BASICS OF FINANCE (18 mks)

Syllabus:
Sources of Finance
Cost Concepts: Necessity of costing, Elements of cost: material,
labor & expenses; Prime cost , overhead cost, Total cost; Break
Even Analysis
Material management: Inventory control – Standard order,
Reserve stock, reorder point, and Lead time. Economic order
quantity, ABC Analysis.
Introduction to Just in Time (JIT) system.
Depreciation: Definition & causes: Methods of calculating
depreciation charges: Straight Line Method, Diminishing Balance
Method, Sinking Fund method. (Simple Numerical)
Obsolescence – Definitions & reasons.
Introduction to GST.

Questions:
1. Explain the terms: (i) Prime cost (ii) Overhead cost (iii) Marginal cost. (6)
2. What is depreciation? (3)
3. An old machine was purchased for Rs. 32000/-. Its life was estimated to
be 10 years & the scrape value is Rs 18000/-. Using diminishing
balance method, calculate the depreciation rate (%) & the depreciation
fund at the end of one year. (6)
4. List various types of sources of finance. (3)
5. Why inventory is considered as a necessary evil? Explain (i) Reorder
quantity (ii) Safety stock (iii) Lead time (6)
6. What is economic order quantity? Write its equation & state all terms
involved. (6)
7. What is depreciation? A machine is purchased for Rs. 40000/-. The
estimated life of machine is 15 years & scrap value is Rs. 15000/-. If the
rate of interest is charged at 5%, calculate the rate of depreciation by
Sinking Fund method. (6)
8. Explain the break-even chart with the help of a neat figure. (6)
9. List the various sources of finance. Explain briefly any two of them. (6)
10. Write a note on ABC analysis. (6)
11. Define obsolescence & write down the reasons of obsolescence. (6)
12. State the principal elements of cost of a product & define each of
them. (3)
13. Explain fixed & variable overheads. (6)
 14. What is depreciation? Explain any 2 methods of calculating
depreciation charges. (6)
15. Explain the importance of Break-even chart with diagram. (6)
16. What are the various sources of finance. Explain. (3)
17. Explain fixed & variable overheads. (3)
18. Explain briefly the need for costing. (3)
19. Explain briefly the internal sources of finance. (6)
20. Explain briefly what obsolescence is. (6)
21. With help of a sketch explain ABC analysis. (6)
22. Explain the following terms related to Economic order quantity: (i)
Base stock (ii) Lead Time (iii) Reorder point, with the help of a neat
sketch. (6)

SOURCES OF FINANCE:
Finance refers to the money/funds required to start or support a business.
Sources of Finance can be classified as follows:
A. Internal Sources of Finance:
Finance raised internally within the business is Internal Finance.
Examples: Retained profit, Personal savings, Sale of unwanted assets
etc.

B. External Sources of Finance:

Finance provided by people or institutions outside the business.
Examples: Loans, Overdraft, Shares, Debentures

External Sources can further be classified into:

1. Short Term 2. Medium Term 3. Long Term Finance

Finance Finance
i. It refers to Funds
i. It means i. These are Funds that are needed
Funds that that are needed for period of more
are needed for for period of more than 10 years,
a period up to than one year and
one year. less than 10
ii. These funds years. Examples:
are required Funds obtained from
for day to day Examples: Issue of shares, Issue of
requirements Funds obtained from Issue Debentures, Ploughing
of business. of preference shares, back of profits, Loans of
 debentures, Public specialized financial
Examples: Funds Deposits, Bank loans, organization.
obtained from Bank Loans from Financial
loan, Trade Credit, institutions etc.
Customer advances,
etc.

1. Owners Investment:
• Also known as Owner’s capital refers to money invested by the owner
of a business from his personal savings.

2. Retained Profit / Ploughing back of profits:

• When Profit made is reinvested back in the business it is called

Retained profit or ploughing back of profits.
• It is a relatively cheap, quick, and easy source of finance.
• However, retained profits can be used by profitable businesses only.

3. Selling of unwanted Assets:

• Funds can be raised by selling assets that are no longer in use or

require frequent repair and maintenance.
• This is a relatively cheap method to raise finance.

The different sources of External finance are:

1. Shares
2. Debentures
3. Internal financing
4. Trade Credit
5. Public Deposits
6. Financial institutions
7. Leasing Institutions

1. Issuing of Shares:
• The total capital required is divided into small units & each unit called
SHARE is sold to public at a particular price to raise funds.
• Shareholders become owners of company & are paid dividend every year
depending on the company performance.
• It is a long-term source of finance.

Advantages:

• Doesn’t have to be repaid.

Disadvantage:

• Profits will be paid out as dividend to Shareholders.

• Shareholders become owners of company.

2. Debentures:
• The debenture is a debt format used by the company to borrow money
from public (investors).
• Company pays money back to investors called debenture holders at a
certain rate of interest at specified intervals.
• Debenture holders can’t claim the ownership of company and get their
money even if company doesn’t make profit.

Merits:

i. Debenture holders get fixed income at lesser risk.

ii. Debenture holders can’t claim the ownership of company.
iii. Ownership or control of company remains unchanged.
iv. Issue of debentures is cheaper then issue of shares to raise funds.

Limitations:

i. With the issue of debentures, the capacity of a company to further

borrow funds reduces.
ii. The company has to repay debenture holders on the specified date,
even if they have financial difficulty.

3. Trade Credit/ trade finance:

• In Trade credit is purchasing goods or services and paying the
supplier at a later scheduled date.
• It is short term finance offered to customers having good financial
status and reputation.

Merits:
 i. Provides interest free finance.
ii. It reduces capital requirement.
iii. Readily available if credit worth of buyer is known to the seller.
iv. It does not require any formal negotiation or agreement.

Limitations:

i. Only limited amount of funds can be generated.

ii. Costly source of funds as compared to most other sources of
raising money.

4. Public Deposits:
• Public deposits are deposits made by public in the business
organizations at fixed rate of interest.
• Any member of the public can fill up the prescribed form and deposit
money with the company.
• Interest rates on public deposits are usually higher than those on
bank deposits.
• A company can invite public deposits for a period of six months to
three years.
• The acceptance of public deposits is regulated by the Reserve Bank of
India.

Merits:

i. Simple procedure
ii. Raising fund through Public Deposit is cheaper than bank loan.

Demerits:

i. New companies generally find it difficult to raise funds through

public deposits
ii. It is an unreliable source of finance as the public may not respond
when the company needs money

5. Government Grants:
• Here the government organization's offers grants to businesses, both
for established and new ones.
• Certain conditions may apply, e.g. Locations
• Not all businesses are eligible for a grant.
• Don’t have to be repaid.

Advantages:
 • Free money
• Gain Credibility
• Flexibility

Disadvantages:

• Time consuming
• Uncertain renewal
• Strings attached

6. Bank Loan:
• To raise funds company can borrow money from bank at an agreed
rate of interest over a set period of time.
• This is a medium or long-term sources of finance.
• Nowadays most of the companies are dependent on bank for finance.

Advantages:

• The repayment is spread over a period of time.

Disadvantages:

• Can be expensive due to interest payment.

• Bank may require security while providing the loan.

7. Financial Institution:
• Financial institutions (also known as Developing banks) provide the
finance to industries for economic development of the country.
• They lend funds at concessional rates of interest.
• They assist nationally desired projects with low & uncertain returns.
• They also provide financial assistance for modernization & for
supporting the sick units in restoring their health etc.

The different financial institutions in India are:

i. Industrial Development Bank of India (I.D.B.I)

ii. Industrial Finance Corporation of India (I.F.C.I)
iii. State Financial Corporation (S.F.C.)
iv. Unit Trust of India (U.T.I.)
v. Life Insurance Corporation (L.I.C.)
vi. Industrial Credit & Investment Corporation of India (I.C.I.C.I.).
 8. Leasing Institutions:
• Leasing finance is a popular and effective financial source for most of
the business organizations.
• Many types of fixed assets such as land, equipment, machinery etc.
can be obtained on lease for a number of years.
• The Lessee takes equipment on lease & pays the rent of same to
lessor.

COSTING:

Cost: - The amount of money spent by a company on the production of

goods or services.

Costing: - It is the process of calculating actual cost of a product after it

has been manufactured (i.e. after knowing the expenditure incurred on
manufacturing).

Necessity of Costing (Why should there be costing in the field of

business?):
Ans:

• Costing is a systematic process for determining the unit price of a product or

service.
• Costing helps in making estimates and then in calling for tenders.
• It reveals the losses incurred by a particular unit.
• It helps to identify the exact cause of a decrease or increase in the profit or
loss of a business.

Elements of Cost:

The total manufacturing cost of a product consists of 3 elements:

1. Cost of Material
2. Cost of labor
3. Expenses

1. Cost of Material: It consists of -

a. Cost of Direct Material
 b. Cost of Indirect Material

a. Direct Material cost:

• It is the cost which can be directly or easily identified in the final
product.
Eg: Cost of paper in books, wood in furniture, plastic in water tank,
and leather in shoes, Timber in furniture, Cloth in dress, etc.
• Direct material cost varies directly with the volume of production.

b. Indirect Material cost:

• It is the Cost of material which cannot be easily identified in the final

product.
• Eg.: Cost of lubricants, Packing materials, Nails in shoes or furniture
etc.
• Indirect material cost does not vary with the direct proportion of volume
of production.
2. Labor cost: 2 types –

a. Direct Labor cost

b. Indirect labor cost

a. Direct Labor cost:

• It refers to the money spent on the workers who are directly engaged
in production (i.e., converting raw material into finished goods) of
goods.
• It varies directly with the level of production.
• Examples: Salaries paid to Assembly line operators, Machine
operators, Painters, Carpenters.
b. Indirect Labor cost:

• It is money spent on workers who are indirectly engaged in the

production of goods.
 • It does not vary directly with the level of output.
• Examples: wages paid to security guards & sweepers, cleaners,
supervisors, inspectors, and store keepers.

3. Other Expenses: Expenses other than material cost & Labor cost are
called Other Expenses.
It’s classified in 2 types –
a. Direct Expenses

b. Indirect Expenses

a. Direct Expenses:

• Those expenses which can be directly allocated to particular job,

process or product are Direct Expenses.
E.g., Excise duty, royalty, special hire charges, etc.
• Direct Expenses vary directly with the level of production.
b. Indirect Expenses:

• Those expenses which cannot be directly allocated to particular job,

process or product are Indirect Expenses.
E.g. factory rent, insurance etc.

Terms related to Costing:

1. Overhead cost / Overheads: The sum of indirect material costs,
indirect labor cost, and indirect expenses is known as Overhead Cost.
Overhead cost = indirect material cost + indirect labor cost + indirect
expenses
Overhead cost may be:

A. Fixed overheads/costs B. Variable overheads/costs

i. are costs that do not change i. costs that vary with changes
with the change in the in the volume of production.
volume of production.

ii. Example: Office rent, ii. Office supplies is an example

insurance, office furniture, of variable cost overhead.
company cars, professional
memberships and other
expenses.

2. Prime Cost: The sum of all direct material, and Direct Labor is called
Prime cost. Prime cost is important:
i. for determining the margin of a product and service &
ii. to calculate the absolute minimum price at which a product can be
sold.
Prime Cost = Direct materials + Direct Labor

3. Total Cost:
• It is the total production cost.
• It can be given as Sum of Prime cost and Overhead cost.
• It can also be given as sum of fixed cost and variable cost.

4. Fixed Cost:
• Costs, which remain fixed or are unaffected by changes in volume
of production, are called as “fixed Costs”.
• For example, the rent and salaries will not change with increase in
the units of production.

5. Variable Cost:
• The cost that varies in direct proportion to the volume of production
is called “variable cost”.
• For example, cost of raw materials consumed changes with the
volume of production.
6. Marginal Cost: Marginal cost is the cost to produce or create one additional
unit of a good or service. For example, say that to make 100 car tires, it costs
 $100. To make one more tire would cost $80. This is then the marginal cost.
Marginal cost helps determine the most efficient level of production.

BREAK EVEN ANALYSIS (cost-volume-profit analysis):

• It is used to determine the volume of sales a business has to do in order

to start making profit.
• It is also useful to decide the price of a product.
• Break even Analysis can be done graphically using Break Even chart.

Break – Even Chart: It is the plot between Total cost (Line AC), & total
revenue earned (OR) against Volume of production (output) is called Break
Even chart.

Break even chart gives following information:

a. Break Even Point: Point at which Total cost = Total revenue is break
even point. It is also called No profit-No Loss point.
b. Region below break even point indicates ‘loss’ (‘Total cost’ > ‘Total
Revenue’). Above break even point (‘Total Revenue’ > ‘Total cost’) indicates
‘profit’.
c. Angle of incidence: It is the Angle formed between the total cost line &
the total sales/ Total revenue line at break-even point. Higher angle of
incidence indicates more profit and vice versa.
d. Margin of safety: It is the difference between sale at break-even point
and actual sales. Smaller margin indicates that the profit will
considerably fall even if there is a small drop in output.

MATERIAL MANAGEMENT:
Material management means Planning, Organizing & Control of flow of
materials, from their initial purchase to destination.

Inventory Control:

• Inventory refers to the material in stock.

• Inventory Control means making the right quantity, of right quality,
available to various departments when needed.
• Inventory control is required because too much inventory requires
huge investment & creates problem of storage & maintenance.
• On the other hand, Low inventory may stop or delay production &
increase overheads.
• Therefore, optimum amount of inventory should be maintained in
stores.

Advantages of Inventory control:

1. No shortage of material at any stage of production.

2. Material is made available at economical rate.
3. Delay & interruption in production does not occur.
4. Exact & accurate delivery dates can be forecast.
5. The material is protected from deterioration & damage.
6. Increase in overall efficiency/productivity.

Determining Inventory Level (Terms related to Inventory control):

The amount of inventory a company should carry is determined by 4 basic

variables that can be studied with the help of following graph:
 1. Order Quantity: The order quantity is the quantity of goods that
company is ordering from its supplier.

2. Lead Time: lead time is the amount of time between placing of

purchase order and receipt of order in the warehouse.

3. Safety Stock/Buffer stock/Reserve Stock/Base Stock: Buffer stock

refers to minimum (extra) inventory kept on hand during
manufacturing delays or an unexpected increase in demand so you
won’t run out of stock.

4. Re-order level/ Re-order-point:

Reorder level (or reorder point) is the inventory level at which a
company would place a new order.
OR
A reorder point (ROP) is a specific level at which the stock needs to be
replenished so you won’t run out of stock.

Methods of inventory control:

1. Economic Order Quantity (EOQ)

2. ABC ANALYSIS (Always Better control Analysis / Alphabetical
approach)
3. Just in Time (JIT) system

Economic Order Quantity (EOQ):

• The procurement cost of inventory falls with the increase in volume of

order.
• However, as the size of inventory grows, the cost of holding the
inventory rises.
 • The economic order quantity (EOQ) is the order quantity that
minimizes total holding (carrying) and ordering costs for the year.
• EOQ is quantity whose procurement cost is equal to inventory holding
cost.

• The formula for EOQ is:

2𝐴𝑃
𝑄=√
𝐶
Where,

A=Total items consumed per year

P= Procurement cost per order

C=Annual Inventory carrying cost per item.

Q= Economic Order Quantity

ABC ANALYSIS (Always Better control Analysis / Alphabetical

approach):

• It is a basic method of controlling different items in stock.

• It divides inventories into 3 groups to minimize efforts & inventory
purchase & storage cost.
• The different groups and their purchase policies are:

Group A Items:
• Approx. 10% of items with approx. 70% of total cost are grouped as A
items.
• Maximum, minimum & reorder limit is set for A items.
• Due to high cost & huge consumption, they should be ordered more
frequently but in small quantities.
 • Future requirement should be planned in advance & proper records
should be maintained.
• Stock control for A items should be looked into by top executives in
purchasing department.
• Minimum safety stock to be kept (15 days or less)

B items:

• Approx. 20% of items with approx. 20% of total cost

• They are ordered less frequently.
• Subjected to moderate control.
• Safety stock should be medium.

C items:

• Approx. 70% of items with approx. 10% of total cost.

• They are low value items therefore the safety stock can be liberal (3
months or more).
• Annual or 6 monthly orders should be placed to reduce paper work,
take advantage of discounts etc.
• In case of these items only routine check is sufficient.

Just in time System:

In Just-in-time, or JIT method goods are received from suppliers only as

they are needed. This is done to reduce inventory holding costs and increase
inventory turnover. A just-in-time system needs to be carefully tracked and
organized.

Advantages:

1. In a just-in-time system you order only what you need, so there’s no

risk of accumulating unusable inventory this reduces inventory waste.
2. Decreases warehouse holding cost: goods are received from suppliers only
as they are needed so there is no need to store your items for long.
3. Gives the manufacturer more control: They can quickly adapt to changes in
demand without having to worry existing inventory.
4. Goods are received from local suppliers as it reduces the transportation time and
cost.
5. Smaller investments

Drawbacks of just-in-time:
1. Just-in-time makes it very difficult to rework orders, as the inventory is
kept to a bare minimum.

2. The manufacturer has to bear any sudden increase in the price of raw
materials.

3. In case of inventory doesn’t reach on time sales may come to a halt, as

there is no excess stock.

DEPRECIATION

The decrease in value & efficiency of the plant, equipment or any fixed asset
due to wear & tear, passage of time, use & climatic conditions is known as
Depreciation.

Causes of Depreciation:

1. Wear & Tear due to continuous usage or passage of time.

2. Physical decay/Deterioration: Erosion in value of assets having very short life.
3. Weather and Accidents: Assets lose their value due to weather, rain, sunshine
or any accident like fire, earthquake etc. or similar other disasters.
4. Deferred Maintenance & neglect.
5. Inadequacy: If its capacity of machine is not sufficient to meet the demands
increased production. It can no longer meet production schedules and requires
replacement.
6. Obsolescence: An asset may become out of date due to development of new
technology, better machine or process.

Methods to calculate Depreciation:

1. Straight Line Method

2. Diminishing Balance Method
3. Sinking Fund Method

1. Straight Line Method:

 • In this method every year a fixed amount is put aside as depreciation
charges during the life of equipment / machinery.
• Yearly Depreciation is calculated using following formula:
𝑐ℎ𝑎𝑟𝑔𝑒𝑠 𝐶 − 𝑆
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑅𝑢𝑝𝑒𝑒𝑠
𝑦𝑒𝑎𝑟 𝑁

Where C – Initial cost of machine

S – Scrap / Salvage value of machine in rupees
N – Estimated life of machine in years.

• It is the simplest method but has following limitations:

▪ Straight-line depreciation does not account for the loss of efficiency or
the increase in repair expenses over the years and is, therefore, not as
suitable for costly assets such as plant and equipment.

2. Diminishing Balance Method:

• Here depreciation is charged at a fixed percentage on the book value of the
asset.
• Since the book value of asset reduces every year, the amount of
depreciation also reduces every year.
• Therefore it is also known as the Reducing Balance Method or Written-
down Value Method.
• Depreciation fund per year is calculated as follows:
Rate of Depreciation/Depreciation ratio/Depreciation factor
1
𝑆 𝑁
is 𝑋 = 1 − ( )
𝐶
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 × 𝑋

where,
S=Scrap value
C=Initial cost
N=No. of years of useful life

3. Sinking Fund Method:

• Sinking fund method is used when the cost of replacement of an asset
is too large.
• The depreciation charge per year is equal to the actual loss in the
value of the asset.
 • This amount is transferred to the sinking fund account which is then
invested in Government securities.
• The interest earned on these securities is also reinvested.
• The amount of depreciation to be charged every year is calculated as
follows –

𝑅(𝐶−𝑆)
𝐷=
1+𝑅𝑁 −1

Where D=Rate of depreciation per year

C=Initial cost in Rupees

R=Rate of Interest on Invested Fund

S=Scrap value

N= Number of years of useful life of asset

OBSOLESCENCE:

Definition:

Obsolescence is the depreciation of existing equipment / asset due to

technological development.

Sometimes even though the machine/equipment is in good operating

condition it becomes obsolete due to change in technology, design &
efficiency.

Causes/reasons of Obsolescence:

1. Invention of new equipment, model which is more efficient, safe or of

better design.
2. Change in manufacturing methods requiring use of another
equipment.
3. Improved & automated machine tools due to which use existing ones
become economical.
4. Existing equipment is inadequate to perform the necessary function
with increased output, more precision & better quality.
5. Due to change in trend, fashion or taste the product demand ceases in
market.
 INTRODUCTION TO GST:

• Goods and Services Tax (GST) is an indirect tax, introduced in India on

1 July 2017.
• It replaced multiple cascading taxes levied by the central & state
Governments.
• GST is levied on all transactions such as sale, transfer, purchase, barter,
lease, or import of goods and/or services.
• India adopted a dual GST model, meaning that taxation is administered
by both the Union and State Governments.
• Transactions made within a single state are levied with Central GST
(CGST) by the Central Government and State GST (SGST) by the State
governments.
• For inter-state transactions and imported goods or services, an
Integrated GST (IGST) is levied by the Central Government.
• GST is a consumption-based, therefore, taxes are paid to the state where
the goods or services are consumed not the state in which they were
produced.

Advantages:

• GST eliminates the cascading effect of tax.

• Higher threshold for registration.
• Composition scheme for small businesses.
• Simple and easy online procedure.
• The number of compliances is lesser.
• Defined treatment for E-commerce operators.
• Improved efficiency of logistics.
• Unorganized sector is regulated under GST.