock of raw material = ---------------------------------------------------------------
2
Average monthly consumption of
Opening stock of raw material + Total purchases of raw material- Closing stock of raw material
of raw material
raw material during the year =---------------------------------------------------
12

The average stocking period thus arrived may be taken as the

requirement of so many months of raw material for the unit and the
estimated value of stocking of raw material required by the unit can
thus be determined on the basis of projected figures.

In case of new units where figures of past performance are not

available, storage period may have to be compared with storage
period of such other units for the purpose of these calculations.

II …………………………. weeks/months’ stores and spares

The calculation for requirement of these items may be done in a

similar manner as in case of raw materials. The average period of
stocking required by the unit is generally, done on the basis of past
performance. After determining the average period, the requirement
is to be calculated on the basis of projected figures

III ………………………… weeks’ stocks in process

Stocks-in-process is an item representing goods remaining in

semi-finished form awaiting certain further processing before these
can be finally converted to finished goods. The requirement of
blockage of funds in these stocks will depend upon the processing
period involved in the manufacturing. The processing period may
differ from unit to unit and in case of new units it may have to be
compared with existing units of similar nature.
Semi finished goods, however, possess another problem in
evaluation. The value representing manufacturing expenses is added
to the cost of raw material to determine the value of stocks in process.
The value of stocks-in-process is thus related to the 'cost of
production’ which may be calculated as under :

Cost of Production

(i) Raw material consumed Rs.

(ii) Other spares Rs.
(iii) Power and fuel Rs.
(iv) Wages Rs.
(v) Repairs and maintenance Rs.
(vi) Other manufacturing expenses Rs.
(vii) Depreciation Rs.
(viii) Sub-total Rs.
[items (i) to items (vii)]
(ix) Add : Opening stocks in process Rs.
(x) Sub-total [item (viii) plus item (ix)] Rs.
(xi) Deduct : Closing stocks in process Rs.
(xii) Cost of Production [item (x) minus item (xi)] Rs.

The average period of stocking of 'stocks in process' may nom

calculated with the following formula :
Average stock in process stocks in process in days
Average period of stocking of = ---------------------------------------------------------------
Daily cost of production
where

Opening stock in process + Closing stock in process

Average stock in process= -------------------------------------------------------------
2

Cost of production
Daily cost of production = ----------------------------
365

Average stocking period which may also be taken as average

processing period may thus be calculated from past records. The
estimated requirements of the unit under this head may be related to
its projected figures as in case of raw material etc. The calculation
will, however, be based on the basis of cost of production which is the
most acceptable principle of valuation of 'stocks-in-process'.

IV . ………………………. month’s finished goods

The stocking period of finished goods may also be different for

different types of units and will mainly depend upon the market
conditions. The valuation of finished goods also possess a little
problem and most accepted principle is for their valuation in terms
of cost of sale which is calculated as under

Cost of sale = Opening stock of finished goods + Cost of

production- Closing stocks of finished goods.
Cost of sale is also equal to net sales minus gross profit.
Average period of stocking of finished goods may be calculated with
the help of the following formula:

Average stock of finished goods

Average period of stocking of finished goods in months = ---------------------------------------
 Monthly cost of sales during the year
where,

Opening stock of finished goods +Closing stock of finished goods

Average stock of finished goods = ---------------------------------------------
2
and

Cost of sales
Monthly cost of sales during the year =------------------------------
12

This period would give an indication as to the average period of

stocking of finished goods by the unit on the basis of its past
performance. This average period so found may now be related to the
projected figures to find out the estimated requirement under this
category. The finished goods will, however, be related to cost of sales
while estimating the requirements.

V ………………. weeks/months’ receivables representing credit sales:

All the sales by any unit may not be against cash in which case the
unit would not require any funds to be blocked under this head. A
part of the sales might be effected on credit in which case the
outstanding under debtors/bills receivable will form a part of total
working capital required by the unit. The average period of blockage
of funds under this head may also likewise be calculated with the
following formula:

Average debtors
Average period of credit in months = ---------- x 12
Total credit sales
 Opening balances debtors + Opening balance of bills
Closing balance debtor’s receivable + Closing of bills receivable
Average debtors = --------------------------------- + -------------------------------------
2 2

where the figures of credit sales are not separately available, we may
take total sales figures in the denominator for the purpose of above
calculation.

After determining the average period of credit sales, the requirement

of the unit under this head may be related to the projected figures.

V1 ………………. One month’s manufacturing and administrative

expenses

The unit has to meet the running, manufacturing and establishment

expenses during the period of manufacture and necessary provision
for funds required for this purpose is necessary. The monthly average
expenditure can be determined by dividing total manufacturing and
administrative expenditure during the last year by 12. Suitable
adjustment in the anticipated expenditure for the next year may be
necessary as per the projected figures.

The total of items No. I to VI is the requirement of the unit for

working capital at the gross level. The unit raises resources to meet
these requirements from many sources besides the liquid surplus
already available with the unit The resources generally available at
the command of the unit may be as under:

CREDIT AVAILABLE ON PURCHASES

All the goods may not be purchased by any unit against cash and the
concern may avail credit for few purchases. The credit available from
the market will reduce the requirement of the unit for working
capital.

Creditors may be treated in the same manner as debtors while

determining availability to the unit under this component. Average
period of credit available to the unit may be determined according to
the following formula:

Average creditors
Average period of credit in months = --------------------- x 12
Total credit purchases

Opening balances creditors + Opening balance of bills payable

Closing balance creditor’s + Closing of bills payable
Average creditors = --------------------------------- + -------------------------------------
2 2

Where figures for credit purchases are not separately available, the
figure of total purchases may be taken in the denominator for the
purpose of the above calculations. After determining the average
number of days for which credit is available, it should be possible to
determine the average total credit available to the unit by relating it
to the projected figures.

4.1.3 Product Costing

Definition: Product costing is not an absolute term having a
permanent definition. The definition of product costing varies with
the purpose behind costing a product. A product costing can be
simply defined as the total amount of costs assigned to a
particular product based on a specific PURPOSE of the
management of the organization.

Costing is a concept not only applicable to for-profit organization, its

applicable to all types of organization which involves in financial
transactions and need financial viability. The principles of costing are
applicable whether we are costing a product, service, subsidized
products by government or NGOs, etc.

EXAMPLE OF PRODUCT COSTING UNDER DIFFERENT

PURPOSES

PRICING FOR OPEN MARKET SELLING

When a company does everything from scratch and sells the product
by its own. The activities starting from research and development for
the product, designing, manufacturing, marketing, distribution and
even customer service are undertaken for a particular product or set
of products. For costing of such a product, all the cost elements
mentioned above should be assigned to the product.

PRODUCT COSTING FORMULA

Product costing formula cannot be a universal truth. With the change

in purpose behind calculating cost of a product, the formula will also
need changes. We have observed above that with different purposes,
the approach significantly changes. One same product will have
different costing formula for different purpose.

What Is Unit Cost:

A unit cost is a total expenditure incurred by a company to produce,
store, and sell one unit of a particular product or service. ... This
accounting measure includes all of the fixed and
variable costs associated with the production of a good or service.
Cost centre refers to a subdivision or any part of the organization, to
which costs are incurred, but does not contribute to the company's
revenues directly.
What is the difference between Cost unit & Cost centre:-
Cost Object is a cost carrier such as Cost element which is used for
posting of transaction and transferring of expenses or revenues.
Whereas Cost Centre is an organizational unit which specifies
total cost of a department. It may be production or service
department .
What Is Element of Cost in Management Accounting?
Management accounting techniques break costs into two major cost
classifications, product costs, which relate to manufacturing, and
period costs, which are all non-manufacturing costs. Product costs
are then broken down into the elements of cost which are labor,
materials and overhead. These make up the cost of products at nearly
every company. Understanding accounting cost classifications can
help you make sure that you are accounting for production at your
company in the correct manner.
Process costing is an accounting methodology that traces and
accumulates direct costs, and allocates indirect costs of a
manufacturing process. ... It is a method of assigning costs to units of
production in companies producing large quantities of homogeneous
products..

The Elements of Cost are the three types of product costs (labor,
materials and overhead) and period costs.

Materials:-

Materials costs are the tangible goods used in producing the product.
These costs can be direct or indirect. Direct materials are the
quantifiable and traceable costs of materials used in production.

Indirect materials either cannot be traced to products or it is not cost

effective to do so. For example, a company producing artisan crafts
may consider wood to be a direct material, as the company can easily
quantify how much wood goes into each craft. However, glue and
other fasteners may not be cost effective to track in this manner. In
that case, these items would be considered indirect materials.

Labor:-

Wages and salaries paid to employees involved in manufacturing are

known as labor costs. These costs can be broken down into direct and
indirect labor. Direct labor costs include the wages that are paid to
employees that physically handle the product. For this reason, direct
labor is also referred to as touch labor.

Indirect labor costs are any other wages and salaries related to
production, but are not traceable back to units of product. For
example, wages for materials handlers and line workers are usually
considered to be direct labor costs. However, factory maintenance
workers, plant supervisors and quality control engineers would be
considered indirect labor.

Equipment:-

All equipment for executing any direct item or items for the project
is also direct cost and considered in a project cost.

Overhead:-

Overhead costs are related to production, but are not classified as

direct labor or direct materials. This includes all indirect labor and
materials costs, as well as any other untraceable costs. Common
overhead costs include depreciation on factory equipment,
manufacturing rents, supplies costs, insurance costs and licensing
fees.

For some small businesses, overhead costs make up the majority of

production costs. In these cases, small-business owners should be
careful to recognize that just because overhead costs are not easily
traceable to products doesn't mean that effective cost management is
any less important.

Period Costs:-

Period costs are costs that are not related to manufacturing and are
not considered an element of cost in management accounting. As
opposed to product costs, which are held in inventory, generally
accepted accounting principles require that period costs be expensed
as soon as they are incurred.

Common small-business period costs include advertising costs, sales

commissions, salaries for owners and top management,
administrative costs and depreciation for non-factory equipment.
Even though period costs are not considered elements of cost in
 managerial accounting, these costs reduce net income just the same.
As such, management may wish to track these costs on an ongoing
basis and intervene if these costs are higher than expected.

4.1.4 Profitability:-

Profitability is a measurement of efficiency – and ultimately its

success or failure. A further definition of profitability is a business's
ability to produce a return on an investment based on its resources
in comparison with an alternative investment.

How we calculate profitability:

Margin or profitability ratios

1. Gross Profit = Net Sales – Cost of Goods Sold.
2. Operating Profit = Gross Profit – (Operating Costs, Including Selling
and Administrative Expenses)
3. Net Profit = (Operating Profit + Any Other Income) – (Additional
Expenses) – (Taxes)

What is the importance of Profitability:=

Profit equals a company's revenues minus expenses. Earning a profit
is important to a small business because profitability impacts
whether a company can secure financing from a bank, attract
investors to fund its operations and grow its business. Companies
cannot remain in business without turning a profit.
How do you determinate profitability in a Project
The profitability index is calculated by dividing the present value of
future cash flows by the initial cost (or initial investment) of
the project. The initial costs include the cash flow required to get the
team and project off the ground.
Profitability Analysis:-
The first step toward customer profitability analysis is
to calculate the profit margin and the profit share per customer.
To calculate the profit margin, take the sum a customer paid and
subtract amortized fixed costs (office, taxes, lease, etc.) and variable
costs (the time you worked)
Definition: Profitability index is a financial tool which tells
us whether an investment should be accepted or rejected. ... PI
greater than one indicates that present value of future cash inflows
from the investment is more than the initial investment, thereby
indicating that it will earn profits.
4.1.5 Break Even Analysis:-
Definition: - A break-even analysis is a useful tool for determining at
what point your company, or a new product or service, will be
profitable. Put another way, it's a financial calculation used to
determine the number of products or services you need to sell to at
least cover your costs.
What is the Break Even Analysis :- A break-even analysis results in
neither a profit nor a loss. Instead, it determines the number of sales
needed to cover all variable and fixed costs. It calculates the
minimum number of units to sell and the sales volume needed to pay
all expenses before making a profit.
How we calculate Break Even Analysis:-To calculate a break-even
point based on units: Divide fixed costs by the revenue per unit
minus the variable cost per unit. The fixed costs are those that do not
change no matter how many units are sold. The revenue is the price
for which you're selling the product minus the variable costs, like
labor and materials.
4.1.6 Financial Ration:-
Financial ratios are categorized according to the financial aspect of
the business which the ratio measures. Liquidity ratios measure the
availability of cash to pay debt. Activity ratios measure how quickly a
firm converts non-cash assets to cash assets. Debt ratios measure the
firm's ability to repay long-term debt.

Important of Financial Ration:-

Financial ratios offer entrepreneurs a way to evaluate their
company's performance and compare it other similar businesses in
their industry. Ratios measure the relationship between two or more
components of financial statements. They are used most effectively
when results over several periods are compared.
Business Account
4.2 Accounting Principle, Methodology
Accounting Principles: - Accounting principles are the general rules
and guidelines that companies are required to follow when reporting
all accounts and financial data.
Whilst there are currently no universally standardised accepted
accounting principles, there are various accounting frameworks
which set the standard body. The most common accounting principle
frameworks used are IFRS, UK GAAP, and US GAAP. There are both
similarities and differences between these three frameworks, where
GAAP is more rule-based whilst IFRS is more principle based.

Importance of accounting principles: - The purpose of having - and

following - accounting principles is to be able to communicate
economic information in a language that is acceptable and
understandable from one business to another. Companies that
release their financial information to the public are required to follow
these principles in preparation of their statements.

Depending on the characteristics of a company or entity, the

company law and other regulations determine which accounting
 principles they are required to apply. The standard accounting
principles are collectively known as Generally Accepted Accounting
Principles (GAAP). GAAP provides the framework foundation of
accounting standards, concepts, objectives and conventions for
companies, serving as a guide of how to prepare and present financial
statements.

Necessity of accounting principles: -GAAP aims to regulate and

standardise accountancy practices by providing a framework to
ensure companies and organisations are transparent and honest in
their financial reporting. Accounting principles serve as a doctrine
for accountants theory and procedures, in doing their accounting
systems.

Accounting principles ensure that companies follow certain

standards of recording how economic events should be recognised,
recorded, and presented. External stakeholders (for example
investors, banks, agencies etc.) rely on these principles to trust that a
company is providing accurate and relevant information in their
financial statements.

Examples of accounting principles: -There are some of the main

accounting principles and guidelines, listed under US GAAP:

1. Conservatism principle - In situations where there are two

acceptable solutions for reporting an item, the accountant should
‘play it safe’ by choose the less favourable outcome. This concept
allows accountants to anticipate future losses, rather than future
gains.
2. Consistency principle - The consistency principle states that once
you decide on an accounting method or principle to use in your
business, you need to stick with and follow this method throughout
your accounting periods.
3. Cost principle - A business should record their assets, liabilities
and equity at the original cost at which they were bought or sold. The
real value may change over time (e.g. depreciation of
assets/inflation) but this is not reflected for reporting purposes.
4. Economic entity principle - The transactions of a business
should be kept and treated separately to that of its owners and other
businesses.
5. Full disclosure principle - Any important information that may
impact the reader’s understanding of a business’s financial
statements should be disclosed or included alongside to the
statement.
6. Going concern principle - The concept that assumes a business
will continue to exist and operate in the foreseeable future, and not
liquidate. This allows a business to defer some prepaid expenses
(accrued) to future accounting periods, rather than recognise them
all at once.
7. Matching principle - The concept that each revenue recorded
should be matched and recorded with all the related expenses, at the
same time. Specifically, in accrual accounting, the matching principle
states that for every debit there should be a credit (and vice versa).
8. Materiality principle - An item is considered ‘material’ if it would
affect or influence the decision of a reasonable individual reading the
company's financial statements. This concept states that accountants
must be sure to include and report all material items in the financial
statement.
9. Monetary unit principle - Businesses should only record
transactions that can be expressed in terms of a stable unit of
currency.
10. Reliability principle - The reliability principle is used as a
guideline in determining which financial information should be
presented in the accounts of a business.
11. Revenue recognition principle - Companies should record their
revenues when it is recognised, or in the same time period of when it
was accrued (rather than when it was received).
12. Time period principle - A business should report their
financial statements (income statement/balance sheet) appropriate
to a specific time period.

Accounting principles and Debtor

A growing business can benefit from an automated accounting

system such as Debtor invoicing software. Debtor allows a business
to generate and produce financial reports at any given time.
Additionally, it can assist you in managing your accounts and
reporting, and help determine the current financial standing of your
business.

4.2.1 Book Keeping:-

Introduction to Bookkeeping:-

The term bookkeeping means different things to different people: ...

For example, a person with little bookkeeping training can use the
accounting software to record vendor invoices, prepare sales
invoices, etc. and the software will update the accounts in the general
ledger automatically.
The activity or occupation of keeping records of the financial affairs
of a business.
"I got in a financial muddle because I didn't keep my bookkeeping up
to date"

Bookkeeping is the recording of financial transactions, and is part of

the process of accounting in business. Transactions include
purchases, sales, receipts, and payments by an individual person or
an organization/corporation.

Type of Book keeping: -

The single-entry and double-entry bookkeeping systems are

the two methods commonly used. While each has its own advantage
and disadvantage, the business has to choose the one which is most
suitable for their business.

Book keeping Task:-

Essentially, book keeping means recording and tracking the numbers

involved in the financial Side of the business in an organized way. It
is essential for business, but is also useful for individuals and non-
profit organizations.

A Bookkeeper job description generally includes:

 Recording transactions such as income and outgoings, and posting
them to various accounts.
 Processing payments.
 Conducting daily banking activities.
 Producing various financial reports.
 Reconciling reports to third-party records such as bank statements.

4.2.2 Financial Statement: -

The financial statements are used by investors, market analysts, and
creditors to evaluate a company's financial health and earnings
potential. The three major financial statement reports are the
balance sheet, income statement, and statement of cash flows.

There are four main financial statements. They are: (1) balance
sheets; (2) income statements; (3) cash flow statements; and (4)
statements of shareholders' equity. Balance sheets show what a
company owns and what it owes at a fixed point in time.

Use of Financial Statement:- The general purpose of the financial

statements is to provide information about the results of
operations, financial position, and cash flows of an organization.
This information is used by the readers of financial statements to
make decisions regarding the allocation of resources.

Importance of P&L or Balance Sheet:-

Every month you look at your profit and loss statement. You've never
thought about looking at your balance sheet because
you're most concerned about profit and loss. Profit and loss
statements only show profit or loss for a specific time period, usually
a month or a year.

4.2.3 Concept of Audit

Definition: Audit is the examination or inspection of various books
of accounts by an auditor followed by physical checking of inventory
to make sure that all departments are following documented system
 of recording transactions. It is done to ascertain the accuracy of
financial statements provided by the organisation.
The objective of an audit is to form an independent opinion on the
financial statements of the audited entity. The opinion includes
whether the financial statements show a true and fair view, and have
been properly prepared in accordance with accounting standards.
For example, an auditor looks for inconsistencies in financial
records. ... An audit might include collecting a sample from a pool of
data using a specific protocol and analyzing the findings to generalize
about the data pool's characteristics.

Types of Audit:
ISO 9001 Audit Types and How They are Executed
 There are two main categories of audits: internal and external. ...
 Internal audits are audits that are performed by your organization
and are a self-examination of your organization's QMS, performed
on-site.

Principle of Auditing:
 Planning. An Auditor should plan his work to complete his work
efficiently and well within time. ...
 Honesty. An Auditor must have impartial attitude and should be free
from any interest. ...
 Secrecy. ...
 Audit Evidence. ...
 Internal Control System. ...
 Skill and Competence. ...
 Work Done by Others. ...
 Working Papers.

Who is an Auditor:-An auditor is a person authorized to review and

verify the accuracy of financial records and ensure that companies
comply with tax laws.
Quality makes a good auditor: The 5 Characteristics of an Auditor
 Have the Required Experience. Certifications are key
academic qualifications for an auditor. ...
 Ability to Make Independent Decisions. An auditor's decision should
not be wavered or influenced by anyone. ...
 Auditors Have the Ability to Understand Different Business Needs. ..
 Dependable. ...
 Effective Communication Skills.

Checklist of Audit:-
An internal audit checklist is an invaluable tool for comparing a
business's practices and processes to the requirements set out by ISO
standards. The internal audit checklist contains everything needed to
complete an internal audit accurately and efficiently.

Disclaimer : All the contents in this note are from internet search of
the respected authors.