GENERAL MANAGEMENT

INDEX

CHAPTER 1 - GENERAL MANAGEMENT

CHAPTER 2 - ORGANIZATIONAL DESIGN AND STRUCTURE

CHAPTER 3 - HUMAN RESOURCE MANAGEMENT

CHAPTER 4 - QUALITY MANAGEMENT

CHAPTER 5 - STRATEGIC PLANNING

CHAPTER 6 - MARKETING MANAGEMENT

CHAPTER 7 - FINANCIAL MANAGEMENT

CHAPTER 8 - PROJECT MANAGEMENT

 CHAPTER 1

GENERAL MANAGEMENT
SCOPE OF THE COURSE

After reading chapter 1, you should be able to:

 Understand the fundamental characteristics of organization

 List the responsibility of each type of managers

 Understand the evolution of management

 Outline all approaches of management

 Explain the processes of management

 Explain the functions of management

INTRODUCTION

1.1 Organization

Organization defined generally as ―Two or more people who work together in a structured way to
achieve a specific goal or set of goals‖. For instance, colleges or universities, hotels and your
neighborhood grocery stores are all an organizations. These are all organizations because they all
share three common characteristics namely distinct purpose, systematic structure and people.

Distinct Systematic
purpose structure

People

Fig 1.1: Characteristics of Organizations

Any organization has a purpose to start business. This is typically expressed in terms of goal or set
of goals. Organization is totally composed of people like workers to top managers. Fig 1.1 shows
the characteristics of organizations. If people involved in the organization, assigning responsibility
and authority to people arise naturally. Who will lead the team? And who shall report to the top
management? Systematic structure in organization answers these questions. It involves creating
rules and regulations, identifying some members as leader and giving them authority over other
workers.

The organization refers to an entity that has a distinct purpose includes people or members and has a
systematic structure. Organizations are broadly classified into two namely formal and informal.

A formal organization is a stable set of a description of the organization structure and the rules like
policies, regulations and procedures that make up an organization.

The army and large corporations are structured very formally for an instance.

The informal organization is a concept in management practice that denotes the network, unrelated
to the firm‘s formal authority structure. It is the aggregate of personal and social relationships that
arise spontaneously as people associate with one another environment.

The informal organization can make the formal organization more effective by providing support to
management, stability to the environment and useful communication channels. To begin with a
simple example, this kind of relationship may exist entirely within a given institution as when a
board or council elite group may have an informal, private existence, as well as its public, official,
institutionalized existence. When the councilors of corporation , for example, meets informally at
the mayor‘s home or gathers for a dinner at the hotel, this organization becomes an informal
organization. The relationship between formal and informal becomes easier to understand while
introducing an influential figure, not member of the institutional group, who come in to the lunch,
dinner, or gathering of friends and play a part in policy making, the interrelationship begins to be
more complex. Here we can say that informal groups representing combinations of formal.

1.2 Goal

Goal is generally mentioned as the purpose that an organization strives to achieve. Organizations
often have more than one goal and goals are fundamental elements of organizations.

Organizations must also acquire and allocate the resources necessary to achieve their goals. All
organizations depend on other organizations for their need. A cricket team cannot play without the
required equipment.
1.3 Management

James Stonner et.al (2003) defined the management as

―The process of planning, organizing, leading and controlling the work of organization members
and of using all available resources to reach stated organizational goals‖.

All organizations have people who are responsible for helping them to achieve their goals. These
people are called managers. Managers are responsible for directing the efforts made by all in the
organization aimed at helping organizations achieving goals. All managers in all organizations have
the same basic responsibility without considering type of organization. Manager who manages
work, leads people and achieves results through their efforts.

1.4 Management is subject to time and human relationships

Management is dealing with matters of time and human relationships. The several elements of time
in organizations are:

 Keeping in mind the past and present, management attempts to forecast the future.

 Management produces consequences and effects over time. The importance of human
relationships also involves

 Managers keep the relationships in which each one is influenced by other.

 Managers try to deal all the activities simultaneously related others.

1.5 Managerial performance

How successfully an organization achieves its objectives and satisfies social responsibilities?. This
is depends on its managers. If managers do their jobs well an organization will certainly achieve its
objectives or goals. This is based on the managerial performance. It is a measure of how efficient
and effective a manager is. This is discussed in detail in the next section. And also how well
managers determine and achieve appropriate objectives. The managerial performance is often
confused with organizational performance which is a measure of how efficient and effective an
organization is and how well organization achieves its objectives.

1.6 Efficiency and Effectiveness

Efficiency, the ability to do things right- is an input-output concept. An efficient manager is one
who acheives outputs that measure up to the inputs like labor, materials and time used to achieve
them.Effecient manager who is able to minimize the cost of the resources needed to achieve goals.

Effectiveness involves choosing right goals. A manager is called as inefficient manager when
he/she selects an inappropriate goal. For an instance, if a manager produces large cars while small
cars are in demand.

1.7 Types of managers

Typically, there are three levels of management in organizations:

 Top-level

 Middle-level

 First-level

The above three levels of managers form a hierarchy, in which they are ranked in order of
importance. In most organizations, the number of managers at each level is such that the hierarchy
resembles a pyramid, with many more first-level managers, fewer middle managers, and the fewest
managers at the top level.

Each of these management levels is described below in terms of their possible job titles and their
primary responsibilities and the paths taken to hold these positions.

Additionally, there are differences across the management levels as to what types of management
tasks each does and the roles that they take in their jobs.

Fig 1.2: Types of Managers

1.7.1 Top-Level Managers

Top-level managers are also called as senior management or executives. These individuals are at the
top one or two levels in an organization. The functions of the top managers are setting goals for the
organization rather directing the day-to-day activities of the firm and direct the company to achieve
them. Ultimately they are responsible for the overall performance of the organization so their
decisions affect the whole firm.

In most organizations they have a great deal of managerial experience and they have promoted
through the ranks of management within the company. An exception to this is a top manager who is
also an entrepreneur; such an individual may start a small company and manage it until it grows
enough to support several levels of management.

Some top managers may be hired from other top management positions in other companies.
Conversely, they may be promoted from within and groomed for top management with
management development activities, coaching, and mentoring. Succession planning is very helpful
to identify high potential managers for top level.

The well known titles of such positions are Chief Executive Officer, Chief Financial Officer, Chief
Operational Officer, Chairperson of the Board, President and Vice president.

1.7.2 Middle-Level Managers

Middle-level managers are responsible for carrying out the goals set by top management. They do
so by setting goals for their departments and other business units. Middle managers can motivate
and assist first-line managers to achieve business objectives. They may also communicate upward,
by offering suggestions and feedback to top managers. Because middle managers are more involved
in the day-to-day workings of a company, they may provide valuable information to top managers
to help improve the organization's bottom line. They include all levels of management between the
supervisory level and the top level of the organization.

Jobs in middle management vary widely in terms of responsibility and salary. Depending on the
size of the company and the number of middle-level managers in the firm, middle managers may
supervise only a small group of employees such as an entire business location. Middle managers
may be employees who were promoted from first-level manager positions within the organization,
or they may have been hired from outside the firm.

The well known titles of such positions are General Manager, Plant manager, Regional manager,
and Divisional manager

1.7.3 First-Level Managers

First-level managers are also called first-line managers or supervisors. These managers have job
titles such as: Office manager, Shift supervisor, Department manager, Store manager. First-line
managers are responsible for the daily management of line workers - the employees who actually
produce the product or offer the service. There are first-line managers in every work unit in the
organization. Although first-level managers typically do not set goals for the organization, they
have a very strong influence on the company.

These are the managers that most employees interact with on a daily basis and if the managers
perform poorly employees may also perform poorly may lack motivation.

In the past, most first-line managers were employees who were promoted from line positions (such
as production or clerical jobs). Rarely did these employees have formal education beyond the high
school level. However, many first-line managers are now a three year bachelor's degree graduate. In
Fig 1.2, last two levels indicate these managers. They are many in number in an organization but
authority given to them is less.

THE EVOLUTION OF MANAGEMENT

The management functions planning, organizing, leading and controlling activities have existed for
thousands of years. The evidence of such organized endeavors are the Egyptian pyramids and the
Great wall of china. More than 1,00,000 people involved in the construction of a pyramid for twenty
years. Who directed each one what to do? Who ensured there would be enough stoned at the site to
keep all workers busy? Management is the answer to such questions. Fig 1.3 shows the
development of most management theories.

1.8 THE HISTORICAL CONTEXT OF MANAGEMENT

Social forces are the norms and values that characterize a culture. Early social forces allowed
workers to be treated poorly; however, more recent social forces have provided for more acceptable
working conditions for workers. Social forces have influenced management theory in areas such as
motivation and leadership.

Economic forces are the ideas behind the concept of a market economy such as private ownership
of property, economic freedom, competitive markets and a limited role for government.
Political forces such as governmental regulations play a significant role in how organizations
choose to manage themselves. Political forces have influenced management theory in the areas of
environmental analysis, planning, control, organization design, and employee rights.

1.9 THE CLASSICAL PERSPECTIVE

1.9.1 Scientific management

Scientific management focuses on ways to improve the performance of individual workers. Some of
the major contributors are:

Frederick W. Taylor saw workers deliberately working under their potential and designed a 4-step
method to overcome this problem.

Taylor’s principles of scientific Management

 The development of a science for each element of a man's work to replace the old rule-
of-thumb methods.

 The scientific selection, training and development of workers instead of allowing them
to choose their own tasks and train themselves as best they could.

 The development of a spirit of hearty cooperation between workers and management to

ensure that work would be carried out in accordance with scientifically devised procedures.

 The division of work between workers and the management in almost equal shares,
each group taking over the work for which it is best fitted instead of the former condition in which
responsibility largely rested with the workers. Self- evident in this philosophy are organizations
arranged in a hierarchy, systems of abstract rules and impersonal relationships between staff.

Frank and Lillian Gilbreth were associates of F.W Taylor. The Gilbreths, had experience in
unionized industry. In Frank Gilbreth's early career, he was interested in standardization and method
study.

While bricklaying at construction sites, no two bricklayers used exactly the same method or set of
motions, he tried to find an improved method.

The result was that he was able to raise output from 1000 to 2700 bricks per day.

From their various studies the Gilbreths developed, the laws of human motion from which evolved
the principles of motion economy.
They coined the term 'motion study' to cover their field of research and distinguished it with 'time
study'; it is a technique that they believed should always precede method study. The use of the
camera in motion study stems from this time and the Gilbreths used micro- motion study in order to
record and examine detailed short-cycled movements as well as inventing cyclographs and
chronocycle graphs to observe rhythm and movement.

Henry Gantt, the third well-known pioneer in the early days of scientific management worked for
F.W.Taylor in USA and is to be remembered for his humanizing influence on management,
emphasizing the conditions that have favorable psychological effects on the worker.

Gantt chart

The Gantt chart is a visual display chart that shows the relationship between work planned and
completed on one axis and time elapsed on the other.

1.10 GENERAL ADMINISTRATIVE THEORISTS

Administrative management focuses on managing the total organization.

Henri Fayol was the first to identify the four management functions such as Planning, Organizing,
Leading and Controlling and he developed guidelines for managers to follow. These guidelines
form fourteen principles for effective management.

1. Division of Work. Specialization provides the individual to build up experience,

continuous improvement in skills. Thereby he can be more productive.

2. Authority. The right to issue commands, along with which must go the balanced
responsibility for its function.

3. Discipline. Employees must obey, but this is two-sided: employees will only obey
orders if management play their part by providing good leadership.

4. Unity of Command. Each worker should have only one boss with no other conflicting
lines of command.

5. Unity of Direction. People engaged in the same kind of activities must have the same
objectives in a single plan. This is essential to ensure unity and coordination in the enterprise. Unity
of command does not exist without unity of direction but does not necessarily flows from it.

6. Subordination of individual interest (to the general interest). Management must see
that the goals of the firms are always paramount.

7. Remuneration. Payment is an important motivator although by analyzing a number of

possibilities, Fayol points out that there is no such thing as a perfect system.

8. Centralization (or Decentralization). This is a matter of degree depending on the

condition of the business and the quality of its personnel.

9. Scalar chain (Line of Authority). A hierarchy is necessary for unity of direction. But
lateral communication is also fundamental, as long as superiors know that such communication is
taking place. Scalar chain refers to the number of levels in the hierarchy from the ultimate authority
to the lowest level in the organization. It should not be over-stretched and consist of too-many
levels.

10. Order. Both material order and social order are necessary. The former minimizes lost
time and useless handling of materials. The latter is achieved through organization and selection.

11. Equity. In running a business a ‗combination of kindliness and justice‘ is needed.

Treating employees well is important to achieve equity.

12. Stability of Tenure of Personnel. Employees work better if job security and career
progress are assured to them. An insecure tenure and a high rate of employee turnover will affect
the organization adversely.

13. Initiative. Allowing all personnel to show their initiative in some way is a source of
strength for the organization. Even though it may well involve a sacrifice of ‗personal vanity‘ on the
part of many managers.
14. Esprit de Corps. Management must foster the morale of its employees. He further
suggests that: ―real talent is needed to coordinate effort, encourage keenness, use each person‘s
abilities, and reward each one‘s merit without arousing possible jealousies and disturbing
harmonious relations.‖

Max Weber outlined the concept of bureaucracy based on a rational set of guidelines for
structuring organizations in the most efficient manner. Bureaucracy is a system characterized by
division of labor, a clearly defined hierarchy, detailed rules and regulations and impersonal
relationships.

1.11 THE HUMAN RESOURCES APPROACH

1.11.1 Early Advocates

There are four individuals recognized the importance of human factors stand out as early advocates
of this approach.

Robert Owen argued that money spent on improving labor was one of the best investments that
business executives could make. And he claimed that showing concern for employees was highly
profitable for management and would relieve human misery. He proposed an ideal workplace where
working hours would be regulated, child labor would be banned, education will be provided and
meals would be furnished.

Hugo Munsterberg created the industrial psychology. This is the scientific study of individuals at
work to maximize their productivity. He suggested the use of psychological tests to improve
employee selection, the study of human behavior in order to understand what techniques are most
effective for motivating workers.

Chester Barnard considers organizations as social systems which require cooperation of human.
He believed that organizations were made up of people who have interacting social relationships.
Barnard introduced a idea that managers had to examine the environment and adjust the
organization to maintain a state of equilibrium.

Mary Parker Follett thought that organizations should be based on a group ethic rather than
individual. She argued that individual potential remained only potential until released through group
association.
1.11.2 The Hawthorne studies

The Hawthorne studies were held at Western Electric and sponsored by General Electric. Elton
Mayo and his colleagues controlled the lighting in one room of workers but not in another.

When the illumination was increased in the experimental group, productivity increased in both
groups. The increase in productivity was attributed to the fact that the workers were having extra
attention paid to them, maybe for the first time.

Other studies found that employees will not work as fast as they can when being paid piece-rate
wages. Instead, they will perform to the level informally set by the group in order to be accepted by
the group.

These two studies led Mayo to the conclusion that individual and social processes played a major
role in shaping workers attitudes and behavior at work.

1.11.3 The human relations movement

The human relations movement, which stemmed from the Hawthorne studies, is based on the idea
that a manager's concern for workers will lead to their increased satisfaction and improved
performance. The movement includes the need theories of motivation, such as Maslow's hierarchy
of needs, and McGregor's Theory X and Theory Y.

1.11.4 Behavioral Science Theorists

Jeffrey Pfeffer, Kenneth Thomas were contributed to the development of organizational behavior
Organizational behavior takes a holistic view of behavior by addressing individual, group, and
organization processes. Their contributions and limitations are listed below:

Contributions

 Gave insights into interpersonal processes in organizations such as motivation and

group dynamics.

 Focused managerial attention on these processes.

 Challenged the view of employees as tools.

Limitations

 The complexity of human behavior makes difficult to predict.

 Managers may be reluctant to adopt some of the behavioral concepts.

 Contributions are often not communicated to the practicing managers in an

understandable form.

1.11.5 THE QUANTITATIVE APPROACH

Quantitative approach to management includes the applications of statistics, optimization models

and computer simulations. It has contributed most directly to management decision making in
planning and control. Management science and Operations Research are specifically focused on the
development of mathematical models. These models help organizations to try out various activities
with the use of a computer. Modeling can help managers locate the best way to do things and save
money and time.

Contributions

 Developed sophisticated quantitative techniques to assist in decision making.

 Models have increased our awareness of complex organizational processes and has
aided in the planning and controlling processes.

Limitations

 Cannot fully explain or predict behavior of people.

 Mathematical sophistication may come at the expense of other important skills.

 Models may require unrealistic or unfounded assumptions.

1.12 INTEGRATIVE APPROACH

1.13.1 The systems approach

A system is an interrelated set of elements functioning as a whole. An organization as a system is

composed of four elements:

 Inputs (material or human resources),

 Transformation processes (technological and managerial processes),

 Outputs (products or services), and

 Feedback (reactions from the environment)

The two basic types of systems are open and closed. Open systems are systems that interact with
their environment. Subsystems are systems within a broader system.

Closed systems are systems that neither influenced by nor with their environment. Fig 1.4 shows an
open system perspectives in an organization. Inputs like Raw materials, Human resources, Capital,
Technology and Information are required for a business firm. The transformation process turns
these inputs into finished products or services through work activities, management activities and
operations methods.

Products & services, Financial results such as break even, profit or loss, Information, Human results
are the outputs from the system. Human results show the employees job satisfaction. The above
activities are mainly depends on other important factor environment. It includes supplier of the
organization, banks, government agencies and customers.

Environment

System
Transformation
Inputs Outputs
Employees work
Raw materials activities Products & services
Human resources Management Financial results
Capital activities Information
Technology Technology and Human results
Information operations methods

Feedback

Fig 1.4: The Systems Approach

1.13.2 The process approach

This approach is originally introduced by Henri Fayol based on the management functions such as
planning, organizing, leading and controlling. These are explained in the following sections.

1.13.3 The contingency approach

Appropriate managerial behavior depends on the elements of the situation. Universal perspectives
tried to identify the "one best way" to manage organizations. Contingency perspective argues that
universal theories cannot be applied to organizations because each is unique. The popular
contingency variables are organization size, routines of task technology, environmental uncertainty
and individual differences.

MANAGEMENT PROCESS

1.13 Planning

Planning typically includes identifying goals, objectives, methods, resources needed to carry out
methods, responsibilities and dates for completion of tasks. Examples of planning are strategic
planning, business planning, project planning, staffing planning, advertising and promotions
planning, etc. Fig 1.5 shows the typical management process. The following are phases in planning:

1. Keep in mind the mission.

Planners have in mind some overall purpose or result that the plan is to achieve during planning.
During planning, it's critical to reference the mission, or overall purpose, of the organization.

2. Consider system environment.

It's important to conduct an environmental scan. This scan usually involves considering various
driving forces, or major influences, that might effect the organization.

3. Analyze the Situation

Planners often conduct a "SWOT analysis". (SWOT is an acronym for considering the
organization's strengths, weaknesses, opportunities and threats faced by the organization). During
this analysis, planners also can use a variety of assessments, or methods to "measure" the health of
systems.

4. Establish Goals

Based on the analysis and alignment to the overall mission of the system, planners establish a set of
goals that build on strengths to take advantage of opportunities, while building up weaknesses and
warding off threats.

5. Establish Strategies to reach goals

The particular strategies chosen depend on matters of practicality and efficiency.

6. Establish Objectives

Along the way to achieve goals, objectives are selected to be timely and indicative of progress
toward goals.

Associate Responsibilities and Time Lines with each objective Responsibilities are assigned,
including for implementation of the plan, and for achieving various goals and objectives. Ideally,
deadlines are set for meeting each responsibility.

7. Write and Communicate a Plan Document

The above information is organized and written in a document which is distributed around the
system.

8. Acknowledge Completion and Celebrate Success

This critical step is often ignored which can eventually undermine the success of many of your
future planning efforts. The purpose of a plan is to address a current problem or pursue a
development goal. It seems simplistic to assert that you should acknowledge if the problem was
solved or the goal met. However, this step in the planning process is often ignored in lieu of moving
on the next problem to solve or goal to pursue.

Fig 1.5 Management Process

1.14 Organizing

Simply say that organizing is allocating and configuring resources to accomplish the preferred goals
and objectives establishing during the planning processes. In the next chapter this process will be
explained more elaborately.

1.15 Leading

Leading is establishing direction and influencing people to follow that direction. In management we
deal mostly with humans. Therefore to achieve our objectives we have to motivate and lead people
who are relevant to achievement of our objectives. When we lead people, motivate them and
constantly communicate with them, they will be interested in carrying out what had been allocated
to them. Unless people are properly led they will not do the intended task. People need to be
constantly motivated and directed to perform the intended task we expect out of them. Then
achievement of our objective will be certain.

1.16 Controlling

Controlling is that we must ensure that all our planning, organizing and leading in fact move us
towards the established objectives. This is, while planning, organizing and leading are carried out as
a process, it must be ensured that we measure the ongoing performance of the task and compare
such current performance with the established objectives, to see whether we are heading towards the
right directions.

If it is clear that our objectives may not be achieved then some corrective actions must be taken to
ensure that we are in fact heading in the right directions to achieve the objectives which were
predetermined.

FUNCTIONS OF MANAGEMENT

1.17 Planning

Planning is concerned with the future impact of today's decisions. It is the fundamental function of
management from which the other four stem. The need for planning is often apparent after the fact.
However, planning is easy to postpone in the short-run.

The organizing, staffing, leading and controlling functions stem from the planning function. The
manager is ready to organize and staff only after plans to reach the goals. Likewise, the leading
function, influencing the behavior of people in the organization, depends on the goals to be
achieved. Finally, in the controlling function, the determination of whether or not goals are being
accomplished and standards met is based on the planning function. The planning function provides
the goals and standards that drive the controlling function.

Planning is important at all levels of management. However, its characteristics vary by level of
management. Fig 1.6 shows the various functions of management.

1.18 Staffing

Management teams on successful organizations doing well at many human resource management
skills. Staffing (including recruiting, selecting, hiring and training of employees) is among the skills
that become more important as the complexity and overall level of performance of organizations
business increases. With increasing size and improving performance comes people complexity:
more things accomplished through employees, more delegation to key employees and more reliance
on employees to maintain a routine that assures superiority.

The organizing function of management defines each position or category of positions on the
organization. Staffing follows with the filling and keeping filled all positions on the organization.

Fig 1.6: Functions of management

Recruiting a pool of applicants for a position, selecting new employees from among the pool of
applicants, training new employees and retaining experienced employees are the key elements of the
staffing function.
Practically all organizations function without a Human Resource Department. The organization
human resource managers must deal with factors external to the company such as labor laws and
regulations, labor markets, practices of other employers. Internal factors such as policies regarding
family members entry into the business, conflict between family and business goals and limited
opportunities for promotion because of flat organization charts must be dealt with. Staffing has both
short-run and long-run effect. In the short-run, positions must be kept filled with qualified people
who can get the work done. In the long run, development of top and middle level management
personnel for business continuity into the next generation tops the list of staffing challenges.

Staffing success depends heavily on the planning and organizing functions of management. In
planning, both farm goals and employees' goals are considered. A business functions best when
business and employee goals are compatible. Job analysis leads to job specifications and job
descriptions. In developing job specifications, the necessary knowledge, skills and abilities for each
position are determined. Job descriptions identify specific tasks for each position. Full success in
staffing rarely comes without analyzing the jobs on the farm, determining what is needed for
success in each job and writing a description of the job.

The following assumptions provide the context of staffing

1. The mission for the farm has been given careful attention by top management and
distributed to the management team and all employees, i.e., the reasons the farm is in business are
known.

2. A management team is in place and able to divide up responsibilities. Top management is

willing and able as needed to delegate responsibilities and authority.

3. Key positions like machinery person, or a full-time office person are being filled. The
process for filling key positions can be modified for part-time and temporary positions.

4. The person hired will be trained to carry out the responsibilities of the position, i.e., it is not
necessary to hire a person who already knows how to do the job.

5. No selection process can guarantee selection success. Even if the "right" person was hired
based on all the information available to the employer at the time the decision was made, six
months, a year or three years later, it may seem that the "wrong" person was hired.

1.19 Leading

Directing or leading is influencing people's behavior through motivation, communication, group

dynamics, leadership and discipline. The purpose of directing is to channel the behavior of all
personnel to accomplish the organization's mission and objectives while simultaneously helping
them accomplish their own career objectives.

The directing function gives the manager an active rather than a passive role in employees
performance, conduct and accomplishments. Managers accomplish their objectives through people.
In blaming others for her or his human resource problems, a manager is denying the management
responsibilities inherent in the directing function. The directing function gives managers a second
responsibility: helping people in the organization accomplish their individual career goals.
Organizations do not succeed while their people are failing. Helping people in the organization with
career planning and professional development is an integral part of the directing function.

The directing function in managing for success has included the motivation, communication,
performance appraisal, discipline and conflict management.

Motivation

Selection, training, evaluation and discipline cannot guarantee a high level of employee
performance. Motivation, the inner force that directs employee behavior, also plays an important
role. Highly motivated people perform better than unmotivated people. Motivation covers up ability
and skill deficiencies in employees. Such truisms about motivation leave employers wanting to be
surrounded by highly motivated people but unequipped to motivate their employees. Employers and
supervisors want easily applied motivation models but such models are unavailable.

Motivation probably tops the list of complex activities with which labor managers deal. Their
intuition suggests an easy answer, "I want everyone around here to be motivated." They often blame
employees for their lack of motivation and performance problems. Employees on the other hand
often blame any performance problems they may have on external factors - their supervisors,
equipment, training, co-workers, weather, unrealistic demands made on them, pressures at home,
lack of recognition etc., etc. Despite the conflicting perceptions held by employers and employees,
employers must deal with employee motivation.

Three ways of looking at motivation are: needs, rewards and effort. The needs approach stems from
the notion that peoples' unsatisfied needs drive their behavior. Figure out a person's needs, satisfy
the needs and the person will be motivated. The rewards approach is based on the expectation that
rewarded behavior is repeated. Giving a person a bonus for excellent performance during a difficult
harvest period encourages the person to make a special effort during the next difficult harvest. The
effort approach to motivation is based on the expectation that effort brings the worker what he or
she wants. The effort approach includes a assumption that the employer is fair, i.e., effort is
recognized and rewarded. Managers cannot reduce motivation to a simple choice of one of these
approaches. Each of the three approaches contributes to an understanding of motivation and how
motivation varies person to person and over time.

The most effective motivation for employees comes from within each employee, i.e., self-
motivation. Possible indicators of self-motivation include: past accomplishments in school, sports,
organizations and work; stated career goals and other kinds of goals; expertise in one or more areas
that shows evidence of craftsmanship, pride in knowledge and abilities, and self-confidence; an
evident desire to continue to learn; and a general enthusiasm for life.

1.20 Controlling

Controlling is a four-step process of establishing performance standards based on the firm's

objectives, measuring and reporting actual performance, comparing the two, and taking corrective
or preventive action as necessary.

Performance standards come from the planning function. No matter how difficult, standards should
be established for every important task. Although the temptation may be great, lowering standards
to what has been attained is not a solution to performance problems. On the other hand, a manager
does need to lower standards when they are found to be unattainable due to resource limitations and
factors external to the business.

Corrective action is necessary when performance is below standards. If performance is anticipated

to be below standards, preventive action must be taken to ensure that the problem does not recur. If
performance is greater than or equal to standards, it is useful to reinforce behaviors that led to the
acceptable performance.

Characteristics of the Control Process

The control process is cyclical which means it is never finished. Controlling leads to identification
of new problems that in turn need to be addressed through establishment of performance standards,
measuring performance etc.

Employees often view controlling negatively. By its very nature, controlling often leads to
management expecting employee behavior to change. No matter how positive the changes may be
for the organization, employees may still view them negatively.

Control is both anticipatory and retrospective. The process anticipates problems and takes
preventive action. With corrective action, the process also follows up on problems.

Ideally, each person in the business views control as his or her responsibility. The organizational
culture should prevent a person walking away from a small, easily solvable problem because "that
isn't my responsibility." In customer driven businesses, each employee cares about each customer.
In quality driven dairy farms, for example, each employee cares about the welfare of each animal
and the wear and tear on each piece of equipment. Controlling is related to each of the other
functions of management. Controlling builds on planning, organizing and leading.

SUMMARY

Management is the the process of planning, organizing, leading and controlling the work of
organization members and of using all available resources to reach stated organizational goals.
Planning, organizing, staffing, leading, and controlling are the functions carried out by managers.
At all organizational levels, organizing is an essential activity but the skills required at the
organizational level are changing nature.

Many writers and practitioners have contributed to the development of management thought. The
major contributors and their works are listed in evolution of management. The management process
approach draws from other theories of management and integrates them into a total system of
managing. The organization is an open system that operates within and interacts with the
environment. The system approach to management includes inputs from the external environment
and from claimants, the transformation process, the communication system, external factors,
outputs, and a way to reenergize the system.
 CHAPTER 2

ORGANIZATIONAL DESIGN AND STRUCTURE

SCOPE OF THE COURSE

After reading chapter 2, you should be able to:

 Draw the distinction between line and staff authority

 Explain the use of organization chart

 Understand span of control

 Elaborate the horizontal dimensions of organizations

 Explain types of organizational structure

 Understand organization design

BASICS OF ORGANIZATIONS

Organization is defined as a unit within a company or an entity within which many activities are
managed as a whole. All activities within an organization share common goals. Organizing is the
process of creating an organization‘s structure that is a framework expressed by its degree of
complexity, formalization and centralization. Degree of complexity refers the amount of
differentiation in the organization and shows the difficulty to coordinate the people and their
activities. Directing the behavior of all the people in an organization, certain rules and policies are
to be formalized. Centralization is the process by which the activities of an organization,
particularly those regarding decision-making, become concentrated within a particular location
and/or group. Decentralization is any of various means of more widely distributing decision-
making to bring it closer to the point of service. Organization Design is a process for integrating
people, information, and technology toward the successful achievement of organizational outcomes.
It seeks to optimize human achievement. When a manager develops or changes an organization
structure, he/she is engaged in organization design.
2.1 BUILDING THE VERTICAL DIMENSION OF ORGANIZATIONS

2.1.1 UNITY OF COMMAND

It refers to the principle that a subordinate should have one and only one superior to whom he or she
is directly responsible. That is no person should report to two or more superior.

2.1.2 AUTHORITY AND RESPONSIBILITY

Organizational structure involves the designation of jobs within an organization and the
relationships among those jobs. There are so many ways to structure jobs within an organization,
but two of the most important forms are simple line structures and line and staff structures. In a line
organization, top management has complete control and the chain of command (the authority
entitles a manager to direct the work of a subordinate) is clear and simple. The chain of command is
shown in Fig 2.1 and explained more on the following section. For an example, small business in
which the top manager may be the owner is positioned at the top of the organizational structure and
has clear "lines" of distinction between him and his subordinates.

Fig 2.1: The chain of command

The line and staff organization combines the line organization with staff departments. These staff
departments support and advise line departments. Most medium and largesized firms comprise line
and staff type organizational structures. The distinguishing characteristic between simple line
organizations and line and staff organizations is the multiple layers of management within line and
staff organizations. Several advantages and disadvantages are present within a line and staff
organization. An advantage of a line and staff organization is

 The availability of technical specialists

 Staff experts in specific areas are incorporated into the formal chain of command.
The main disadvantage is conflict between line and staff personnel.

Line and Staff Positions

The primary and secondary positions exist within a line and staff organization. Some positions are
primary to the company's mission, whereas others are secondary in the form of support and indirect
contribution. Although positions within a line and staff organization can be differentiated in several
ways, the simplest approach classifies them as being either line or staff. Fig 2.2 illustrates the line
and staff positions.

A line position is directly involved in the day to day operations of the organization, such as
producing or selling a product. Line positions are occupied by line personnel and line managers.
Line personnel carry out the primary activities of a business and are considered essential to the
basic functioning of the organization. Line managers make the majority of the decisions and direct

line personnel to achieve company goals. Line manager is a marketing executive, for an example.

Fig 2.2: Line and Staff Organization

Although a marketing executive does not actually produce the product, he or she directly
contributes to the firm's overall objectives through market forecasting and generating product
demand. Staff positions serve the organization by indirectly supporting line functions. Staff
positions consist of staff personnel and staff managers. Staff personnel use their technical expertise
to assist line personnel and aid top management in various business activities. Staff managers
provide support, advice and knowledge to other individuals in the chain of command.

Although staff managers are not part of the chain of command related to direct production of
products, they do have authority over personnel. An example of a staff manager is a legal adviser.
He or she does not actively engage in profit-making activities, but does provide legal support to
those who do. Therefore staff positions whether personnel or managers engage in activities that are
supportive to line personnel.

Line and Staff Authority

Authority within a line-and-staff organization can be differentiated. Three types of authority are
present: line, staff, and functional. Line authority is the right to carry out assignments and exact
performance from other individuals.

Line Authority

Line authority flows down the chain of command. For example, line authority gives a production
supervisor the right to direct an employee to operate a particular machine and it gives the vice
president of finance the right to request a certain report from a department head. Therefore, line
authority gives an individual a certain degree of power relating to the performance of an
organizational task.

The line authority does not ensure effective performance and is not restricted to line personnel. The
head of a staff department has line authority over his or her employees by virtue of authority
relationships between the department head and his or her directly- reporting employees.

Staff Authority

Staff authority is the right to advise line authority. For an example, human resource department
employees help other departments by selecting and developing a qualified workforce. A quality
control manager aids a production manager by determining the acceptable quality level of products
or services at a manufacturing company by initiating quality programs and carrying out statistical
analysis to ensure compliance with quality standards. Therefore, staff authority gives staff personnel
the right to offer advice in an effort to improve line operations.
2.1.3 ORGANIZATION CHART

In a business of more than one person, unless the business has equal partners then there are
managers and subordinates. Subordinates are workers controlled by the manager. A hierarchy
describes the structure of the management from the top of the company ie., the managing director
through to the shop floor worker who reports to their foreman in a business. The hierarchy of a
business is usually best understood by drawing an organization chart showing which levels of
management and employees report to whom. The following Fig 2.3 shows a typical organization
chart.

Fig 2.3: organization Chart

2.1.4 SPAN OF CONTROL

A span of control is the number of people who report to one manager in a hierarchy. That is how
many subordinates a manager can effectively and efficiently supervise. The more people under the
control of one manager are the wider of the span of control and it leads to ineffective and dangerous
span of control. The Less people under the control of one manager are the narrower span of control
and it leads to effectiveness. The following figure 2.4 and 2.5 shows the narrower and broader span
of control. Fig 2.6 shows the effective span of control.

The advantages of a narrow span of control are:

 Manager could communicate quickly with the employees under them and control them more
easily

 Feedback from the workers will be more effective

 Less management skill required

Fig 2.4: Broader span of control

Fig 2.5: Narrower span of control

1 2 3 4 5

Fig 2.6: Optimum span of control

The advantages of wide span of control are:

 There are less layers of management to pass an information so the information reaches
more employees faster

 It costs less money to run a wider span of control because a business does not need to
employ as many managers

The width of the span of control depends on:

The type of product

Products which are easy to make or deliver will need less supervision and so can have a wider span
of control
Skills of managers and workers

A more skillful workforce can operate with a wider span of control because they will need less
supervision. Based on decision making organization is classified in to tall or flat organization. A tall
organization (Fig 2.4) has a larger number of managers with a narrow span of control whilst a flat
organization (Fig 2.3) has few managers with a wide span of control. A tall organization can suffer
from having too many managers and decisions can take a long time to reach the bottom of the
hierarchy. But, a tall organization can provide good opportunities for promotion and the manager
does not have to spend so much time managing the staff

Chain of command

It is the line on which orders and decisions are passed down from top to bottom of the hierarchy. In
a hierarchy the chain of command means that a production manager may be higher up the hierarchy
but will not be able to tell a marketing person what to do.

The advantages of hierarchies are:

 Helps to create a clear communication line between the top and bottom of the business
and this improves co-ordination and motivation

 Create teams and motivation is advantage of working in teams. The disadvantages of hierarchies
are:

 Departments work for themselves and not the greater good of the business.

 Departments do not see the whole picture in making decisions.

 Hierarchies can be inflexible and difficult to adjust,

2.1.5 CENTRALIZATION

Organizations with a centralized structure have several layers of management that control the
organization by maintaining a high level of authority. With a centralized structure, line and staff
employees have limited authority to carry something out without prior approval. This organizational
structure tends to focus on top-down management, whereby executives at the top communicate by
telling middle managers. Then middle managers tell first-level managers who then tell the staff
what to do and how to do. Since this organizational structure tends to be fairly bureaucratic,
employees have little freedom. Centralized organizations are known for decreased span of control
which has a limited number of employees report to a manager. And manager then reports to the next
management level (Fig 2.7).

Fig 2.7: Centralized organizational Structure

2.1.6 DECENTRALIZATION

Because of more management cost in a centralized organization, many organizations continue to

downsize into a more decentralized structure. Decentralization seeks to eliminate the unnecessary
levels of management and to place authority in the hands of first line managers and staff. Thus it
widens the span of control, with more employees reporting to one manager. Because more
employees are reporting to a single manager than before, the managers are forced to delegate more
work and to hold the employees more accountable. Downsizing has also helped to change the flow
of communication, so that top management hears staff concerns and complaints in a more direct
manner and management has a more hands-on approach. The hands-on approach involves less
bureaucracy which means there is a faster response to situations that demand immediate attention.
This structure also takes advantage of bottom-up communication, with staff issues being addressed
in a timely manner (Fig 2.8).

Fig 2.8: Decentralized organizational Structure

2.2 BUILDING THE HORIZONTAL DIMENSION OF ORGANIZATIONS

2.2.1 DIVISION OF LABOR

Division of labor means that instead of giving the entire job to a worker, just broken down the job
into a number of steps and each step being completed by separate workers. This allows the
individual to specialize in a particular area of the job rather than an entire activity. Assembly line
production is one of the best examples of division of labor. It makes use of the diversity of skills
and capabilities which is possessed by the employee. If all workers involve in all step of production
processes, performing most demanding and least demanding jobs will be easy. Hereby division of
labor is focused as an unending source of increased productivity.

2.2.2 DEPARTMENTALIZATION

Organizations can be divided into various departments with individuals who specialize in a given
area such as marketing, finance, sales, and so forth. Having each unit to perform specialized jobs is
known as departmentalization. Departmentalization is done according to five major categories:

 Product, which requires each department to be responsible for the product being
manufactured

 Geographic, which divides the organization based on the location of stores and offices

 Customer, which separates departments by customer type

 Functional, which breaks departments into specialty areas;

 Process, which creates departments responsible for various steps in the production
process.
All of the above categories of departmentalization are indicated in fig.2.9.

Fig 2.9: Departmentalization

Functional Departmentalization

Every organization of a given type must perform certain jobs in order do its work. For example, key
functions of a manufacturing company include production, purchasing, marketing, accounting, and
personnel. Grouping jobs that require the same knowledge, skills, and resources allows them to be
done efficiently and promotes the development of greater expertise. A disadvantage of functional
groupings is that people with the same skills and knowledge may develop a narrow departmental
focus and have difficulty in appreciating any other view of what is important to the organization; in
this case, organizational goals may be sacrificed in favor of departmental goals. In addition,
coordination of work across functional boundaries can become a difficult management challenge
especially as the organization grows in size and spreads to multiple geographical locations.

Geographic Departmentalization

Organizations that are spread over a wide area may find advantages in organizing along geographic
lines so that all the activities performed in a region are managed together. In a large organization,
simple physical separation makes centralized coordination more difficult. Also important
characteristics of a region may make it advantageous to promote a local focus. For example,
marketing a product in USA may have different requirements than marketing the same product in
Southeast Asia. Companies that market products globally sometimes adopt a geographic structure.
In addition, experience gained in a regional division is often excellent training for management at
higher levels.

Product Departmentalization

Large, diversified companies are often organized according to product. All the activities necessary
to produce and market a product or group of similar products are grouped together. In such an
arrangement, the top manager of the product group typically has considerable autonomy over the
operation. The advantage of this type of structure is that the personnel in the group can focus on the
particular needs of their product line and become experts in its development, production, and
distribution. A disadvantage, at least in terms of larger organizations, is the duplication of resources.
Each product group requires most of the functional areas such as finance, marketing, production,
and other functions. The top leadership of the organization must decide how much redundancy it
can afford.

Customer/Market Departmentalization

An organization may find it advantageous to organize according to the types of customers it serves.
For example, a distribution company that sells to consumers, government clients, large and small
businesses may decide to base its primary divisions on these different markets. Its personnel can
then become proficient in meeting the needs of these different customers. In the same way, an
organization that provides services such as accounting or consulting may group its personnel
according to these types of customers. Figure 2.10 depicts an organization grouped by customers
and markets.
 Fig 2.10: Types of departmentalization

2.2.3 MATRIX ORGANIZATIONAL STRUCTURE

Some organizations find that none of the afore-mentioned structures meet their needs. One approach
that attempts to overcome the inadequacies is the matrix structure, which is the combination of two
or more different structures. Functional departmentalization commonly is combined with product
groups on a project basis. For example, a product group wants to develop a new addition to its
line; for this project, it obtains personnel from functional departments such as research, engineering,
production, and marketing. These personnel then work under the manager of the product group for
the duration of the project, which can vary greatly. These personnel are responsible to two
managers. Fig 2.11 shows such type of organization. One advantage of a matrix structure is that it
facilitates the use of highly specialized staff and equipment.
 Fig 2.11: Matrix Organizational Structure

The disadvantages of a matrix organization arise from the dual reporting structure. The
organization's top management must take particular care to establish proper procedures for the
development of projects and to keep communication channels clear so that potential conflicts do not
arise. Top management is responsible for arbitrating such conflicts, but in practice power struggles
between the functional and product manager can prevent successful implementation of matrix
structural arrangements. Besides the product/function matrix, other bases can be related in a matrix.
Large multinational corporations that use a matrix structure most commonly combine product
groups with geographic units. Product managers have global responsibility for the development,
manufacturing, and distribution of their own product or service line, while managers of geographic
regions have responsibility for the success of the business in their regions.

2.2.4 STRATEGIC BUSINESS UNITS

Strategic Business Units (SBU) generally are set up like separate companies, with full profit and
loss responsibility invested in the top management of the unit often the president of the unit of the
larger corporation. This manager is responsible to the top management of the corporation. This
arrangement can be seen as taking any of the aforementioned departmentalization schemes. The
SBUs might be based on product lines, geographic markets, or other differentiating factors. Figure
2.12 depicts SBUs organized by geographic area.
 Fig 2.12: Strategic Business Units

2.3 TYPES OF ORGANIZATIONAL STRUCTURE

I. Three main components of organizational structure

A. Complexity: degree of differentiation of activities

1. Horizontal complexity: number of units across organization

2. Vertical complexity: depth of organizational hierarchy

a. Flat structures: small number of levels, wide span of control (# of

workers each managers oversees)

b. Tall structures: many levels, narrower spans of control

3. Spatial complexity: geographical dispersion of physical and human resources

B. Formalization: degree of standardization

C. Centralization: degree of concentration of decision-making

II. Mechanistic vs. Organic structures

A. Structure types

1. Mechanistic structure: high complexity and formalization; centralized decision-

making (also, rigid relationships, fixed duties, downward communication, little participation in
decision-making)

2. Organic structure: low complexity and formalization; decentralized decision-

making (also, adaptable duties, flexible relationships, horizontal and upward communication)

B. Factors leading to structure types

Table 2.1 Factors leading to structure types

Factor Mechanistic Organic

1. Size Large Small
2. Strategy Cost-minimization, Innovation, single product line
imitation
3. Technology Mass production, routineUnit production, intensive
tasks, well-defined technology (combining
problems services tailored to customer),
non-routine tasks, ill-defined
Problems
4. Environment Placid-randomized, placid- Disturbed-reactive, turbulent
clustered Field

INTRODUCTION TO ORGANIZATIONAL DESIGN

2.4 ORGANIZATIONAL DESIGN

Designing an organization involves choosing an organizational structure that will enable the
company to most effectively achieve its goals. Combination of organization design and emergent
organizational behavior forms an efficient and resilient organizational- control framework.
Emergent organizational behavior is an on-line and primarily bottom- up process in which agents
look for interaction and local control decisions that have been effective in the past and give similar
decisions preference in the future.
Fig 2.13: Organizational design framework

By representing these preferences explicitly and aggregating them together, an emergent

organizational structure can be created. In contrast, designed organizations are created by using
organization-design knowledge and task-environment information to develop an explicit
organizational structure that is then elaborated by the individual agents into appropriate behaviors.
Coupled together, an initial designed organization can provide ballpark organizational behavior
preferences that can be refined in an emergent fashion, and emergent organizational behavior can
provide a stimulus for improved organizational design. Significant tension between the designed
organization and potential emergent organizational behavior is an indication that the current
organizational structure may have become inappropriate and provides important information for
organizational restructuring or redesign.

Organization design is the creation of an organization's structure, traditionally functional, divisional,

and matrix. In a functional organization, authority is determined by the relationships between group
functions and activities. Functional structures group similar or related occupational specialties or
processes together under the familiar headings of finance, manufacturing, marketing, accounts
receivable, research, surgery, and photo finishing. Economy is achieved through specialization.
However, the organization risks losing sight of its overall interests as different departments pursue
their own goals.

In a divisional organization, corporate divisions operate as relatively autonomous businesses under

the larger corporate umbrella. In a conglomerate organization, divisions may be unrelated.
Divisional structures are made up of self-contained strategic business units that each produces a
single product. A central headquarters focusing on results, coordinates and controls the activities
and provides support services between divisions. Functional departments accomplish division goals.
A weakness however, is the tendency to duplicate activities among divisions.

In a matrix organization shown in fig 2.14, teams are formed and team members report to two or
more managers. Matrix structures utilize functional and divisional chains of command
simultaneously in the same part of the organization. It is used to develop a new product, to ensure
the continuing success of a product to which several departments directly contribute and to solve a
difficult problem. By superimposing a project structure upon the functional structure, a matrix
organization is formed that allows the organization to take advantage of new opportunities. This
structure assigns specialists from different functional departments to work on one or more projects
being led by project managers. Project managers have authority over activities geared toward
achieving organizational goals while functional managers have authority over promotion decisions
and performance reviews. Matrix organizations are particularly appealing to firms that want to
speed up the decision-making process. However, the matrix organization may not allow long-term
working relationships to develop. Furthermore, using multiple managers for one employee may
result in confusion as to manager evaluation and accountability. Thus, the matrix system may
elevate the conflict between product and functional interests.

Fig 2.14: Matrix organization

Boundaries less organizations share many of the characteristics of flat organizations, with a strong
emphasis on teams. Cross-functional teams dissolve horizontal barriers and enable the organization
to respond quickly to environmental changes and to spearhead innovation. Boundary less
organizations shown in fig 2.15, can form relationships (joint ventures, intellectual property,
distribution channels, or financial resources) with customers, suppliers, and competitors. A
boundary less environment is required by learning organizations to facilitate team collaboration and
the sharing of information. When an organization develops the continuous capacity to adapt and
survive in an increasingly competitive environment because all members take an active role in
identifying and resolving work-related issues, it has developed a learning culture. A learning
organization is one that is able to adapt and respond to change. This design empowers employees
because they acquire and share knowledge and apply this learning to decision-making. They are
pooling collective intelligence and stimulating creative thought to improve performance.
Supervisors facilitate learning by sharing and aligning the organization's vision for the future and
sustaining a sense of community and strong culture.

Fig 2.15: Boundary less organization

2.4.1 Organizational Design Types

I. Functional: Grouping by task (each group does something different)

A. Advantages

 Allows task specialization and expertise to develop

 Don‘t have redundancy of functions across groups that occurs in divisional design
B. Disadvantages

 Poor communication across functional areas

 Hard to identify who is responsible for failures, success (for example for poor sales of a
product)

II. Divisional: Grouping by product, customer, location, topic, etc. (each group does same tasks
but for a different topic, customer, product, location, etc.)

A. Advantages

 Coordination within product lines made easier

 More adaptable to changes in environment (e.g., can shut down a division when a

 a product is no longer selling)

 Responsibility for failures, successes identifiable

 Competition across divisions can serve as a motivator

B. Disadvantages

 Redundancy of functions across divisions

 Competition for resources, power

 Lack of development of expertise in functional areas

III. Hybrid: Functional at one level, divisional at another level

A. Advantages

 Functional support at top for product groups can eliminate redundancy problem of
divisional design and increase expertise available

 Can use functional groupings where need advantages of functional grouping, and
divisional groupings where need advantages of using divisional grouping

B. Disadvantages

 Difficulties in coordinating can occur across levels because of different modes of operating
 Power struggles can develop because of non-authority of functional groups at
headquarters over product groups below

IV. Matrix: Functional and divisional simultaneously (e.g., cross-functional project teams)

A. Advantages

 Uses human and physical resources more efficiently

 Increases technical quality and product integrity simultaneously

B. Disadvantage

Requires lots of communication and coordination (e.g., between functional and divisional bosses)

V. New trends in structure

A. Networked structure: Disaggregation of organizations (use of independent contractors,

joint ventures, etc.)

1. Advantages:

 Allows organization more flexibility

 Doesn‘t require as many resources (e.g., employee benefits, office space, financing
for ventures, etc.)

2. Disadvantages:

 More difficult to control quality—requires controls, e.g., in contracts

 Increases need to coordinate, communicate effectively

B. Increased use of cross-functional teams (from matrix) in conjunction with other more
traditional structures.

SUMMARY

The structural relationships in which people work, holds employee attitudes and behavior in
addition to individual and group factors. We mean that the structure has an impact on both attitudes
and behavior because it reduces ambiguity for employees and clarifies concerns such as ―What I am
supposed to do?‖ ―To whom I report?‖ it shapes their attitudes and facilitates and motivates them to
higher levels of performance.

Structure also constraints employees to some extent that it limits and controls what they should do.
For an instance, organizations structured around high levels of formalization and specialization,
strict adherence to the chain of command, limited delegation of authority, and narrow spans of
control give employees little autonomy. Controls in such organization are tight, and behavior will
tend to vary within narrow range. In contrast, organizations that are structured around limited
specialization, low formalization, wide spans of control, and the like provide employees greater
freedom and, thus will be characterized by greater behavioral diversity.
 CHAPTER 3

HUMAN RESOURCE MANAGEMENT

SCOPE OF THE COURSE

After reading chapter 3, you should be able to:

 Explain the constraints under which the recruitment process takes place

 Understand steps in selection process

 Understand need for training and development

 Outline the methods of performance appraisal

 Define promotion, separation, and transfer

INTRODUCTION

Human Resource Management (HRM) is the management function deals with recruitment,
placement, training and development of organizational members. This is also dealing with
performance issues and ensuring your personnel and management practices conform to various
regulations. Activities also include managing your approach to employee benefits and
compensation, employee records and personnel policies. The HRM function and Human Resource
Development (career development, organizational development and so on) have undergone many
changes over the past years. In past, large organizations looked to the Personnel Department, mostly
to manage the paperwork around hiring and paying people. More recently, organizations consider
the HR Department as playing a major role in staffing, training and helping to manage people so
that people and the organization are performing at maximum capability in a highly fulfilling
manner. In this chapter, two types of Human Resource processes is included for the view of its
importance.

3.1 THE HRM PROCESS

The fig 3.1 shows the HRM process includes the following activities:

1. Human Resource Planning

2. Recruitment

3. Selection

4. Socialization

5. Training and development

6. Performance appraisal

7. Promotions, Transfers and Separations

All the above activities are explained elaborately in the following sections.

Fig 3.1: The Human Resource Management Process

ASTD MODEL FOR HRM

In recent years there has been relative agreement among HRM specialists as to what constitutes the
field of HRM. The model shown in fig 3.2 that provided the focus was developed by the American
Society for Training and Development (ASTD). In its study, ASTD identified nine human resource
areas:

1. Training & Development

2. Organization and Development

3. Organization/ Job Design

4. Human Resource Planning

5. Selection and Staffing

6. Personnel Research and Information systems

7. Compensation/Benefits

8. Employee Assistance

9. Union/Labor Relations

These nine areas have been termed spokes of the wheel in that each area impacts on the human
resource outputs: quality of work life, productivity, and readiness for change. Fig is a representation
of this model, and the focus of each spoke.

Quality of Work Life

Quality of work life is a multifaceted concept. The premise of quality of work life is having a work
environment where an employee‘s activities become more important. This means implementing
procedures or policies that make the work less routine and more rewarding for the employee. These
procedures or policies include autonomy, recognition, belonging, progress and development, and
external rewards. Autonomy deals with the amount of freedom that employees can exercise in their
job. Recognition involves being valued by others in the company. Belonging refers to being part of
the organization.
 PERS ONNEL

Fig 3.2: ASTD Model for HRM

Progress and development refer to the internal rewards available from the organization; challenge,
and accomplishment. External rewards in the form of salary and benefits but also include
promotion, rank and status.

Productivity

Productivity is the quantity or volume of the major product or service that an organization provides.
Many components constitute the productivity factor; we can condense these components into four
categories- capital investment, innovation, learning, and motivation.

Capital investment includes having the best possible machinery available that will help improve the
efficiency of the workers. This machinery or equipment can be in many forms –from roots to word
processors.

Innovation is a process whereby new and creative ideas are welcomed, studied for their feasibility
and if feasible, implemented.

Learning looks at training issues. Not only do we want individuals to work effectively but we want
them to be efficient as well. For this, employees must have the proper skills; and in many cases,
these skills have to be taught.

Productivity is contingent on an employee‘s motivation. The best trained employee, one who not
only has the ability but has access to the most advanced piece of equipment, will not be productive
if he or she is unwilling to be so. Attitude plays an important role as to whether an individual has
the propensity to work. Accordingly, to increase productivity we must in part change an employee‘s
attitude or in academic terms, increase his or her morale.

Readiness for change

Change is a fact of life-in both our private and our work lives. At the work site, we must be aware
that changes will occur. The change might be subtle, such as getting a new boss. Or it might be a
major endeavor, such as an organization installing a computer system for the first time-automating
many of the manual operations. But change rarely comes easily for everyone; in some cases it is
resisted. To reduce the fear associated with change, training is important. From an organizational
perspective, employers must make changes to remain competitive. But it is also their responsibility
to communicate the forthcoming changes to their employees, identify why the changes are
necessary, and lend their total support in ensuring that the change takes place. Through this process,
employers can create a work atmosphere that views change as a positive and progressive endeavor.

3.2 HUMAN RESOURCE PLANNING

Human resource planning is the planning done for the future personnel needs of an organization
taking into account both internal factors in the external environment. Internal factors such as current
and expected skill needs, vacancies and departmental expansions and reductions are considered.
Labor market is considered as the factor in the environment.

3.2.1 Developing a Human Resources Plan

HR plan can serve as information for many purposes such as:

 Identifying HR requirements to better meet business objectives

 Promoting career planning

 Reducing the time and cost of future staffing

 Signaling potential work load and work force adjustment

 Predicting potential shortfalls in the labor force and market availability

 Highlighting retirements and resignations and developing appropriate succession plans

 Identifying seasonal hiring patterns

For making effective planning procedures, some of the basic aspects are required. They are planning
for future needs and objective by deciding what skills of people the organization need and by setting
departmental strategic objectives for the next year and next three years. The second aspect is
planning to balance of future by comparing forecasted supply and future demand. The
organization's future supply and demand for employees to meet the business plans involves the
functions need to be performed and the current functions evolve in the organization. The structuring
the organization also leads to forecast supply through grouping the positions and levels. Type of
competencies or qualifications is required, also used to forecast supply. Fig 3.3 shows the steps for
effective human resource planning.

The capabilities and capacities of the organization's current workforce mean that there are existing
employees who can do the work at this time. At the same time analyzing the strengths and
weaknesses of the existing people is significant. The most important factor is the labor markets in
which likely candidates are located to forecast supply.

The third aspect is planning for recruiting and laying off the employees in the organization. This is
sometimes called as downsizing or restructuring the organization. HR manager at many companies
helps the laid off employees to find new job. And the final aspect is planning to develop HR plan.
This is to ensure that the organization has the steady supply of skilled personnel.

3.3 RECRUITMENT

Recruitment is the process whereby a firm attracts or finds capable individuals to apply for
employment. Of course, the objective is to find these applicants at the lowest possible cost. This
process begins when new recruits are sought and ends when applicants have submitted application
forms or resumes. The result is a pool of job-seekers from which the firms can select the most
qualified. Smart companies recruit employees they can retain, and retention depends on getting the
right people in the right job in the first place. Before going to recruitment, the job analysis to be
done (i.e. an analytical study of the tasks to be performed to determine their essential factors)
written into a job description so that the selectors know that the applicants physical and mental
characteristics. It is useful to investigate the desirable qualities and attitudes

Selection is buying an employee (the price being the salary multiplied by probable years of service)
and bad buys can be very expensive. For that reason some firms use external expert consultants for
recruitment and selection. However, the cost of poor selection is such that, even for the ordinary day
to day jobs, those who recruit and select should be well trained to judge the suitability of applicants.

3.3.1 Sources of Recruitment

Internal promotion

Employment Exchanges

Agencies for the unemployed

Advertising (often via agents for specialist posts)

 Fig 3.3: Key Steps in Effective HR Planning

The form on which the applicant is to apply (personal appearance, letter of application, completion
of a form) will vary according to the posts vacant and numbers to be recruited.

It is very desirable in many jobs that claim about experience and statements about qualifications are
thoroughly checked. Before letters of appointment are sent any doubts about medical fitness or
capacity should be resolved by requiring applicants to attend a medical examination. For example,
in the case of apprentices, the recruitment is for a contractual period or involves the firm in training
costs. Interviewing can be carried out by manager or panels of interviewers or in the form of
sequential interviews by different experts and can vary from a five minute 'chat' to a process of
several days. Ultimately personal skills in judgment are probably the most important, but techniques
to aid judgment include selection testing for: Aptitude test, General intelligence. In more senior
posts other techniques are: Leaderless groups, Command exercises and Group problem solving.

Training in interviewing and in appraising candidates is clearly essential to good recruitment. For
consistency rating often consists of scoring candidates for experience, knowledge, physical or
mental capabilities, intellectual levels, motivation, prospective potential, leadership abilities. These
are all according to the needs of the post.

3.3.2 Constraints on Recruitment

3.3.3 Firms seek to recruit give guarantees the number of qualified applicants. However
there are often some constraints on the recruitment process. They are:

Organizational Policies

Affirmative action Programs

Recruiter Habits

Environmental Conditions

Job Requirements

Organizational Policies

An example of an organizational policy might be a promote from within policy. Such policies are
encountered in unionized firms where the collective agreement stipulates that job openings must be
posted internally prior to seeking applicants from outside the organization.
Further, in many unionized environments, policies may restrict the number of part-time employees
working for the firm. This is clearly a recruitment constraint in so far as it places limitations on the
firm. However, it may well also limit the number of applicants because some very highly qualified
applicants may simply prefer part-time employment.

Affirmative action Plans

Occasionally, firms may adopt affirmative action policies in an effort to attain a workforce that is
more representative of the general public. In efforts to increase workforce diversity, firms may
choose to voluntarily hire persons with specific characteristics. More often, such affirmative action
policies are mandated by law.

Recruiter Habits

Recruiter habits may also constitute a recruitment constraint. For example, past successes may lead
to habits or preferred tendencies in recruitment. One recruiter, who had played cricket, had
considerable success recruiting other cricket enthusiasts. Whereas he had luckily an initial success,
he may seek out cricket players in his recruitment. Obviously, cricket skills are not necessarily the
indicators of job related success. Such recruiter habits do not constitute good recruitment practices.

Environmental Conditions

The rate of unemployment in an area can have an influence on recruitment. High unemployment or
surplus of labor supply may result in a larger number of skilled applicants for a particular job. For
example firms can take advantage of layoffs in related industries as skilled workers become
available. On the other hand, the recruiting activities of competitors can limit the supply of qualified
applicants.

Changes in legislation governing the employment of certain classes of employees can also constrain
recruitment activities. If the degree of qualification necessary to do a particular job is changed by
way of legislation, then the firm's recruitment activities may also need to change.

Job Requirements

Generally, skilled workers are more difficult to find than unskilled workers. A limited pool of
potential applicants causes firms to use different recruiting techniques. Whereas an advertisement
placed in a newspaper's classified section may serve to attract unskilled workers, recruitment of
skilled workers may require more sophisticated techniques.
3.3.4 Internal Recruitment

Should the recruitment process be started from internally or externally? There is nothing inherently
better about either internal or external recruitment. However, there are some advantages to internal
recruitment.

Increased morale for employees (one promotion leads to another vacant position and
this chain effect contributes further to increased morale)

Reward good performance or loyalty.

Human Resource data is immediately available for any employee recruited internally.

Organization can save money with no orientation sessions because an internal recruit
will be familiar with the firm. This employee will be familiar with the firm's products, clients,
organizational policies, and corporate culture.

The disadvantages of this recruitment are

Whereas the firm saves money by eliminating orientation sessions for employees
recruited internally, other training costs may go up. If company policies mandate internal
recruitment, then employees promoted from within may not have all the requisite skills required for
the job. In such cases, employees will have to be trained for their new jobs. This can be a costly
process.

Another unintended negative consequence of internal recruitment might be

organizational politics. This may occur when more than one employee aspires to the job vacancy.
Those not getting the promotion will be disappointed and may be unwilling to grant the new job-
holder the authority required to do the job. Further, the unsuccessful applicants co-workers may also
resent the successful candidate.

3.3.5 External Recruitment

The opposite of internal recruitment is external recruitment. The most obvious advantage of
external recruitment is the availability of a greater pool of applicants. Thus, only those applicants
who have the exact qualifications will apply and be selected. This has consequences for the
organization's training budget. Whereas external recruits will require orientation upon being hired,
they will not require any extra training.
External recruits also bring new ideas and external contacts to the firm hiring them. Also, if political
infighting over a promotion might be a possibility, then external recruitment is one way of
eliminating that occurrence.

3.3.6 Internet Recruiting

Finding well-qualified applicants quickly at the lowest possible cost is a primary goal for recruiters.
Recent trends indicate that, if you're looking for a job in the technical field or to fill a technical job,
you need consider using the Internet. The same may well be true for non technical jobs in the near
future.

Advantages

Internet more cost-effective

Access to more people and a broader selection of applicants

Ability to target the type of people needed

Access to people with a technical background who know computers

Convenience and Ease of use

Quicker response

Disadvantages

Attraction of the passive job seeker, the person who is not actively searching on the
Internet

An increased volume of applicants

Not everyone has access to or uses the Internet

3.4 SELECTION PROCESS

Selection is the process of making a hire or no hire decision regarding each applicant for a job. The
process typically involves determining the characteristics required for effective job performance and
then measuring applicants on those characteristics. The characteristics required for effective job
performance are typically based on a job analysis.
Recruitment is the process of generating a pool of qualified candidates for a particular job. The
firm must announce the job‘s availability to the market and attract qualified candidates to
apply. The firm may seek applicants from inside the organization, outside the organization or both.

3.4.1 Steps in the selection process

Formal application

The figure 3.4 shows the steps in the selection process. The purpose of the formal application
indicates applicants desired position and also provides information for interviews. This process
considers the need for the position and examines the possibility of job redesign. Human Resource
Manager must make available up-to-date position description of the job. This process finds the
deficient applicants who applied for the job.

Interview

Selection committee must be constituted by the HR department before conducting interview. In the
selection committee at least one member is trained in Staff Selection. This committee ensures all
information relevant to the selection process to be kept confidential and equal opportunity issues are
drawn to the attention of members. And all members are involved at all stages of the selection
process. The committee also provides feedback system for unsuccessful applicants. The screening
interview in this process is conducted for quick evaluation of applicants suitability. In this process
selection committee asks questions on their experience and salary expectation. It is also the process
of evaluating the qualifications of individuals in an applicant pool against established position
qualifications to determine which applicants in the pool meet minimum qualifications.

Testing

Firms should endeavor to act on objective data and this is true for compensation management and
performance appraisal and it is certainly true for the selection process where firms wish to assess
the match between job applicants and job requirements.
 Fig 3.4: Steps in the selection process

A way to ensure that selection decisions are based on objective data used employment tests. Employment
tests provide firms with objective data for purposes of comparing applicants. Based on these data,
inability or poor interpersonal qualities of applicants are identified. As the employment test score is
related to actual performance of job, it is necessary to validate the score. This test bear the resemblance to
the job related task a successful applicants must to do.

Reference checks

Reference check is the process of obtaining information from former employers, supervisors, co-
workers or others regarding a candidate‘s work performance or behavior. This information is used by
the selection committee along with other information collected during the selection process to
determine the candidate‘s suitability for the advertised position, and ultimately to determine which
candidate is best suited for employment. If any applicant had the misbehavior in the former
organization, it is possible to account his behavior. This check identifies the kind of the applicant and is
the applicant is a reliable worker?

Physical exam

In depth selection interview will be conducted before admitting applicant to physical test.
The following steps should be followed to conduct in depth interview:

 Conduct formal job analyses

 Write accurate job descriptions

 Interviewers review job-relatedness of potential question by consulting appropriate

job descriptions

 Interviewers write out all questions before the interviews

 Use panel interviews

 Create rating forms for the interviews

 Anchor interview questions to job behaviors

 Standardize interviews

Physical examination is followed by in depth interview to ensure effective performance of applicant and
protect other employees against diseases. Also this is useful to maintain employee‘s health record and
protects firm against unjust worker‘s compensation claims.

For this purpose many of the company has its own medical doctor.

Analysis and decision (Job offer)

This is the end of the selection process. At this stage, successful (as well as unsuccessful) applicants
must be notified of the firm's decision. Since money and effort has been spent on all applicants, the HR
department may wish to consider even the unsuccessful applicants for other openings in the
organization.

The applications of unsuccessful applicants are often kept on file and the applications of successful
applicants will be retained in the employees' personnel files. When a job offer is made, it should include
the following information:

 The position offered

 Location of the job

 Salary

 Benefits
 Starting date

 Any papers or information that should be brought on the first day of work

 Date by which the applicant must respond to your job offer, so you can move on to
the next candidate if your first choice doesn't accept.

3.5 SOCIALIZATION

Socialization involves orienting new employees in the organization and to the units in which they will be
working. It is important that new employees become familiar with the company‘s policies, procedures,
and performance expectations. Socialization can make the difference between a new worker‘s feeling like
an outsider and feeling like a member of the team. Most people are starting a new job with nervous and
perhaps concerned about performing up to their employer's expectations. And also their work is being
accepted by other employees. A thorough orientation program takes time and effort but will increase
worker productivity, decrease confusion, and provide satisfaction for both employer and employee.

Two questions need to be answered in regards to the orientation of a new employee. They are who will
orientate the new employee? And what should be covered during orientation? One person should be in
charge of handling orientation certainly by the HR people. Having just one individual in charge of
orientation ensures a consistent message to new employees. The orientation of a new employee can
involve several people even though one person has overall responsibility.

Information covered will change from organization to organization but a basic core of material should be
discussed with the new employee, including such specific characteristics of the organization as layout
of operation, other employees, history, mission, goals, and role of the employee. This kind of
information provides the big picture of the farm to the employee. Personnel policies including
probationary period, disciplinary actions, work schedule, safety rules, and use of equipment also need to
be covered.

New employees are always interested in their benefits. Items such as pay, vacation, sick leave, and other
benefits should be covered. Discuss specific responsibilities the new employee will be assigned, how the
job relates to other work and safety rules. Finally, be sure to introduce the new employee to management
team, including family members and other employees. It is helpful to develop an employee handbook so
policies and benefits can be accessible and clear to both employer and employee.

Answer all of the immediate questions that the new employee might have. It is important to develop
open, two-way lines of communication between the employer and employee right from the beginning.
Consider the time spent for orientation as an investment for both you and the employee. The well-
defined expectations will pay dividends and reduce possible misunderstandings between employer and
employee. By orientating the new employee properly, a smooth transition can be made to train.
3.6 TRAINING AND DEVELOPMENT

Training program is a process designed to maintain or improve current job performance. Development
process is a process designed to develop skills necessary for further work activities.

Within an organization training and development is necessary in order to:

 Develop workers to undertake higher-grade tasks;

 Provide the conventional training of new and young workers

 Raise efficiency and standards of performance;

 Meet legislative requirements (e.g. health and safety);

 Inform people (induction training, pre-retirement courses, etc.);

From time to time meet special needs arising from technical, legislative and knowledge need changes.
Meeting these needs is achieved through the training loop. The diagnosis of other than conventional
needs is complex and often depends upon the intuition or personal experience of managers and needs
revealed by deficiencies. Group training is concerned in addition to formal courses there are:

 Lectures and talks by senior or specialist managers

 Discussion group (conference and meeting) activities

 Briefing by senior staffs

 Role-playing exercises and simulation of actual conditions

 Video and computer teaching activities

 Case studies (and discussion) tests, quizzes, games, observation exercises and
inspection and reporting techniques.

Evaluation of the effectiveness of training is done to ensure that it is cost effective, to identify needs to
modify or extend what is being provided, to reveal new needs and redefine priorities and most of all to
ensure that the objectives of the training are being met.

The latter may not be easy to ascertain where results cannot be measured mathematically. In the case of
attitude and behavioral changes sought, leadership abilities, drive and ambition fostered, etc.,
achievement is a matter of the judgment of senior staffs. Exact validation might be impossible but unless
on the whole the judgments are favorable the cooperation of managers in identifying needs, releasing
personnel and assisting in training ventures will cease.
3.6.1 Steps in Training

The training process can be broken down into five steps each of these will assist the employer or trainer
in understanding this process.

Prepare : The first step in this process is to prepare the learner. The trainer should put the learner at ease
and explain why the skill to be learned is important. Explain any hazards or problems that may be
involved and how to deal with them. Answer any questions that the learner may have about the task.

Tell : Explain the task thoroughly. Break it down into key parts or steps. Most employees will find that
learning several smaller tasks and putting those together is easier than trying to learn one large skill all
at once.

Show : Demonstrate for the employee exactly how the task or skill is to be performed. Involve the
employee by asking questions and getting feedback. Have the learner explain the process or skill back
to the trainer.

Do :The learner now has the opportunity to perform the task. The trainer needs to help the learner develop
confidence by at first carefully monitoring the learner, then allowing him/her to work without
supervision. The employee needs to make sure that the employee performs each step correctly and avoids
developing any bad habits.

Review : Provide honest feedback to the learner in terms of encouragement, constructive criticism and
additional comments. This is a great opportunity to praise the employee or correct his/her progress. [Dr.
Bernie Erven]

3.6.2 Management Development Programs

On the job methods

Coaching is the training of an employee by his/her immediate superior. The definition of coaching is

―a process that enables learning and development to occur and thus performance to improve. To be a
successful a Coach requires a knowledge and understanding of process as well as the variety of styles,
skills and techniques that are appropriate to the context in which the coaching takes place‖ [Eric
Parsloe, 1999].

The coach facilitate the exploration of needs, motivations, desires, skills and thought processes to assist
the individual in making real, lasting change. He/she use questioning techniques to facilitate
subordinate own thought processes in order to identify solutions and actions rather than takes a wholly
directive approach. The other functions of coach are

 Support the junior in setting appropriate goals and methods of assessing progress in relation to
these goals

 Observe, listen and ask questions to understand the subordinate situation

 Creatively apply tools and techniques which may include one to one training, facilitating,
counseling & networking.

 Encourage a commitment to action and the development of lasting personal growth & change.

 Ensure that subordinates develop personal competencies and do not develop unhealthy
dependencies on the coaching or mentoring relationship.

 Evaluate the outcomes of the process, using objective measures wherever possible to ensure the
relationship is

 Encourage to continually improve competencies and to develop new developmental alliances

where necessary to achieve their goals.

 Work within their area of personal competence.

 Possess qualifications and experience in the areas that skills-transfer coaching is offered.

 Manage the relationship to ensure the subordinate receives the appropriate level of service and
that programmes are neither too short, nor too long.

Job rotation involves shifting employees from position to position so that they can broader their
experiences and familiarize themselves with various aspects of firm‘s operations. For an example one
day a manager may be working in one part of the factory and the next day he/she may work in a
different part. This avoids the employee becoming bored as with job rotation they are doing different
jobs all the time and learning new skills. Multi skilling is when people have many skills so they are able
to carry out many different jobs. Multi skilling benefits the employer as if they are short of staff in one
area, they can move people across.

In training positions, trainees are given staff post under a manager as ‗assistant to‘. This is done because
to create a chance to work with senior manager.

In planned work activities, trainees are given some assignments to improve their ability and also asked
them to participate in an important meeting to get develop skills.

Off the job methods

There are many off the job methods. Two of the most important methods are
Class room instruction: Experts from inside or outside of the organization teach trainee a particular
subject. Analyzing case studies, role playing and business games are the part of the class room
instruction.

University-sponsored management development programs: This type of programs is conducted from a

week to three months or more. All IIMs are conducting such type of programs for managers.

3.7 PERFORMANCE APPRAISAL

Performance appraisal may be defined as a structured formal interaction between a subordinate and
supervisor, that usually takes the form of a periodic interview (annual or semi-annual), in which the work
performance of the subordinate is examined and discussed, with a view to identifying weaknesses and
strengths as well as opportunities for improvement and skills development.

Performance appraisal systems began as simple methods of income justification. That is, appraisal was
used to decide whether or not the salary or wage of an individual employee was justified. The process
was firmly linked to material outcomes. If an employee's performance was found to be less than ideal, a
cut in pay would follow. On the other hand, if their performance was better than the supervisor expected,
a pay rise was in order. Little consideration, if any, was given to the developmental possibilities of
appraisal. If was felt that a cut in pay, or a rise, should provide the only required impetus for an
employee to either improve or continue to perform well. In many organizations - but not all - appraisal
results are used, either directly or indirectly, to help determine reward outcomes. That is, the appraisal
results are used to identify the better performing employees who should get the majority of available
merit pay increases, bonuses, and promotions. These appraisal results are used to identify the poorer
performers who may require some form of counseling or in extreme cases, dismissal or decreases in
pay.

3.7.1 Basic Purposes

Performance appraisal systems contain two basic systems operating in conjunction.

 evaluation system

 feedback system

The main aim of the evaluation system is to identify the performance gap. This gap is the shortfall that
occurs when performance does not meet the standard set by the organization as acceptable. The main
aim of the feedback system is to inform the employee about the quality of his or her performance.

3.7.2 Appraisal Methods

The three most common appraisal methods in general use are

 Rating scales

 Essay methods

 MBO methods

3.7.2.1 Rating Scales

The rating scale method offers a high degree of structure for appraisals. Each employee trait or
characteristic is rated on a bipolar scale that usually has several points ranging from poor to excellent.

The traits assessed on these scales include employee attributes such as co-operation, communications
ability, initiative, punctuality and technical skills. The nature and scope of the traits selected for
inclusion is limited only by the imagination of the scale's designer.

The one major provision in selecting traits is that they should be in some way relevant to the appraisee's
job. The traits selected by some organizations have been unwise and have resulted in legal action on the
grounds of discrimination.

Advantages

The advantage of rating scales are

 Structured and standardized.

 Encourages equality in treatment for all appraisees

 Easy to use and understand.

Disadvantages

The disadvantages of rating scales are

 Irrelevant rating-scale traits of appraises

 Assumption that all the true and best indicators of performance are included and all
false and irrelevant indicators are excluded.

 Perceptual Errors

This includes various well-known problems of selective perception as well as problems of perceived
meaning. Selective perception is the human tendency to make private and highly subjective assessments
of what a person is really like and then seek evidence to support that view. An example is the supervisor
who believes that an employee is inherently good (halo effect) and so ignores evidence that might
suggest otherwise. Instead of correcting the slackening employee, the supervisor covers for them and
may even offer excuses for their declining performance. On the other hand, a supervisor may have
formed the impression that an employee is bad (horns effect). The supervisor becomes unreasonably
harsh in their assessment of the employee, and always ready to criticize and undermine them.

 Problems of perceived meaning

This occurs when appraisers do not share the same opinion about the meaning of the selected traits and
the language used on the rating scales.

 Rating Errors

3.7.2.2 Essay Method

In the essay method approach, the appraiser prepares a written statement about the employee being
appraised. The statement usually concentrates on describing specific strengths and weaknesses in job
performance. It also suggests courses of action to remedy the identified problem areas. The statement
may be written and edited by the appraiser alone, or it be composed in collaboration with the appraisee.

Advantages

 Less structured than rating scale method.

 Examines relevant attribute of performance.

 freedom of expression

Disadvantages

 Time-consuming

 Difficult to administer.

 Through freedom of expression appraisers can upset and distort.

 Difficult to compare and contrast the results of individuals

3.7.2.3 MBO (Management By Objectives)

MBO methods of performance appraisal are results-oriented ie, they seek to measure employee
performance by examining the extent to which predetermined work objectives have been met. Usually
the objectives are established jointly by the supervisor and subordinate.
An example of an objective for a Production manager might be: Increase the production volume to
15000 units by 30 November.

Once an objective is agreed, the employee is usually expected to self-audit; that is, to identify the skills
needed to achieve the objective. Typically they do not rely on others to locate and specify their strengths
and weaknesses. They are expected to monitor their own development and progress.

Advantages

 Concentrates on actual outcomes.

 Employees are judged according to real outcomes and not on their potential for success

 Results can be observed whereas the traits and attributes of must be guessed at or inferred.

 Recognizes the fact that it is difficult to neatly dissect all the complex and varied elements that
go to make up employee performance.

Disadvantages

 Leads to unrealistic expectations about what can and cannot be reasonably accomplished.

 Inflexible objectives to survive by the organization.

3.8 Benefits of Appraisal

 Appraisal offers a valuable opportunity to focus on work activities and goals, to identify and
correct existing problems and to encourage better future performance. Thus the performance of the
whole organization is enhanced.

 Performance appraisal can have a profound effect on levels of employee motivation and
satisfaction for better as well as for worse.

 Performance appraisal offers an excellent opportunity perhaps the best that will ever occur - for
a supervisor and subordinate to recognize and agree upon individual training and development needs.

 Appraisal data can be used to monitor the success of the organization's recruitment and
induction practices.

3.9 PROMOTIONS, TRANSFERS AND SEPARTIONS

The movement of personnel within an organization is their promotion, transfer, demotion and
separation. These are the major aspects of human resource management.
3.9.1 PROMOTIONS

Promotion is the shift of an employee from one position to another having more responsible duties or
involving more skill (higher classification). To be promoted, the employee must meet the qualification
required by the new position. Provisions will be made by each institution to provide opportunities for
promotion. Promotions are most significant way to recognize superior performance. So this is to be fair
and based on merit and untainted by favoritism. Even if it is fair, it creates a number of problems.

1. Employees who bypassed for promotion feel resentful which may affect their morale and
productivity.

2. Discrimination against women, older employees and minority groups in promotion.

3.9.2 TRANSFERS

Transfer is defined as the reassignment of an employee without examination from one position to another
position in the same class or to a position in a similar or related class with the same salary range.
Transfers are used to give people to broader their job experiences as their part of development. This is
mainly done to fill vacancy. Many times inadequately performing employees may be transferred to
other jobs simply because a senior manger is reluctant fire them. Some employees are refusing transfers
because they do not want to move their families.

3.9.3 SEPARATION

Separation means that a person is leaving active duty, but not necessarily leaving the service entirely.

Resignation:

Employees who voluntarily resign from organization normally expected to give at least one month prior
notice. The notice is to be written and should include the specific reason for the resignation as well as
the proposed separation date.

Dismiss

Before dismissing an employee, employer must be aware of potential allegation of wrongful dismissal if
required, seek legal advice and advise employee of dismissal in private with the help of witness present
and provide copies of documentation, if requested (written warnings, company policy and performance
appraisals)

Lay off

Lay off is the separation from a permanent position because of lack of work or lack of funds, or because
the position has been abolished or reclassified, or because an employee has exhausted all leave
privileges after illness or injury.

SUMMARY

Employers usually find advantageously to use internal promotion and transfer to fill vacancies because
it rewards employees for past performance and send signal to other employees that their future efforts
will pay off. Outside sources for recruitment are especially useful for filling jobs with special
qualifications and to acquire individuals with new skills, ideas, and perspectives. Interviews are
customarily used in conjunction with application forms, biographical information blanks, references,
background investigations, medical examinations, cognitive ability tests, job knowledge tests, and work
sample tests. The interviews can be unstructured, wherein the interviewer is free to pursue whatever
approach and sequence of topics might seem appropriate.

In addition to provide training needed for effective job performance, employers offer training in such
areas as personal growth and wellness. Managers must establish a context for training by deciding
where training is needed, how it connects with strategic goals, and how organizational resources can
best be used. On-the-job and off-the-job are used to train of non managerial personnel by apprenticeship
training and classroom training respectively.

Performance appraisal programs serve many purposes, but in general those purposes can be clustered
into two categories: administrative and developmental. The administrative purposes include decisions
about who will be promoted, transferred, or laid off. Developmental decisions include those related to
improving and enhancing an individual‘s capabilities.

a. What are some possible causes of this anxiety?

b. How may the anxiety be reduced?

2. Indicate what training methods you would use for each of the following jobs. Give
reasons for your choices.

File clerk, computer operator, pizza maker

3. What are the major purposes of performance appraisal?

4. Describe the relationships among performance appraisal and selection, training and
development.
 CHAPTER 4

QUALITY MANAGEMENT
SCOPE OF THE COURSE

After reading chapter 4, you should be able to:

 Explain Deming‘s 14 points on quality

 Outline the principles of quality management

 Understand TQM

 Understand benchmarking process

 Understand need of ISO 9000

INTRODUCTION

4.1 Definition

Quality management is the policy and associated procedures, methods and standards required for the
control of projects. The purpose of quality management is to increase certainty by reducing the risk of
project failure. It also provides the opportunity for continuous improvement.

4.2 Deming’s 14 points

Point 1: Create constancy of purpose toward improvement of the product and service so as to become
competitive, stay in business and provide jobs.

One management concern must be to deal with running the business on a day-to-day basis and the other
must be to look after the future of the business. The latter requires constancy of purpose and dedication
to improvement. Top management must spend time to innovate, put resources into research and
education, constantly improve the design of the product and service, and put resources into maintenance
of equipment, furniture and fixtures.

In this point Deming is thus condemning 'short-termism'.

Point 2: Adopt the new philosophy. We are in a new economic age. We no longer need live with
commonly accepted levels of delay, mistake, defective material and defective workmanship.

Deming's new philosophy is simple. The levels of error that could be tolerated yesterday cannot be
tolerated today. Deming stresses that only management is in the position to do something about the vast
majority of errors and it is management's task to remove the obstacles that prevent the worker from doing
the job correctly.

Point 3: Cease dependence on mass inspection; require, instead, statistical evidence that quality is built
in.

The problem with mass inspection is that it is an attempt to control the product rather than the process,
and in any case, mass inspection is frequently subject to high levels of inaccuracy. In short, it is too late,
ineffective and costly.

Point 4: Improve the quality of incoming materials. End the practice of awarding business on the basis
of a price alone. Instead, depend on meaningful measures of quality, along with price.

Many of the problems of poor quality and low productivity are due to the poor quality of incoming
materials and the low quality of tools and machines.

Point 5: Find the problems; constantly improve the system of production and service. There should be
continual reduction of waste and continual improvement of quality in every activity so as to yield a
continual rise in productivity and a decrease in costs.

Point 6: Institute modern methods of training and education for all. Modern methods of on-the-job
training use control charts to determine whether a worker has been properly trained and is able to
perform the job correctly. Statistical methods must be used to discover when training is complete.

Point 7: Institute modern methods of supervision. The emphasis of production supervisors must be to
help people to do a better job. Improvement of quality will automatically improve productivity.
Management must prepare to take immediate action on response from supervisors concerning problems
such as inherited defects, lack of maintenance of machines, poor tools or fuzzy operational definitions.

It is part of a supervisor's job to coach the people that are being supervised.

Point 8: Fear is a barrier to improvement so drive out fear by encouraging effective two-way
communication and other mechanisms that will enable 'everybody to be part of change, and to belong to
it'. Fear can often be found at all levels in an organisation: fear of change, fear of the fact that it may be
necessary to learn a better way of working and fear that their positions might be usurped frequently
affect middle and higher management, whilst on the shop-floor, workers can also fear the effects of
change on their jobs. The results of fear can be seen in inspection: operators may record incorrectly the
results of inspecting their own work for fear of exceeding the quota of allowable defects and inspectors
may falsify results to avoid the wrath of their colleagues.

Point 9: 'Break down barriers between departments and staff areas. People in different areas such as
research, design, sales, administration and production must work in teams to tackle problems that may
be encountered with products or service'.

Barriers result in sub optimisation as each area tries to do what is best for itself rather than co-operating
in order to achieve what is good for the organisation as a whole. Deming points out that one clear
symptom of sub optimisation is proliferation of paperwork. Quoting studies that show that 14 per cent of
freight charges are spent on paperwork.

Point 10: 'Eliminate the use of slogans, posters and exhortations for the work force, demanding zero
defects and new levels of productivity without providing methods. Such exhortations only create
adversarial relationships; the bulk of the causes of low quality and low productivity belong to the
system, and thus lie beyond the power of the work force'.

Although Deming is portrayed by some authors as being against the use of all posters, he does spell out a
type of poster that he feels would be useful.

Posters that explain to everyone on the job what the management is doing month by month to (for
example) purchase better quality of incoming materials from fewer suppliers, better maintenance, or to
provide better training, or statistical aids and better supervision to improve quality and productivity, not
by working harder but by working smarter, would be a totally different story, they would boost morale.
People would then understand that the management is taking some responsibility for hang- ups and
defects. and is trying to remove obstacles?

Point 11: 'Eliminate work standards that prescribe numerical quotas for the work force and numerical
goals for people in management. Substitute aids and helpful leadership; use statistical methods for
continual improvement of quality and productivity'.

Joiner and Scholtes cite examples that support Deming's argument against such schemes as
management by objectives (MBO) and management by results (MBR): An electronics firm typically
ships 30% of its production on the last day of the month. Why? In order to meet the monthly shipment
quota. How? By expediting parts from around the country, by moving partially completed instruments
ahead of their place in line and, occasionally, by letting quality standards slip.

Another firm sometimes ships incomplete instruments. A service representative then flies around the
country installing the missing parts. The shipment quota for the month is met again. Profits, at least on
paper, hold firm.

A chemical plant reports it cannot efficiently run at the mandated inventory levels, so it keeps
inventories higher until June 30 and December 31 when inventories are measured. For those days, it
depletes the inventories to an acceptable level, perhaps losing two days production as a consequence.

Many managers annually negotiate safe goals and manage to exceed them, just barely. Some managers
include on their list of negotiable goals [figures] which were already secretly accomplished prior to the
negotiations.

Production which exceeds the standards is stored so it can be pulled out and used another day.

Joiner and Scholtes also cite the following entertaining example, which we suspect might be
apocryphal:

It is interesting to note that Management by Control is widely used in the Soviet Union. Typical is this
story. Several years ago there was a surplus of large nails and a shortage of small ones. Why? Managers
were held accountable for the tons of nails produced. Later the control was changed to the number of
nails produced. This led to a shortage of large nails, since the smaller nails gave higher counts. Neave
cites an example taken from Deming of what should be done instead of using the types of control based
on arbitrary targets which Deming claims do not work:

Christine had a job with an airline, answering the telephone to give information and to make reservations.
She had just been told to increase her number of calls to 25 per hour... Deming [suggested] what could
be done to improve matters. Christine could classify the type of call (information, reservation, our
airline, other airlines, etc.). The times for the various types of calls could be automatically recorded. The
processes involved in these various strata could be examined to see if they were stable or not; if not,
special causes could be identified and appropriate actions taken. Once the processes were stabilised, data
could be analysed to better understand common causes of variation, and then maybe systems (computer
information systems, documented information, etc.) could be improved so that Christine could deal with
her calls more efficiently and thus satisfy more customers per hour. This approach would be far more
effective, and it would not demoralise her or her fellow-workers. This is not now shooting for arbitrary
goals, but is shooting instead for continual improvement.

Point 12: Remove the barriers that rob hourly workers, and people in management, of their right to pride
of workmanship. This implies, abolition of the annual merit rating (appraisal of performance) and of
management by objective. Again, the responsibility of managers, supervisors, foremen must be changed
from sheer numbers to quality.

Deming claims that the system of reward used in many organisations is one of the main constraints that
prevent them from developing a 'win-win' culture.

Point 13: 'Institute a vigorous programme of education, and encourage self- improvement for everyone.
What an organisation needs is not just good people; it needs people that are improving with education.
Advances in competitive position will have their roots in knowledge'.

Point 14: Top management's permanent commitment to ever-improving quality and productivity must
be clearly defined and a management structure created that will continuously take action to follow the
preceding 13 points.

Deming stresses that the emphasis must be on action by top management, not just support.

4.3 The Quality Management Principles

With growing global competition, Quality Management is becoming increasingly important to the
leadership and management of all organizations. Quality Management Principles provide understanding
of and guidance on the application of Quality Management. By applying following eight Quality
Management Principles, organizations will produce benefits for customers, owners, people, suppliers
and society at large. The standard could be found at ISO 9000.

Principle 1 - Customer-Focused Organization

Organizations depend on their customers and therefore should understand current and future customer
needs, meet customer requirements, and strive to exceed customer expectations.

Principle 2 - Leadership

Leaders establish unity of purpose and direction of organization. They should create and maintain the
internal environment in which people can become fully involved in achieving the organization's
objectives.

Principle 3 - Involvement of People

People at all levels are the essence of an organization and their full involvement enables their abilities to
be used for the organization's benefit.

Principle 4 - Process Approach

A desired result is achieved more efficiently when related resources and activities are managed as a
process.

Principle 5 - System Approach to Management

Identifying, understanding, and managing a system of interrelated processes for a given objective
improve the organization's effectiveness and efficiency.

Principle 6 - Continual Improvement

Continual improvement should be a permanent objective of the organization.

Principle 7 - Factual Approach to Decision Making

Effective decisions and actions are based on the analysis of data and information.
Principle 8 - Mutually Beneficial Supplier Relationships

An organization and its suppliers are independent, and a mutually beneficial relationship enhances the
ability to create value.

Definition of Quality Management Principle:

―A comprehensive and fundamental rule or belief, for leading and operating an organization, aimed at
continually improving performance over the long term by focusing on customers while addressing the
needs of all stakeholders‖.

4.4 Total Quality Management (TQM)

TQM is a common approach to implementation of the programmes for quality improvement within an
organization; the way of managing the organization focused on quality, based on participation from all
the members of the organization fulfilling the users‘ needs and aiming at long term success and well
being of all the members of the organization and the social community;

Tools

Tools & Techniques, Benchmarking

ISO 9000

Quality Function Deployment Statistical Process Control

4.4.1 What is Benchmarking?

The term benchmarking was originally used by early land surveyors, who used the term to identify a
fixed point from which all other measurements are made. In the late 1970's however, it took a broader
meaning. Applied to an organization, benchmarking is a process to determine who else does a particular
activity the best and emulating what they do to improve performance. A more formal definition is

"simply the systematic process of searching for best practices, innovative ideas and highly effective
operating procedures that lead to superior performance."

Businesses such as AT&T, Motorola, Xerox, as well as most major corporations and many smaller ones
have embraced benchmarking as standard operating procedure since the mid- to late 1980's. It has a
particular significance in technology, where the rapid change of the business climate can leave a
company out in the cold. However, governmental and non-profit organizations have begun
implementing benchmarking as late as the early 1990's.

The issue of government benchmarking was among many in Vice-President Gore's National Partnership
for Reinventing Government Report (NPR). The report states that "federal agencies have been
reinventing their operations to become more businesslike, many have been benchmarking against
worldclass private sector companies, other organizations, and other federal agencies that have become
really good at what they do (2)." This led to the Federal Benchmarking Consortium Study Report in
February 1997. It is being used by agencies such as the EPA and NASA, as well as the City of Reno and
the Salt Lake City and various other federal, state, and local government agencies to improve their
procedures and practices.

Benchmarking is both different and similar in ways to other types of business improvement practices.
These practices include total quality management (TQM), reengineering, and performance
measurement.

Benchmarking vs. TQM

Total Quality Management, or TQM for short, consists of three main points (3). First, collaboration with
suppliers to ensure that the supplies utilized in work processes are well designed and fit for use. Second,
taking continuous employee analysis of work processes to improve their functioning and reduce process
variation. Third, maintaining close communication with customers to identify and understand what they
want and how they define quality.

TQM works by either one of two processes, consultant-oriented TQM or project- oriented TQM.
Consultant-oriented TQM typically involves the creation of separate quality control bodies that oversee
the implementation of improvement and the control of quality improvement procedures. This process is
generally problematic in the public-sector because the TQM bodies exist outside the chain of command,
confusing accountability. These bodies often fail to become a part of the hierarchical structure of
government organizations. In project-oriented TQM, some of the shortcomings of consultant-oriented
TQM are addressed. This entails including all employees in the process and including their needs as
well as the customer's, as well as using established procedures as a foundation instead of implementing
new ones.

In general, TQM uses internal methods and the ideas of people within an organization to improve itself
from the inside out. This does not include comparing one's organization to that of another, which is
critical in benchmarking. However, due to the potential unwillingness of employees to accept ideas
without understanding their logic, both TQM and benchmarking require the input of everyone in an
organization and a general resistance to change must be overcome.

Benchmarking vs. Reengineering

Another type of method of performance review and improvement is reengineering. Reengineering has
been defined as "the fundamental rethinking and radical redesign of business processes to achieve
dramatic improvements in contemporary measures of performance, such as cost, quality, service, and
speed (4)." This generally involves discarding old practices with completely new ones. The new
practices are usually determined from a process that requires a team and consultant to come up with,
measure, and convince others to take up new ideas.

Reengineering can be problematic in government because they are don't have profits and completely
discarding old processes and breaking down barriers between departments run into political, trade
union, or other pressures. This sometimes results in the creation of new agencies rather than
overhauling old ones. Reengineering is very expensive and prone to failure rates in over fifty percent of
cases. It also requires TQM after its successful implementation.

While reengineering is cutting-edge and dramatic, and encourages employees to think big, it is still an
internal process. It does not involve the practices of one organization to compare itself to those of
another. While benchmarking may result in the use of completely new ideas similar to reengineering, it
often is simply improving on existing ones. In addition, after performing reengineering, organizations
often turn to TQM, to maintain their success.

Benchmarking vs. Performance Measurement

―Performance Measurement is government's way of determining whether it is providing a quality

product at a reasonable cost (5).‖ In fact, more than half of all

U.S. cities collect performance measures of some type (6). Performance measurement is also used in
both government and the private sector for reporting to management.

Performance measurement can be used to measure such things as productivity, effectiveness, quality,
and timeliness. When performance measures are used extensively and consistently they can be quite
effective improving an organization‘s output. Government agencies used for the following reasons (7):

• Better decision-making: it provides managers with information to perform their management

control functions;

• Performance appraisal: it links both individual and organizational performance to aspects of

personnel management and motivates public employees;

• Accountability: it fosters responsibility on the part of managers;

• Service delivery: Improvements in public service performance;

• Public participation: clear reporting of performance measures can stimulate the public to take a
greater interest in and provide more encouragement for government employees to provide quality
services; and

• Improvement of civic discourse: it helps to make public deliberations about service delivery more
factual and specific.

What benchmarking does is to use data collected as performance measures and compare it to other
organizations that perform those duties or processes. By comparing to other organizations through
benchmarking, performance measurement becomes something other than "bean counting". However,
since performance measurement is a prerequisite to benchmarking, the two have become intertwined, but
they are not the same.

Summary Table 4.1 Comparison

TQM Performance Re-engg Benchmarking

Measurement

Focus Internal Internal Internal External

Main Develop dialogue Take measurements for Develop Compare processes with
Principles within a process to comparison and completely new others who do the same and
improve it through improvement methods for determine best
gradual increments obsolete or failing methods
processes

These processes can be thought of as the following situation. An organization is seeking improvement.
First, it takes performance measures and determines what processes need to be improved. Then, TQM
can be employed to improve these processes internally. In addition, an organization may look beyond
itself to other organizations for insight, and benchmark. If both TQM and benchmarking are not enough
of an improvement, an organization may seek re-engineering, and restructure the whole process. In any
case, performance measurement and TQM will need to be employed to insure that the processes
developed remain at the proper levels. Finally, the whole process will need to be repeated as new
improvements are needed.

4.4.1.2 The History of Benchmarking

Brief History

G.H. Watson outlines the development of benchmarking in five phases (8):

Phase 1 1950-1975 Reverse Engineering

Phase 2 1976-1986 Competitive Benchmarking
Phase 3 1982-1988 Process Benchmarking
Phase 4 1988+ Strategic Benchmarking
Phase 5 1993+ Global Benchmarking

Reverse engineering was tearing things apart, examining them, improving them, and putting them back
together. Benchmarking really began in its modern form with the introduction of competitive
benchmarking began with Rank Xerox, and its implementation of benchmarking in beginning around
1976. This was followed by process benchmarking which included looking for ideas outside of the
direct competition. Strategic benchmarking involves fundamentally changing the business, not just the
process (9). Global Benchmarking is the newest and involves comparing your organization on a global
scale.

The Xerox Case

In the 1970s, Xerox was the largest manufacturer of copiers in the world. However, Japanese
manufacturers were making better copiers, selling them for less, and making a good profit. This
prompted the company to directly compare itself with its direct and best competitors to determine what
it could do to increase productivity while decreasing costs.

The results from their benchmarking were astonishing. They found (10):

• Xerox's ratio of indirect to direct staff was twice that of direct competition;

• It had nine times the number of production suppliers;

• Assembly line rejects were in the order of ten times worse;

• Product time to market was twice as long;

• Defects per 100 machines were seven times worse.

However, Xerox's Japanese joint venture, Fuji Xerox, was performing well. The problem was large, and
forced some changes.

Over the next five years, Xerox would have to increase productivity 18% to keep up with its
competitors. It did this through a strategy known as leadership through quality, which became the
foundation of the revival of the company. For example, Xerox benchmarked L.L. Bean, a Maine
outdoor sporting goods retailer, because of their excellent warehouse procedures that are now the
standard at most companies. It also benchmarked almost 230 performance areas by the time it won the
Malcolm Baldridge National Quality award in 1989 (11).

Public Sector Cases

Due to the relative infancy of benchmarking in the public sector, results of many cases are still not fully
known. The demand for better for less has many taxpayer wanting a government that acts like a
business, and treats them as a paying customer. In and age when everything is available at the click of a
mouse or a swipe of a card, no one wants a government full of red tape and long waits.

A couple of early federal examples are the Bureau of the Census and the IRS. The Bureau of Census set
up four teams that were each to do a specific task. One team withdrew due to a lack of support from
team members. Yet another withdrew because it could not find sponsors. A third team took a very
informal approach that proved of little use. Only one team finished, but it proved difficult to even find a
room to meet and get all the team members to be there at the same time.

The IRS, however, succeeded in benchmarking its information system. The IRS hired outside
consultants. They started by speaking to top IRS executives. Then the executives showed managers
examples in benchmarking. The managers then decided what to benchmark. This was followed by
literature review and outside contacts. Finally, using a method similar to Xerox‘s they benchmarked
four areas (12). These included software measurement, picking and packing in form distribution centers,
personnel recruitment and retention, and assistance at walk-in taxpayer sites. As a best-in-class
performer, the Ogden, Utah site was emulated for its recognized service record. It went so well, that they
now require a benchmarking study as part of standard methodology (13).

Successful benchmarking was done by NASA in the early 1990s as well. NASA conducted 47 separate
benchmarking studies. They have been so successful that other federal agencies have turned to NASA for
help in benchmarking.

Government benchmarking also reached state and municipal levels. States such as Maryland and
Oregon benchmark various agencies very well. Municipalities that have benchmarked successfully
include Reno, Boston, Salt Lake City, and Indianapolis. Reno, frustrated by traffic accidents,
benchmarked survey techniques from Harrah‘s Casino Hotels. After surveying residents and noting
complaints, Reno Police were able to write fewer tickets while lowering the number of accidents by
twenty percent (14). As a result, the department‘s approval soared from forty percent to ninety percent.

Growth and Demand

As mentioned earlier, benchmarking is a standard tool for most private sector companies. However, in
the case of government, it is growing very rapidly. Many agencies and organizations nationwide and
worldwide are beginning to look at benchmarking as a tool to help them achieve better results for less.
This can be much easier in government in some cases because sharing information is "the cheapest and
most efficient, effective, and compelling means for improvement performance (15)."

Advantages:

Benchmarking has many advantages which will be discussed in this section. Rank Xerox's experience
with benchmarking led them to the following benefits (16):

• Benchmarking brings out the newness and innovative ways of managing operations.

• It is an effective team building tool.

• It has increased general awareness of costs and performance of products and services in relation to
those of competitor organizations.

• It brings together all the divisions and helps to develop a common front for facing competition.

• It highlights the importance of employee involvement and, as such, encourages recognition of

individual/team efforts.

These illustrate the benefits of competitive benchmarking, which is used in both the business sector and
the public sector. Some of the advantages that will be discussed here are team building,
comprehensibility, flexibility, creativity, and evolution.

Team Building

Benchmarking cannot be successful without the full involvement of everyone in contact with a project.
It creates a united front for an organization and gives those who work within it a common goal to
accomplish. It also includes the ideas and concerns of those affected.

Along with good work on such a project comes recognition. As mentioned there are several awards for
an organization to receive. Within an organization may be yet more awards for individuals, teams, or
agencies that have exemplary performance. This is achieved by setting goals, then meeting, or
exceeding them.

Comprehensibility

Unlike some methods, benchmarking is easy to understand. This is due largely to the fact that
benchmarking produces a direct comparison to another organization. After determining whom to
follow, you study what they do, and emulate it. There is no misunderstanding of the overall goal of
being the best.

Flexibility

Benchmarking is flexible and can be interdisciplinary. Benchmarking can be used on almost any
organization, public, private, or, non-profit. It can be fitted to a large multinational corporation or a local
shop, from a federal agency to the government of a small village.

Identifying the best does not necessarily mean that a competitor has the best solution. It may be a
company who just does something well. When Rank Xerox needed to make its shipping better, it relied
on L.L. Bean. This sort of out-of-the-box thinking can create new standards rather than emulating
someone else's practices.

Creativity

Sometimes an organization might know where their goals are, but the path to meet them is not clear.
Furthermore, even if another organization is perceived to be doing something the best, it does not mean
it couldn't be done better. After clearly defining goals, however, it can be easier to come up with new,
innovative ways of getting there. It could also create news ways of obtaining information or making
partnerships, such as Remington, a shotgun shell manufacturer, getting information on how to make
shinier shells from Maybelliene‘s lip stick containers.

Evolution

Benchmarking evolves with the consumer and doesn't require a large up-front cost. As things change in
the world, so does who is the best. Because benchmarking involves constant reiteration, evaluating and
changing, it changes as the market or consumer does. Although benchmarking is constantly in change, it
isn't a big price tag up-front. All one needs are office supplies and a list of the best performers to get
started.

Disadvantages:

Benchmarking can require a large investment in time, labor, and capital. Costs for a large project can
easily reach into the hundreds of thousands of dollars. These can be minimized through careful,
thoughtful, and deliberate planning. As Robert Graham of Medrad notes, ―Typically, there are expenses
related to travel as well as indirect costs associated with employee time devoted to trips and team
meetings. With careful planning benchmarking costs can be kept to a minimum (17).‖

Size

The size and scope of a benchmarking project is related directly to the cost. An easy way to minimize
costs is to take on a stepwise approach. This minimizes the amount of investment and risk taken
concurrently.

Dividing Costs

Organizations can pool resources by taking joint benchmarking projects and dividing costs accordingly.
This is more easily done in organizations that are not directly competing, such as government agencies.
Various organizations have pooled their resources and knowledge into benchmarking groups.

Consultants

Many consultant firms will also aid an organization in a benchmarking project. These organizations have
the technical knowledge and experience to more efficiently gather and interpret data. Careful
background research of a consultant must be made to make this process more effective and it comes at a
price. However, this does not require hiring additional staff or expanding roles of current staff.

Education and Travel

Benchmarking does require education and travel costs. Once a team is chosen, they often need to be
educated on the methods of benchmarking. This is accomplished through workshops, seminars,
meetings, and courses. Then, this information must be disseminated to others. When researching
organizations, sometimes it is best to see the organization in action and meet with the team that
performed and implemented the changes to gain first-hand knowledge of the processes involved.

Communication

One of the most important methods of keeping benchmarking costs low is effective communication.
This involves knowing what you need and where your own deficiencies are and sharing information
about yourself. Also, informing others inside of your organization of what has been learned through
reports, analyses, etc. and its method of implementation involving flowcharts, matrices, schematics, etc.
is critical. Clear communication also lets management know how the project is going and its status. This
reduces confusion and conflicts among management and the team and among team members
themselves.

Process:

Custom Fit

As mentioned earlier, benchmarking is flexible to almost any application. The process of how to go
about benchmarking varies as much as organizations themselves and their ideologies do. Processes vary
widely by goals, philosophies, industry, cultures, management plan, and organizational structure. This
section will explain some of the explicit processes developed by companies that have benchmarked.
The most general and best for a first-try at benchmarking is the most general process, which is the
Motorola Five-Step Process described later. An experienced benchmarker such as Rank Xerox, use a
much more detailed process.

Rank Xerox Process

Rank Xerox revolutionized business thinking with its benchmarking plan. It had a clear goal and
determined upper management team. A five-phase, twelve-step process was developed by Robert C.
Camp, Manager of Benchmarking Competency Quality and Customer Satisfaction at Xerox (18):

Xerox Twelve-Step Process Phase 1: Planning

1. Identify what to benchmark

2. Identify comparative companies

3. Determine data collection method and collect data Phase 2: Analysis

4. Determine current performance gap

5. Project future performance levels Phase 3: Integration

6. Communicate findings and gain acceptance

7. Establish functional goals Phase 4: Action

8. Develop action plans

9. Implement specific actions and monitor progress

10. Recalibrate benchmarks Phase 5: Maturity

11. Attain leadership position

12. Fully integrate practices into processes

AT&T and Other Processes

Two-time, Baldrige Award winning AT&T, an active benchmarker, has developed a nine-step model
(19):

AT&T Nine-Step Process

1. Identify what to benchmark

2. Develop a benchmarking plan

3. Choose data collection method

4. Collect data

5. Choose best-in-class companies

6. Collect data during a site visit

7. Compare processes, identify gaps, and develop recommendations

8. Implement recommendations

9. Recalibrate benchmarks

Other processes have been developed such as the Motorola five-step process and the seven-step process
(20).

Motorola Five-Step Process

1. Decide what to benchmark

2. Find companies to benchmark

3. Gather data

4. Analyze data and integrate results into action plans

5. Recalibrate and recycle the process Seven-Step Process

1. Determine which function(s) to benchmark

2. Identify key performance variable to measure

3. Identify best-in-class companies

4. Measure performance of best-in-class companies

5. Measure your own performance

6. Specify programs and actions to meet and surpass

7. Implement and monitor results

SPI Five Phase Model

The model produced by the Strategic Planning Institute's (SPI) Council on Benchmarking produced the
Simple Consensus Model summarizing the five phases of benchmarking in generic terms. This can then
be mapped over the above-mentioned processes. These fives steps are:

Step Description 1 Launch

2 Organize

3 Reach Out

4 Assimilate

5 Act

These steps can then be "mapped" onto the Motorola Five-Step Process as follows : Table 4.2.Motorola
Five-Step Process

Description Launch Organize Reach Out Assimilate Act

 1. Decide what to benchmark x

2. Find companies to benchmark x

3. Gather the data x

4. Analyze data and integrate x

5. Recalibrate and recycle the process x

Readiness

Readiness is determining whether an organization is capable of starting and sustaining a benchmarking

process. There are five broad categories for assessing an organization's readiness for best practices.
These are (23):

 Benchmarking readiness deals with matching the benchmarking organization and its
benchmark partners on various dimensions.

 Culture readiness concerns the readiness of the benchmarking organization and its
environment for importing best practice.

 Implementation readiness covers activities that prepare the specific organizational

entity and the benchmark practice itself for implementation in the new setting.

 Operation readiness addresses the last and most enduring issues: those that monitor
the status and insure the successful ongoing operation of the practice once it is in place

 Technical readiness centers on the technical skills needed to conduct a benchmarking

study and to import a best practice.

Various techniques are used to determine whether an organization is ready. This can be accomplished
by asking questions or a scoring system.

4.4.2 ISO 9000

ISO 9000 - Benefits and Problems

ISO 9000 has received much publicity. Some managers see it as a prerequisite for conducting business.
For others, it substitutes for the difficulties and vagaries of Total Quality Management (TQM). Some see
only a needless bureaucratic boondoggle. Depending on the situation, any of these views might be
correct.

Sensibly applied, ISO 9000 is a qualifier for international markets or specific domestic customers.
Certification can be a valuable marketing tool. The standards are a sound blueprint for a quality system.
They can lead the way to the more difficult and sophisticated approaches of Total Quality Management.
ISO 9000 can improve a company's cost structure by 5%-20%.

Approached unwisely, ISO 9000 can be costly and unproductive. It may create a quality bureaucracy
which adds to the cost structure and slows product development. It can focus people on paperwork
instead of customers. It can divert management concentration and energy from more vital issues.

What Is ISO 9000?

The ISO 9000 standards define minimum requirements for business quality assurance systems. These are
"consensus standards" promulgated by the International Standards Organization in Europe and the
American National Standards Institute (ANSI) in the United States. The ANSI standards are officially
titled the "Q90" series. They are identical to the ISO 9000 series and people use the names
interchangeably.

Conformance is voluntary. However, many European firms use them as a requirement for suppliers.
Within the United States, some firms also use the standards for supplier certification.

ISO 9000 (Q90) is a guideline for selection and use of quality system standards. It provides insight for
various situations and conditions as well as definitions and explanations.

ISO 9001 (Q91) defines minimum quality system requirements for design/development, production,
installation and servicing. It is the most complete standard. It applies to manufacturing and service
businesses engaged in all these activities.

ISO 9002 (Q92) is essentially a subset of 9001. It applies only to production and installation activities.

ISO 9003 (Q93) applies to final inspection and test.

ISO 9004 (Q94) is a guideline for quality system elements. It is like a textbook which describes, explains
and recommends.

Requirements

The standards use proven management principles:

 Policy Definition
 Clear Responsibility & Authority

 Appropriate Documentation

 Corrective Action

 Capable People & Equipment

 Adequate Resources

Conformance requires that firms apply these principles to areas which impact quality. It further requires
consistent practice which is usually most difficult.

Under section 4.4, for example, ISO 9001 requires that product design projects should be planned, that
design input parameters shall be defined and at design completion, the resulting design is confirmed as
meeting the input requirements. It requires that the design, as well as any changes, be documented. The
standard also requires that design changes be approved by the organization or persons who made the
original design.

Experienced product design engineers recognize these requirements as common sense–– taken for
granted in successful design organizations. Product design disasters can usually be traced to violation of
one or more of the above requirements.

Certification

The American Society for Quality Control has organized a Registrar Accreditation Board (RAB). This
board oversees the training and activities of assessors and certify conformance. Certification is evidence
to customers, potential customers and others that a business meets the standard's requirements.

Assessors typically spend 1-3 days at a site. They examine documents, interview employees and
observe processes. They look for evidence to confirm compliance or non-compliance. To obtain
certification, a business may contract with an accredited assessor. An important customer may wish to
assess as part of their supplier certification. Management may wish a self-assessment for internal
evaluation.

Who Should Use ISO?

Any firm whose customers make their buying decisions on quality issues should consider using these
standards. Firms whose customers require conformance and certification as a qualifier will need a
certificate of conformance from an approved Assessor.

Firms who perceive quality as a marketing tool may obtain certification as part of their marketing
strategy.
In markets where quality is not a dominant issue firms may use the standards as a guide, but not attempt
certification.

Firms may use the standards for their own suppliers requiring certification as a condition of doing
business.

Implementation

An important implementation issue is speed. Most firms require 18 months or longer to achieve
certification. Another issue is the current state of quality. Those with severe quality problems may need
a maximum effort. Is certification necessary for your firm? Is the need urgent enough for a maximum
effort? Or should the standards be used internally for their intrinsic value?

The first step is awareness. Management must convince the organization that conformance is important.
People within the organization must know the basics.

Special purpose teams are an effective implementation tactic. They establish procedures and practices
for various parts of the organization or for certain requirements of the standard.

An especially important requirement of the standard is ongoing self-assessment. The authors consider
self assessment and correction as essential for continuing compliance.

Total Quality Management Fits

Total Quality Management emphasizes leadership, management, worker involvement, low-level

responsibility, process control and continuous improvement.

The standard requires clear responsibility and authority. It emphasizes decision procedures, their
documentation and implementation. The standards will enhance and complement either TQM or
conventional quality systems.

Conformance does not guarantee world-class quality. An organization can conform and still have a
mediocre output quality and a high quality cost.

Your Competitive Edge?

ISO 9000 can be many things to many organizations. For sound decisions, management should know
what it requires and, equally important, what it does not require. The implementation should consider
each firm's size, markets, and current quality position. A knowledgeable and experienced assessor is
vital.

For many firms, ISO 9000 can be part of a competitive edge. It can contribute to marketing, reduce
costs, and be a qualifier for certain markets or customers. It is a strong foundation for Total Quality
Management and Lean Manufacturing.

SUMMARY

Quality management is the policy and associated procedures, methods and standards required for the
control of projects. Deming‘s basic message is that cause of inefficiency and poor quality is the system,
not the people, and it is management's responsibility to correct the system to achieve desired results.
Quality Management principles provided understanding of and guidance on the application of Quality
Management. By applying eight Quality Management Principles, organizations will produce benefits
for customers, owners, people, suppliers and society at large.

Total Quality Management (TQM) is a common approach to implementation of the programmes for
quality improvement within an organization; the way of managing the organization focused on quality,
based on participation from all the members of the organization fulfilling the users‘ needs and aiming at
long term success. Benchmarking, a tool for TQM, is the systematic process of searching for best
practices, innovative ideas and highly effective operating procedures that lead to superior performance.
 CHAPTER 5
STRATEGIC PLANNING
SCOPE OF THE COURSE

After reading chapter 5, you should be able to:

 Explain use of strategic planning

 Outline the steps of strategic planning

 Define strategic management

 Understand chances of increasing strategic plan

INTRODUCTION

The objectives of strategic planning are including understanding the benefits of strategic planning;
understanding the products of strategic planning; and learning the keys to successful planning and
implementation. Many organizations spend most of their time reacting to unexpected changes instead of
anticipating and preparing for them. This is called crisis management. Organizations caught off guard
may spend a great deal of time and energy "playing catch up". They use up their energy coping with
immediate problems with little energy left to anticipate and prepare for the next challenges. This vicious
cycle locks many organizations into a reactive posture.

It does not have to be that way. A sensible alternative is a well tested process called strategic planning
which provides a viable alternative to crisis management.

Strategic planning is a step by step process with definite objectives and end products that can be
implemented and evaluated. Very simply, it is a process by which we look into the future, paint a picture
of that future based on current trends, and influence the forces that will affect us.

Strategic planning looks three to five years ahead. It charts a definite course based on strong indicators of
what the business environment will be like in those years.

Indicators include census demographic statistics, economic indicators, government policies, and
technological advances. They reveal strong trends regarding changes in lifestyles and the economic and
political climates, which are important factors influencing the facilities planning and management
industry. Some of these trends are potential opportunities, some potential threats, and some are both.
Examining the possibilities and formulating strategies to meet the challenges can help the organization
take full advantage of opportunities and minimize threats. In short, we can take control of the future.
We can use our energies and resources more effectively and conduct our business more successfully,
despite changes in the environment.

5.1 Why Strategic Planning?

Besides the personal satisfaction of taking charge of the organizations future, strategic planning offers at
least five compelling reasons for its use:

Forces a look into the future and therefore provides an opportunity to influence the future, or assume a
proactive posture.

Provides better awareness of needs and of the facilities related issues and environment.

Helps define the overall mission of the organization and focuses on the objectives.

Provides a sense of direction, continuity, and effective staffing and leadership. Plugs everyone into the
system and provides standards of accountability for people, programs, and allocated resources.

In summary, strategic planning is the key to helping us collectively and cooperatively gain control of the
future and the destiny of our organization.

5.2 Five Products of Strategic Planning

The overall goal of strategic planning is to produce a workable plan. Along the way, we will develop,
evaluate, and refine these five products:

Environmental issues and trends: Factors that may impact the organization and the way it conducts
business. Internal issues include staff, services, skills, resources, and needs. External factors include
such things as threats of outsourcing. A strategic planning committee compiles an environmental scan, a
body of information about the environment. Broad issues, singled out as potentially having significant
effect on the facilities planning and management industry, are referred to as mega issues.

Needs Survey: Provides information from clients and peer institutions. The prioritized needs and
expectations resulting from the survey are crucial as a basis for setting objectives.

Mission Statement: Defines the organization‘s fundamental reason for existence and establishes the
scope of its business.

General Objectives: Broadly describe the results of what the organization wants to achieve in light of
needs and relevant issues.

Strategies: Specific, measurable actions and directions designed to reach the objectives established.
Strategies are fulfilled through creation, continuation, change, or elimination of programs.
The mission statement, general objectives, and strategies are the meat of the plan. The issues and results
of the needs survey are the input into the plan, and they provide the basic assumptions for developing a
realistic and feasible plan.

5.3 Keys to Successful Implementation

Suppose our organization thoroughly develops all five products of strategic planning, completes the
process, and comes up with a strategic plan. Everyone has the best intentions but when we get back to
our units, we are overwhelmed with daily details. Soon it's "business as usual," the plan sits on the shelf,
and before we know it, another year has passed. However, this need not happen.

The three major keys to successful strategic planning and implementation are commitment, credibility,
and communication.

Up-front commitment by the leaders must include an adherence to the full and thorough process of
strategic planning. There must also be a commitment to implementing the strategies recommended by
the strategic planning committee. The leaders should implement programs and services and commit
allocations to meet the objectives of the strategic plan at a level that is "doable" for the organization and
level of activity. As one person has put it, "To commit to plan, is to commit to change." A strategic
planning committee researches, collects input, and makes recommendations. But, it is up to member of
the organization to implement the recommendations.

Credibility is created and maintained by following these three guidelines: representative participation,
adherence to the complete process, and clear documentation. The strategic planning committee should
have representatives from all areas of the organization and adhere to the steps of the process. While the
actual logistics of research and implementing the plan can be tailored to the available resources, all five
products should be carefully developed and evaluated.

The committee should document all of its research and activities to serve as the basis for the strategic
plan and its background materials. It will also serve as a clear record of the committee's activities open
for all to see and evaluate. There should be nothing exclusive or secret about strategic planning. It
should be open to all for review and input.

Input, feedback, and understanding are crucial at every step. A key concept to remember is that strategic
planning is a cooperative and participatory process. Everyone should have input and, ideally, everyone
should feel a sense of ownership over the final plan. Such personal commitment will facilitate the
implementation process.

It is important to explain the principles and goals of strategic planning to everyone in the organization.
We need to assure each person that although he or she may not be on the committee, everyone can have
input and evaluate the recommendations. It is up to the staff and committees to determine how to fulfill
each objective. The strategic planning committee makes general recommends on what they think should
be done. The leadership, operating committees, and staff determine how it will be done.

An additional aid to implement the strategic plan is to create an integrated system by which the strategic
plan becomes the "benchmark" (measuring stick) for progress in our organization. It then becomes a
system of accountability. The best way to set up an integrated system is for the directors to accept the
strategic plan and make the mission statement part of the directives. The strategic plan can then become
the context from which programs and services flow. Strategic planning is the key to assuring that our
organization is prepared for the challenges of tomorrow.

5.4 Basic steps in a strategic planning process

Strategic Planning Model

Many books and articles describe how best to do strategic planning, and many go to much greater
lengths than this planning response sheet, but our purpose here is to present the fundamental steps that
must be taken in the strategic planning process. Below is a brief description of the five steps in the
process. These steps are a recommendation, but not the only recipe for creating a strategic plan; other
sources may recommend entirely different steps or variations of these steps. However, the steps outlined
below describe the basic work that needs to be done and the typical products of the process. Thoughtful
and creative planners will add spice to the mix or elegance to the presentation in order to develop a
strategic plan that best suits their organization!

Step One - Getting Ready

To get ready for strategic planning, an organization must first assess if it is ready. While a number of
issues must be addressed in assessing readiness, the determination essentially comes down to whether an
organization's leaders are truly committed to the effort, and whether they are able to devote the
necessary attention to the "big picture". For example, if a funding crisis looms, the founder is about to
depart, or the environment is turbulent, then it does not make sense to take time out for strategic
planning effort at that time. An organization that determines it is indeed ready to begin strategic
planning must perform five tasks to pave the way for an organized process:

Identify specific issues or choices that the planning process should address Clarify roles (who does what
in the process)

Create a Planning Committee Develop an organizational profile

Identify the information that must be collected to help make sound decisions.

The product developed at the end of the Step One is a Workplan.

Step Two - Articulating Mission and Vision

A mission statement is like an introductory paragraph: it lets the reader know where the writer is going,
and it also shows that the writer knows where he or she is going. Likewise, a mission statement must
communicates the essence of an organization to the reader. An organization's ability to articulate its
mission indicates its focus and purposefulness. A mission statement typically describes an organization
in terms of its:

Purpose - why the organization exists, and what it seeks to accomplish

Business - the main method or activity through which the organization tries it fulfill this purpose

Values - the principles or beliefs that guide an organization's members as they pursue the organization's
purpose

Whereas the mission statement summarizes the what, how, and why of an organization's work, a vision
statement presents an image of what success will look like. For example, the mission statement of the
Support Centers of America is as follows:

The mission of the Support Centers of America is to increase the effectiveness of the nonprofit sector
by providing management consulting, training and research. Our guiding principles are: promote client
independence, expand cultural proficiency, collaborate with others, ensure our own competence, act as
one organization.

We envision an ever increasing global movement to restore and revitalize the quality of life in local
communities. The Support Centers of America will be a recognized contributor and leader in that
movement.

With mission and vision statements in hand, an organization has taken an important step towards
creating a shared, coherent idea of what it is strategically planning for.

At the end of Step Two, a draft mission statement and a draft vision statement is developed.

Step Three - Assessing the Situation

Once an organization has committed to why it exists and what it does, it must take a clear-eyed look at
its current situation. Remember, that part of strategic planning, thinking, and management is an
awareness of resources and an eye to the future environment, so that an organization can successfully
respond to changes in the environment. Situation assessment, therefore, means obtaining current
information about the organization's strengths, weaknesses, and performance - information that will
highlight the critical issues that the organization faces and that its strategic plan must address. These
could include a variety of primary concerns, such as funding issues, new program opportunities,
changing regulations or changing needs in the client population, and so on. The point is to choose the
most important issues to address. The Planning Committee should agree on no more than five to ten
critical issues around which to organize the strategic plan. The products of Step Three include: a data
base of quality information that can be used to make decisions; and a list of critical issues which
demand a response from the organization - the most important issues the organization needs to deal
with.

Step Four - Developing Strategies, Goals, and Objectives

Once an organization's mission has been affirmed and its critical issues identified, it is time to figure out
what to do about them: the broad approaches to be taken (strategies), and the general and specific
results to be sought (the goals and objectives). Strategies, goals, and objectives may come from
individual inspiration, group discussion, formal decision-making techniques, and so on - but the bottom
line is that, in the end, the leadership agrees on how to address the critical issues.

This can take considerable time and flexibility: discussions at this stage frequently will require
additional information or a reevaluation of conclusions reached during the situation assessment. It is even
possible that new insights will emerge which change the thrust of the mission statement. It is important
that planners are not afraid to go back to an earlier step in the process and take advantage of available
information to create the best possible plan.

The product of Step Four is an outline of the organization's strategic directions - the general strategies,
long-range goals, and specific objectives of its response to critical issues.

Step Five - Completing the Written Plan

The mission has been articulated, the critical issues identified, and the goals and strategies agreed upon.
This step essentially involves putting all that down on paper. Usually one member of the Planning
Committee, the executive director, or even a planning consultant will draft a final planning document
and submit it for review to all key decision makers (usually the board and senior staff). This is also the
time to consult with senior staff to determine whether the document can be translated into operating
plans (the subsequent detailed action plans for accomplishing the goals proposed by the strategic plan)
and to ensure that the plan answers key questions about priorities and directions in sufficient detail to
serve as a guide. Revisions should not be dragged out for months, but action should be taken to answer
any important questions that are raised at this step. It would certainly be a mistake to bury conflict at this
step just to wrap up the process more quickly, because the conflict, if serious, will inevitably undermine
the potency of the strategic directions chosen by the planning committee.

5.5 Standard Format for a Strategic Plan

A strategic plan is a simply a document that summarizes, in about ten pages of written text, why an
organization exists, what it is trying to accomplish, and how it will go about doing so. Its "audience" is
anyone who wants to know the organization's most important ideas, issues, and priorities: board
members, staff, volunteers, clients, funders, peers at other organizations, the press, and the public. It is a
document that should offer edification and guidance - so, the more concise and ordered the document,
the greater the likelihood that it will be useful, that it will be used, and that it will be helpful in guiding
the operations of the organization. Below is an example of a common format for strategic plans, as well
as brief descriptions of each component listed, which might help writers as they begin trying to organize
their thoughts and their material. This is just an example, however, not the one and only way to go
about this task. The point of the document is to allow the best possible explanation of the organization's
plan for the future, and the format should serve the message.

The final document should include a table of contents. These are the sections commonly included in a
strategic plan:

I. Introduction by the President of the Board

A cover letter from the president of the organization's board of directors introduces the plan to readers.
The letter gives a "stamp of approval" to the plan and demonstrates that the organization has achieved a
critical level of internal agreement. (This introduction is often combined with the Executive Summary
below.)

II. Executive Summary

In one to two pages, this section should summarize the strategic plan: it should reference the mission
and vision; highlight the long-range goals (what the organization is seeking to accomplish); and perhaps
note the process for developing the plan, as well as thank participants involved in the process. From this
summary, readers should understand what is most important about the organization.

III. Mission and Vision Statements

These statements can stand alone without any introductory text, because essentially they introduce and
define themselves.

IV. Organization Profile and History

In one or two pages, the reader should learn the story of the organization (key events, triumphs, and
changes over time) so that he or she can understand its historical context (just as the planning
committee needed to at the beginning of the planning process).

V. Critical Issues and Strategies

Sometimes organizations omit this section, choosing instead to "cut to the chase" and simply present
goals and objectives. However, the advantage of including this section is that it makes explicit the
strategic thinking behind the plan. Board and staff leaders may refer to this document to check their
assumptions, and external readers will better understand the organization's point of view. The section
may be presented as a brief outline of ideas or as a narrative that covers several pages.

VI. Program Goals and Objectives

In many ways the program goals and objectives are the heart of the strategic plan. Mission and vision
answer the big questions about why the organization exists and how it seeks to benefit society, but the
goals and objectives are the plan of action - what the organization intends to "do" over the next few
years. As such, this section should serve as a useful guide for operational planning and a reference for
evaluation. For clarity of presentation, it makes sense to group the goals and objectives by program unit
if the organization has only a few programs; if some programs are organized into larger program groups
(e.g., Case Management Program in the Direct Services Program Group), the goals and objectives will
be delineated at both the group level and the individual program level.

VII. Management Goals and Objectives

In this section the management functions are separated from the program functions to emphasize the
distinction between service goals and organization development goals. This gives the reader a clearer
understanding both of the difference and the relationship between the two sets of objectives, and
enhances the "guiding" function of the plan.

VIII. Appendices

The reason to include any appendices is to provide needed documentation for interested readers. Perhaps
no appendices are truly necessary (many organizations opt for brevity). They should be included only if
they will truly enhance readers' understanding of the plan, not just burden them with more data or
complicating factors.

5.6 Increasing chances of implementing our strategic plan

Organizations and their leadership are often reluctant to commit time and resources to a planning process
because of the fear of the plan "ending up on the shelf." This article addresses a key question regarding
the strategic plan: What can I do to ensure the plan does not end up on the shelf? There are three areas
that must be addressed to ensure that the planning process and resulting strategic plan are valuable and
useful for the organization:

The process that is used to develop the plan can guarantee success or failure. Credibility and ease of use
are often direct results of how the plan was created. The format of the plan will influence how and when
people use the document in the workplace. Complex, outdated documents are doomed to remain on the
shelf.
Management's use and respect for the plan influences the acceptance for the rest of the staff and board
members. There is no reason for program directors to refer to established goals and objectives if the
executive director does not.

Ensuring the Plan Has Impact

During the strategic planning process, it is important to include the following process, content, and usage
elements to ensure the usefulness of the strategic plan to the organization.

Process Elements

Engage leadership

Include the informal and formal organizational leaders when conducting a process. Active involvement
communicates a message of organizational importance and priority.

Work from a common understanding

Provide training on the process and establish a list of expectations and results to ensure that everyone is
working towards the same outcomes.

Include individuals who will implement plan

Encourage all levels of staff to contribute to the process. Involving these individuals will ensure that the
plan is realistic and help motivate staff to implement the plan.

Address critical issues for the organization

Failure or unwillingness to put these critical issues on the table for discussion and resolution might lead
staff to implicitly or explicitly challenge the credibility of the plan, its priorities, and/or its leadership.

Agree on how the plan will be operationalized

Specify who will implement which parts of the plan, scheduling routine evaluation meetings to review
progress.

Content Elements

Include an internal and external focus

Remember to address structural, board/staff development, and communication issues in your plan.

Do not get too detailed

Use the strategic plan to articulate the broad framework, direction and, priorities of the organization and
its programs. Extremely specific plans become quickly outdated and end up on the shelf.

Create a balance between the dream and reality

Ensure that your plan is grounded in the reality of what can and cannot be accomplished.

Keep language, concepts and format simple

Make sure that the language is easy to understand, especially for those that are unfamiliar with your
organization. Structure the document so that it is user friendly.

Usage Elements

Actively use the plan as a management tool

Actively using the plan for short-term guidance and decision making will establish a model for use.

Incorporate sections of the plan in everyday management

Formalize the usage of the plan into the day-to-day activities of the organization. For example, one
organization reads the mission statement at the opening of every business meeting to remind the
membership of the organization's focus and purpose. In another organization, the executive director
requires that all ideas for program changes or expansion directly address how the changes relate to the
organization's mission.

Organize the work of the organization in the context of the plan

Establish operational goals and activities within the context of the strategic plan (e.g., include goals and
objectives in individual and program evaluations or have program directors refer to the plan to provide
guidance in decision making).

Design a system for controlling the process

Ensure that there are mechanisms (e.g., evaluation meetings, monthly reports against plan) to inform
management on progress.

By employing the strategies listed above, you can be sure that the effort you put into the strategic
planning process will direct your organization and become a useful tool to both management and staff.

SUMMARY

Strategic planning is a step by step process with definite objectives and end products that can be
implemented and evaluated. Very simply, it is a process by which we look into the future, paint a picture
of that future based on current trends, and influence the forces that will affect us. Environmental issues
and trends, needs Survey, mission Statement, general Objectives, and strategies are the five products of
Strategic planning.
 CHAPTER 6

MARKETING MANAGEMENT
SCOPE OF THE COURSE

After reading chapter 6, you should be able to:

 Define marketing and marketing management

 Explain the marketing management orientations

 Understand market segmentation

 Distinguish the types of product

INTRODUCTION

Today's successful companies at all levels have one thing in common: they are strongly customer
focused and heavily committed to marketing. These companies share a passion for understanding and
satisfying the needs of customers in well- defined target markets. They motivate everyone in the
organization to help build lasting customer relationships through superior customer value and
satisfaction.

6.1 WHAT IS MARKETING?

Marketing, more than any other business function, deals with customers. Building customer
relationships based on customer value and satisfaction is at the very heart of modern marketing. Although
we will soon explore more detailed definitions of marketing, perhaps the simplest definition is this one:
Marketing is managing profitable customer relationships. The twofold goal of marketing is to attract
new customers by promising superior value and to keep and grow current customers by delivering
satisfaction.

Sound marketing is critical to the success of every organization—large or small, for- profit or not-for-
profit, domestic or global.

You already know a lot about marketing—it's all around you. You see the results of marketing in the
abundance of products in your nearby shopping mall. You see marketing in the advertisements on your
TV, in your magazines, stuff in your mailbox. At home, at school, where you work, and where you play,
you see marketing in almost everything you do. Yet, there is much more to marketing than meets the
consumer's casual eye. Behind it all is a massive network of people and activities competing for your
attention and purchases.

In this chapter, we begin by defining marketing and its core concepts.

6.1.1 Marketing Defined

What does the term marketing mean? Many people think of marketing only as selling and advertising.
And no wonder—every day we are bombarded with television commercials, newspaper ads, direct-mail
offers, sales calls, and Internet pitches. However, selling and advertising are only the tip of the
marketing iceberg. Although they are important, they are only two of many marketing functions and are
often not the most important ones.

Today, marketing must be understood not in the old sense of making a sale—"telling and selling"—but
in the new sense of satisfying customer needs. If the marketer does a good job of understanding
consumer needs, develops products that provide superior value, and prices, distributes, and promotes
them effectively, these products will sell very easily. Thus, selling and advertising are only part of a
larger "marketing mix"—a set of marketing tools that work together to affect the marketplace. We
define marketing as a social and managerial process by which individuals and groups obtain what they
need and want through creating and exchanging products and value with others. To explain this
definition, we will examine the following important core marketing concepts: needs, wants, and
demands; marketing offers (products, services, and experiences); value and satisfaction; exchanges,
transactions, and relationships; and markets. Figure 1.1 shows that these core marketing concepts are
linked, with each concept building on the one before it.

6.1.2 Needs, Wants, and Demands

The most basic concept underlying marketing is that of human needs. Human needs are states of felt
deprivation. They include basic physical needs for food, clothing, warmth, and safety; social needs for
belonging and affection; and individual needs for knowledge and self-expression. These needs were not
created by marketers; they are a basic part of the human makeup.

Wants are the form human needs take as they are shaped by culture and individual personality. An
American needs food but wants Big Mac, french fries, and a soft drink. A person in Mauritius needs
food but wants a mango, rice, lentils, and beans. Wants are shaped by one's society and are described in
terms of objects that will satisfy needs. When backed by buying power, wants become demands.
Given their wants and resources, people demand products with benefits that add up to the most value
and satisfaction.

Outstanding marketing companies go to great lengths to learn about and understand their customers'
needs, wants, and demands. They conduct consumer research and analyze mountains of customer sales,
warranty, and service data. Their people at all levels—including top management— stay close to
customers.

6.1.3 Marketing Offers—Products, Services, and Experiences

Companies address needs by putting forth a value proposition, a set of benefits that they promise to
consumers to satisfy their needs. The value proposition is fulfilled through a marketing offer—some
combination of products, services, information, or experiences offered to a market to satisfy a need or
want. Marketing offers are not limited to physical products. In addition to tangible products, marketing
offers include services, activities or benefits offered for sale that are essentially intangible and do
not result in the ownership of anything. Examples include banking, airline, hotel, tax preparation, and
home repair services. More broadly, marketing offers also include other entities, such as persons,
places, organizations, information, and ideas. Many sellers make the mistake of paying more attention
to the specific products they offer than to the benefits and experiences produced by these products.
They see themselves as selling a product rather than providing a solution to a need.

A manufacturer of quarter-inch drill bits may think that the customer needs a drill bit. But what the
customer really needs is a quarter-inch hole. These sellers may suffer from "marketing myopia." They
are so taken with their products that they focus only on existing wants and lose sight of underlying
customer needs. They forget that a product is only a tool to solve a consumer problem. These sellers will
have trouble if a new product comes along that serves the customer's need better or less expensively.
The customer with the same need will want the new product.

Thus, smart marketers look beyond the attributes of the products and services they sell. They create
brand meaning and brand experiences for consumers.

Value and Satisfaction

Consumers usually face a broad array of products and services that might satisfy a given need. How do
they choose among these many marketing offers?

Consumers make choices based on their perceptions of the value and satisfaction that various products
and services deliver.

Customer value is the difference between the values the customer gains from owning and using a
product and the costs of obtaining the product. Customers form expectations about the value of various
marketing offers and buy accordingly. How do buyers form their expectations? Customer expectations
are based on past buying experiences, the opinions of friends, and marketer and competitor information
and promises.

Customer satisfaction with a purchase depends on how well the product's performance lives up to the
customer's expectations. Customer satisfaction is a key influence on future buying behavior. Satisfied
customers buy again and tell others about their good experiences. Dissatisfied customers often switch to
competitors and disparage the product to others.

Marketers must be careful to set the right level of expectations. If they set expectations too low, they
may satisfy those who buy but fail to attract enough buyers. If they raise expectations too high, buyers
will be disappointed. Customer value and customer satisfaction are key building blocks for developing
and managing customer relationships.

6.1.4 Exchange, Transactions, and Relationships

Marketing occurs when people decide to satisfy needs and wants through exchange. Exchange is the act
of obtaining a desired object from someone by offering something in return. Whereas exchange is the
core concept of marketing, a transaction, in turn, is marketing's unit of measurement. A transaction
consists of a trade of values between two parties: One party gives X to another party and gets Yin
return.

In the broadest sense, the marketer tries to bring about a response to some marketing offer. The
response may be more than simply buying or trading products and services. A political candidate, for
instance, wants votes, a church wants membership, and a social-action group wants idea acceptance.

Marketing consists of actions taken to build and maintain desirable exchange relationships with target
audiences involving a product, service, idea, or other object. Beyond simply attracting new customers
and creating transactions, the goal is to retain customers and grow their business with the company.
Marketers want to build strong economic and social connections by promising and consistently
delivering superior value.

Markets

The concepts of exchange and relationships lead to the concept of a market. A market is the set of
actual and potential buyers of a product. These buyers share a particular need or want that can be
satisfied through exchange relationships. The size of a market depends on the number of people who
exhibit the need, have resources to engage in exchange, and are willing to exchange these resources for
what they want. Originally the term market stood for the place where buyers and sellers gathered to
exchange their goods, such as a village square. Economists use the term market to refer to a collection
of buyers and sellers who transact in a particular product class, as in the housing market or the grain
market. Marketers, however, see the sellers as constituting an industry and the buyers as constituting a
market.

Marketers are keenly interested in markets. Each nation's economy and the whole world economy
consist of complex, interacting sets of markets that are linked through exchange processes. Marketers
work to understand the needs and wants of specific markets and to select the markets that they can serve
best. In turn, they develop products and services that create value and satisfaction for customers in these
markets. The result is profitable long-term customer relationships.

Marketing

The concept of markets finally brings us full circle to the concept of marketing. Marketing means
managing markets to bring about profitable exchange relationships by creating value and satisfying
needs and wants. Thus, we return to our definition of marketing as a process by which individuals and
groups obtain what they need and want by creating and exchanging products and value with others.

Creating exchange relationships involves work. Sellers must search for buyers, identify their needs,
design good marketing offers, set prices for them, promote them, and store and deliver them. Activities
such as product development, research, communication, distribution, pricing, and service are core
marketing activities. Although we normally think of marketing as being carried on by sellers, buyers
also carry on marketing. Consumers do marketing when they search for the goods they need at prices
they can afford. Company purchasing agents do marketing when they track down sellers and bargain for
good terms.

6.2 MARKETING MANAGEMENT

We define marketing management as the art and science of choosing target markets and building
profitable relationships with them. This involves getting, keeping, and growing customers through
creating, delivering, and communicating superior customer value. Thus, marketing management
involves managing demand, which in turn involves managing customer relationships.

6.2.1 Customer and Demand Management

Some people think of marketing management as finding enough customers for the company's current
output. But this view is too limited. Marketing management is not concerned with serving all customers
in every way. Instead, marketers want to serve selected customers that they can serve well and
profitably.

The organization has a desired level of demand for its products. At any point in time, there may be no
demand, adequate demand, irregular demand, or too much demand. Marketing management must find
ways to deal with these different demand states. It may be concerned not only with finding and increasing
demand but also with changing or even reducing it.

For example, the Golden Gate Bridge sometimes carries an unsafe level of traffic, and Yosemite
National Park is badly overcrowded in the summer. Power companies sometimes have trouble meeting
demand during peak usage periods. In these and other cases of excess demand, demarketing may be
required to reduce the number of customers or to shift their demand temporarily or permanently. For
example, to reduce demand for space on congested expressways in Washington, D.C., the Metropolitan
Washington Council of Governments has set up a Web site encouraging commuters to carpool and use
mass transit. Thus, marketing management seeks to affect the types of customers served and the level,
timing, and nature of their demand in a way that helps the organization achieve its objectives. Simply
put, marketing management is customer management and demand management.

6.2.2 Marketing Management Orientations

We describe marketing management as carrying out tasks to build profitable relationships with target
consumers. What philosophy should guide these marketing efforts? What weight should be given to the
interests of the organization, customers, and society? Very often these interests conflict. There are five
alternative concepts under which organizations conduct their marketing activities: the production,
product, selling, marketing, and societal marketing concepts.

The production concept holds that consumers will favor products that are available and highly
affordable. Therefore, management should focus on improving production and distribution efficiency.
This concept is one of the oldest orientations that guides sellers.

The production concept is still a useful philosophy in two types of situations. The first occurs when the
demand for a product exceeds the supply. Here, management should look for ways to increase
production. The second situation occurs when the product's cost is too high and improved productivity is
needed to bring it down. For example. Henry Ford's whole philosophy was to perfect the production of
the Model T so that its cost could be reduced and more people could afford it. He joked about offering
people a car of any color as long as it was black.

Although useful in some situations, the production concept can lead to marketing myopia. Companies
adopting this orientation run a major risk of focusing too narrowly on their own operations and losing
sight of the real objective—satisfying customers' needs.

The product concept holds that consumers will favor products that offer the most in quality,
performance, and innovative features. Thus, an organization should devote energy to making
continuous product improvements. Some manufacturers believe that if they can build a better
mousetrap, the world will beat a path to their door. But they are often rudely shocked. Buyers may well
be looking for a better solution to a mouse problem but not necessarily for a better mousetrap. The
solution might be a chemical spray, an exterminating service, or something that works better than a
mousetrap. Furthermore, a better mousetrap will not sell unless the manu- facturer designs, packages,
and prices it attractively; places it in convenient distribution channels; brings it to the attention of
people who need it; and convinces buyers that it is a better product.

Thus, the product concept also can lead to marketing myopia. For instance, railroad management once
thought that users wanted trains rather than transportation and overlooked the growing challenge of
airlines, buses, trucks, and automobiles. Kodak assumed that consumers wanted photographic film
rather than a way to capture and share memories and at first overlooked the challenge of digital
cameras. Although it now leads the digital camera market in sales, it has yet to make significant profits
from this business.

Many companies follow the selling concept, which holds that consumers will not buy enough of the
firm's products unless it undertakes a large-scale selling and promotion effort. The concept is typically
practiced with unsought goods—those that buyers do not normally think of buying, such as insurance or
blood donations. These industries must be good at tracking down prospects and selling them on product
benefits.

Most firms practice the selling concept when they face overcapacity. Their aim is to sell what they
make rather than make what the market wants. Such marketing carries high risks. It focuses on creating
sales transactions rather than on building long-term, profitable customer relationships. It assumes that
customers who are coaxed into buying the product will like it. Or, if they don't like it, they will possibly
forget their disappointment and buy it again later. These are usually poor assumptions. Most studies
show that dissatisfied customers do not buy again. Worse yet, whereas the average satisfied customer
tells three others about good experiences, the average dissatisfied customer tells ten others about his or
her bad experiences.

The marketing concept holds that achieving organizational goals depends on knowing the needs and
wants of target markets and delivering the desired satisfactions better than competitors do. Under the
marketing concept, customer focus and value are the paths to sales and profits. Instead of a product-
centered "make and sell" philosophy, the marketing concept is a customer-centered "sense and respond"
philosophy. It views marketing not as "hunting," but as "gardening." The job is not to find the right
customers for your product, but the right products for your customers. Instead of a product-centered
"make and sell" philosophy, the marketing concept is a customer-centered "sense and respond"
philosophy. It views marketing not as "hunting," but as "gardening." The job is not to find the right
customers for your product, but the right products for your customers.

The societal marketing concept holds that the organization should determine the needs, wants, and
interests of target markets. It should then deliver superior value to customers in a way that maintains or
improves the consumer's and the society's well-being. It questions whether the pure marketing concept
overlooks possible conflicts between consumer short-run wants and consumer long-run welfare. Is a firm
that senses, serves, and satisfies individual short-term wants always doing what's best for consumers and
society in the long run?

Consider the fast-food industry. Most people see today's giant fast-food chains as offering tasty and
convenient food at reasonable prices. Yet many consumer and environmental groups have voiced
concerns. Critics point out that hamburgers, fried chicken, french fries, and most other foods sold by fast-
food restaurants are high in fat and salt. The products are wrapped in convenient packaging, but this
leads to waste and pollution. Thus, in satisfying short-term consumer wants, the highly successful fast-
food chains may be harming consumer health and causing environmental problems.

The societal marketing concept calls on marketers to balance three con- siderations in setting their
marketing policies: company profits, consumer wants, and society's interests. Originally, most companies
based their marketing decisions largely on short-run company profit. Eventually, they recognized the
long-run importance of satisfying consumer wants, and the marketing concept emerged. Now many
companies are beginning to think of society's interests when making their marketing decisions.

6.2.3 Customer Relationship Management

No matter what its orientation, marketing management's crucial task is to create profitable relationships
with customers. Until recently, customer relationship management (CRM) has been defined narrowly as
a customer database management activity. By this definition, it involves managing detailed information
about individual customers and carefully managing customer. Companies today recognize that they
cannot appeal to all buyers in the marketplace or least not to all buyers in the same way. Buyers are too
numerous, too widely scattered, and In varied m their needs and buying practices. Moreover, the
companies themselves vary widely) their abilities to serve different segments of the market. Rather
than trying to compete in an entire market, sometimes against superior competitors, each company
must identify| the market that it can serve best and most profitably.

Thus, most companies are being more choosy about the customers with whom they wish to build
relationships. Most have moved away from mass marketing and toward market segmentation and
targeting—identifying market segments, selecting one or more of them, and develop products and
marketing programs tailored to each. Instead of scattering their marketing effort (the "shotgun"
approach), firms are focusing on the buyers who have greater interest in the values they create best (the
"rifle" approach).

Companies have not always practiced market segmentation and targeting. For most of the past century,
major consumer products companies held fast to mass marketing—mass-producing, mass-distributing,
and mass-promoting about the same product in about the same way to all consumers. Henry Ford
typified this marketing strategy when he offered the Model T Ford to buyers; they could have the car "in
any color as long as it is black." Similarly, Coca-Cola at one time produced only one drink for the whole
market, hoping it would appeal to everyone.

These companies argued that mass marketing creates the largest potential market, which leads to the
lowest costs. This, in turn, can translate into either lower prices or higher margins. However, many
factors now make mass marketing more difficult. For example, the world's mass markets have slowly
splintered into a profusion of smaller segments. The marketers, now find it very difficult o create a
single product or program that appeals to all of these diverse groups.

The proliferation of distribution channels and advertising media has also made it difficult to practice
"one-size-fits-all" marketing. Today's consumers can shop at megamalls, superstores, or specialty
shops; through mail catalogs, by telephone, or from online retailers. They are bombarded with messages
in media ranging from old standards such as television, radio, magazines, newspapers, and telephone to
newcomers such as Web ads, faxes, and e-mails. No wonder some have claimed that mass marketing is
dying. Not surprisingly, many companies are retreating from mass marketing and turning to segmented
marketing.

6.3 TARGET MARKETING

There are three major steps in target marketing. The first is market segmentation— dividing a market
into smaller groups of buyers with distinct needs, characteristics, or behaviors who might require
separate products or marketing mixes. The company identifies different ways to segment the market and
develops profiles of the resulting market segments. The second step is target marketing—evaluating
each market segment's attractiveness and selecting one or more of the market segments to enter. The
third step is market positioning—setting the competitive positioning for the product and creating a
detailed marketing mix. We discuss each of these steps in turn.

6.3.1 Market Segmentation

Markets consist of buyers, and buyers differ in one or more ways. They may differ in their wants,
resources, locations, buying attitudes, and buying practices. Through market segmentation, companies
divide large, heterogeneous markets into smaller segments that can be reached more efficiently and
effectively with products and services that match their unique needs. In this section, we discuss four
important segmentation topics: segmenting consumer markets, segmenting business markets,
segmenting international markets, and requirements for effective segmentation.

Segmenting Consumer Markets

There is no single way to segment a market. A marketer has to try different segmentation variables,
alone and in combination, to find the best way to view the market structure. Now we look at the major
geographic, demographic, psychographic, and behavioral variables, which can be used o segment the
consumer market.

Geographic Segmentation

Geographic segmentation calls for dividing the market into different geographical units such as
nations, regions, states, counties, cities, or neighborhoods. A company may decide to operate in one or a
few geographical areas, or to operate in all areas but pay attention to geographical differences in needs
and wants.

Many companies today are localizing their products, advertising, promotion, and sales efforts to fit the
needs of individual regions, cities, and even neighborhoods.
Demographic Segmentation

Demographic segmentation divides the market into groups based on variables such age, gender,
family size, family life cycle, income, occupation, education, religion, race, generation, a nationality.
Demographic factors are the most popular bases for segmenting customer groups. One reason is that
consumer needs, wants, and usage rates often vary closely with demographic variables. Another is that
demographic variables are easier to measure than most other types of variables. Even when market
segments are first defined using other bases, such as benefits sought or behavior, their demographic
characteristics must be known in order to assess the size of the target market and to reach it efficiently.

Age and Life-Cycle Stage. Consumer needs and wants change with age. Some companies use age and
life-cycle segmentation, offering different products or using different marketing approaches for
different age and life-cycle groups. For example, McDonald's targets different age groups—from
children and teens to adults and seniors—with different ads and media. Its ads to teens feature dance-
beat music, adventure, and fast-paced cutting from scene to scene; ads to seniors are softer and more
sentimental. Procter & Gamble boldly targets its Oil of Olay Pro Vital moisturizing creams and lotions
at women over 50 years of age—it helps to improve the elasticity and revitalize the appearance of
"maturing skin.

Gender segmentation has long been used in clothing, cosmetics, toiletries, and magazines. For
example, Procter & Gamble was among the first with Secret, a brand specially formulated for a woman's
chemistry, packaged and advertised to reinforce the female image.

Income segmentation has long been used by the marketers of products and services such as
automobiles, boats, clothing, cosmetics, financial services, and travel. Many companies target affluent
consumers with luxury goods and convenience services.

Psvchographic segmentation divides buyers into different groups based on social class, life style or
personality characteristics. People in the same demographic group can have very different
psychographic makeups.

Behavioral segmentation divides buyers into groups based on their knowledge, attitudes, uses or
responses to a product. Many marketers believe that behavior variables are the best starting point for
building market segments.

Occasions. Buyers can be grouped according to occasions when they get the idea to buy, actually make
their purchase, or use the purchased item. Occasion segmentation

can help firms‘ build up product usage. For example, orange juice is most often consumed at breakfast,
but orange growers have promoted drinking orange juice as a cool and refreshing drink at other times of
the day.
Benefits Sought. A powerful form of segmentation is to group buyers according to the different
benefits that they seek from the product. Benefit segmentation requires finding the major benefits
people look for in the product class, the kinds of people who look for each benefit, and the major brands
that deliver each benefit. For example, our chapter-opening example pointed out that Procter & Gamble
has identified several different laundry detergent segments. Each segment seeks a unique combination of
benefits, from cleaning and bleaching to economy, fabric softening, fresh smell, strength or mildness,
and lots of suds or only a few. User Status. Markets can be segmented into groups of nonusers, ex-users,
potential users, first-time users, and regular users of a product. For example, one study found that blood
donors are low in self-esteem, low risk takers, and more highly concerned about their health; nondonors
tend to be the opposite on all three dimensions. This suggests that social agencies should use different
marketing approaches for keeping current donors and attracting new ones. A company's market position
also influences its focus. Market share leaders focus on attracting potential users, whereas smaller firms
focus on attracting current users away from the market leader.

Usage Rate. Markets can also be segmented into light, medium, and heavy product users. Heavy users
are often a small percentage of the market but account for a high percentage of total consumption.
Marketers usually prefer to attract one heavy user to their product or service rather than several light
users.

Loyalty Status. A market can also be segmented by consumer loyalty. Consumers can be loyal to brands
(Tide), stores (Wal-Mart), and companies (Ford). Buyers can be divided into groups according to their
degree of loyalty. Some consumers are completely loyal—they buy one brand all the time. Others are
somewhat loyal—they are loyal to two or three brands of a given product or favor one brand while
sometimes buying others. Still other buyers show no loyalty to any brand. They either want something
different each time they buy or they buy whatever's on sale.

A company can learn a lot by analyzing loyalty patterns in its market. It should start by studying its own
loyal customers.

By studying its less loyal buyers, the company can detect which brands are most competitive with its
own. If many Pepsi buyers also buy Coke, Pepsi can attempt to improve its positioning against Coke,
possibly by using direct-comparison advertising. By looking at customers who are shifting away from
its brand, the company can learn about its marketing weaknesses. As for non-loyals, the company may
attract them by putting its brand on sale.

Target Marketing

Market segmentation reveals the firm's market segment opportunities. The firm now has to evaluate the
various segments and decide how many and which ones to target. We now look at how companies
evaluate and select target segments.
Evaluating Market Segments

In evaluating different market segments, a firm must look at three factors: segment size and growth,
segment structural attractiveness, and company objectives and resources. The company must first
collect and analyze data on current segment sales, growth rates, and expected profitability for various
segments. It will be interested in segments that have the right size and growth characteristics. But "right
size and growth" is a relative matter. The largest, fastest-growing segments are not always the most
attractive ones for every company. Smaller companies may lack the skills and resources needed to serve
the larger segments. Or they may find these segments too competitive. Such companies may select
segments that are smaller and less attractive, in an absolute sense, but that are potentially more
profitable for them.

The company also needs to examine major structural factors that affect long- run segment
attractiveness. For example, a segment is less attractive if it already contains many strong and
aggressive competitors. The existence of many actual or potential substitute products may limit prices
and the profits that can be earned in a segment. The relative power of buyers also affects segment
attractiveness. Buyers with strong bargaining power relative to sellers will try to force prices down,
demand more services, and set competitors against one another—all at the expense of seller
profitability. Finally, a segment may be less attractive if it contains powerful suppliers who can control
prices or reduce the quality or quantity of ordered goods and services.

Even if a segment has the right size and growth and is structurally attractive, the company must
consider its own objectives and resources in relation to that segment. Some attractive segments could be
dismissed quickly because they do not mesh with the company's long-run objectives. The company must
consider whether it possesses the skills and resources it needs to succeed in that segment. If the company
lacks the strengths needed to compete successfully in a segment and cannot readily obtain them, it
should not enter the segment. Even if the company possesses the required strengths, it needs to employ
skills and resources superior to those of the competition in order to really win in a market segment. The
company should enter only segments in which it can offer superior value and gain advantages over
competitors.

Selecting Target Market Segments

After evaluating different segments, the company must now decide which and how many segments it
will target. A target market consists of a set of buy who share common needs or characteristics that the
company decides to serve. Because buyers have unique needs and wants, a seller could potentially view
each buyer as a separate target market. Ideally, then, a seller might design a separate marketing program
for each buyer. However, although some companies do attempt to serve buyers individually, most face
Undifferentiated Marketing
Using an Undifferentiated marketing (or mass marketing) strategy, a firm might decide ignore
market segment differences and target the whole market with one offer. This marketing strategy focuses
on what is common in the needs of consumers rather than on what is different. The company designs a
product and a marketing program that will appeal to all the buyers. It relies on mass distribution and
mass advertising, and it aims to give product a superior image in people's minds. Most modern
marketers have strong doubts about this strategy. Difficulties arise in developing a product that will
satisfy all consumers. Moreover, mass marketers often have trouble competing with more-focused firms
that do a better job of satisfying the needs of specific segments and niche.

Using a differentiated marketing (or segmented marketing) strategy, a firm decides to cater to several
market segments and designs separate offers for each.

Genera] Motors tries to produce a car for every "purse, purpose, and personality." Nike offers athletic
shoes for a dozen or more different sports, from running, fencing, golf, and aerobics to bicycling and
baseball.

By offering product and marketing variations to segments, companies hope for higher and a stronger
position within each market segment. Developing a stronger position within several segments creates
more total sales than Undifferentiated marketing across all segments Procter & Gamble gets more total
market share with eight brands of laundry detergent as could with only one.

But differentiated marketing also increases the costs of doing business. A firm usually finds it more
expensive to develop and produce, say, 10 units of 10 different products than 100 of one product.
Developing separate marketing plans for the separate segments requires extra marketing research,
forecasting, sales analysis, promotion planning, and channel management trying to reach different
market segments with different advertising increases promotion. Thus, the company must weigh
increased sales against increased costs when deciding on a differentiated marketing strategy.

6.3.2 Concentrated Marketing

A third market-coverage strategy, concentrated marketing (or niche marketing), is especially

appealing when company resources are limited. Instead of going after a small share of a large market,
the firm goes after a large share of one or a few segments or niches. Whereas segments are fairly large
and normally attract several competitors, niches are smaller and may attract only one or a few
competitors. Through concentrated marketing, the firm achieves a strong market position because of its
greater knowledge of consumer needs in the niches it serves and the special reputation it acquires. It can
market more effectively by fine-tuning its products, prices, and programs to the needs of carefully
defined segments. It can also market more efficiently, targeting its products or services, channels, and
communications programs toward only consumers that it can serve best and most profitably.

Niching offers smaller companies an opportunity to compete by focusing their limited resources on
serving niches that may be unimportant to or overlooked by larger competitors.

Many companies start as nichers to get a foothold against larger, more resourceful competitors, then
grow into broader competitors. For example. Southwest Airlines began by concentrating on serving
intrastate, no-frills commuters in Texas but is now one of the nation's eight largest airlines. Wal-Mart,
which got its start by bringing everyday low prices to small towns and rural areas, is now the world's
largest company.

Today, the low cost of setting up shop on the Internet makes it even more profitable to serve seemingly
minuscule niches. Small businesses, in particular, are realizing riches from serving small niches on the
Web. Here is a "Webpreneur" who achieved astonishing results:

Whereas Internet giants like Amazon.com have yet to even realize a consistent profit, Steve Warrington
is earning a six-figure income online selling ostriches—and every product derived from them—online.

6.3.3 Micromarketing

Differentiated and concentrated marketers tailor their offers and marketing programs to meet the needs
of various market segments and niches. At the same time, however, they do not customize their offers to
each individual customer. Micromarketing is the practice of tailoring products and marketing programs
to suit the tastes of specific individuals and locations. Micromarketing includes local marketing and
individual marketing.

Local Marketing. Local marketing involves tailoring brands and promotions to the needs and wants of
local customer groups—cities, neighborhoods, and even specific stores. Retailers such as Sears and Wal-
Mart routinely customize each store's merchandise and promotions to match its specific clientele.
Citibank provides different mixes of banking services in its branches, depending on neighborhood
demographics. Kraft helps supermarket chains identify the specific cheese assortments and shelf
positioning that will optimize cheese sales in low-income, middle-income, and high-income stores and
in different ethnic communities.

Local marketing has some drawbacks. It can drive up manufacturing and marketing costs by reducing
economies of scale. It can also create logistics problems as companies try to meet the varied
requirements of different regional and local markets. Further, a brand's overall image might be diluted if
the product and message vary too much in different localities. Still, as companies face increasingly
fragmented markets, and as new supporting technologies develop, the advantages of local marketing
often outweigh the drawbacks. Local marketing helps a company to market more effectively in the face
of pronounced regional and local differences in demographics and lifestyles. It also meets the needs of
the company's first-line customers—retailers—who prefer more fine-tuned product assortments for their
neighborhoods.
Individual Marketing. In the extreme, micromarketing becomes individual marketing-tailoring products
and marketing programs to the needs and preferences of individual customers. Individual marketing has
also been labeled one-to-one marketing, customized marketing, and markets-of-one marketing.

The widespread use of mass marketing has obscured the fact that for centuries consumers were served
as individuals: The tailor custom-made the suit, the cobbler designed shoes for the individual, the
cabinetmaker made furniture to order. Today, however, new technologies are permitting many
companies to return to customized marketing. More-powerful computers, detailed databases, robotic
production and flexible manufacturing, and immediate and interactive communication media such as e-
mail, fax, and the Internet—all have combined to foster "mass customization." Mass customization is the
process through which firms interact one-to-one with masses of customers to create customer-unique
value by designing products and services tailor- made to individual needs.

Thus, Dell Computer delivers computers to individual customers loaded with customer-specified
hardware and software.

6.4 Positioning for Competitive Advantage

Beyond deciding which segments of the market it will target, the company must decide what positions it
wants to occupy in those segments. A product's position is the way the product is defined by
consumers on important attributes—the place the product occupies in consumers' minds relative to
competing products. Positioning involves implanting the brand's unique benefits and differentiation in
customers' minds. Tide is positioned as a powerful, all-purpose family detergent; Ivory Snow is
positioned as the gentle detergent for fine washables and baby clothes. In the automobile market, the
Toyota Echo and Ford Focus are positioned on economy, Mercedes and Cadillac on luxury, and
Porsche and BMW on performance. Volvo positions powerfully on safety. At Subway restaurants, you
"Eat Fresh." At Olive Garden restaurants, "When You're Here, You're Family."

Consumers are overloaded with information about products and services. They cannot reevaluate
products every time they make a buying decision. To simplify the buying process, consumers organize
products, services, and companies into categories and "position" them in their minds. A product's
position is the complex set of perceptions, impressions, and feelings that consumers have for the product
compared with competing products.

Consumers position products with or without the help of marketers. But marketers do not want to leave
their products' positions to chance. They must plan positions that will give their products the greatest
advantage in selected target markets, and they must design marketing mixes to create these planned
positions.
6.5 Choosing a Positioning Strategy

Some firms find it easy to choose their positioning strategy. For example, a firm well known for quality
in certain segments will go for this position in a new segment if there are enough buyers seeking
quality. But in many cases, two or more firms will go after the same position. Then, each will have to
find other ways to set itself apart. Each firm must differentiate its offer by building a unique bundle of
benefits that appeals to a substantial group within the segment.

The positioning task consists of three steps: identifying a set of possible competitive advantages upon
which to build a position, choosing the right competitive advantages, and selecting an overall positioning
strategy. The company must then effectively communicate and deliver the chosen position to the market.

Identifying Possible Competitive Advantages

The key to winning and keeping target customers is to understand their needs better than competitors do
and to deliver more value. To the extent that a company can position itself as providing superior value,
it gains competitive advantage. But solid positions cannot be built on empty promises. If a company
positions its product as offering the best quality and service, it must then deliver the promised quality
and service. Thus, positioning begins with actually differentiating the company's marketing offer so that
it will give consumers more value than competitors' offers do.

To find points of differentiation, marketers must think through the customer's entire experience with the
company's product or service. An alert company can find ways to differentiate itself at every point where
it comes in contact with customers. In what specific ways can a company differentiate its offer from those
of competitors? A company or market offer can be differentiated along the lines of product, services,
channels, people, or image.

Product differentiation takes place along a continuum. At one extreme we find physical products that
allow little variation: chicken, steel, aspirin. Yet even here some meaningful differentiation is possible.
For example, Perdue claims that its branded chickens are better—fresh and more tender—and gets a 10
percent price premium based on this differentiation. At other extreme are products that can be highly
differentiated, such as automobiles, clothing, and furniture. Such products can be differentiated on
features, performance, or style and design.

Beyond differentiating its physical product, a firm can also differentiate the services accompany the
product. Some companies gain services differentiation through speedy, convenient, or careful delivery.
For example, BankOne has opened full-service branches in super markets to provide location
convenience along with Saturday, Sunday, and weekday-evening hours.

Installation can also differentiate one company from another, as can repair services. Manya automobile
buyer will gladly pay a little more and travel a little farther to buy a car from a dealer that provides top-
notch repair services. Some companies differentiate their offers by providing customer training service
or consulting services—data, information systems, and advising services. Firms that practice channel
differentiation gain competitive advantage through the way they design their channel's coverage,
expertise, and performance. Caterpillar's success in the construction-equipment industry is based on
superior channels. Its dealers worldwide are renowned for their first-rate service. Amazon.com, Dell
Computer, and Avon distinguish themselves by their high-quality direct channels. And lams pet food
achieved success by going against tradition, distributing its products only through veterinarians and pet
stores.

Companies can gain a strong competitive advantage through people differentiation—hiring and training
better people than their competitors do. Thus,

Disney people are known to be friendly and upbeat. Singapore Airlines enjoys an excellent reputation
largely because of the grace of its flight attendants. IBM offers people who make sure that the solution
customers want is the solution they get: "People Who Get It. People Who Get It Done." People
differentiation requires that a company select its customer-contact people carefully and train them well.
For example, Disney trains its theme park people thoroughly to ensure that they are competent,
courteous, and friendly—from the hotel check-in agents, to the monorail drivers, to the ride attendants,
to the people who sweep Main Street USA. Each employee understands the importance of
understanding customers, communicating with them cheerfully, and responding quickly to their requests
and problems. Each is carefully trained to "make people happy."

Even when competing offers look the same, buyers may perceive a difference based on company or
brand image differentiation. A company or brand image should convey the product's distinctive benefits
and positioning. Developing a strong and distinctive image calls for creativity and hard work. A
company cannot plant an image in the public's mind overnight using only a few advertisements. If Ritz-
Carlton means quality, this image must be supported by everything the company says and does.
Symbols—such as the McDonald's golden arches, the Prudential rock, the Nike swoosh, the Intel Inside
logo, or the Pillsbury doughboy—can provide strong company or brand recognition and image
differentiation. The company might build a brand around a famous person, as Nike did with its Air
Jordan basketball shoes and Tiger Woods golfing products. Some companies even become associated
with colors, such as IBM (blue), Campbell (red and white), or UPS (brown). The chosen symbols,
characters, and other image elements must be communicated through advertising that conveys the
company's or brand's personality.

What is a Product?

A Sony DVD player, a Ford Taurus, a Costa Rican vacation, a Caffe Mocha at Starbucks, Cha Schwab
online investment services, and advice from your family doctor—all are products. define a product as
anything that can be offered to a market for attention, acquisition, use consumption and that might
satisfy a want or need. Products include more than just tangible goods. Broadly defined, products
include physical objects, services, events, persons, places, organizations, ideas, or mixes of these
entities. Thus, throughout this text, we use the term product broadly to include any or all of these
entities.

Because of their importance in the world economy, we give special attention to services. Services are a
form of product that consists of activities, benefits, or satisfactions offered for that are essentially
intangible and do not result in the ownership of anything. Examples are hotel, airline, retail, tax
preparation, and home repair services.

Products, Services, and Experiences

Product is a key element in the market offering. Marketing-mix planning begins with formulating an
offering that brings value to target customers and satisfies their needs. This offering becomes the basis
upon which the company builds profitable relationships with customers.

A company's market offering often includes both tangible goods and services. Each component can be a
minor or a major part of the total offer. At one extreme, the offer may consist of a pure tangible good,
such as soap, toothpaste, or salt—no services accompany the product. At the other extreme are pure
services, for which the offer consists primarily of a service. Examples include a doctor's exam or
financial services. Between these two extremes, however, many goods-and-services combinations are
possible.

Today, as products and services become more and more commoditized, many companies are moving to
a new level in creating value for their customers. To differentiate their offers, they are developing and
delivering total customer experiences. Whereas products are tangible and services are intangible,
experiences are memorable. Whereas products and services are external, experiences are personal and
take place in the minds of individual consumers. Companies that market experiences realize that
customers are really buying much more than just products and services. They are buying what those
offers will do for them.

Levels of Product and Services

Product planners need to think about products and services on three levels. Each level adds more
customer value. The most basic level is the core benefit, which addresses the question What is the
buyer really buying? When designing products, marketers must first define the core, problem-solving
benefits or services that consumers seek. A woman buying lipstick buys more than lip color. Charles
Revson of Revlon saw this early: "In the factory, we make cosmetics; in the store, we sell hope."
Charles Schwab does more than sell financial services—it promises to fulfill customers' "financial
dreams."
At the second level, product planners must turn the core benefit into an actual product. They need to
develop product and service features, design, a quality level, a brand name, and packaging. For example,
a Sony camcorder is an actual product. Its name, parts, styling, features, packaging, and other attributes
have all been combined carefully to deliver the core benefit—a convenient, high-quality way to capture
important moments.

Finally, product planners must build an augmented product around the core benefit and actual product
by offering additional consumer services and benefits. Sony must offer more than just a camcorder. It
must provide consumers with a complete solution to their picture-talking problems. Sony and its dealers
also might give buyes a warranty on parts and workmanship, instructions on how to use the camcorder,
quick repair services when needed, and a toll-free telephone number to call if they have problems or
questions.

Consumers see products as complex bundles of benefits that satisfy their needs. When developing
products, marketers first must identify the core consumer needs the product will satisfy, They must then
design the actual product and find ways to augment it in order to create the bin-die of benefits that will
provide the most satisfying customer experience.

Product and Service Classifications

Products and services fall into two broad classes based on the types of consumers that use them-
consumer products and industrial products. Broadly defined, products also include other marketable
entities such as experiences, organizations, persona, places, and ideas.

Consumer Products

Consumer products are products and services bought by final consumers for personal consumption.
Marketers usually classify these products and services further based on how consumers go about buying
them. Consumer products include convenience products, shopping products, specialty products, and
unsought products. These products differ in the ways consumers buy them and therefore in how they are
marketed.

Convenience products are consumer products and services that the customer usually buys frequently,
immediately, and with a minimum of comparison and buying effort. Examples include soap, candy,
newspapers, and fast food. Convenience products are usually low priced, and marketers place them in
many locations to make them readily available when customers need them.

Shopping products are less-frequently-purchased consumer products and services that customers
compare carefully on suitability, quality, price, and style. When buying shopping products and services,
consumers spend much time and effort in gathering information and making comparisons. Examples
include furniture, clothing, used cars, major appliances, and hotel and airline services. Shopping
products marketers usually distribute their products through fewer outlets but provide deeper sales
support to help customers in their comparison efforts.

Specialty products are consumer products and services with unique characteristics or brand
identification for which a significant group of buyers is willing to make a special purchase effort,
Examples include specific brands and types of cars, high-priced photographic equipment, designer
clothes, and the services of medical or legal specialists. A Lamborghini automobile, for example, is a
specialty product because buyers are usually willing to travel great distances to buy one. Buyers
normally do not compare specialty products. They invest only the time needed to reach dealers carrying
the wanted products.

Unsought products are consumer products that the consumer either does not know about or knows
about but does not normally think of buying. Most major new innovations are unsought until the
consumer becomes aware of them through advertising. Classic examples of known but unsought
products and services are life insurance, cemetery plots, and blood donations to the Red Cross. By their
very nature, unsought products require a lot of advertising, personal selling, and other marketing efforts.

Industrial Products

Industrial products are those purchased for further processing or for use in conducting a business.
Thus, the distinction between a consumer product and an industrial product is based on the purpose for
which the product is bought. If a consumer buys a lawn mower for use around home, the lawn mower is
a consumer product. If the same consumer buys the same lawn mower for use in a landscaping business,
the lawn mower is an industrial product.

The three groups of industrial products and services include materials and parts, capital items, and
supplies and services. Materials and parts include raw materials and manufactured materials and parts.
Raw materials consist of farm products (wheat, cotton, livestock, fruits, vegetables) and natural
products (fish, lumber, crude petroleum, iron ore). Manufactured materials and parts consist of
component materials (iron, yarn, cement, wires) and component parts (small motors, tires, castings).
Most manufactured materials and parts are sold directly to industrial users. Price and service are the
major marketing factors; branding and advertising tend to be less important.

Capital items are industrial products that aid in the buyer's production or operations, including
installations and accessory equipment. Installations consist of major purchases such as buildings
(factories, offices) and fixed equipment (generators, drill presses, large computer systems, and
elevators). Accessory equipment includes portable factory equipment and tools (hand tools, lift trucks)
and office equipment (computers, fax machines, desks). They have a shorter life thai installations and
simply aid in the production process.

The final group of business products is supplies and services. Supplies include opera ting supplies
(lubricants, coal, paper, pencils) and repair and maintenance items (paint, nails, brooms). Supplies are
the convenience products of the industrial field because they are usually purchased with a minimum of
effort or comparison. Business services include maintenance and repair services (window cleaning,
computer repair) and business advisory services (legal, management consulting, and advertising). Such
services are usually supplied under contract.

Organizations, Persons, Places, and Ideas

In addition to tangible products and services, in recent years marketers have broadened the concept of a
product to include other market offerings—organizations, persons, places, and ideas.

Organizations often carry out activities to "sell" the organization itself. Organization marking consists of
activities undertaken to create, maintain, or change the attitudes and behavior of target consumers toward
an organization. Both profit and nonprofit organizations practice organization marketing. Business firms
sponsor public relations or corporate advertising campaigns to polish their images. Corporate image
advertising is a major tool companies use to market themselves to various publics. For example. Lucent
puts out ads with the tag line "We make the things that make communications work." IBM wants to
establish itself as the company to turn to for ―e-Business Solutions." And General Electric "brings good
things to life." Similarly, not-for-profit organizations, such as churches, colleges, charities, museums,
and performing arts groups, market their organizations in order to raise funds and attract members or
patrons.

People can also be thought of as products. Person marketing consists of activities undertaken to create,
maintain, or change attitudes or behavior toward particular people. All kinds of people and
organizations practice person marketing. Today's presidents market themselves, their parties, and their
platforms to get needed votes and program support. Entertainers and sports figures use marketing to
promote their careers and improve their impact and incomes. Professionals such as doctors, lawyers,
accountants, and architects market themselves in order to build their reputations and increase business.
Businesses, charities, sports teams, fine arts groups, religious groups, and other organizations also use
person marketing. Creating or associating with well-known personalities often helps these organizations
achieve their goals better. That's why more than a dozen different companies combined— including
Nike, Target, Buick, American Express, Disney, and Titleist—pay more than $50 million a year to link
themselves with golf superstar Tiger Woods.

Place marketing involves activities undertaken to create, maintain, or change attitudes orj behavior
toward particular places. Cities, states, regions, and even entire nations compete to | attract tourists, new
residents, conventions, and company offices and factories. Texas advertises "It's Like a Whole Other
Country," and New York State shouts, "I Love New York!" Michigan says "Great Lakes, Great Times"
to attract tourists, "Great Lakes, Great Jobs" to attract residents, and "Great Lakes, Great Location" to
attract businesses. The Irish Development Agency has attracted more than 1,200 companies to locate
their plants in Ireland. At the same time, the Irish Tourist Board has built a flourishing tourism business
by advertising "Live a different life: friendly, beautiful, relaxing." And the Irish Export Board has
created attractive markets for Irish exports.

Ideas can also be marketed. In one sense, all marketing is the marketing of an idea, whether it be the
general idea of brushing your teeth or the specific idea that Crest toothpastes "create smiles every day."
Here, however, we narrow our focus to the marketing of social ideas. This area has been called social
marketing, defined by the Social Marketing Institute as the use of commercial marketing concepts and
tools in programs designed to influence individuals' behavior to improve their well-being and that of
society.6 Such programs include public health campaigns to reduce smoking, alcoholism, drug abuse,
and overeating. Other social marketing efforts include environmental campaigns to promote wilderness
protection, clean air, and conservation. Still others address issues such as family planning, human
rights, and racial equality.

6.5 Product and Service Decisions

Marketers make product and services decisions at three levels: individual product decisions, product line
decisions, and product mix decisions. We discuss each in turn.

Individual Product and Service Decisions

We will focus on decisions about product attributes, branding, packaging, labeling, and product support
services. '

Product and Service Attributes

Developing a product or service involves defining the benefits that it will offer. These benefits are
communicated and delivered by product attributes such as quality, features, and style and design.

Product Quality

Product quality is one of the marketer's major positioning tools. Quality has a direct impact on
satisfaction. In the narrowest sense, quality can be defined as "freedom from defects." But most
customer-centered companies go beyond this narrow definition. Instead, they define quality ii terms of
customer satisfaction.

Total quality management (TQM) is an approach in which all the company's people an involved in
constantly improving the quality of products, services, and business processes During the past two
decades, companies large and small have credited TQM with greatly improve their market shares and
profits. Product quality has two dimensions—level and consistency. In developing a product, the
marketer must first choose a quality level that will support the product's position in the target market.
Here, product quality means performance quality—the ability of a product to perform its functions. For
example, a Rolls-Royce provides higher performance quality than a Chevrolet: It has a smoother ride,
handles better, and lasts longer. Companies rarely try to offer the highest possible performance quality
level—few customers want or can afford the high levels of quality offered in products such as a Rolls-
Royce automobile, a Sub-Zero refrigerator, or a Rolex watch. Instead, companies choose a quality level
that matches target market needs and the quality levels of competing products.

Beyond quality level, high quality also can mean high levels of quality consistency. Here, product
quality means conformance quality—freedom from defects and consistency in delivering a targeted level
of performance. All companies should strive for high levels of conformance quality. In this sense, a
Chevrolet can have just as much quality as a Rolls-Royce. Although a Chevy doesn't perform as well as
a Rolls, it can as consistently deliver the quality that customers pay for and expect.

Many companies today have turned customer-driven quality into a potent strategic weapon. They create
customer satisfaction and value by consistently and profitably meeting customer‘s needs and
preferences for quality.

Product Features. A product can be offered with varying features. A stripped-down model, one without
any extras, is the starting point. The company can create higher- level models by adding more features.
Features are a competitive tool for differentiating the company's product from competitors' products.
Being the first producer to introduce a needed and valued new feature is one of the most effective ways
to compete.

How can a company identify new features and decide which ones to add to its product? The company
should periodically survey buyers who have used the product and ask these questions? How do you like
the product? Which specific features of the product do you like most? Which features could we add to
improve the product? The answers provide the company with a rich list of feature ideas. The company
can then assess each feature's value to customers versus its cost to the company. Features that customers
value little in relation to costs should be dropped; those that customers value highly in relation to costs
should be added.

Product Style and Design Another way to add customer value is through distinctive product style and
design. Design is a larger concept than style. Style simply describes the appearance of a product. Styles
can be eye-catching or yawn producing. A sensational style may grab attention and produce pleasing
aesthetics, but it does not necessarily make the product perform better. Unlike style, design is more than
skin deep—it goes to the very heart of a product. Good design contributes to a product's usefulness as
well as to its looks.

Good style and design can attract attention, improve product performance, cut production costs, and
give the product a strong competitive advantage in the target market.

Branding
Perhaps the most distinctive skill of professional marketers is their ability to create, maintain, protect,
and enhance brands of their products and services. A brand is a name, term, sign, symbol, or design, or
a combination of these, that identifies the maker or seller of a product or service. Consumers view a
brand as an important part of a product, and branding can add value to a product. For example, most
consumers would perceive a bottle of White Linen perfume as a high-quality, expensive product. But the
same perfume in an unmarked bottle would likely be viewed as lower in quality, even if the fragrance
were identical.

Branding has become so strong that today hardly anything goes unbranded. Salt is packaged in branded
containers; common nuts and bolts are packaged with a distributor's label, and automobile parts—spark
plugs, tires, filters—bear brand names that differ from those of the automakers. Even fruits, vegetables,
and poultry are branded—Sunkist oranges, Dole pineapples, Chiquita bananas, Fresh Express salad
greens, and Perdue chickens.

Branding helps buyers in many ways. Brand names help consumers identify products that might benefit
them. Brands also tell the buyer something about product quality. Buyers who always buy the same
brand know that they will get the same features, benefits, and quality each time they buy. Branding also
gives the seller several advantages. The brand name becomes the Packaging

Packaging involves designing and producing the container or wrapper for a product. The package
includes a product's primary container (the tube holding Colgate Total toothpaste). It may also include a
secondary package that is thrown away when the product is about to be used (the cardboard box
containing the tube of Colgate). Finally, it can include a shipping package necessary to store, identify,
and ship the product (a corrugated box carrying six dozen tubes of Colgate). Labeling—printed
information appearing on or with the package—is also part of packaging.

Traditionally, the primary function of the package was to contain and protect the product. In recent
times, however, numerous factors have made packaging an important marketing tool. Increased
competition and clutter on retail store shelves means that packages must now perform many sales
tasks—from attracting attention, to describing the product, to making the sale.

Companies are realizing the power of good packaging to create instant consumer recognition of the
company or brand. For example, in an average supermarket, which stocks 15,000 to 17,000 items, the
typical shopper passes by some 300 items per minute, and more than 60 percent of all purchases are
made on impulse. In this highly competitive environment, the package may be the seller's last chance to
influence buyers. It becomes a "five-second commercial." The Campbell Soup Company estimates that
the average shopper sees its familiar red-and-white can 76 times a year, creating the equivalent of $26
million worth of advertising.

Innovative packaging can give a company an advantage over competitors. In contrast, poorly designed
packages can cause headaches for consumers and lost sales for the company. Developing a good
package for a new product requires making many decisions. First, the company must establish the
packaging concept, which states what the package should be or do for the product. Should it mainly
offer product protection, introduce a new dispensing method, suggest certain qualities about the
product, or do something else? Decisions then must be made on specific elements of the package, such
as size, shape, materials, color, text, and brand mark. These elements must work together to support the
product's position and marketing strategy.

Labeling

Labels may range from simple tags attached to products to complex graphics that are part of the
package. They perform several functions. At the very least, the label identifier the product or brand,
such as the name Sunkist stamped on oranges.

The label might also describe several things about the product—who made it, where it was made, when it
was made, its contents, how it is to be used, and how to use it safely. Finally, the label might promote
the product through attractive graphics.

Labeling has been affected in recent times by unit pricing (stating the price per unit of standard measure),
open dating (stating the expected shelf life of the product), and nutritional labeling (stating the
nutritional values in the product). the use of health-related terms such as low-fat, light, and high-fiber.
Sellers must ensure that their labels contain all the required information.

Product Support Services

Customer service is another element of product strategy. A company's offer to the marketplace usually
includes some support services, which can be a minor or a major part of the total offering.

The first step is to survey customers periodically to assess the value of current services and to obtain
ideas for new ones. For example, Cadillac holds regular focus group interviews with owners and
carefully watches complaints that come into its dealerships. From this careful monitoring, Cadillac has
learned that buyers are very upset by repairs that are not done correctly the first time.

Once the company has assessed the value of various support services to customers, it must next assess
the costs of providing these services. It can then develop a package of services that will both delight
customers and yield profits to the company. Based on its consumer interviews, Cadillac has set up a
system directly linking each dealership with a group of 10 engineers who can help walk mechanics
through difficult repairs. Such actions helped Cadillac jump, in one year, from fourteenth to seventh in
independent rankings of service.

Many companies are now using the Internet and other modern technologies to provide support services
that were not possible before. Using the Web, 24-hour telephone help lines, self-service kiosks, and other
digital technologies, these companies are now empowering consumers to tailor their own service and
support experiences. For example, Kaiser-Permanente, the nation's largest health maintenance
organization (HMO), has rolled out a Web site that lets members register online for office visits and
send e-mail questions to nurses and pharmacists (and get responses within 24 hours). Kaiser also
plans to give members access to lab results and pharmaceutical refills online.

Product Line Decisions

Beyond decisions about individual products and services, product strategy also calls for building a
product line. A product line is a group of products that are closely related because they function in a
similar manner, are sold to the same customer groups, are marketed through the same types of outlets,
or fall within given price ranges. For example, Mike produces several lines of athletic shoes and apparel,
Nokia produces several lines of telecommunications products, and Charles Schwab produces several lines
of financial services.

The major product line decision involves product line length—the number of items in the product line.
The line is too short if the manager can increase profits by adding items; the line is too long if the
manager can increase profits by dropping items. The company should manage its product lines
carefully. Product lines tend to lengthen over time, and most companies eventually need to prune
unnecessary or unprofitable items from their lines to increase overall profitability.

Product line length is influenced by company objectives and resources. For example, one objective
might be to allow for upselling. Thus BMW wants to move customers up from it's 3-series models to 5-
and 7-series models. Another objective might be to allow cross-selling: Hewlett-Packard sells printers
as well as cartridges. Still another objective might be to protect against economic swings: Gap runs
several clothing-store chains (Gap, Old Navy, Banana Republic) covering different price points.

A company can lengthen its product line in two ways: by line stretching or by line filling. Product line
stretching occurs when a company lengthens its product line beyond its current range. The company can
stretch its line downward, upward, or both ways.

Companies located at the upper end of the market can stretch their lines downward. A company may
stretch downward to plug a market hole that otherwise would attract a new competitor or to respond to a
competitor's attack on the upper end. Or it may add low-end products because it finds faster growth
taking place in the low-end segments. DaimlerChrysler stretched its Mercedes line downward for all
these reasons. Facing a slow-growth luxury car market and attacks by Japanese automakers on its
high-end positioning, it successfully introduced its Mercedes C- Class cars. These models sell at less
than $30,000 without harming the firm's ability to sell other Mercedes for $100,000 or more. Similarly,
Rolex launched its Rolex Tudor watch retailing for about $1,350, compared with a Rolex Submariner,
usually priced at $3,875.16
Companies at the lower end of a market can stretch their product lines upward. Sometimes, companies
stretch upward in order to add prestige to their current products. Or they may be attracted by a faster
growth rate or higher margins at the higher end. For example, each of the leading Japanese auto
companies introduced an upmarket automobile: Toyota launched Lexus, Nissan launched Infinity, and
Honda launched Acura. They used entirely new names rather than their own names.

Companies in the middle range of the market may decide to stretch their lines in both directions.
Marriott did this with its hotel product line. Along with regular Marriott hotels, it added the Renaissance
Hotels line to serve the upper end of the market and the TownePlace Suites line to serve the moderate
and lower ends. Each branded hotel line is aimed at a different target market. Renaissance aims to
attract and please top executives; Marriotts, upper and middle managers; An alternative to product line
stretching is product line filling—adding more items within the present range of the line. There are
several reasons for product line filling: reaching for extra profits, satisfying dealers, using excess
capacity, being the leading full-line company, and plugging holes to keep out competitors. Sony filled its
Walkman line by adding solar-powered and water- proof Walkmans, an ultralight model that attaches to
a sweatband for exercisers, the MiniDisc Walkman, the CD Walkman, and the Memory Stick Walkman,
which enables users to download tracks straight from the Net. However, line filling is overdone if it
results in cannibalization and customer confusion. The company should ensure that new items are
noticeably different) existing ones.

6.6 Product Mix Decisions

An organization with several product lines has a product mix. A product mix (or product
assortment) consists of all the product lines and items that a particular seller offers for sale. Avon's
product mix consists of four major product lines: beauty products, wellness products, jewelry and
accessories and "inspirational" products (gifts, books, music, and home accents). Each product line
consists several sublines. For example, the beauty line breaks down into makeup, skin care, bath
and beai fragrance, and outdoor protection products. Each line and subline has many individual
items. Altogether, Avon's product mix includes 1,300 items. In contrast, a typical Kmart stocks
15,000 items 3M markets more than 60,000 products, and General Electric manufactures as many as
250,000 items.

A company's product mix has four important dimensions: width, length, depth, and consistency.
Product mix width refers to the number of different product lines the company carries. Pro &
Gamble markets a fairly wide product mix consisting of 250 brands organized into many product
lines. These lines include fabric and home care, baby care, feminine care, beauty care, health care, a
food and beverage products. Product mix length refers to the total number of items the company
carries within its product lines. P&G typically carries many brands within each line. For example, it
s seven laundry detergents, six hand soaps, five shampoos, and tour dishwashing detergents.

Product line depth refers to the number of versions offered of each product in the line. Thus, P&G's
Crest toothpaste comes in 13 varieties, ranging from Crest Multi care, Crest Cavity Protection, and
Crest Tartar Protection to Crest Sensitivity Protection, Crest Dual Action Whitening, Crest
Whitening Plus Scope, Kid's Cavity Protection, and Crest Baking Soda & Peroxide Whitening
formulations.

Finally, the consistency of the product mix refers to how closely related the various product lines
are in end use, production requirements, distribution channels, or some other way. P&G's product
lines are consistent insofar as they are consumer products that go through the same distribution
channels. The lines are less consistent insofar as they perform different functions for buyers.

These product mix dimensions provide the handles for defining the company's product strategy. The
company can increase its business in four ways. It can add new product lines, thus widening its
product mix. In this way, its new lines build on the company's reputation in its other lines. The
company can lengthen its existing product lines to become a more full-line company. Or it can add
more versions of each product and thus deepen its product mix. Finally, the company can pursue
more product line consistency— or less—depending on whether it wants to have a strong reputation
in a single field or in several fields.

SUMMARY

Marketing is a social and managerial process by which individuals and groups obtain what they
need and want through creating and exchanging products and value with others. Significantly,
companies address needs by putting forth a value proposition which is a set of benefits that they
promise to consumers to satisfy their needs. Hereby marketing management is defined as the art and
science of choosing target markets and building profitable relationships between organizations and
customers. This involves getting, keeping, and growing customers through creating, delivering, and
communicating superior customer value. There are three major steps in target marketing. The first is
market segmentation—dividing a market into smaller groups of buyers with distinct needs,
characteristics, or behaviors who might require separate products or marketing mixes. The company
identifies different ways to segment the market and develops profiles of the resulting market
segments. The second step is target marketing— evaluating each market segment's attractiveness
and selecting one or more of the market segments to enter. The third step is market positioning—
setting the competitive positioning for the product and creating a detailed marketing mix.
 CHAPTER 7

FINANCIAL MANAGEMENT
SCOPE OF THE COURSE

After reading chapter 7, you should be able to:

 Understand the fundamentals of accounting

 Explain the elements of cost

 Understand when order would be placed to purchase materials

 Know about inventory systems and wage systems

 Distinguish between management and cost accounting

 Understand cost-volume profit analysis and break even analysis

INTRODUCTION TO FINANCIAL ACCOUNTING

7.1 Definition of accounting

In 1941, the committee on terminology of the American Institute of certified public accounts
(AICPA) formulated the following definition which was widely quoted for many years:

―Accounting is the art of recording, classifying and summering in a significant manner, and in terms
of money transactions and events which are, in part at least, of a financial character, and interpreting
the results thereof.‖

In 1966, the American accounting association (AAA), in order to emphasize the broader perspective
of accounting, provided the following definition of accounting.

―Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by users of the information.‖ More recently, in 1970 the
AICPA of the US defined accounting with reference to the concept of information.‖

―Accounting is a service activity. Its function is to provide quantitative information, primarily

financial in nature, and about economic activities, that is intended to be useful in making decisions
that effect the organization. Today‘s accounting focuses on the ultimate needs of those, who use
accounting information, whether these users are inside or outside the business itself.

Users of accounting information

Accounting provides useful information about the activities of an entity to individuals or group a for
their use in making informed judgments and decisions. The users of accounting information can be
broadly divided into categories:

1. Management if managers

2. Users with direct financial interest

3. Users with indirect financial interest

Fig. 7.1 shows different users of accounting information and different decision made by them.

Accounting

Management (directors, Users with direct

financial interest Users with indirect
officers of the company,
(present and potential financial interest
managers, department heads,
creditors, employee, (customers, taxation
and supervisors) Decisions:
suppliers.) Decisions: authorities, regulatory
Assessing profitability
Share investment agencies financial
financial position and actual
decisions. Credit analysts and advisers,
performance in terms of
decisions, assessing brokers, underwriters,
plans and goals, making
company status and planners, labour, unions,
plans and policies.
prospects, approving consumer groups, general
public, press etc.
supply decisions
Decisions: Assessing
taxes, protecting
investors and public
interest, advising on
investment decisions,
setting economic policies,
measuring social and
environmental protection
programmes, negotiating
labour agreements.

Fig. 7.1: Different Users of Accounting information

Principal Financial Statements

The end product of the financial accounting process is a set of reports that are called financial
statements. The following constitute the financial statements:

1. Profit and loss account

2. Balance Sheet

3. Statement of Changes in Financial Position (SCFP)

Profit and loss account also known as income statement, presents the results of operations of a
business enterprise for a period of time. This statement shows net profit or net income of an entity
for a period of time.

Balance sheet shows the financial position of a business on a certain date. For this reason, it is often
called the statement of financial position... Balance sheet indicates the investing and financing
activities of a business enterprise at a point of time and shows a firm‘ assets, liabilities an equity
capital.

A Statement of changes in Financial Position (SCFP) shows where in financial resources (funds)
have come from (sources) and where they have gone (users).

7.1 Postulates, Concepts And Principles Postulates

Accounting postulates are basic assumptions which are generally accepted as self-evident truths in
accounting. Postulates are established or general truths which do not require any evidence to prove
them. They are the propositions taken for granted.

Concepts

Accounting concepts are also self evident Statements or truths. Accounting concepts provide the
conceptual guidelines for application in the financial accounting process. The concepts are
important because they (a) help explain the ‗why‘ of accounting (b) provide guidance when new
accounting situations are encountered, and (c) significantly reduce the need to memories accounting
procedures when learning about accounting.

Accounting Postulates

1. Entity Postulate: The entity postulate assumes that the financial statements and other
accounting information are for the specific business enterprise which is distinct form its owners.
Attention in financial accounting is focused on the economic activities of individual business enterprise.

2. Going Concern Postulate: An accounting entity is viewed as continuing in operation

in the absence of evidence to the contrary. Because of the relative permanence of enterprises,
financial accounting is formulated assuming that the business will continue to operate for an
indefinitely long period in the future.

3. Money measurement Postulate: A unit of exchange and measurement is necessary to

account for the transactions of business enterprises in a uniform manner. The common denominator
chosen in accounting is the monetary unit.

4. Accounting Period Postulate: Financial accounting provides information about the

economic activities of an enterprise for specified time periods that are shorter than the life of the
enterprise. Normally the time periods are of equal length to facilitate comparison.

Accounting Concepts and Principles

1. Cost Principle: The cost principle requires that assets be recorded at the exchange
price, i.e. acquisition cost or historical cost. Historical cost is recognized as the appropriate
valuation basis for recognition of the acquisition of all goods and services, expenses, costs and
equities.

2. Dual-Aspect Principle: This principle lies at the heart of the whole accounting
process. Accounts recording systems have therefore developed so as the show two main things; (a)
the source of wealth, and (b) the form it takes.

3. Accrual Principle: Accrual accounting is based not only on cash transactions but also
on credit transactions, barter exchanges, changes in prices, changes in the form of assets or
liabilities, and other transactions, events, and circumstances that have cash consequences for an
enterprise but involve no concurrent cash movement.

4. Conservatism Principles: The concept of accounting conservatism suggests that when

and where uncertainty and risk exposure so warrant, accounting takes a wary and watchful stance
until the appearance of evidence to the country.

5. Matching Principle: The matching principle in financial accounting is the process of

matching (relating) accomplishments or revenues (as measured by the selling prices of goods and
services delivered) with efforts or expenses (as measured by the cost of goods and services used) to
a particular period for which the income is being determined.
6. Consistency Principle: This principle requires that once an organization has decided
on one method, it should use the same method for all subsequent transactions and events of the
same nature unless it has sound reason to change methods.

7. Materiality Principle: Materiality concept implies that the transactions and events
that have immaterial or insignificant effects should not be recorded and reported in the financial
statements. It is argued that the recording of insignificant events cannot be justified in terms of its
subsequent poor utility to users.

8. Full disclosure principle: The principle of full disclosure requires that a business
enterprise should provide all relevant information to external users for the purpose of sound
economic decisions.

Basic Accounting Equation Or Model

The framework of the financial statements and the elements shown in these statements rests on
important and basic relationship, referred to as basic or fundamental accounting equation or basic
accounting model. This basic equation is expressed by the balance sheet equation, and therefore, is
known as the balance sheet equation also. The balance sheet equation indicates that

Sources of Funds = Uses of Funds (Or) Equities = Assets (Or) Proprietor‘s

Equity (Capital) + outside Liability = Assets

The above accounting equation signifies that assets of a business are always equal to the total of
outside liabilities and proprietor‘s equity.

Example:

On January 1, 1999, a company Super Consultants India Ltd. Was incorporated. The following
transactions occurred during January 1999.

January

1. Business was started with capital of Rs. 10,000 cash.

4 Equipment was rented (and paid) for the month at a cost of Rs. 1,200.

8 Paper stationery purchased on credit Rs. 800.

15. The company charged Rs. 3,000 as consulting fees from the customers during January. This
amount is due to be received next month.
20. Miscellaneous expense of Rs. 600 were paid.

29. Land was purchased by borrowing Rs. 40,000 from a bank

The loan is due to be repaid in five years. Interest payments are due at the end of each money
beginning July 31.

30. Salaries of Rs.700 for the month were paid.

31. Lesson fees were billed to customers in the amount of Rs. 2,800. (They are due to be
received next month).

Prepare a summary of the preceding transactions. Determine balances after each transaction to show
that the basic equation is in balance.

Prepare an income statement, a statement of retained earnings, balance sheet for January 1999.

Solution: SUPER CONSULTANT INDIA LTD.

SUMMARY OF TRANSACTIONS, January 1999

INCOME STATEMENT FOR THE MONTH ENDED JANUARY 31, 1999

Revenues: (Rs.)

Consulting fees 3,000

Lesson Fees 2,800
Total Revenues 5,800

Less: Expenses
Rent expense 1,200
Paper & Stationery 800
Salaries 700
Misc. expenses 600
3,300

Net Income 2,500

STATEMENT OF RETAINED EARNINGS

Accounting Records

Accounting is based on a double-entry system, which means that we record the dual effects of a
business transaction. Each transaction affects at least two accounts. For example, an owner‘s cash
investment in the business increases both the Cash account and the Capital account of the business.
It would be incomplete to record only the increase in the entity's cash without recording the increase
in its owner's equity.

Consider a cash purchase of supplies. What are the dual effects of this transaction? The purchase (1)
decreases cash and (2) increases supplies. A purchase of supplies on credit

(1) increases supplies and (2) increases creditors. All transactions have at least two effects on the
entity.
The T-Account

The most widely used account format is called the T-account because it takes the form of the capital
letter "T." The vertical line in the T-account divides the account into its left and right sides. The
account title rests on the horizontal line. For example, the Cash account of a business appears in the
following T-account format:

The left side of the account is called the debit side, and the right side is called the credit side. Debit
and credit are abbreviated as follows:

Dr = Debit Cr = Credit

The account category determines how increases and decreases in it are recorded. For any given
account, all increases are recorded on one side, and all decreases are recorded on the other side.

Rules of Debit and Credit

Increases in assets are recorded on the left (debit) side of the account. Decreases in assets are
recorded on the right (credit) side.

Conversely,

Increases in liabilities and owner's equity are recorded by credits. Decreases in liabilities and
owner's equity are recorded by debits.

Whether an account is increased or decreased by a debit or a credit depends on the type of account.
This pattern of recording debits and credits is based on the accounting equation:

Assets = Liabilities + Owner's Equity Debits = Credits

Assets are on the opposite side of the equation from liabilities and owner's equity. Therefore,
increases and decreases in assets are recorded in the opposite manner from those in liabilities and
owner's equity. And liabilities and owner's equity, which are on the same side of the equal sign, are
treated in the same way.
Cash Book

This records all receipts of and payments in cash. Usually the deposits into bank accounts
maintained by the business, withdrawals from such accounts and cheque payments are also recorded
in the Cash Book. Sometimes a separate book for recording receipts and payments by cheques/DDs
etc., is kept, known as the Bank Book. A Cash Book which is used to record both cash and bank
transactions is referred to as a Two-column Cash Book. The format of this cash book is given
below:

Table 7.1 Cash book

Date Receipts Cash Bank Date Payments Cash Bank

(Rs.) (Rs.) (Rs.) (Rs.)
2000 2000
April 1 To Balance b/d 1,500 13,000 April 2 By wages 50
6 To Sales 800 5 By electricity 400
7 To Arvind Co 2,000 8 By Plumbing 400
11 To Bela Corporation 2,350 15 repairs 10,800
20 To Sales 500 30 2,350 6,150
2,800 2,800 17,350

Journal

The Books of Accounts maintained by an organization other than the cash book may be classified
into Journals and Ledgers. The Journal is used as the book of first entry for all transactions which
cannot be recorded in the Cash Book. In other words, all non- cash transactions should be recorded
in the journal. For practical convenience the journal is maintained by using a number of books
called the subsidiary books. For example, the following subsidiary books may constitute the journal
for an enterprise.

(i) Purchase Book

(ii) Purchase Returns Book

(iii) Sales Book

(iv) Sales Returns Book

(v) Bill Receivable Book

(vi) Bills Payable Book

(vii) Journal Proper

Specimen formats of these books and brief explanations regarding their use are given in the
following sections.

Purchases book

Also known as the purchases Journal, this book is used to record credit purchases of goods only.
The term ‗goods‘ covers only those items procured by the business for resale.

Table 7.2 Purchase Book of Johnson Co.

Date Name of Supplier Ledger Folio Inward Invoiced Amount Rs.

No.
2000
April 2 Y Limited 3354 10,950
12 Sharp Enterprises 401 2,700
20 Best and Company 5542 3,900

Total 17,550

Purchase Returns Books

This subsidiary book is used to record the goods purchased on credit and sent back to suppliers as
they are found not conforming to specifications or for any other reason.

Table 7.3 Purchase Returns Book of Johnson Co.

Date Name of Supplier Ledger Folio Debit Note No Amount (Rs.)

2000
April 5 Sharp Enterprises 80 1,000
25 Best and Company 81 900

Total 1,900

Sales Book
Also known as the Sales Journal, this subsidiary book is used to record all sales of goods on credit.

Table 7.4 Sales book

Date Name of Supplier Ledger Folio Outward Invoice Amount (Rs.)

No.
2000
April 3 Beta Corporation 1001 2,410
5 Zeta Company 1002 3,940
6 Quality Dealers 1003 4,990
15 Sooraj Traders 1004 1,800
25 Star Enterprises 1005 19,500
Total 32,550

Sales Returns Book

This book is used to record the transactions relating to goods sold on credit and received back form
the customers as not conforming to the specifications or for any other reason.

Table 7.5 Sales Returns Book

Date Name of Customer Ledger Folio Credit Note Amount (Rs.)

No

2000

April 10 Company 10 540

27 Star Enterprises 11 2,000

Total 2,540

Bills Receiveable Book

The bills Receivable of an enterprise consists of all Promissory Notes is given by customer our Bills
of Exchange accepted by customers in respect of amounts due from them the bills Receivable Book
is used to record all such promissory Notes given or such bills of Exchange accepted by customers.

Table 7.5 Bills Receivable Book of Johnson Co

 Date From Acceptor Date of Term Date of Where Amount. How
Whom bills maturity payable (Rs.) Disposed
reced.
April Quality Quality 8.4.95 90 10.7.95 Bank of 4,900 Discounted
12 Dealers Dealers days India on 20.4.95

18 Sooraj Sooraj 16.04.95 10.6.95 Central 1,800

Traders Trader 60 Bank of
days India, New
Delhi
6,700

Bills Payable Book

The Bills Payable consists of all Promissory Notes given or Bills of Exchange accepted by the
business in respect of amounts owing to its suppliers. The Bills Payable Book is used to record all
such Promissory Notes given or Bills of Exchange accepted by the business

Table 7.6 Bills Payable Book of Johnson Co

N Date Name of thePayee Date of Term Date of Where Amount. Remark

drawer Bills maturity payable
1995 April 25 Best & Co. Best & 25.4.95 92 27.7.95 Canara 3,000
Co. Days Bank,
Bombay

Journal Proper

This Book is used to record all transactions which cannot be included in the cash book or any of the
other six subsidiary books, discussed above. The transactions that will be recorded in Journal Proper
are, purchase or sale of fixed assets and investments on credit, adjusting entries, rectification entries
etc.

Table 7.7 Journal Proper

Date Particulars Ref. Ledger Folio Debit (Rs.) Credit (Rs.)

April 10 Furniture and Fitting A/c 4,000 4000
Dr.
To Furniture Mart A/c
(being the purchase of furniture on
credit)

April 30 Repairs to machinery A/c Dr. 5,000 5,000

To Machinery A/c
(being the rectification of a wrong
posting of a repair expense to
asset (A/c)

Ledger

An accounting system typically contains a large number of accounts. Collectively these individual
account are contained in a record know as the ledger. A ledger is simply the grouping of the
accounts that are used to prepare financial statements for a business. A ledger account is a summary
device and its simplest form is shaped like the letter and called a T account

Relationship between Journal and Ledger

Journal and ledger are the most important books maintained in an enterprise. They are closely
interrelated. Business transactions are recorded first in Journal and other books of original entry and
then from these books that are transferred to ledger. Journal records transaction in a chronological
order while the ledger records the transactions in a classified form.

Posting

Posting is a process of transferring debits and credits from the Journal and other books of original
entry to their respective account in the ledger. The aim of posting is to make a classified and
summarized record of business transactions in appropriate accounts.

Posting Of Different Account Books:

Cash book

Rules regarding posting of cash book are given below:

(i) Transactions recorded on the debit side of Cash Book are posted on the credit side of
accounts opened in the ledger.

(ii) Transactions recorded on the credit side of the cash book are posted on the debit side of
different account in the ledger.

Purchase Book

In purchases Books, credit purchases of goods in which the enterprises deals are recorded. Accounts
of all those persons who have supplied goods are to be opened and credited with the amount of
purchase made from the. Total of purchases book is to be posted on the debit side of purchases
account. This is illustrated below:

Harish Jain, Delhi

Dr. Cr.
Rs. Rs.
1.6.94 By Purchase a/c 10,000

Summant Prasad

Dr.
Rs. Rs.
31.5.94 By Purchase a/c 20,000

Purchased a/c

Dr. Cr.
Rs. Rs.
1.6.94 To Sundries a/c 30,000

Purchase Return Book

Purchases Return Book, also called Returns Outward Book, records returns of Purchase made to
suppliers. Personal accounts of all these persons to whom goods have returned are debited and total
of purchase returns book is credited to purchase returns account as illustrated below

Harish Jain, Delhi

 Dr. Cr.
Rs. Rs.
15.7.94 To Purchases Return a/c 1,000 1-7-94 By Purchases a/c 10,000

Summant Prasad

Dr. Cr.
Rs. Rs.
20-6- To Purchase return a/c 3,000 31.5.94 By Purchases a/c 20,000
94

Purchase Returns a/c

Dr. Cr.
Rs. Rs.
31.7.94 By Sundries 4,000

Sales Book

Sales Book records all credit sales. While posting Sales Book to ledger, Personal accounts of the
customers are opened and debited by the amount of sales made to them total of Sakes us redited to
Sales account. This is illustrated below.

Ram Pershad

Rs. Rs.
2.7.94 To Sale a/c 15,000

Devi Prasad

Rs. Rs.
25.6.94 To Sales a/c 20,000

Sales A/c

Rs. Rs
31.7.94 By Sundries 15,000
Sales Returns Book/Returns Inward Book

When goods are returned by customer they are recorded in sales returns book/returns inward book.
While posting Sales Returns book to Ledger, personal accounts of the customer are credited and
total of Sales Returns Book is debited to Sakes returns a/c. this is illustrated below:

Ram Prashad

Dr. Cr.
Rs. Rs.
2.7.94 To Sales a/c 15,000 14.7.94 By Sales returns a/c 4,000

Devi Dass

Dr. Cr.
Rs. Rs.
25.6.94 To Sales a/c 20,000 10.7.94 By Sales return a/c 4,000

Sales A/c

Dr. Cr.
Rs. Rs.
15.7.94 To Sundries 8,000

Bills Receivable Book

In bills receivable book, bills received by the enterprise are recorded. While posting Bills receivable
book, Personal accounts of the persons giving the bills are credited. Total of Bills Receivable book
is debited to Bills Receivable a/c

Sunder Kumar

Dr. Cr.
Rs. 1994 Rs.
July 10 By B/R a/c 10,000
Suresh Chander

Dr. Cr.
Rs. 1994 Rs.
July 7 By B/R 15,000

Bill Receivables a/c

Dr. Cr.
Rs. Rs.
15.7.94 To Sundries 25,000

Bills Payable Book

The enterprise may accept so many bills in the business. Acceptances given are recorded in Bills
payable book. While posting Bills payable Book acceptances given are debited to the personal
accounts of the persons to whom they have been given and total of Bills Payable book is posted to
the credit side of Bills payable a/c. This is illustrated below:

Ram Prasad

Dr. Cr.
Rs. Rs.
2.7.94 To B/P 8,000

Chandra Mohan

Dr. Cr.
Rs. Rs.
10.7.94 To B/p a/c 7,000

Dr. Cr.
Rs. Rs.
15.7.94 By Sundries 15,000

Posting Of Journal

When we journalize a transaction we write out in the journal as to which account is to be debited
and which account is to be credited. The same information is transferred to Ledger in the two
concerned accounts. This is illustrated below:
Table 7.8 Posting of Journal

Particulars Rs. Rs.

Furniture a/c 70,000 70,000
Dr.
To Jain & Co.
7,000 7,000
(Being furniture bought from Jain & Co. on Credit
Depreciation Dr. a/c
To Furniture a/c

Furniture a/c

Dr. Cr.
Rs. Rs.
To Jain & Co. 70,000 By depreciation a/c 7,000

Depreciation a/c

Dr. Cr.
Rs. Rs.
To Furniture a/c 7,000

Jain & Co.

Dr. Cr.
Rs. Rs.
To Furniture a/c 70,000

Balancing of an Account

Balancing of an account implies a process of ascertain the net balance of an account after
considering and comparing the total of both sides-viz debit side and credit side. The Balance is put
on the side which is smaller and the two totals-debit side and credit side. The Balance is put on the
side which is smaller and the two totals-debit side and credit side are made equal. Against the
balance a reference is put that is has been carried forward (C/F). The balance of an account will be
termed as debit balance if the total of debit side is greater than the total of credit side. On the other
hand, if total of credit side is greater than total of debit side, balance will be a credit balance. This is
illustrated below:
Mohan

Table 7.9 Balancing of an Account

Rs. Rs.
5.5.94 To B/p a/c 7,000 1.5.94 By purchase a/c 15,000
6.5.94 To purchase returns 2,000 16.5.94 By purchase a/c 25,000
17.5.94 To Bank a/c 15,000
31.5.94 To Balance c/d 16,000

40,000 40,000

By balance b/d 16,000

Furniture a/c

Rs. Rs.
1.5.94 To Bank a/c 16,000 31.5.94 By balance c/d 16,000

16,000 16,000

1.6.94 To Balance b/d

16,000

Trial Balance

When all accounts of the ledger are in balance, a Trial Balance is prepared. A Trial Balance is a
listing of all the accounts and their respective balances. Trial balance is a statement of debit
balances and credit balance extracted from ledger accounts on a particular date. A Trial Balance is,
thus, a summary of all the ledger balances outstanding as on a particular date.

Performa of a Trial Balance is as follows:

Trial Balance as at….

Ledger accounts Debit Balance Credit Balance

It must be stated here that total of debit balance column must be equal to total of credit balances
column. This is so because under double entry system, for each item of debit there is a
corresponding credit and secondly all the transactions recorded in the books of original entry are
transferred to ledger.
Objectives of Preparing a Trial Balance

The following are the objectives of preparing a Trial Balance:

1. To check the

2. Arithmetical accuracy of accounting entries posted in the ledger- When the trail
balances tallies, it is an indication of the fact that ledger accounts are arithmetically accurate. It also
indicates that: (i) For each transaction, the debits and credits were recorded in equal amounts. (ii)
The balance (debit balances and credit balance)for each account was calculated correctly. (iii) The
balances of the various debit and credit accounts have been correctly added together to arrive at the
total equality of the debit and credits. Of course there may be certain errors in the books of accounts
inspite of the agreement of Trial Balance. These have been discussed later in a subsequent chapter.

3. To Provide a Basic for Financial statement- Trial Balance is a first step towards
preparation of financial statement of an organization. If trail balance is not prepared, it will be
impossible to prepare the financial statement.

4. Trial Balance serves as a summary of all the ledger accounts and provides a
complete picture of each account in the ledger.

Example

During January 1999, Anil Kumar transacted the following business. You are required to make
journal entries for the transactions and prepare cash book and other necessary ledger accounts based
on the journal entries.

January 1999
1 Commenced business with cash 20,000
2 Purchased goods on credit from Shyam 15,000
3 Purchased goods for cash 500
4 Paid Gopal an advance for goods ordered 1,000
5 Received cash from Muthy as advance for goods ordered by him 1,500
6 Purchased furniture for office use for cash 1,000
7 Paid wages 250
8 Received commission (in cash) 300
9 Goods returned to Shyam 100
10 Goods sold to kamal 5,000
11 Paid for postage and telegrams 100
 12 Goods returned by kamal 250
15 Paid for Stationery 100
18 Paid into bank 250
20 Good sold for cash 375
22 Bought goods for cash 500
25 Paid salaries 350
28 Paid rent 250
31 Drew cash for personal use 500

Table 7.10 Solution

Date Particulars L.F Debit Credit

(Rs.) (Rs)
1999 Cash account 20,000
Jan.1 Dr.
To Capital account 20,000
( Being the cash brought into business as capital)
Jan. 2 Purchase account 15,000
Dr
To Shyam‘s account 15,000
(Being the goods purchased on credit)
Jan 3 Purchase account 500
Dr
To Cash account 500
(Being the goods purchased for cash)
Jan 4 Gopal account 1,000
Dr
To Cash account 1,000
(Being the amount paid to Gopal)
Jan 5 Cash account 1,500
Dr
To Murthy account 1,500
(Being the cash received from Murthy)
Jan 6 Furniture account 1,000
Dr
To cash account 1,000
(Being the furniture purchased for office use for
cash)
Jan 7 Wages account 250
Dr
To cash account (Being the wages paid) 250
Jan 8 Cash account 300
Dr
To commission received a/c (Being the 300
commission received)
Jan 9 Shyam account 100
Dr
To purchase returns account (Being goods 100
returned to shyam)
Jan 10 Kamal account 5,000
Dr
To sales account 5,000
(Being goods sold to kamal on credit)
Jan. 11 Postage and telegrams account 100
Dr
To Cash account 100
(Being the goods returned by kamal)
Jan 12 Sales returns account Dr 250
To Kamal account
(Being the goods returned by kamal) 250
Jan.15 Stationary account 100
Dr
To cash account 100
(Being the amount paid for stationary)
Jan 18 Bank account Dr 250
To cash account
(Being the amount deposited in to the bank) 250
 Jan 20 Cash account Dr 475
To sales account
(Being the goods sold for cash) 475
Jan 22 Purchase account To cash account Dr 500
(Being the goods purchased for cash)
500
Jan 25 Salaries account To cash account Dr 350
( Being the amount paid as salaries
350
Jan 28 Rent account Dr 250
To cash account
( Being the rent paid) 250
Jan 31 Drawings account To cash account Dr 500
(Being the cash drawn for personal use)
500

LEDGER ACCOUNTS

Table 7.11 Cash Book

Dr Cr
Date Receipts Ledg Cash (Rs.) Bank (Rs) Date Payments Ledg Cash (Rs.) Bank (Rs)
er Folio er Folio
1999 1999
Jan.1 To capital a/c 20,000 Jan.3 By Purchase a/c 500
Jan.5 To Murhty a/c 1,500 Jan.4 By Gopal a/c 1,000
Jan.8 To commission a/c 300 Jan.6 By Furniture a/c 1,000
Jan.18 To cash a/c C 250 Jan.7 By wages a/c 250
Jan.20 To sales a/c 375 Jan.12 By postage &
telegrams 100
Jan.15 By stationary a/c 100
Jan.18 By bank a/c C 250
Jan.22 By purchase a/c 500
Jan.25 By salaries a/c 350
Jan.28 By rent a/c 250
Jan.31 By drawings a/c 500
Jan.31 By balance c/d 17,375 250

22,175 250 22,175 250

Note : The letter ‗C‘ in the Ledger Folio column denotes a contra entry. This is an entry for which
the debit and credit aspects are found in the cash book itself.

Purchase Book

Dr. Cr.
Date Name of supplier Ledger Folio Inward Invoice Amount (Rs.)
No
1999
Jan.2 Shyam 15,000
Total 15,000

Purchase Returns Book

Date Name of supplier Ledger Folio Inward Invoice Amount (Rs.)

No
1999
Jan 9 Shyam 100

Total 100

Sales Book

Date Name of supplier Ledger Folio Inward Invoice Amount (Rs.)

No
1999
Jan.10 Kamal 5,000

Total 5,000

Sales Returns Book

Date Name of supplier Ledger Folio Inward Invoice Amount (Rs.)

No
1999
Jan.13 Kamal

Total 250
250
GENERAL LEDGER

Capital Account

Date Rs. Date Rs.

1999 1999 By cash a/c By
Jan.31 To balance c/d 20,000 Jan. 1 balance b/d 20,000
20,000 20,000
Feb.1 20,000

Shyam’s Account

Date Rs. Date Rs.

1999 1999
Jan.9 To Purchase 100 Jan.2 By purchase a/c 15,000
Jan.31 returns 14,900
To balance c/d 15,000 15,000
Feb.1 By balance b/f 14,900

Purchase Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.2 To Shyam a/c 15,000 Jan.31 By balance c/d 16,000
Jan.3 To cash 500
Jan.22 To cash 500

Feb.1 By balance b/d 16,000 16,000

16,000 16,000

Sales Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.31 To balance c/d 5,375 Jan.13 By Kamal a/c 5,000
Jan.20 By cash 375
5.375 5,375
 Feb.1 By balance b/d

5,375

Purchase Returns Accounts

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.31 To balance c/d 100 Jan.9 By Shayam a/c 100
100 100

Feb.1 By balance b/d 100

Sales Returns Account

Dr Cr
Date Rs. Date Rs.
1999 1999
Jan 13 To Kamal a/c To 250 Jan.31 By balance 250
Feb.1 balance b/d 250 250
250

Gopal’s Accounts

Dr Cr.
Date Rs. Date Rs.

1,000 1,000
1,000 1,000
Feb.1 To balance b/d 1,000

Wages Account

.Dr Cr.
Date Rs. Date Rs.
1999 To Cash a/c To 1999
250 By balance c/d 250
 Jan 6 balance b/d 250 Jan.31 250
250
Feb.1

Commission Received Account

Dr Cr.
Date Rs. Date Rs.
1999 1999 By cash a/c By
Jan 13 To balance c/d 300 Jan.8 balance b/d 300
300 300
Feb.1 300

Kamal’s Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To sales a/c 5,000 Jan.31 By Sales returns 250
5,000 Jan.31 a/c 4,750
Feb.1 4,750 By Balance c/d 5,000

Postage and Telegrams Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 100 Jan.31 By Balance c/d 100
100 100
Feb.1 To balance b/d 100

Stationary Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 100 Jan.31 By Balance c/d 100
100 100
 To balance b/d 100
Feb.1

Salaries Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 350 Jan.31 By Balance c/d 350
350 350
Feb.1 To balance b/d 350

Rent Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 250 Jan.31 By Balance c/d 250
250 250
Feb.1 To balance b/d 250

Drawing Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 500 Jan.31 By Balance c/d 500
500
Feb.1 To balance b/d 500

Murthy’s Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To balance b/d 1,500 Jan.5 1,500
1,500 By Balance c/d 1,500
Feb.1 Feb.1 1,500
Furniture Account

Dr Cr.
Date Rs. Date Rs.
1999 1999
Jan.10 To cash a/c 1,000 Jan.31 By Balance c/d 1,000
1,000 1,000
Feb.1 To balance b/d 1,000

7.2 Preparation of Financial Statements: Profit and Loss Account and Balance Sheet
Trial Balance is first step towards preparation of financial statement namely trading and Profit and
Loss Account and Balance Sheet. Trading and Profit and Loss Account are prepared in order to
determine the income earned or loss incurred during the accounting period. Balance Sheet indicates
the financial position of the enterprise. However, before preparing trading account, profit and loss
account and balance sheet, certain adjustment entries are required.

Adjustment Entries

As stated earlier, financial accounting uses accrual basis of accounting which is supported by
Generally Accepted Accounting Principle (GAAP). Under accrual basis of accounting.

1. Revenues are recognized when earned, without regard to the timing of cash receipts.

2. Expenses are recognized either (a) in the period in which related revenues are recognized or
(b) when incurred, without regard to the riming of cash disbursement.

When the accrual basis of accounting is used, adjusting entries are required at the end of the period
to record any previously unrecognized changes in assets, liabilities, revenues, or expenses.
Adjusting entries are made to modify certain account balances at the end of the accounting period so
that they will reflect fairly the situation as of the end of the period.

Generally, four general types of adjustment (adjusting entries) are needed at the end of the
accounting period prior to the preparation of financial statements:

1. Reflecting unrecorded revenue earned during the accounting period.

2. Reflecting unrecorded expenses incurred during the accounting period.

3. Reflecting or aligning recorded costs with the appropriate accounting periods

i.e. considering expenditures benefiting more than one accounting period.

4. Reflecting or aligning recorded revenue with the appropriate accounting period

i.e. considering revenues received in advance.

Adjustment in the first two categories- unrecorded revenues and unrecorded expenses =- are
referred to as accruals such as salaries and wages incurred but not paid, interest earned but nor
received. Adjustments in the last to categories – reflecting recorded costs and revenues with the
appropriate periods- are referred to as deferrals such as prepaid expenses, unearned revenue and
depreciation.

Adjusting entries have following features:

1. Every adjusting entry affects both the profit and loss account and the balance sheet.

2. Adjusting entries do not directly affect the cash account.

3. They are generally recorded at the end of the accounting period.

4. A profit and loss account balance (revenue or expense) is changed.

5. A balance sheet account balance (asset or liability) is changed.

Types of Adjusting Entries

The different items or situations which are subject to adjusting entries before preparing financial
statements are explained below:

1. Closing Inventory: Under the periodic verification method, the closing inventory of
every item is arrived at by physically counting the inventory available and assigning a value to the
same. In concerns adopting the periodic verification method, the value of closing inventory will be
brought into the books of account through the following journal entry:

Closing inventory A/c Dr.

To Trading A/c

While the closing inventory appears on the credit side of the trading account to reduce the cost of
goods sold, it also appears as an asset in the Balance Sheet.

2. Outstanding or Accrued Expense: The nominal accounts record the actual expense
paid during the accounting period. However, prior to the preparation for the financial statements, it
must be ensured that all expenses which have fallen due to be paid but which have not been paid
during the accounting period are also brought into the books to help in the proper matching of
revenues and expenses. For example, ABC Trading Company had the practice of paying the salaries
of the employees of 4th of the subsequent month. During the financial year ending 31st March 1995
the salaries account shows a debit balance of Rs.55, 000. The salaries of Rs.6, 000 pertaining to
March 1995 were paid on 4th April. 1995. While preparing the financial statements for the year
ending 31st March, 1995, the salaries of Rs. 6,000 of March must also be included. This is done with
following adjusting journal entry:

Salaries A/c Dr. Rs. 6,000

To Outstanding Salaries A/c Rs. 6,000

The above journal entry increase the salaries to the correct amount of Rs. 61,000 and the
Outstanding salaries of Rs. 6,000 will be shown as a liability in the Balance Sheet.

The adjusting journal entry to record any outstanding expense is Expense A/c Dr.

To Outstanding Expense A/c

While the amount of expense taken from the Trial Balance will be increased by the amount
Outstanding and shown in the Trading and Profit and Loss Account, the actual amount outstanding
will be shown as a liability in the Balance Sheet. In the subsequent accounting period, the
outstanding expense liability will be transferred to the expense or nominal account and will be set
off by the entry of actual payments when it is made.

3. Prepaid Expense: Certain expenses paid may relate to more than one accounting
period. In such cases, it is necessary to identify the portion of the expenditure for which the benefit
is yet to be received by the concern and treat that part of the expenditure as prepaid.

ABC Trading Company took an insurance cover for all assets against fire on Ist October 1994 and
paid the annual premium of Rs. 2,400 on the same day. Since the benefit of the entire expenditure
will expire only on 30th September, 1995, it is necessary to recognize this aspect while preparing the
financial statements as on 31st March, 1995.

The amount of expense prepaid on 1st October, 1994= (1/2x2, 400 = Rs. 1,200). The adjusting entry
to record the prepaid insurance is
Prepaid Insurance A/c Dr. Rs. 1,200

To Insurance A/c Rs. 1,200

This ensures that the insurance expense is reported at the correct figure of Rs. 1,200 in the profit
and loss account and the prepaid amount is shown as an asset in the balance sheet.

The journal entry to record any prepaid expense is,

Prepaid Expense A/c

To Expense A/c

In the subsequent accounting period, the balance in the prepaid expense account will be transferred
back to the expense account.

4. Outstanding Accured Income: An income appearing in the ledger account may not
represent the income that must have been received during the year. If a portion of an income has not
yet been received or is outstanding as at the end of the accounting period then the outstanding
amount must be brought into books.

ABC Trading Company would have received the interest of Rs. 350 [5,000x (14/100)x 1/2}] during
the accounting period ending 31st march, 1993, the interest of Rs. 350 for the next six months will
be received only in the subsequent accounting period. However, while preparing the financial
statements, the total interest revenue to be recognized is the amount of Rs. 350 actually received
plus the interest of Rs. 175 pertaining to the period Ist January, 1993 to 31st March, 1993.

The following adjusting entry will bring into books the amount of outstanding interest:

Outstanding Income A/c Dr. Rs. 175

To Interest Received A/c Rs. 175

While the interest received will be increased to Rs. 525 and shown in the profit and loss account,
the outstanding interest account will be listed as an asset in the Balance Sheet.

In the subsequent accounting period, the amount in the outstanding interest A/c will be transferred
to interest received A/c and the actual receipt of the interest will offset the former transfer entry.

Outstanding Income A/c Dr.

To Income A/c

5. Income Received in Advance: While preparing the financial statements,

adjustments may be necessary in respect of any incomes received in advance. Assume a Law
publication has received subscriptions amounting to Rs. 50,000 during the financial year ending 31st
December, 1992. Out of this, Rs. 2,500 represents subscriptions relating to the next financial year.

The entry to adjust for the income received in advance will be,

Subscription A/c Dr. Rs. 2,500

To Subscription received in Advance Rs. 2,500

With the posting of the above journal entry, the subscriptions account will be shown in the profit
and loss account at the credit figure of Rs. 47,500 and in the balance sheet, the subscriptions
received in advance as a liability. Any income received in advance is a liability as benefits are yet to
be conferred to the person from whom the amount has been received. The journal entry to record the
adjustment of any income received in advance is

Income A/c Dr.

To Income Received in Advance A/c

6. Depreciation: Depreciation is the acquisition cost of an asset (less the expected

salvage value) spread over the economic life of that asset. The purpose of charging depreciation
over the economic life of the asset is to match the cost of the asset over the period for which the
revenue is earned by using the asset.

Preparing Profit And Loss Account

From a given trial balance, we can prepare a Profit and Loss account to determine the profit and loss
made by a business firm during a particular period. At the time of preparation of profit and loss
account, the following point may be kept in mind:

All expenses are debited to Profit and Loss Account All incomes are credited to Profit and Loss
Account

Further, we may have to give special treatment to certain adjustment also (discussed in detail earlier
in the chapter)
Balance Sheet

A balance sheet, also commonly referred to as a statement of financial positions, is a statement of

assets and liabilities of business enterprises at a particular date. The balance sheet summarizes and
reveals the financial position of enterprises on a particular date, by showing what it owns and what
is owes. Because the balance sheet is a snap shot of an instant in time, it is a status report rather than
flow report.

The balance sheet is a fundamental or first accounting statement in the sense that every accounting
transaction can be analyzed in terms of its dual impact on the balance sheet. Moreover, most often,
revenues and expenses are defined in terms of changes in assets and liabilities. Thus, a thorough
understanding of the nature and measurement of assets and liabilities is needed to understand net
income and its component. A Balance Sheet has no debit and credit side. It is a prepared on a
particular date and as such, it shows the assets and liabilities of business enterprises on that date.
Even a single transaction will cause a change in the assets and liabilities of the enterprises as shown
in the Balance Sheet. Therefore, it is true only for the date on which it has been prepared. It is called
a Balance sheet because it is actually a sheet containing balances of ledger accounts which have not
been closed by transfer to trading and profit and loss a/c.

Arrangement of Assets and Liabilities Items On The Balance Sheet

In the case of a company, The Companies Act 1956 provides that balance sheet should be prepared
as per schedule VI given therein and assets and liabilities should be written in the sequence (or
order) shown in the Schedule. However, in the case of sole proprietorship, and partnership, no rule
is provided for recording assets and liabilities on the balance sheet.

Example

On 31.12.1999 the following Trial Balance was prepared from the books of Raju:

Dr. (Rs) C. (Rs)

Sundry Debtors 50,600 10,000
Surndry Creditors - -
Bills Receivable 5,000 -
Plant & Machinery 75,000 -
Purchases 90,000 70,000
Capital - -
Freehold Premises 50,000 -
 Salaries 11,000 -
Wages 14,400 -
Postage and Stationary 750 -
Carriage In 750 -
Carriage Out 1,000 -
Bad debts 950 -
Bad Debts Provisions - 1,000
General Charges 1,500 -
Cash at Bank 5,300 -
Cash in Hand 800 -
Bills Payable - 5,000
Reserve - 20,000
Sales - 2,31,700
Closing Stock 29,,300 -

3,37,050 3,37,500

The following adjustments are required:

(1) Raju gets a salary of Rs. 9,000 p.a

(2) Allow 5% interest on capital

(3) Bad debts provision to be adjusted to 21/2% on sundry debtors.

(4) 21/2% of the net profit to be credited to Reserve.

(5) It was discovered in January 1999 that stock sheets as on 31.12.1998 were
overcast by Rs 1,000.

You are required to prepare Trading and Profit and Loss account for the year ended 31st December,
1999 and a balance Sheet as at that date.

Solutions:

Table 7.12 Trading and Profit and Loss A/c for the year ending 31st December, 1999
Rs. Rs.
To Purchases 90,000 By Sale 2,31,700
Less: Overcast stock 1,000 89,000
To Wages 14,400
To Carriage inward 750
To gross profit 1,27,550
2,31,700 2,31,000
By Gross Sales 1,27,550
To Salaries 11,000
Add O/S 9,000 20,000
To Post & Stationary 750
To Carriage out 1,000
To Bad debts
Add: New Provision 950
1,265
Less: Old provision 2,,215
To General Charges 350
To Interest On Capital 1,865
To Net Profit transferred 1,500
To Capital Account 3,500
98,935
1,27,550 1,27,550

Table 7.13 Balance Sheet as at 31st December, 1999

Liabilities Rs. Assets Rs.
Capital 70,000.00 Plant & 75,000.00
Add: Interest on 3,500.00 Machinery 50,000.00
Capital 73,500.00 1,69,961.60 Freehold Premises50,600.00
96,461.60 10,000.00 Sundry Debtors 1,265.00 49,335.00
Add: Net Profit 5,000.00 Less: Provision 5,000.00
Sundry Bills Receivable 30,000.00
Creditors 20,000.00 Closing Stock 1,000.00
Bills Payable 2,473.40 22,473.40 Overstated Stock
Reserve 9,000.00 90 5,300.00
Add: 2x1/2 % Cash In Bank 800.00
Net P. Cash in Hand
O/S Salaries

2,16,435.00 2,16,435.00
COST ACCOUNTING

7.3 Important Definitions

Cost: Cost is the amount of expenditure actual (incurred) or notional (attributable) relating to a
specific thing or activity may be a product, job, service, process or any other activity. Cost is the
cash or cash equivalent values sacrificed to obtain some goods or services. Cash equivalent means
that non cash assets can be exchanged for the desire d goods or services.

Costing: Coasting Accounting and Coasting have distinctly different meaning. Coasting is the
process of determining the cost of doing something, e.g. the cost of manufacturing an articles,
rendering a services, or performing a function. The article manufactured, service rendered, or
function performed is known as the object of coasting. Objects of coasting are always activities.
Coasting includes the techniques and processes of ascertaimomg costs.

Cost Accounting: Cost accounting, as a tool of management, is an integral part of the management
process. Cost accounting records relevant date from production and other activities on a regular
basis and reports these data to management for managing the undertaking. Cost accounting is the
processing and evaluation of monetary and non- monetary data to provide information for internal
planning, control of business operations, managerial decisions and special analysis, external
reporting.

Objectives of Cost Accounting

Cost accounting aims primarily to serve the information needs of management for planning, control
and decision-making. Cost accounting has the following three important objectives:

1. To determine product costs.

2. To facilitate planning and control of regular business activities.

3. To supply information for short-and long-run decisions.

1. Product Costing

The objectives of determining the cost of product is of prime importance in cost accounting. The
total product cost and cost per unit of product are important in making inventory valuation, deciding
price of the product, and managerial decision-making. Product costing covers the entire cycle of
accumulating manufacturing and other costs and subsequently assigning them to work-in-progress
and finished goods.
2. Planning and Control

Another important objective of cost accounting is the creation of useful cost data and information
for the purposes of planning and control by management. The cost formulation in a well designed
cost accounting system is oriented to help in planning, control and decision-making. The different
alternative plans are evaluated in terms of respective cost and associated benefits. The management
control over business operations aims to establish balance between actual and budgeted
performances. A properly designed cost accounting system includes the following steps in the
control process:

1. Comparing actual business performances with budgets and estimates.

2. Analyzing and variance between budgets and actual by causes, and management
responsibility so that corrective action may be taken.

3. Providing managers with data and reports about their individual performances and
performances of subordinates.

Cost data and information, thus, is an integral and vital part of management control.

Information for Decision

An important purpose of the cost accounting system is to provide data and special analysis for short
and long-run decisions of a non-recurring nature. These decisions generally involve high cost
commitments, such as buildings and equipments to be used for several years. They also represent
unique opportunities, such as the possibility of developing new products and new market.
Appropriate cost information must be accumulated to facilitate a wide variety of short-and long-run
decisions. The concept of appropriate cost data is relevant to these matters in that no single type of
cost information can satisfy all decision problems facing management.

Cost Accounting Vs. Financial Accounting

Both financial and cost accounting generates information and involves the analysis and flow of
useful data. However, they differ in the following respects.

4. Nature

Basically, financial accounting classifies, records, presents and interprets, in terms of money,
transactions and events that are of a financial character, and provides management with the facts
and figures necessary for the preparation of the periodic financial statements, the balance sheet and
the income statement. In contrast to financial accounting, cost accounting classifies records,
presents and interprets in a significant manner the material, labor and overhead costs involved in
manufacturing and selling each product or each job or rendering a service.

5. Primary users of information

The users of financial accounting statements are mainly external to the business enterprises.
External users include shareholders, creditors, financial analysts, government authorities, stock
exchange, labor unions etc.

The information generated under the cost accounting system is used by members of management at
different levels. Thus, different sets of information could be developed under cost accounting and
supplied to different person responsible for activities in the organization.

6. Accounting Method

Financial accounting follows the double-entry system for recording, classifying and summarizing
business transactions. This accounting process results in aggregate balances of all accounts
maintained in a firm‘s books. Cost accounting is not based on the double-entry system. The data
under cost accounting may be gathered for small or large segments or activities of an organization
and monetary as well as other measures can be used for different activities in the firm.

7. Unit of Measurement

All information under financial accounting is in terms of money. That is, transactions measured in
terms of money have already occurred. In comparison, cost accounting applies any measurement
unit that is useful in a particular situation. Besides a\the monetary units, that cost accounting may
find it necessary to use such measures as labor hours, machine hours and product unit for the
purpose of analysis and decision-making.

8. Time Span

Financial accounting data and statements are developed for a definite period, such as annually, half-
yearly, quarterly. It requires that financial statements be developed and presented at regular time
intervals. Company annual reports may be prepared semi-annually or quarterly but the important
point is that they are prepared on a regular basis.

Cost accounting report and statements are prepared whenever needed. Reports may be prepared on a
monthly weekly or even daily basis. Frequency of reports is determined by particular planning and
controlling needs, objectives of cost control and cost determination.

Cost Centres

A cost centre may be defined as a location, person or item of equipment (or group of these) for
which costs may be ascertained and sued for the purposes of cost control. A cost centre is an
organizational segment or areas of activity for which it is desirable to accumulate costs. It is the
segment that is considered to accumulate costs, but not to generate revenues. The accounting
departments are also most universally considered cost centers as well as other staff functions. The
following are the types of cost centers usually found in a manufacturing company.

Impersonal Cost Centre

A cost centre which consists of a location of item or equipment (or a group of these).

Personal Cost Centre

A cost centre which consists of a person or group of persons

Operation Cost Centre

A cost centre which consists of the machine and/or persons carrying out similar operations.

Process Cost Centre

A cost centre which consists of a specific process or a continuous sequence of operations.

Cost Unit

Cost unit is a unit of quantity of product, service or time (or a combination of these), in relation to
which cost may be ascertained or expressed.

The following are a few examples of cost units:

Industry Cost unit

Building house or square foot of area

Chemical tone, pound or kilogram

Cement tone

Automobile number
Steel tone

Transport tonne-kilometre, passenger-kilometer

Cable meter

Gas Cubic foot or cubic meter

Nuts and bolts Gross or some measure of standard weight

Power Kilo-watt hour

Paper rim

Timber Cubic foot

Elements of Cost

The cost of a product consists of the following cost components or elements:

1. Direct Material: Direct materials refer to the cost of materials which become a major
part of the finished product. They are the raw materials that become an integral part of the
finished product and are conveniently and economically traceable to specific units of output. Some examples
of direct materials are: raw cotton in textiles, crude oil to make diesel, steel to make automobile bodies.

2. Direct labor: Direct labor is defined as the labour associated with workers who are
engaged in the production process. It is the labour costs for specific work performed on products
that is conveniently and economically traceable to end products. Direct labour is expended directly
upon the materials comprising the finished product. Examples are the labour of machine operators
and assemblers.

3. Direct expenses include any expenditure other than direct material and direct labour
directly incurred on a specific cost unit (product or job). Such special necessary expenses can be
identified with cost units and are charged directly to the product as part of the prime cost. Some
examples of direct expenses are: (a) cost of special layout, designing or drawings; (b) hire of tools
or equipment for a particular production or product; (c) maintenance costs of such equipments.

The above three items: materials, labour and direct expenses constitute prime cost. According to
Official Terminology of Chartered Institute of Management Accountant (London), Prime cost is the
total cost of direct material and direct labour. Thus, direct expenses is not included in prime cost as
per CIMA defines direct cost of the expenditure which can be economically identified with a
specific saleable cost unit.

4. Factory overhead: Factory overhead also called manufacturing expenses or factory

burden may be defined as the cost of indirect materials, indirect labour and indirect expenses. The
term ―indirect materials‖ refers to materials that are needed for the completion of the product but
whose consumption with regard to the product is either so small or so complex that it would not
waste, hand tools, works stationery. The term ―indirect labour‖ is the labour cost of production
related activities that can not be associated with or conveniently and economically traced to end
products. Some examples of indirect labour are; foreman, shop clerks, general helpers, cleaners,
materials handlers, plant guards, employees engaged in maintenance work or other service work.
The term ―Indirect expenses‖ covers all indirect expenditure incurred by the manufacturing
enterprise from the time production has started to its completion and transfer to the finished goods store.
Any expenses not classified as direct expenses are known as indirect expenses.

5. Selling and Distribution and Administrative Overhead: Selling and distribution

overhead is also known as marketing or selling overhead. Distribution expenses usually begin when
the factory costs end. Such expenses are generally incurred when the product is in saleable
condition. It covers the cost of marking sales and delivering/dispatching products. These costs
include advertising, salesmen salaries and commissions, packing, storage, transportation, and sales
administrative costs. Administrative overhead includes costs of planning and controlling the general
policies and operations of business enterprises. Usually, all costs which cannot be charges either to
the production or sales division are considered as administrative costs of the general accounting
department. Sometimes, some of such expenses as manger‘s salary are often allocated to
manufacturing and included in factory overhead.

The sum of prime cost, factory overhead, distribution and administrative overhead is the cost to
make and sell.

Fixed, Variable And Mixed Cost

Cost can be classified into (I) fixed cost (ii) variable cost and (iii) mixed costs, in terms of
variability of cost in relation to charges in activity or volume.

Fixed Cost: Fixed cost is a cost which does not change in total for a given time period despite wide
flections in output or volume of activity. This includes expenses which must be incurred
irrespective of the changes in use of direct materials and in production. Examples of fixed costs are
rent, property taxes, supervising salaries, depreciation on office facilities, advertising, insurance,
etc. These fixed costs accrue or are incurred with the passage of time and not with the production of
the product or the job. This is the reason why fixed costs are expressed in terms of time, such as per
day, per month or per year and not in terms of unit. It is totally illogical to say that a supervisor‘s
salary is so much per unit. But it can be said that a supervisor is salary is so much per month. Fixed
cost per unit varies due to change in output. If production declines, fixed cost per unit increases. In
case of higher output fixed cost per unit decreases.

Fixed costs can be further classified in the following categories for the purpose of analysis

1. Committed Costs: Such costs are primarily incurred to maintain the company‘s
facilities and physical existence, and over which management has little or no discrimination, taxes,
insurance premium rate and rent charges are examples of committed costs.

2. Managed costs: Managed costs are related to current operations which must continue to
be paid to ensure the continued operating existence of the company, e.g., management and staff
salaries.

3. Discretionary costs: They are also known as programmed costs. Discretionary costs are
not related to current operations or activities and are subject to management discretion and control.
These costs result from special policy decisions. management programmers, new researches,etc.
Such costs can be avoided at management‘s discretion in a relatively short period of time as
compared to committed costs. Some examples of such costs are research and development costs,
marketing programmes, new system development costs.

Variable Cost: Variable costs are those costs that vary directly and proportionately with the output.
There is a constant ratio between the change in the cost and change in the level of output. Direct
materials cost and direct labour cost the costs which are generally variable costs. For example, if
direct material cost is Rs. 5 per unit, then for producing each additional unit, direct material cost
increases in direct proportion to increase in units manufactured. However, it should be noted that it
is only the total variable costs that change as more units are produced; the per unit variable cost
remains constant. Variable costs result from the utilization of raw materials and direct labour in the
production departments. Variable manufacturing overhead like factory supplies, indirect materials,
sales commission, office supplies are some other examples of variable costs. Variable costs
accumulate because units of product are being manufactured, not because a period of time has
passed.

Mixed Costs: Mixes costs are made up of fixed and variable elements. They are a combination of
semi-variable costs and semi-fixed costs. Because of the variable component, they fluctuate with
volume; because of the fixed component, they do not change in direct proportion to output. Semi-
fixed costs are those costs which remain constant unto a certain level of output after which they
become variable. Semi-variable cost is the cost which is basically variable but whose slope may
change abruptly when a certain output level is reached. An example of a mixed cost is the earnings
of a worker who is paid a salary of Rs.1, 000 per week (fixed) plus a bonus of 50 paise for each unit
completed (variable). If he increases his weekly output from 1,000 units to 1,500 units, his earnings
increases from Rs. 1,000 to Rs. 1,250. As increase of 50% in output brings only a 25 % increase in
his earnings. Mathematically, mixed cost can be expressed as follows: Total Mixed Cost + (Units X
Variable Cost per Unit)

Direct Cost and Indirect Cost: A direct cost is one that can be economically traced to a single cost
object. In manufacturing, the cost object is a unit of finished product. An indirect cost is one that is
not directly traceable to the manufactured product, is associated with the manufacture of two or
more units of finished product, or is an immaterial cost that cannot be economically traced to single
unit of finished product. A comparison of the labour cost of an assembly man and a repairman in a
cabinet shop will illustrate the difference between direct and indirect costs. The assembly man‘s
salary is typically classified as a direct cost because it is a significant portion of the cabinet‘s total
cost and because it is easy to trace the assemblyman‘s efforts to a particular set of cabinets. The
machine repairman‘s salary would probably be classified as an indirect cost. It is difficult, or
impossible, to trace the repairman‘s effort to a unit of output. The repairman is responsible for
keeping all machines running properly. Since the repairman works on several machines and the
machines work on several different cabinets each day, we cannot trace his salary to a particular
cabinet. Also, the repairman‘s salary is generally immaterial in relation to the total cost of the
product. However, even if it were material, the lack of traceability would require that it be classified
as an indirect cost.

Example: A company manufactures and retails clothing. You are required to group the costs which
are listed below and numbered 1 to 20 in to the following classification: (Each cost is intended to
belong to only one classification).

(a) Direct Materials

(b) Direct Labour

(c) Direct Expenses

(d) Indirect Production Overhead

(e) Selling and Distribution Costs

(f) Research and Development Costs

(g) Finance Cost

(h) Administration Costs

1. Telephone rental plus metered calls.

2. Wages of security guards for factory.

3. Parcels sent to customers.

4. Wages of operators in cutting department

5. Developing a new product in the laboratory

6. Wage of fork lift truck drovers who handle raw materials

7. Wages of storekeepers in materials store

8. Chief accountant‘s salary

9. Cost of painting advertising slogans in delivery vans.

10. Auditor‘s fee

11. Cost of advertising on television

12. Lubricants for sewing machines.

13. Floppy disks for general office computer.

14. Maintenance contract for office photo-copying machine.

15. Interest on bank overdraft

16. Market research undertaken prior to new product launch.

17. Carriage on purchase of raw material

18. Royalty paid on number of units of a particular product produced.

19. Road licenses for delivery vehicles.

20. Amount payable to a company for broadcasting music throughout the factory.

Solutions:

Cash Element Numbers

Direct Materials 17
Direct Labour 4
Direct Expenses 18
Financial Cost 15
Research and Development Expenses 5
Selling and Distribution Cost 16,19,3,11,9
Administration Cost, 13,14,1,10,8
Indirect production Costs 12, 20,2,7,6

Martial Cost accounting and control

The term ―materials‖ generally used in manufacturing concerns, refers to raw materials used for
production, sub-assemblies and fabricated parts. The terms ―materials‖ and ―stores‖ are sometimes
used interchangeably. However, both the terms differ. ―Stores‖ is wider in meaning and comprises
many other items besides raw materials, such as tools, equipments, maintenance and repair items,
factory supplies, components, jigs, fixtures. Sometimes, finished goods and partly finished goods
are also included within the scope of this term.

Purchasing and Receiving Procedure

Purchasing procedures vary with different business firms, but all of them follow a general pattern in
the purchases and receipt of materials and payment of obligations. The important steps may be
listed as follows:

1. Purchase requisition: A from known as a purchase requisition is commonly used as a

formal request to the purchasing department to order goods or services. Usually, purchase
requisitions are prepared by the storekeepers for regular store items which are below or approaching
the minimum level of stock or to replace stock of materials and part in stores.

The production control department can also give requisitions for the purchase of specialized
materials. A typical purchase requisition contains details, such as number, date, and department.
Quantity, description, specification, signature of the person initiating the requisition, and signature
of one or more officers approving the purchase. Copies of the purchase requisition are sent to the
purchasing department and accounting department.

ABC COMPANY LIMITED

Purchase requisition

Purchase Requisition No Purchase Order No.

Date Department

Delivery Required

Item No. Quality Particulars of Grade or Remarks

articles quality

Required By Checked By Approved By

2. Purchase order: After the requisition is received duly approved, the purchasing
department places an order with a supplier, offering to buy certain materials at stated prices and
terms. For routine purchases, the order is placed through established suppliers. In other cases, the
purchasing department may ask for bids or send out requests for quotation before placing the order.

3. Receiving materials: The receiving department performs the function of unloading and
unpacking materials which are received by an organization. This will need an inspection report
which is sometimes incorporated in the receiving report, indicating the items accepted and rejected,
with reason. Two functions are performed by the receiving report:

(i) It determines and places initial responsibility for materials on the receiving
clerk; the receiving clerk continues to have this responsibility until delivery is made to the
storeroom. In some business firms the store department functions as the receiving department also.

(ii) It notifies the accounting department that the materials have been received and that a voucher
can be pre pared for payment.

4. Approval of invoices: Invoice approval indicates that good according to the purchase
order have been received and payment can now be made. However, if the goods or equipment
received are not of the type ordered, or are not in accordance with specifications, or are damaged,
the purchasing department issues a return order indicating that the goods are to be retuned to the
supplier. When the invoices of goods are received by the purchasing department, the process of
gathering the relevant documents connected with each purchase and the preparation of the voucher
begin.

5. Making Payment: After the purchase invoice total is approved, the process of making
payment begins. Payment depends on the terms agreed upon on any particular order, and any terms
which differ from normal practice should be considered individually. When it is found that items
written on the invoice qualify for payment, a remittance advice is prepared after providing of
deduction of discounts, if any.

Issues In Materials Procurement

It is generally accepted that quantities be bought in economic size so that there may not be
overstocking. If a company purchases in large quantities, the cost of carrying the inventory would
be high because of the high investment involved. Working capital which could have been used for
other productive purposes has to be diverted. Over-stocking requires more storage space which in
turn, means increases in insurance expenses, storage cost and deterioration in quality and
depreciation in quantity. In contrast, if purchases are made in small quantities (under-stocking),
frequent orders would have to be placed for the purchase of materials. There will be danger of
―stock outs‖ also. Because of under-stocking, production is likely to suffer; materials have to be
purchased immediately at high process; low output would increase cost and decrease profit; the
other department‘s work may be adversely affected.

Economic Order Quantity (EOQ) (Reorder Quantity)

The EOQ is the optimum or the most favorable quantity which should be purchased each time the
purchases are to be made. The EOQ is one where the costs of carrying inventory are equal or almost
equal to the cost of not carrying inventory (Cost of placing order). Also at EOQ level, the total of
these two costs is minimum.

The cost of carrying the inventory is the real out-of-pocket cost associated with having inventory on
hand, such as warehouse charges, insurance, heat, light, and losses due to spoilage, breakage,
pilferage. Another opportunity cost, which is not out-of-pocket cost, is important and should be
considered, i.e., cost incurred (capital used) in purchasing the inventory. If funds have been
borrowed to finance the inventory purchase, interest payments on borrowed funds will be the direct
cost. Carrying or holding costs of inventory are explicit as well as implicit, that is, some costs are
readily ascertained from accounting records while others require extensive study to estimate them
because they are not expressly state. Insurance on inventory is an explicit cost while the cost of
funds invested in inventory is implicit cost. Generally, inventory carrying costs are considered to be
proportional to the value of inventory carried.

The costs of not carrying adequate inventory arise because of frequent placing of order at short
intervals. This includes costs, such as extra purchasing, handling and transportation costs, higher
price due to small order quantities, frequent stock-outs resulting in disruption of production
schedules, overtime and extra set up time, loss of sales and customer goodwill, etc.

The costs of carrying the inventory and ordering costs change in the reverse order. The costs of
placing the order decrease as the size of the order increase since with a bigger size of order, the
number of the order will be lower. However, simultaneously the costs of carrying the inventory will
go up because purchases have been made in large quantities. It may be possible to have a point
which provides the lowest total cost and this point (ideal size) is known as the EOQ. This
equilibrium can be determined mathematically as follows:

EOQ= (2U *O) /(I *C )

Where U = Annual usage in units

O = Cost of placing an order

I = Percent cost of carrying inventory C = Cost per unit of material

Assume

Annual usage units = 6,000

Cost of placing an order = Rs. 30

Carrying cost as a percent of inventory = 20%

Cost per unit of material = Rs.5

Then, EOQ= (2 * 6000 * 30) /(5 * 20% ) = 3,60,000 = 600 units

In the above example, the EOQ is 600 units. That is, ten orders per year are needed. At the level of
600 units, the ordering costs and the carrying costs are equal and also the total cost is at minimum
as it is clear from Table 14.1

Table 7.14 shows that quantities of other orders resulting in more or less than ten orders per year are
not economical as they involve higher total costs.

The EOQ formula is sometimes expressed in the following manner which is not in any way
different from the formula explained earlier

EOQ = (2U * P) / S

Where U = Annual demand or consumption or purchased quantity (in units)

P = Cost of placing an order

S = Annual cost of carrying inventory per unit (Storage and interest)

Table 7.14 Quantities of other orders

Annual Orders Units Average Value PerAverage Order Carrying Total

Usage Per Year Per Inventory Order Inventory Cost Cost Cost
Order (units) (Rs.) Amount (20%) (Rs.)
(Rs.)
6,000 1 6,000 3,000 30,000 15,000 30 3,000 2,030
units 2 3,000 1,500 15,000 7,500 30 1,500 1,500

3 2,000 1,000 10,000 5,000 90 1,000 1,090

4 1,500 750 7,500 3,750 120 750 870
5 1,200 600 6,000 3,000 150 600 750
6 1,000 500 5,000 2,500 180 500 680
7 857 429 4,285 2,142 210 428 638
8 750 375 3,750 1,875 240 376 616
9 667 334 3,335 1,668 270 334 604
10 600 300 3,000 1,500 300 300 600
11 545 273 2,725 1,363 330 272 602
12 500 250 2,500 1,250 360 250 610
When to order (Reorder Level)

The EQQ determines how much to buy at a particular time. But the question ―When to buy‖ is
equally important for business firms. This question is easy to answer only if we know the lead time
– the time interval between placing an order and receiving delivery – and know the EOQ, and are
certain of the consumption pattern during lead time. The order point or re-order level is a point or
quantity level at which if materials in stores reach, the order for supply of materials must be placed.
This point automatically initiates a new order. The order point is calculated from three factors:

1. The expected usage

2. The time interval between initiating an order and its receipt, referred to as the lead time

3. The minimum inventory, or safety stock

For example, if daily usage is 400 units of material which have a lead time of 20 days and the safety
(minimum) stock is 500 units, the order point will be calculated as follows:

Daily consumption * lead time = 400 * 20 = 8,000

Add safety stock = 500

Order point units = 8,500

The order point is determined after considering the worst possible expected conditions. This only
ensures that the minimum stock will always remain in the inventory and will not be used at least in
the short run. However, situations may arise where there will be stock – out and thus, the order
point may not be an absolutely accurate forecasting.

Determinations of Safety or Minimum Stock Levels

It is advisable to carry a reserve or safety stock to prevent stock-out. The safety should be used only
in abnormal circumstances, and the working stock in ideal or normal conditions. Therefore, for
normal working conditions, the stock should not be allowed to fall below the safety limit, kept only
for emergencies. If the usage pattern is known with certainty, and the lead time is also known
accurately, then no safety stock would be needed. However, if either usage or lead time is subject to
verification then it is necessary for a business firm to maintain safety stock levels equal to the
difference between the expected usage over lead time and the maximum usage over lead time that
the firm feels is necessary for cost minimization. The safety stock level can be computed by using
the following formula:
Safety stock level = Ordering level – (Average rate of consumption * Re-order period) Or

Safety stock level = (Maximum rate or consumption – Average rate of consumption)

* Lead time

That is, = (425 – 400) * 20 days

= 500 units

Maximum Stock Level

The maximum level ensures that the stocks will not exceed this limit although there may be low
demand for materials or quick delivery from the suppliers. Maximum stock level can be computed
as follows:

Maximum stock level = EQQ + Minimum stock

Or

Maximum stock level = Re-order level + EOQ – (Minimum Consumption * Minimum re-order
period)

Danger Level

Generally the danger level of stock is indicated below the safety or minimum stock level.
Sometimes, depending on the practices of the firm and circumstances prevailing, the danger level is
determined between re-order level and minimum level. In the second case (danger level being
between re-order level and minimum level), the firm can only take steps to ensure that materials
ordered will arrive in time.

Average stock Level

Average stock level is computed in the following manner:

= Minimum stock + Maximum stock

2

Or

= Minimum level + Re-order quantity

2
The following example further illustrates the different stock levels.

Maximum usage (units) 650 per days

Minimum usage (units) 300 per days

Normal usage (units) 500 per days

Economic order quantity (units) 75000

Re-order period –lead time 25 to 30 days

Minimum level (units) 5000

(10 days at normal usage)

The different stock levels will be as follows:

Re-order level = Normal usage x Normal lead time + Minimum level

= (500 * 30) + 5,000

= 20000 units

Maximum level = Reorder level + EOQ –Minimum quantity used in re-order period

= 20,000 +75,000 – (300 * 25)

= 87,000 units

Average Level = Maximum +Minimum

2

= 87,500+5,000
2

=46,250 units

After placing an order, if usage goes above average or if the lead time is longer than expected, then
the stock will fall below minimum. However, stock will not be exhausted, so long as the maximum
usage and maximum re-order periods are not exceeded. In the above example, maximum usage
during the lead time would cause an extra 4500 units (30 days X 150 units) to be consumed.
Therefore, in this situation, the purchasing officer should try to chase supplies to ensure that
delivery promises are kept.

Example

The Ganges pump Company uses about 75,000 valves per year and the usage is fairly constant at
6,250 per month. The valves cost Rs.1.50 per unit when bought in quantities and the carrying cost is
estimated to be 20 % of average inventory investment on the annual basis. The cost to place an
order and process the delivery is Rs.18.

It takes 45 days to receive from the date of an order and a safety stock of 3,250 valves is required.
You are required to determine:

(i) The most economic order quantity and frequency of orders

(ii) The order point

(iii) The most economic order quantity if the valves cost Ts 4.50 each instead of Rs.1.50 each

= 3,000 units or 25 orders per year

(ii) The order point

= Safety Stock + (Average rate of consumption x Lead time)

= 3,250 + (6,250 units‘ p.m * 1.5 months)

= 3,250 + 9,375

= 12,625 units

(iii) EOQ when cost per valve is Rs.4.50

EOQ = (2 * 75000 *18) /(4.5 * 20% )

 = 30,00,000

= 1,733 unit‘s approx. or 43 order approx. per year

Example

Material X and Y are used as follows:

Minimum usage – 50 units each per week.

Maximum usage – 150 units each per week

Normal usage –100 units each per week

Ordering quantities X = 600 units

Y= 1000 units

Deliver period X= 4 to 6 weeks

Y = 2 to 4 weeks

Calculate for each material: (a) Minimum level: (b) Maximum level: and (c) Order level

Solution

Material X

Ordering level = Maximum usage * Maximum delivery period

= 150 * 6

= 900 units

Minimum level = Ordering level – (Normal usage * Normal delivery period)

= 900 – (100 * 5)

= 900-500

= 400 units

Maximum level = (Ordering level + Ordering quantity) –

 (Minimum usage * Maximum delivery period)

= 900 + 600-(50 * 4)

= 1,500-200

= 1,300 units

Material Y

Ordering level = Maximum usage * Maximum delivery period

= 150 * 4

= 600units

Minimum level = Ordering level – (Normal usage * Normal delivery period)

= 600 – (100 * 3)

= 600-300 = 300 units

Maximum level = (Ordering level + Ordering quantity) –

(Minimum usage * Maximum delivery period)

= 600 +1,000-(50 * 2)

= 1,600-100 = 1,500 units

Notes: Normal period of delivery has been computed as follows:

Material X = (4+6) =5 weeks

2

Material Y = (2+4) = 3 weeks

2

7.4 INVENTORY SYSTEMS

There are two principal ways of accounting for inventories:

Perpetual Inventory System

The perpetual inventory method requires a continuous record of additions to or reductions in
materials, work-in-progress, and cost of good sold on a day-to-day basis. Physical inventory counts
are usually taken at least once a year in order to check on the validity of the accounting records. The
Institute of Cost and Management Accountant (U.K.) has defined perpetual inventory as:

A system of records maintained by the controlling department which reflects the physical
movement of stocks and their current balance. A

perpetual inventory is usually checked by a programme of continuous stocktaking, and the two
terms are sometimes loosely considered synonymous. Perpetual inventory means the system of
records, whereas continuous stocktaking means the physical checking of those records with actual
stocks."

The perpetual inventory method has the following advantages:

 The stock-taking task which is long and costly is avoided under this method.

 The inventory of different items of materials in accordance with the stores ledger can be
promptly prepared for the preparation of the income statement and balance sheet at interim periods
if required without a physical inventory being taken.

 Management may be informed daily of the number of units and the value of each kind of
material on hand-information which tends to eliminate delays and stoppage in production.

 The investment in materials and supplies may be kept 'at the lowest point in confined with
operating requirements.

 A system of internal check is always in operation and the activities of different

departments, such as purchasing, stores and production are continuously checked against each other.

 It is not necessary to stop production so as to carry out a complete physical stock- taking.

 Discrepancies and errors are promptly discovered and localized and remedial action can be
taken to avoid their occurrence in the future.

 This method has a moral effect on the staff, makes them disciplined and careful and acts as a
check against dishonest actions.

 The disadvantages of excessive stock are avoided, such as loss of interest on capital invested
in stock, loss through deterioration, risk of obsolescence.

Periodic Inventory System

Under the periodic method, the entire book inventory is verified at a given date by an actual count
of materials on hand. This physical inventory is usually taken near the end of the accounting period.
This method provides for the recording of purchases, purchase returns and purchase allowances on a
daily basis but does not provide for a continuous inventory or for a daily computation of the cost of
goods sold. At the end of each accounting period, a physical count is made of the quantity of goods
on hand and the value of the inventory is determined by using an inventory pricing method (FIFO,
LIFO or Average Cost) and attaching cost to units counted. The cost of good sold is computed by
deducting closing inventory from the sum of opening inventory and purchases made during the
current period. It is assumed that goods not on hand at the end of accounting period have been sold.
There is no system and accounting for shrinkage, losses, theft and waste throughout the accounting
period and they can be discovered only after the end of the period

Labour Cost Accounting and Control

Proper control and accounting for la90ur costs is one of the most important objectives of all
business firms. Cost accounting for labour has three primary objectives:

 Determining labour costs in the cost of product or service.

 Reporting labour costs for planning and control.

 Reporting labour costs for decision-making.

For a manufacturing business firm engaged in producing a specific product, labour costs are
accumulated and charged to the product as they are produced. Similarly, in a service (not-for-profit)
organization, total cost as well as the cost of different functions (services) is to be determined. This
helps the Organization to know what it costs them to provide a service or perform some activities.
The second objective is to provide management with labour cost information for effective planning
of the labour force in the organization and for, adequate control of labour costs. The control process
of labour cost involves a comparison of actual labour costs with standard labour cost. The
differences between the two are then analysed and possible reasons are determined so that
management can take suitable action to control the labour cost expenditure in future periods.

Labour cost information is used for decision-making purposes also. Many managerial decisions,
such pricing decision, expansion of business, dropping a product line, replacement of plant and
equipment, entering into a new market, etc. require information about current actual labour costs
and emerging trends there in

7.5 Wage Systems

An important aspect of labour cost control is a wage system designed primarily for exercising
management control over labour. The following objectives should be considered in the selection of
a wage system:

 Acceptance by employees to avert slowdowns and work stoppages.

 Provision for flexibility.

 Provision for economy in administration.

 Supplying of labour statistics for use in industrial relations and for trade associations,
government agencies and competitors.

 Stabilisation of labour turnover.

 Minimising of absenteeism.

 Provision for incentive plans.

Basically there are two wage systems to pay for labour: (i) straight time which is by hour, day, or
week, and (ii) piece work, which is by the unit of product.

Straight Time

Under the time basis, the worker is paid at an hourly, daily or weekly rate and his remuneration
depends upon the time for which he is employed and not upon his production. If a worker works for
overtime, the wage agreement usually provides that all hours worked in excess of an agreed number
are paid for at a higher rate. The time basis wage system for direct labour is found in those
industries where:

 The speed of production cannot be influenced by the energy or dexterity of the workmen

 The quality of work is of paramount importance.

 It is difficult to measure the work done by the employee.

Piece Work

Under this method, a fixed rate is paid for each unit produced, job performed or number of
operations completed, and the worker's wages thus depend upon his output and not upon the time he
spends in the factory.

Incentive Wage Plans

The basic purpose of an incentive wage is to induce a worker to produce more so that he can earn a
higher wage and, at the same time, unit costs can be reduced. Incentive wage plans aim to ensure
greater output, to help control over labour costs by minimisation of total cost for a volume of
production and to have a basis for reward from hours served to work accomplished.

Incentive wage scheme has the following objectives:

1. Un-interrupted and higher production without any dispute between the labour and
management.

2. Stability in labour turnover.

3. Reducing labour absenteeism.

4. Developing cooperation, mutual trust, attitude of team work among workers and between
workers and supervisory staff.

5. Control of labour cost and reduction in labour cost per unit of output.

6. Improving administrative efficiency.

7. Accurate budgeting through reliable labour cost information.

8. Generating workers' satisfaction by avoiding work stoppage, slow down, and by providing
incentive scheme.

The following are the essentials (desirable characteristics) of a successful incentive wage plan:

1. A wage incentive system should be based upon standards of performance - time and motion

a. Studies, job evaluation, and merit rating.

2. The incentive plan should be understood by all employees before installation (or hiring).
3. All direct labour tasks should be on an incentive basis.

4. Only standard or acceptable quality production should be considered while determining the
bonus.

5. Once the standard is set, it should not be changed unless the method changes.

6. The incentive. Programme must be fairly and intelligently administered.

7. It is highly desirable that indirect personnel share in the incentive plan.

8. A high reward should be paid for performance above standard.

9. Individual incentives should be used wherever it is possible to do so.

10. Minimum wage should be guaranteed to every worker.

11. The views of both employers and employees should be considered while designing incentive
schemes.

12. The cost of establishing and operating the incentive plans should be reasonable.

13. The incentive plans should help in standard cost and budgetary control programmes.

Incentive wage plans involve wage rates based upon various combinations of output and time and
are known as "different piece-rates" and "bonus-plans' as well. Generally, the following types of
incentive plans are used:

 Taylor Differential Piece-rate System

 Merrick Differential Piece-rate System

 Gantt Task Bonus Plan

 Premium Bonus Plans (Halsey. Halsey-Weir. Rowan. Bedaux, Emersion, etc.)

Taylor Differential Piece-rate System

Under this system there are low wage rates, a low one for output below standard and a higher one
for above standard predominance. The system aims to discourage below average workers by
providing no guaranteed hourly wage and by setting low piece rates for low level production, and a
high rate resulting in high earnings if an efficient level of production is attained. For example, in a
factory, workers earn Rs. 24 per eight hour day and that production averages 12 units per hour per
worker or 2S paise per unit. The Taylor system might suggest a pay of 20 paise per unit if the
worker averaged 14 units or less per hour, but 30 paise per unit to workers averaging IS units or
more per hour. The main advantages of the Taylor system are that it provides a strong incentive to
the efficient worker, and is simple to understand and operate. But the incentive level may, be set so
high that it cannot attract most workers.

Merrick Differential Piece-rate System

This is an improvement over the Taylor system and depends on using three rates instead of two as
in the Taylor system. Normal' piece-rates are paid on output, when it does not exceed 83% of the
standard output. 110% of normal price rate are paid when the output is between 83% and 100%, and
120% of the normal piece-rate is' paid if the output is above 100%.

The Merrick system is useful to highly efficient workers as it provides incentives for higher
production. Similarly, it takes into account the less efficient worker who can at least achieve 83% of
the standard output. This minimum output. Is probably achievable by all workers?

Calitt Task and Bonus Plan

This system combines a guaranteed lime-rate with a bonus and piece rate plan using the differential
piece-rate principle. Remuneration under the 'plan is computed as follows:

Output Payment

1. Output below standard (high task) Time-rate (guaranteed)

2. Output is standard Bonus @ 20% on the time-rate

3. Output above standard High piece-rate on worker's whole output

This plan provides incentives and opportunities to those who reach high level production. At the
same time it provides security and encouragement to less skilled workers. It is simple to understand
and workers are also satisfied in that they receive the total reward for their efforts. A limitation of
the plan is the tendency on the part of trade unions to demand a high fixed guaranteed time-rate.
Buuhe incentive element of the plan would be lost in case too high a rate is fixed.

Premium Bonus Plans

Under the time-rates basis, any additional production above normal levels benefits the employer,
whereas with the piece-rates system the benefit goes to the employees (apart from indirect benefits
to the employer). Bonus plans have been developed to produce a compromise, in that any savings
are shared between employer and employee. The following are the principal schemes under
premium bonus plans.

Halsey Premium Plan

The principle of the Halsey scheme is that the worker receives a fixed proportion of any time which
he can save by completing the job in less than the allowed time. The most common fixed proportion
is 50% but this can be varied. This plan ensures that the employee receives time wages until he
produces in less than standard time. For above standard production, savings are shared with the
employer with the result that the rates of increase happen to be lower for the employee. The cost per
unit decreases when production exceeds standard.

Halsey- Weir Plan

This plan is also know as the Weir Premium Scheme and is based on a 33*1/3:66*2/3 sharing plan.
Under this scheme the total enrolments of a worker are the aggregate of guaranteed hourly wages
for actual time worked, plus the amount of bonus at the rates of 33*1/3 % of the time saved. Bonus
is allowed at the same hourly rate at which he shall be paid for actual time worked.

Rowan Plan

This scheme is similar to the Halsey Plan in that a standard time is fixed for the completion of a job
and the bonus i~ paid in respect of the item saved. But a ceiling is applied to the size of the bonus.
The bonus hours are calculated as a proportion of the time taken which the time saved bears to the
time allowed, and is paid for at time-work rates. The bonus may be computed as follows:

Time taken
Bonus = x --------------------------Time saved x Ti me rate
Time allowed

Bedaux Point Plan

Under the Bedaux point plan a guaranteed hourly rate is paid until standard production is attained,
and a premium or additional wage is paid for units in excess of standard. Instead of being paid as
piece rate, an hour's work is converted to points by dividing a standard hour's production in units
into 60 minutes. In other words, if 10 units are standard, then each unit is 6 points and if 15 units are
standard then each unit is 4 points. At standard performance the worker produces a point per minute
and for the first 60 points produced in an hour, the worker receives the hourly rate. For excess
production, it is common practice to pay the worker 75% of the rate, and the foremen, supervisors
and the other indirect labour personnel receive 25% of the rate.

Emerson Efficiency Plan

Under the Emerson plan a minimum daily wage is guaranteed and a standard time is determined for
each job or operation. During each payroll period a record is kept of the hours worked and the units
produced, and the efficiency of each employee is then determined by dividing actual hours into the
standard' time for the units produced. For example, if the standard is 10 units per hour and a worker
produces 320 units in an 80- hour week, the standard time for his output is 32 hours and he has
worked at 80% efficiency. Below 67% efficiency, the worker is paid his hourly rate, and from 67%
upto 100% efficiency, step bonus rates apply. Above 100% efficiency, an additional bonus of 1 %
of the hourly rate is paid for each 1% increase in efficiency.

Labour Turnover

Labour turnover is the rate at which elll11Joyees leave employment _ at a factory and is normally
measured as the ratio of the number of persons leaving in period tie the average number on the
payroll For example, if 100 persons leave a company in a year and the average number on the
payroll is 500, labour turnover is expressed as 20% p.a. In this calculation all persons who leave
must be included, whether they leave voluntarily or are dismissed and irrespective of whether they
are replaced. There are three methods of measurement of labour turnover.

(All employees leaving/ Average number employed) * 100

(Number of replacement in a period/ Average number employed) * 100

(All employees leaving plus new employees/ Average number employed) * 100

Among the three methods, the first method is to be preferred, as it is more appropriately a long-term
indicator. This formula is more satisfactory as management is primarily concerned with the loss of
labour, after money has been spent on training. The effects of a high or low turnover rate should
then be analysed e.g., on training costs, on production efficiency and employees morale

Overhead Costs: Allocation and Absorption

The total or full cost of a product consists of direct costs and indirect costs. The direct costs are
easily traced or identified with the product or job without any difficulty. In a manufacturing
organization, direct materials, direct labour and direct expenses are examples of direct costs.
Indirect costs or overhead* costs are not directly traceable to a product or job because they are
incurred for two or more products; their clear identification with one product is not possible. There
is no direct and observable way of determining how much of overhead costs belongs to each
product. Due to these features, overhead costs are termed indirect costs. Indirect materials, indirect
labour and indirect expenses are examples of indirect or overhead costs. There is a need to develop
methods to decide the share of overhead costs for different products. The procedure of distributing
or sharing out overhead costs to different is known as absorption of overheads.

The stages or steps involved in the absorption of overhead costs are: Stage I: Collection or
GatheJing of Overhead Cost Information'

Stage II: Allocation and Apportionment of Overheads to Production and Service Departments.

Stage III: Apportionment of Service Department Overheads to Production Departments Stage IV:
Calculation of Appropriate Overhead Rates.

The overhead rates obtained finally after completing the above stages are used to charge overhead
to products and jobs.

STAGE I: COLLECTION OR GATHERING OF OVERHEAD COSTS

INFORMATION

The first step in accounting and distribution of overhead costs is their collection under proper
headings Overhead costs items should be gathered and subsequently grouped together. The
groupings of overhead

Costs are done through a technique known as codification. Codification is a method of identifvii1g
and describing various overhead expenses in members or letters or in a combination of both %", 0
that cost data can easily be collected. Codification of the entire items is done through a 'proper
coding system. Costs are done through a technique known as codification. Codification is a method
of identifying and describing various overhead expenses in members or letters or in a combination
of both %, 0 that cost data can easily be collected. Codification of the entire items is done through a
'proper coding system.

Methods of Codification

Some important methods of codification are mentioned below:

Serial Numbering System Number Blocks

Combination of Alphabets and numbers Numerical Codes

Mnemonic Method

Sources of Overhead Collection

Different sources are available in an organization to collect overhead expenses such as:

 Stores requisitions for items like indirect materials.

 Financial accounts - A large number of items may be taken from the financial
accounts of the business enterprise.

 Wage book - Most indirect wages and labour-related costs.

 Cash book - for indirect expenses.

 Registers and reports - Plant and machinery register for depreciation, scrap, waste
and spoilage can be discovered through investigation.

STAGE II: ALLOCATION AND APPORTIONMENT OF OVERHEAD COST TO

PRODUCTION AND SERVICE DEPARTMENTS

The second stage in the charging of overhead costs is to identify overhead costs for different
production and service departments. This stage is known as primary distribution also.

Some overhead costs can be directly identified with a particular department or cost centre as having
been included for that cost centre. These items of overhead cannot be traced to products or jobs but
can be allocated specifically to departments. Examples of such overhead costs are repairs and
maintenance expenses incurred in specific departments, supervision, indirect labour, overtime,
indirect materials and factory supplies including equipment depreciation.

Expenses such as power, light, rent, depreciation of factory building, expenses shared by all
departments, cannot be charged directly to a department, be it producing or service. They are
incurred for all and must, therefore, be apportioned to any or all departments using such
items. The apportionment should be done on some rational and equitable bases. It would be difficult
to give a comprehensive list of the bases of apportionment. However, the following bases are in
common use:

 Floor area occupied - Overheads such as lighting and heating, rent and rates,
depreciation on building, building repairs, caretaking, watching and patrolling.

 Capital values - Depreciation on plant and machinery, insurance on building and

plant and machinery, maintenance of plant and machinery.

 Direct labour hours and/or machine hours - Insurance on jigs, tools and fixtures,
power, works management remuneration, repairs and maintenance cost.

 Number of workers employed - Canteen, accident insurance, medical, dental and first
aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time
office, wages department.

 Technical estimate - Fire prevention, oil and grease, steam, water without meter.

Example

The Modem Co. is having four departments. A, Band C are the producing departments and D is a
servicing department. The actual costs for a period are as follows:

Rs.
Rent 2,000
Repair 1,200
Depreciation 900
Light 200
Supervision 3,000
Insurance 1,000
Employee's Insurance 300
Employer's liability Power 1,800

The following data are also available in respect of four departments

Dept.A Dept. B Dept.C Dept.D

Area Sq. ft 150 110 90 50
Number of workers 24 16 12 8
Total wages Rs. 8,000 Rs.6,000 Rs. 4,000 Rs.2,000
Value of Plant Rs. 24,000 Rs. 18,000 Rs.12,000 Rs.6,000
Value of Stock Rs. 15,000 Rs. 9,000 Rs.6,000 -

Apportion the costs to the various departments on the most equitable method.

Table 7.15 Solution: Overhead Distribution Summary

 Name of the Basis Departments
Expense A B C D
Rent Area 750 550 450 250
Repairs Plant value 480 360 240 120
Depreciation -do- 360 270 180 90
Supervision No. of workers 1,200 800 600 400
Insurance Value of stock 500 300 200 -
Employee‘s Wages 120 90 60 30
Insurance Area 75 55 45 25
Lighting Plant value 720 540 360 180
Power

Total 4,205 2,965 2,135 1,095

Example

The modern company has four departments A, B, C is the production departments and D is the
servicing department. The actual costs for a period are as follows:-

Rs.
Production department A 950
B 1,200
C 200
Servicing department 1,500
Indirect wages:
Production department A 900
B 1,100
C 300
Servicing department 1,000
Rent 2,000
Repair 1,200
Depreciation 900
Light 200
Supervision 3,000
Insurance 1,000
Employee‘s insurance (employer‘s liability) 300
Power 1,800
The following data are also available in respect of four departments

Departments
A B C D
Area 150 110 90 50
No. of workers 24 16 12 8
Total Wages Rs.8000 Rs.6000 Rs.4000 Rs.2000
Value of plant Rs.24000 Rs.18000 Rs.12000 Rs.6000
Value of stock Rs.15000 Rs.9000 Rs.6000 -

Apportion the above costs to the various departments on the most equitable method:

Table 7.16 Solution:

Items Basis Total Departments

A B C D
Indirect
wages Allocation 3,850 950 1,200 200 1,500

Indirect Allocation 3,300 950 1,100 300 1,000

wages Area 2,000 750 550 450 250
Plant value 1,200 480 360 240 120
Rent Plant value 900 360 270 180 90
Repairs Area 200 75 55 45 400
Depreciation No. of workers 3,000 1,200 800 600 -
Light Value of stock 1,000 500 300 200 30
Supervision Wages 300 120 90 60 25
Insurance
Employees Plant value 1,800 720 540 360 180

Insurance
Power
17,550 6,055 5,265 2,635 3,595
STAGE III: APPORTIONMENT OF SERVICE DEPARTMENTS' OVERHEAD TO
PRODUCING DEPARTMENTS

In Stage III. Overhead costs of service departments are apportioned to production departments. The
logic for such apportionment is that service departments do not themselves manufacture anything
and it is the production departments which produce. Such apportionment 'is termed as Secondary
Distribution.

The general basis for apportioning service departments overheads to producing departments are the
following:

1. Service rendered (benefits obtained): This. is perhaps the most popular method of
apportioning service department costs. The services rendered to different departments, i.e., benefits
obtained by them can be a suitable basis. If a producing department has received large benefits, it
must be charged for a share of overhead costs incurred to provide that quantity of benefits.

2. Ability to pay: This method suggests that a large share of servicing. Departments' overhead
costs should be ·assigned to those producing depal1ments whose product contributes the most to the
income of a business enterprise.

3. Surveyor analysis: This method is applied where a suitable base is difficult to find or it would
be too costly to select a method which is considered suitable. For example, the postage cost could
be apportioned on a survey of postage used during a year.

4. Efficiency or incentives: This method uses standards and budgets and apportions the overhead
costs on the basis of a present budget or standard.

In selecting a suitable base for apportioning service departments' overheads, considerations should
be given to practicability, simplicity. economy, theoretical soundness and assistance in accurate
costing and cost control. If a service department overhead is allocated on the basis over which the
production manager has no control, the prorated cost may result in an inappropriate charge to the
producing department.

The following list gives a few service departments and bases commonly used to apportion the
respective overhead costs:

Service Department Apportionment Base

Personal Number of employees, labour hours, labours cost

Purchasing Number of orders cost of materials.

Receiving Cost of materials, number of units, number of orders

Stores Cost of materials, number of requisitions, filled,

number of units handled

Factory office Number of employees, labour hours, labour cost

Machine maintenance and Repair Machine hours, labour hours, labour cost, service
rendered

Engineering Machine hours, labour hours, service rendered

Payroll Total labour or machine hours or number of employees

in each department

Welfare, Canteen, Recreation Number of employees in each department & Medical

Building, service Department Relative area of each department

Internal Transport Service Weight, value, graded products, weight and distance

Inter-Departmental Service

While apportioning service departments' overheads, one may notice two situations: (i) first,
the entire amount of a servicing department is to be distributed only to the producing department.
This does not involve any practical difficulty and provides the simplest and quickest method for
apportioning costs of the servicing department. (ii) Second, service provided by some servicing
departments is used partly by other servicing departments. That is, many service departments serve
each other. For example, the payroll department in a firm prepares payroll for the entire
organisation, but it depends on the building maintenance department for repair and maintenance
services. Similarly, the building maintenance department provides services for all departments using
the building, but it gets service from departments like stores, factory office and personnel. This
second situation is known as inner-departmental services.

There are mainly two methods to deal with apportioning overheads under inter- departmental
service:

A Continuous apportionment: In this methods the. Process of apportioning service departments'

overheads is continued until the figures become immaterial or totally exhausted. The following
stages are involved in this method:

 Use the given percentages to apportion the original total of the first service department. This
closes the account of the first service department and transfers prorated amounts to other
departments.

 Use the given percentages of the second service department whose total is made up of
original amount plus prorated amount of service department first. This closes the account of the
second service department and assigns prorated amounts to the other departments including service
department also.

 Follow the same procedure with respect to all other service departments.

 Repeat a second cycle of apportionment starting with the service department first, whose
total consists, at present, only of amounts prorated from other service departments. In this way, the
service department totals become less and less with each cycle of apportionment because each time
a substantial amount is apportioned to the producing departments.

 Stop the above cycle at any point where it is found that the remaining figures (to be
apportioned) are too small to be of any consequence or when the figures are totally exhausted.

Example

The overhead of a manufacturing company has been analysed to the point of primary distribution.

Rs.
Production departments: Machine 10,000
Assembly 4,000
Service departments: Canteen 2,000
Powerhouse 3,000

The canteen is to be apportioned on the basis of employees

Employee‘s %
Machine 240 60
Assembly 140 35
Powerhouse 20 5
400 100

The powerhouse is to be apportioned on the basis of electricity used:

 Thousand kilowatt %
Machine 270 75
Assembly 36 10
Canteen 54 15
360 100

The apportionment would be done in the following manner

Machine Assembly Canteen Powerhouse

Primary apportionment 10,000 4,000 2,000 3,000
Apportion : Canteen 1,200 700 -2000 100
Power house 2,325 310 4,675 -3,100
Canteen 279 163 -465 23
Powerhouse 18 2 3 -23
Canteen 2 1 -3

Total Service Dept 3,824 1,176

Total Production over 13,824 5,176

head

B. Algebraic method or Simultaneous Equation: This method helps in finding out the amount of
overhead of each service department by solving simultaneous equations. The total expenses of
service departments can be directly transferred to the production departments.

Example

A company has there production departments, A, B and C and two service departments P and Q.
The following figures are available as per departmental distribution summary:

Rs.
Production A 3,150
B 3,700
C 1,400
Service departments P 2,250
Q 1,000

The expenses of the service departments are to be apportioned on a percentage basis as follows:
 A B C P Q
Service dept P40 % 30 % 20 % - 10 %
Service dept Q30 % 30 % 20 % 20 % -

Solution:

Let X= total overhead of dept. P

Y= total overhead of dept Q

There fore, X = 2,250 + 20/100Y

Y = 1,000 + 10/100X

10X=22,500 + 2Y

10Y=10,000 + 1X

Multiplying equation (3) by 5

50 X – 10 Y = 1, 12,500

-X + 10Y = 10,000
49 X = 1, 22,500

X= 2,500 And Y = 1,250

Table 7.17 Secondary Distribution Summary

Total Production Service Department

departments
A B C D P Q

As per summary 11,500 3,150 3,700 1,400 2,250 1,000

Service dept. P 1,000 750 500 -2,250 250
11,500 4,150 4,450 1900 - 1,250
Service dept Q 375 375 250 250 -1,250
11,500 4,525 4,825 2,150 - -
Service department‘s overheads represent the sum of the service department costs plus the costs
apportioned form other service departments. After obtaining total overhead costs of servicing
department the total of each service department is apportioned to the producing departments on the
basis of percentage or proportion ( for the services rendered) of the specific producing departments.

Example

PH Ltd is a manufacturing company having there production departments A, B and C and two
service departments X AND Y. The following is the budget for December 1999.

Total A B C X Y
Rs Rs. Rs. Rs Rs Rs
Direct material Direct wages 1,500 2,000 4,000 2,000 1,000
Factory rent Power 5,000 2,000 8,000 1,000 2,000
Depreciation Other 4,000
overheads 2,500
1,000
9,000

Additional information Area

(sq.ft.)
500 250 500 250 500
Capital value (Rs. Lakhs) of
assets
Machine hours
20 40 20 10 10
Horse power of machines
1,000 2,000 4,000. 1,000 1,000
50 40 20 15 25

A technical assessment of the apportionment of expanses of service departments is as under:

A B C X Y
% % % % %
Service dept X 45 15 30 - 10
Service dept Y 60 35 - 5 -
Required

(viii) A statement showing distribution of overheads to various departments

(ix) A statement showing re-distribution of service departments expenses to production

departments and

(x) Machine hour rates of the production department A,B and C

Table 7.18 Solution: Overhead Distribution Summary

Basis Total Rs A B C X Y
Rs. Rs. Rs Rs Rs

Direct Material Direct - - - - 2,000 1,000

Direct wages - - - - - 1,000 2,000
Factory rent Area 4,000 1,000 500 1,000 500 1,000
Power H.P.X 2,500 500 800 800 150 250
Depreciation M/chr 1,000 200 400 200 100 100
Cap. Value 9,000 1,000 2,000 4,000 1,000 1,000
Overheads M/c hr

2,700 3,700 6,000 4,750 5,250

Table 7.19 Re-distribution of Service Department‘s Expenses

A B C X Y

Rs. Rs. Rs Rs Rs
 Total overheads 2,700 3,700 6,000 4,750 5360

Dept. X Overheads apportioned In 2,138 712 1,425 -4,750 475

the ratio (45:15:30:10)

Dept. Y Overhead apportioned In

the ratio ( 60:35:5)

Dept. X Overheads apportioned In

the ratio (45:15:30:10)
3,495 2,039 - 87 291 -5825
Dept. Y Overhead apportioned In
- -291
the ratio ( 60:35:5)

Dept. X Overheads apportioned In

the ratio (45:15:30:10) 131 44

2 29

17 10

-2 29

1 -

8,482 6,505 7,513 - -

Machine Hour Rate

A B C
Machine hours 1,000 2,000 4,000
Machine rate (Rs.) 8.48 3.25 1.88

STAGE IV: CALCULATION OF OVERHEAD RATES

After all services departments' overhead costs have been apportioned to the producing departments,
the next step is to spread factory overhead to different products or jobs produced. This is termed as
'overhead absorption' in cost accounting. Known by different names such as recovery, overhead
application, overhead costing, levy, burden rate etc. the term "absorption" implies that expenses
pertaining to a producing department or cost centre are finally charged to or absorbed in the cost of
products, jobs, etc. passing through it. As a result of absorption, the cost of each unit of product of
the producing department includes an equitable share of the total overhead of that department.
Overhead rates can be calculated by using any one of the following methods:

1. Percentage on Direct Materials

In such a case, the rate is obtained by dividing total estimated factory overhead by total direct
materials cost expected to be used in the manufacturing process. If factory overhead is Rs. 3, 00,000
and materials cost is Rs. 2, 50,000, the absorption rate will be: 3,00,000/2,50,000 x 100 = 120%

Each job or product would be charged on the basis of 120% absorption rate. For example, if the
materials cost of a product is Rs. 5,000, the factory overhead to be charged for their product would
be Rs. 6,000 (5,000 x 120%).

Advantages

The percentage on direct material cost method is simple and easy to understand and apply. This
method will give correct overhead cost figures where the price of raw materials do not differ
significantly, where quantity and cost of materials in each product are unit form, and where
processing for the different products is also uniform. It is useful in very simple types of small
business firms.

Disadvantages

This method has the following disadvantages:

 There is no logical relationship between materials cost of a product and factory

overhead used in production

 Materials prices are subject to fluctuations quite often and this phenomenon leads to
high or low overhead costs, even though overhead figures remain unchanged.

 Most of the overhead expenses vary with time and not on materials consumed. But
the use of direct material cost totally ignores the time factor which is an important factor in
allocation/apportionment of overhead costs.
 The mere fact that a job consumes materials of a very expensive nature does not
imply that the overheads incurred on that job will also be heavier.

2. Percentage on Direct Wages

The direct labour cost basis is the most widely used method of applying overhead to jobs or
products.

This is computed in the following manner:

(Factory overhead/Direct labour cost) * 100

If factory overhead is Rs. 20,000 and the direct labour cost is also Rs. 20,000, then absorption rate
based on direct wages will be 100%.

20,000/ 20,000 * 100

A job or a product with a direct labour cost of Rs. 3,000 would be charged with Rs. 3,000 for
factory overheads. Labour rates fluctuate but less frequently than that of prices of materials

Advantages

 It is simple to operate and understand.

 It considers the time factor, as labour cost is computed by multiplying the number of
hours spent on work by an hourly labour rate, the more hours worked, the higher the greater the use
and therefore the charge for factory overheads.

 Labour cost and the greater the use and therefore the charge for factory overheads.

Disadvantages

The disadvantages are:

 It depends on the cost of direct labour which may not reflect accurately the
contribution of factory overheads in the cost of product.

 It does not consider the share of other factors of production other than direct labour
factor, for example, machinery.

 It does not take into account variations, if any, in the rates of remuneration for
different types of labour and therefore, the wages incurred on different jobs are not necessarily in
the same ratio as the hours spent.

3. Prime Cost Percentage

The prime cost basis combines the total of direct materials cost and direct labour cost and uses this
total as a basis for charging overhead. The formula used in determining the rate is:

(Factory Overhead/ Prime cost) * 100

If in a case, the factory overhead is Rs. 4, 56,000 and prime cost is Rs. 6, 00,000, then prime cost.
Percentage rate will be:

(4, 56,000/ 6, 00,000) * 100 = 76% or prime cost

Advantages

This method is simple to operate. It considers both materials and labour in charging overheads to
each job or product. The prime cost data is easily available without any additional problem of
accumulation.

Disadvantages

The disadvantages are:

 Two items, i.e. materials and labour both of which possess many disadvantages
influence the charging of factory overheads to jobs and products.

 Where the cost of materials is a larger part of the prime cost, the time factor (direct
labour costs) will be ignored which is more related to the factory overhead.

 It ignores the time factor in absorbing factory overhead.

4. Unit of Production Basis

The unit of production method is the simplest and most direct method of charging factory overhead.
The unit might be a kilo, foot, a machine, a hundred pieces or whatever unit of measure is used for
the product. As a formula, the computation is as follows: Factory overhead/ Units of Production

If factory overhead is Rs. 3,00,000 and the company intends to products 2,50,000 units during the
next period, each unit completed would be charged with Rs. 1.20(3,00,000 -7- 2,50,000 units) as its
share of factory overhead. Thus, an order with 1,000 completed units would be charged Rs. 1,200 (l,
000 units x Rs. 1.20) for factory overhead.

5. Labour Hour/Production Hour Rate

One of the most widely used methods for overhead application is the labour hour basis. The
equation for determining the overhead rate under this method is:

= Factory overhead / Direct labour hours

If factory overhead is Rs. 4,00,000 and direct labour hours are 2,00,000, then the overhead rate
based on direct labour hours would be Rs. 2 per hour of direct labour (Rs. 4,00,000 ÷2,00,000
hours). A product that requires 5,000 direct labour hours would be charged with Rs. 10,000 (5,000
hours * Rs. 2) for factory overhead.

Advantages

The following are the advantages:

1. As long as direct labour is the chief factor in manufacturing processes, the direct
labour hour‘s method is useful as the most equitable basis for charging overheads.

2. This method uses the time factor and production taking into account that the same
time is charged with the same amount of overhead, though the direct laborer may be getting
different wage rates.

Disadvantages

The disadvantages are:

1. The method requires accumulation of direct labour hours by job, product or

department Timekeeping should be adequate to provide this information.

2. This method cannot be used where machines are used extensively for production.
In other words, this method assumes that direct labour is only the major factor of production.

6. Machine Hours Rate

The machine hour rate is similar to the labour hour rate method and is used where the work is
performed primarily on machines. The formula used in computing the rate is:

= Factory overhead/ Machine hours

If factory overhead is Rs. 3, 00,000 and total machine hours are 1, 50,000, the machine hour rate is
Rs. 2 per machine hour (Rs. 3, 00,000 ÷ 1, 50,000 hours).

Advantages

The method can be used advantageously where the machine is the major factor in production. In
capital-intensive industries, plants and machines are used is large quantities and one operator may
attend to several machines or several operators may attend to a single machine. By making the
machine the basis, therefore, overhead costs can be equitably absorbed among different products.

Disadvantages

The disadvantages are:

1. Machine hour data has to be collected and therefore it requires additional clerical work.

2. The method cannot be used universally by all business concerns. It can be used where
production is mainly through machines.

Two types of machine hour rates can be calculated:

1. Ordinary machine hour rate-This rate takes into account only those overhead expenses which
are directly attributed to the running of a machine. Such expenses are power, fuel, repair,
maintenance and depreciation. The total of all these expenses is divided by the total machine hours.

2. Composite machine hours rate-This method takes into account not only expenses directly
connected with the machine as mentioned above, but also other expenses which are known as
standing or fixed charges. Such expenses are rent and rates, supervisory labour, lighting and
heating, etc. These expenses being fixed in nature are determined for a particular period and then
apportioned among different departments on some equitable basis. The overhead expenses thus
apportioned to each department are further apportioned among the machines (machine cost centers)
in that department on an equitable basis.

7.6 MANAGERIAL ACCOUNTING

Managers in all types of organizations need frequent information about business activities to plan
accurately for the future, to control business results, to direct an enterprise towards achieving its
goals and to make decisions that affect the operations of the business. Information is vital for the
management process i. e. for functions carried out by the managers namely, planning, controlling
and decision-making. In the goal of providing information, managerial accounting identifies,
collects, measures, classifies and reports information that is useful to managers in fulfilling the
management process.

Managerial accounting is that field of accounting which deals with providing information including
financial accounting information to managers for their use in planning, decision-making,
performance evaluation, control, management of costs, and cost determination for financial
reporting. Managerial Accounting contains reports prepared to fulfill the needs of managements.

The National Association of Accountants (USA), in Statement No. IA (Statements on Management

Accounting, 1982) has defined management accounting as:

―... The process of identification, measurement, accumulation, analysis, preparation and

communication of financial information used by management to plan, evaluate, and control within
the organisation and to assure appropriate use and accountability for its resources."

The CIMA (UK) defines the term management accounting in the following manner: "Management
accounting is an integral part of management concerned with identifying, presenting and interpreting
information used for:

(1) Formulating strategy

(2) Planning and controlling activities

(3) Decision taking

(4) Optimizing the use of resources

(5) Disclosure to shareholders and others external to the entity

(6) Disclosure to employees and

(7) Safeguarding assets."

Thus, managerial accounting is concerned with data collection from internal and external sources,
analysis, processing, interpreting and communicating the information for use within the
organisation so that management can more effectively li1an, make decisions and control operations.

COST ACCOUNTING AND MANAGERIAL ACCOUNTING

Cost accounting is mainly concerned with ascertainment of product costs and the techniques of
product costing and deals with only cost and price data. It is limited to product costing procedures
and related information processing. It helps management in planning and controlling costs relating
to both production and distribution activities.

Inspite of the differing parameters of cost accounting and managerial accounting, cost accounting i
generally indistinguishable from what is known as management or managerial accounting. Both
these accounting systems are closely linked as they use common basic data and reports to a material
degree. Much of the information used to prepare accounting statements and reports in cost
accounting are also used in managerial accounting reports. Cost accounting largely uses data about
production, sales, wages, and overhead services. Managerial accounting utilises the same (and also
additional) data to prepare budgets, performance reports, and control reports and data analyses for
decision- making purposes. Special decision methods, use of highly quantitative methods,
behavioral techniques, information systems and budgeting are areas of managerial accounting. Gray
and Ricketts I illustrate the relationship between cost accounting and managerial accounting in
these words:

"The database (for cost accounting and managerial accounting) includes common data, i.e. the same
data are used, by managerial accounting and by cost accounting, but in different ways. For example,
historical data on labour costs are used by cost accounting to determine inventory values and cost of
goods sold. The historical data on labour cost might be used to estimate the labour cost for the
coming year to determine the size of workforce needed to meet anticipated production requirements
and to estimate the cash requirements to meet weekly payrolls. This represents the use of cost
accounting data to develop managerial accounting data for planning decisions. The historical data
on labour costs might be compared with the estimated labour costs to determine if labour is being
used effectively and efficiently. This represents the use of cost accounting data to develop
managerial accounting data for control decisions. The data base also include ... special data for cost
accounting and special data for managerial accounting, obviously called special because they are
data used only be either cost accounting or by managerial accounting."

MANAGEMENT PROCESS AND ROLE OF MANAGERIAL ACCOUNTING

The Management process implies the four basic functions of (I) Planning, (2) Organizing 3)
Controlling, and (4) Decision-making. Managerial accounting plays a vital role in these managerial
functions performed by managers.

(I) Planning: Planning is formulating short term and long-term plans and actions to achieve a
particular end. The long-term plan indicates management's expectation of the future during the next
three to five years or perhaps even longer. A budget is the financial planning showing how
resources are to be acquired and used over a specified time interval. Managerial accounting is
closely interwoven in planning both because it provides information for decision-making and
because the entire budgeting process is developed around accounting-related reports. Managerial
accounting helps managers in planning by providing reports which estimate the effects of
alternative actions on an enterprise's ability to achieve desired goals. For example, if a business
enterprise determines a target profit for a year, it should also determine how to reach that target. For
example, what products are to be sold at what prices? The management accountant develops data
that help managers identify the more profitable products. Similarly, the effects of alternative prices
and selling efforts (say, what will profit be if we cut prices by 5% and increase volume by 15%,
etc.) can easily be determined by the management accountant.

(2) Organizing: Organizing is a process of establishing an organizational framework and assigning

responsibility to people working in an organisation for achieving business goals and objectives. The
type of organizational structure differs from one business enterprise to another. Organizing requires
clarity about each manager's responsibility and lines of authority. The various departments and units
are inter-related in a hierarchy, with a formal communication structure in which information and
instructions are passed downwards to the lower level management and upwards to the top
management level.

Managerial accounting helps managers in organizing by providing reports and necessary

information to regulate and adjust operations and activities in the light of changing conditions. For
example, the reports under managerial accounting can be prepared on product lines on which basis
managers can decide whether to add or eliminate a product line in the current product mix.
Similarly, the management accountant can provide sales report, production report to the respective
managers for taking suitable action about the sale and production position.

(3) Controlling: Control is the process of monitoring, measuring, evaluating and correcting actual
results to ensure that a business enterprise's goals and plans are achieved. Control is accomplished
with the use of feedback. Feedback is information that can be used to evaluate or correct the steps
being taken to implement a plan. Feedback allows managers to decide to let the operations and
activity continue as they are, take remedial actions to put some actions back in harmony with the
Original plan and goals or do some rearranging and preplanning at the midstream.

Managerial accounting helps in the control function by producing performance reports and control
reports which highlight variances between expected and actual performances. Such reports serve as
a basic for taking necessary corrective action to control operations. The use of performance and
control report follows the principle of management by exception. In case of significant differences
between budgeted and actual results, a manager will usually investigate to determine what is going
wrong and possibly, which subordinates or units might need help.

(4) Decision-making: Decision-making is a process of choosing among competing alternatives.

Decision-making is inherent in each of three management functions described above, namely
planning. Organizing and controlling. Before knowing the role of the management in the decision-
making area. It is first necessary to understand the decision-making process. The decision-making
process includes the following steps: 2

 Identifying a problem requiring managerial action.

 Specifying the objective or goal to be achieved (e.g. maximizing return on investment).

 Listing the possible alternative courses of action.

 Gathering the information about the consequences of each alternative.

 Making a decision, by selecting one of the alternatives.

Decision-Making Process

Managerial accounting plays a critical role in step 4 of the decision-making process. Managerial
Accounting. System contains a storehouse of valuable information for predicting the results of
various courses of action. The managerial accounting can assist the management in formally
structuring decision. Problems as well as placing the alternatives and their consequences in a form
that will be easier for the management to evaluate. It should be understood that the management
accountant sometimes needs to do special analyses and develop information for some decisions
which are made at relatively infrequent intervals, such as whether, to build a new factory, introduce
a new product or enter a foreign market. The data for such decisions and analyses may be readily
available in the needed form. The management accountant in such a situation. determines what data
are needed, presents those data in an understandable form and manner and explains the analyses and
report to the managers who are to make decisions.

While developing and gathering information for decision-making purposes, the management
accountant should include qualitative information also in his report to help managers better in their
decision-making tasks. Dominiak and Londerback III observe: "Although managers use accounting
data 'extensively as they make decisions, such data do not answer the questions that managers face.
People make decision and people bring to decision making their experience, values and knowledge
which often cannot be incorporated into quantitative analyses. An action that seems based on an
analysis of the accounting data might not be taken because of some factor not captured in those
data. For example, because the managers of a firm want the company to maintain technological
leadership, they might launch a new product that is expected to be unprofitable. Quantifying the
benefits of such leadership is not easy. It is unlikely that such quantification would be included in
the management accountant's analysis of the desirability of bringing out the new product. It is,
however, quite likely that a report of that analysis would include a comment about the inability to
quantify such benefits. That is, reports from managerial accountants are very likely to recognize
factors whose financial implications are not incorporated in the reports."

7.6.1 DIFFERENCES BETWEEN MANAGERIAL ACCOUNTING AND FINANCIAL

ACCOUNTING

The accounting information system in an organisation can be divided into two important subsystems
or branches: (i) Management or Managerial Accounting and (ii) Financial Accounting. As stated
earlier, managerial accounting, also known as internal accounting, identifies, collects, measures,
classifies and reports information that is useful to managers in planning, control and decision-
making. On the other hand, financial accounting, also known as external accounting, produces
information and reports for external users. The subject matter and scope of managerial accounting
and financial accounting are displayed in Figure 7.2.

Managerial accounting and financial accounting differ from each other in the following respects:

(1) Primary users of information: The users of financial accounting statements are mainly
external to the business enterprise. The financial statements prepared under financial accounting
show how the resources have been used by a business enterprise during a specific period of time
and thus are useful to external users in making sound economic decisions. These financial
statements are relevant to management but are not adequate for the purpose of planning, control and
decision-making. External users include shareholders, creditors, financial analysts, government
authorities, stock exchange, labour unions etc.
Fig 7.2 Accounting classification

Management accounting aims at preparing reports and supplying information to the management
for planning, controlling and decision-making. The information generated under the accounting
system is used by members of the management at different levels. The nature of internal reports and
data varies for different levels of management in conformity with their information requirements for
analysing business operations and for planning and control purposes.

(2) Accounting methods: Financial accounting follows the double-entry system for recording
classifying and summarizing business transactions. This accounting process results in aggregate
balance of all accounts maintained in a firm's books. Managerial accountings are not based on the
double-entry system. The data under managerial accounting may be gathered for small or large
segments or activities of an organisation and monetary as well as other measures can be used for
different activities in the firm.

(3) Accounting principles: Financial accounting data is primarily meant for external users. The
generally accepted accounting principles' are important in financial accounting and are used
extensively while recording, classifying, summarizing, and reporting business transactions. The use of
GAAP adds credibility and reliability to financial statements and creates confidence among the financial
statement users. On the contrary, managerial accounting is not bound to use the ·generally accepted
accounting principles. It can use any accounting technique or practice which generates useful information.
Besides data developed in management accounting may be facts, estimates, projections, analysis etc.

(4) Unit of measurement: All information under financial accounting is in terms of money. That
is transactions measured in terms of money have already occurred. In comparison, managerial
accounting applies any measurement unit that is useful in a particular situation. Besides the
monetary units, the management accountant may find it necessary to use such measures, as number
of labour hours, machine hours and product units for the purpose of analysis and decision-making.
The common objective in all measurement, reporting and data analysis in managerial accounting is
usefulness for a particular purpose.

(5) Time Span: Financial accounting data and statements are developed for a definite period,
usually: a year or a half-year. It requires that financial statements be developed and presented at
regular time intervals. Company annual reports may be prepared semi-annually or quarterly but the
important point is that they are prepared on a regular basis.

Managerial accounting reports and statements are prepared whenever needed. Reports may be
prepared on a monthly, weekly or even daily basis. Frequency of reports is determined by particular
planning controlling and decision-making needs.

(6) General Purpose Report vs. Specific Purpose Report: Financial accounting produces
information and reports which are general purpose reports in order to serve the informational needs
of many external users such as shareholders, creditors, potential investors, customers, suppliers,
regulatory authority‘s employees and the general public. On the contrary, the reports and data
developed in managerial accounting are known as specific purpose reports designed for a particular
user (manager) or particular decision. Managerial accounting uses internal reports to evaluate the
performance of entities, product lines, departments and managers.

(7) Historical vs. Futuristic Data: Financial accounting has a historical orientation and records
and reports what has happened. Financial accounting concentrates on the results of past decisions.
Managerial .accounting has a futuristic orientation and concentrates on what is likely to happen in
the future. This is due to the fact that managerial accounting emphasizes on developing information
for planning, control and decision-making purposes. Therefore, managerial accounting focuses on
the future more than financial accounting.

(8) Detailed and aggregated information: Managerial accounting provides detailed and
disaggregated information about products, individual activities, divisions, plants, operations, tasks
or any other responsibility centers. On the other hand, financial accounting focuses on the company
as a whole. Sometimes, in financial accounting, some information is given about different products
or lines of activity due to financial reporting requirements as provided in the Companies Act/other
rules and regulations.

(9) Use of disciplines: Managerial accounting uses other disciplines to prepare the most useful
reports and analyses for the managers. Some such disciplines are economics, finance, management,
information system, industrial engineering, operations research, marketing, computer science,
production management, statistics, psychology and sociology etc. In this way, managerial
accounting is much broader than financial accounting.

Despite the above differences between managerial and financial accounting, there are some
similarities between the two accounting systems. Both managerial accounting and financial
accounting are part of the total accounting information system. Both deal with economic events.
Both try to quantify the results of economic activity and transaction. Both are concerned with
financial statements, revenues, expenses, assets, liabilities and cash flows. The accounting
information system that accumulates and classifies information and generates financial statements is
the same system used for many reports and analysis which are prepared under managerial
accounting. Further, the reports prepared in management accounting and financial accountings are
based on the same databases which are originally created to fulfill the accounting and reporting
requirements of financial accounting. This is the reason that when the accounting system in an
organisation collects and classifies information, it does so in a manner and format which can be
appropriate for both the accounting systems. To achieve this dual purpose in developing the
database, many business enterprises expand this database so as to fulfill adequately the
informational needs of their managers and decision-makers. For example, investors and other users
are primarily interested in the overall profitability of a company. However, the managers within the
company are more interested in the profitability of individual products. In this situation, the
accounting system can be developed and designed so as to provide both total company profits as
well as profits for the individual products. The vital point about the accounting system is the
flexibility that is, the accounting system should be flexible to provide different data to different
persons for different purposes.

Managerial and financial accounting are also similar with regard to determination and
measurement of costs, their assignment to different accounting periods and allocation of costs to
different departments and segments. The concepts and principles which are used in the areas of
financial accounting for the purposes of cost accumulation and cost allocation may also be
suitable for management accounting as well. It means any method, principle or concept which are
developed for financial accounting, can be used for Preparing reports and analyses in
management accounting if they are found useful for managerial purposes.

7.6.2 COST-VOLUME-PROFIT ANALYSIS

Cost- Volume-Profit (CVP) analysis is an important tool that provides the management with useful
information for managerial planning and decision-making. Profits of a business firm are the result
of interaction of many factors. Such factors determine whether we have profits or losses and
whether profits increase or decrease over time. Among the many factors influencing the level of
profits, the following are considered the key factors:

(i) Selling price

(ii) Volume of sales

(iii) Variable costs on a per unit basis

(iv) Total fixed costs and

(v) Sales mix (proportions or combinations in which different products are sold). To do an
effective job in planning and decision-making, the management must have analyses which allow
reasonably correct predictions of how profits will be affected by a change in anyone of these
factors. Also, management needs an understanding of how revenues, costs and volumes interact in
providing profits. All these analyses and information are provided by cost-volume-profit analysis.

Cost- Volume-Profit analysis is a systematic method of examining the relationships between selling
price, total sales revenue, and volume of production, expenses and profit. This analysis simplifies
the real world conditions that a business enterprise is likely to face. CVP analysis can play an
important role by providing the management with information regarding financial results if a
specified level of activity or volume fluctuates, information on relative profitability of its various
products, information on probable effects of changes i n selling price and other variables. Such
information can help the management improve the relationship between these variables. For
example, an analysis of sales and cost data can be helpful in determining the level of sales volume
necessary for the business to achieve a desired or target profit. Similarly, CVP analysis may be used
in setting selling prices, selecting the products mix to sell, choosing among alternative marketing
strategies and analysing the effects of cost increase or decrease on the profitability of the business
enterprise.

CVP analysis focuses on prices, revenues, volume, costs, profits and sales mix and on the
interrelationship between them during the short-run. The short-run is generally considered a period
of one year or less than one year during which the production of a business enterprise cannot be
increased and is limited to the available current operating capacity of the enterprise. During the
short-run, the capacity of the plant and machinery cannot be increased (this is possible during the
long-term only) and therefore, production is limited in terms of available plant facilities. Similarly,
it takes time to reduce the capacity of plant and machinery and therefore, a business enterprise
should operate during the short-run relatively on a constant quantity of production resources.
Besides, no changes in cost and prices data can be generally made during the short-term as they
might have already been determined. During the short-run, however, some resources like materials
and unskilled labour can be increased at a short notice. Thus during the short run, sales volume and
short-run profitability can be the only vital area which may be found uncertain. CVP analysis herein
reveals the effect of changes in sales volume on the level of profits. CVP analysis, in this. way, is an
integral part of financial planning and managerial decision-making.

In CVP analysis, all expenses are classified into fixed and variable. Semi-variable expenses have to
be divided into their fixed and variable elements. These steps are important prerequisites to any
CVP analysis and a proper understanding of them is essential for reliable conclusions. Based upon a
knowledge of fixed and variable cost elements and CVP analysis, it is possible to determine break-
even sales volume, to compute the sales needed to generate desired profits and to supply answers to
many questions that arise in the course of management planning and decision-making.

TECHNIQUES OF CVP ANALYSIS

CVP analysis uses the following techniques or analyses while answering to many questions in the
area of managerial planning and decision-making:

(1) Contribution Margin Concept

(2) Break-Even Analysis

(3) Profit-Volume (P/ V) Analysis

CONTRIBUTION MARGIN CONCEPT

Contribution margin concept indicates the profit potential of a business enterprise and also
highlights the relationship between cost, sales and profit. It is a highly useful technique for planning
and decision making by the management.

Contribution margin is the excess of sales revenue over variable costs and expenses. Under
contribution margin concept, variable costs include all variable costs, i.e. variable production costs
and variable selling and administrative expenses, if any. From the contribution margin, fixed costs
and expenses are deducted giving finally operating income or loss. Contribution margin is thus
used to recover/cover fixed costs. Once the fixed costs are covered, any remaining contribution
margin adds directly to the operating income of the firm. Contribution Margin Ratio (Also known
as CIS ratio or P/V ratio)

The contribution margin can also be expressed in the form of a percentage. The contribution margin
ratio is also known as 'contribution to sales' (C/S) ratio or profit- volume (PN) ratio. This ratio
denotes the percentage of each sales rupee available to cover the fixed costs and to provide
operating income to a firm. Taking an example, assume the following information in case of a
company.

Sales 1, 00,000
Variable Costs 60,000
Fixed Costs 30,000

In this case, contribution margin is Rs. 40,000; profit Rs. 10,000 and contribution margin is 40% as
shown by the following computation:

(i) Sales 1, 00,000

Variable costs 60,000
Contribution margin 40,000
Fixed Costs 30,000
Profit Rs. 10,000

(ii) Contribution Margin Ration (or C/S or P/V Ration)

= Sales –Variable Costs

Sales

= Rs. 1, 00,000 – Rs 60,000

Rs.1, 00,000

= Rs.40, 000 = 40 %
Rs.1, 00,000

The P/V ratio helps in knowing the effect on income of a firm due to increase or decrease in sales
volume. For instance, in the above example, a business enterprise may be interested in studying the
effect of having additional sales of Rs. 40,000 on the income of the firm. Multiplying the P/V ratio
(40%) by the change in sales volume (Rs. 40,000) indicates an increase in operating income by Rs.
16,000 if additional sales are possible. The total income will be Rs. 26,000 as is clear from the
following computation:

(Rs.)

Sales 1, 40,000
Less: Variable costs (Rs. 1, 40,000 x 60%) 84,000
Contribution margin 56,000
(Rs. 1, 40,000 x 40%)

Less: Fixed costs 30,000

Net Income 26,000

In the above example, variable costs as percentage are 60% of sales (l00 - P/V ratio which is 40%).
Thus, variable costs, as a percentage of sales are always equal to 100% minus the P/V ratio.

The P/V ratio is useful to the management in deciding whether to increase sales volume. For
example, if the P/V ratio of a business enterprise is large and the enterprise is operating at less than
100% capacity, it will be advantageous for the firm to go for increase in sales volume as net income
will go up because of higher sales volume. On the other hand, a firm with a small P/V ratio will not
find profitable to have increase- in sales volume much profitable. Infact, enterprises having a lower
P/V ratio should aim at reducing costs and expenses before thinking of increasing the sales volume.

The use of P/V ratio in specific analysis is based on the assumption that except sales volume, other
factors such as the unit selling price, percentage of variable cost to sales, amount of fixed costs
remain constant. If there are changes in any of these factors, the effect of such change should be
considered in making the analysis involving the P/V ratio.

UNIT CONTRIBUTION MARGIN

Unit contribution margin or contribution margin on per unit basis is equally useful as it also
indicates the profit potential of a product or activity. The unit contribution margin is the money
available from sale of each unit to cover fixed costs and provide profits to a firm. For example, if selling
price of a company's product is Rs. 10 and variable costs per unit Rs. 6, the unit contribution margin will be
Rs. 4 (Rs. 10 Rs. 6).

While the P/V ratio is most useful when the increase or decrease in sales volume is measured in
terms of Rupees, the unit contribution margin is most useful when increase or decrease in sales
volume is measured in sales unit (quantities). If a business firm has been able to cover fixed costs,
the net income of the firm will increase by unit contribution margin multiplied by additional sales
units.

7.6.3 BREAK-EVEN ANALYSIS

A break-even analysis is performed to identify the level of operations at which the

.entity has covered all costs but has not yet earned any profit. The break-even point identifies the
volume of activity at which total revenues equal total costs. This is an important point to the
management because it represents a minimum acceptable level of operations and it indicates that
profitable operations can only result when the level of activity exceeds the break-even point.

Break-even Analysis in Units

Break even analysis utilizes the contribution margin approach to compute net income, which splits
costs into a fixed and variable classification. The break-even point in units can be computed by
dividing total fixed costs (F) by the contribution margin provided by each unit.

Break-even in units = Total fixed costs = FC

Contribution margin per unit S-VC

The contribution margin per unit is sales price per unit (S) less variable cost per unit (VC). An
example will illustrate the use of this formula.

Example

SAX manufactures and sells one type of calculator called Model Q. Model Q sells for Rs. 400, and
the variable expenses associated with it are Rs. 200 for manufacturing and Rs.

50 for selling. Fixed costs are Rs. 7, 50,000 for manufacturing and Rs. 1, 50.000 for selling and
administration. How many units must be produced and sold in order to break- even?

Solutions:

Break-even point in units =

Fixed Cost
Sale price per unit – Variable cost per unit

= Rs.9, 00,000 = 6,000 units

Rs.400 –Rs 2.50
When the price exceeds the variable cost, as in the example above, each unit contributes something
(Rs. 150) toward, covering fixed costs and providing a profit. The break-even point has been
reached as soon as the cumulative amount of the contribution margin (6,000 x Rs. 150) equals the
total fixed costs (Rs. 9, 00,000).

BREAK-EVEN CHARTS

A break-even chart is a graphical representation of the relationships between costs, revenues and
profits. It is developed by plotting the total cost curve and total revenue curve on a piece of graph
paper. The above example has been used to illustrate the construction. The revenue and cost curves
are:

Revenue = Rs. 400 (per unit)

Cost = Rs. 90, 0000 fixed costs + Rs. 250 (per unit variable costs)

The break-even point is the point at which the total revenue curve intersects the total cost curve.
Sales above this level will provide a profit, while sales below this level will result in a loss. The
amount of the profit or loss is shown by the vertical distance between the total revenue and total
cost curves.

BREAK-EVEN ANALYSIS IN SALES RUPEES

The concept of the break-even point does not change when the analysis is performed in sales rupees.
The break-even point merely identifies the amount of sales rupees required to cover all costs but
generates no profit.

Equation for Break-even point in Sales Rupees: One method of computing break-even in sales
rupees is to compute break-even in units and multiply the number of units by the sales price per
unit. However, sometimes it may not be convenient or efficient because of the way the data is given
to first compute the break-even point in units. The break-even point in sales rupees equal to fixed
costs divided by the contribution margin ratio.

Break-even point in sales Rupees =

Fixed Costs
Contribution margin ratio

For an amount of desired profit, the following formula is used:

 Fixed costs + Desired Profit
- Contribution Margin Ratio (CIS Ratio)

By definition, the contribution margin ratio is the ratio of the contribution margin to sales. The
Contribution margin is the sale price minus variable costs and the ratio is computed by dividing
contribution margin by the sales price.

Contribution margin ratio = Sales price per unit - Variable cost per unit
Sales price per unit OR

Contribution margin ratio = Total sales - Total Variable Costs

Total Sales

Example

All time company manufactures and sells a watch at Rs. 250. Variable costs are Rs. 200 per unit and
fixed costs total Rs, 100,000 per year. What is the required sales revenue for the company to break-
even? The contribution margin ratio is first computed and then divided into the total fixed costs.

Solution:

Contribution margin ratio = Rs, 250- Rs, 200

Rs.250 =20%

Break-even point in sales Rs. = 1, 00,000 = Rs. 5, 00,000

20%

BREAK-EVEN ANALYSIS FOR MULTIPLE PRODUCTS

The analysis so far has assumed that only one product was being produced and sold, which is not
very realistic for most companies. Break-even analysis can still be performed in case of multiple
products using either units of production or sales rupees by assuming that the company's sales mix
will remain constant. Sales mix refers to the ratio or relative combination of each product's sales to
total sales. It is the composition of total sales broken down among various products or product lines.

Example

Multi Products Company has three products labeled Model X, Model Y and Model

Z. Sales on a monthly basis are expected to be as follows:

 Model X Model Y Model Z Total
Units 1,000 1,500 2,500 5,000
Sales Ratio 20% 30% 50% 100%

Product mix is usually stated in a ratio, such as (2: 3: 5) for models X, Y and Z respectively. This
means that for every 2 units of Model X that are sold, there are 3 units of model Y and 5 units of
model Z. Another way of viewing sales mix is to consider a market basket that represents the
average expected sales of a company. Within that basket, representing .one product mix, multi
products would have 2 units of model X, 3 units of model Y and 5 units of model Z, for a total of 10
units.

Break-even Analysis in Units for Multiple Products

A market basket approach is used to compute a break-even point in units. A market basket
representing the average sales mix is developed. The contribution margin provided by the basket is
used to compute the number of baskets that must be sold to break-even.

The number of individual products required to fill the baskets at the break-even point is then
determined

Example:

Multi Products Company has a sales ratio of 2: 3: 5 for models X, Y and Z respectively. Total fixed
costs for the year are Rs. 200,000. The sales price, variable costs and contribution margin associated
with each product are as follows:

Model X Model y Model Z

Sales price Rs. 50 Rs.25 Rs.10
Variable costs 30 15 8
Contribution margin Rs.20 Rs.10 Rs.2

Solution:

The average market basket is based on the sales ratio and consists of 10 units with a total
contribution margin of Rs. 80 (2 x Rs. 20) + (3 x Rs. 10) + (5 x Rs. 2). The break-even point in
market baskets is computed using the formula for break-even point in units.

X = Rs.200, 000 = 2500 baskets

Rs.80
In order to fill 2,500 baskets, it will take the following amounts for each model.

Model X 5,000 units (2,500 x 2)

Model Y 7,500 units (2,500 x 3)

Model Z 12,500 units (2,500 x 5)

This, then, is the break-even point in units as long as the sales mix stays at 2: 3: 5.

Break-even Analysis in Sales for Multiple Products

The break-even point in sales for a multiple product entity can be computed by using an average
contribution margin ratio. The average contribution margin ratio can be computed on a per unit
basis or it can be developed from the income statement. In both cases, the fixed costs are divided by
the average contribution margin ratio. The difference is in the level of aggregation in computing the
average contribution margin ratio.

When the average contribution margin ratio is computed on a unit basis, the average unit sale price
is divided into the average unit contribution margin.

Example:

Using the data above for Multi Products Company, the average sale price is computed by
multiplying the sales ratio by the sale price for individual products and totaling the results. The
average contribution margin is computed in a similar manner and the contribution margin ratio is
the average contribution margin divided by the average sale price.

Average sale price = (20% x Rs. 50) + (30% x Rs. 25) + (50% x Rs. 10)

= Rs. 22.50

Average contribution margin =

(20% x Rs. 20) + (30% x Rs. 10) + (50% x Rs. 2) = Rs. 8.00

Average contribution margin ratio

(Rs. 8.00 -:- Rs. 22.50) x 100 = 35.555%

Break-even point in sales

 Rs. 20,000 = Rs.5, 62,500 per year
35.555 %

Example

ABC Company has twenty products and the contents of an average market basket are not known.
They reported the following net income for January, 1999. The sales mix and costs for January are
expected to continue throughout the coming year. Management was disappointed with the results
and wants to know the sales level required to break-even.

Rs.

Sales 1, 20,000 100%

Variable costs 90,000 75%
Contribution margin 30,000
Fixed costs 40,000
Net income (loss) (10,000)

Solution:

The average contribution ratio is 25% (Rs. 30,000/Rs. 120,000) and the break-even points in sales
are Rs. 160,000 (Rs. 40,000/25%). Assuming the product mix and costs remain the same as in
January, ABC Company must sell Rs. 160,000 per month to break-even. Break-even analysis in
sales is generally easier to compute than break-even analysis in units for multiple product entities
because it does not require knowledge of the product mix and the average market basket. A
contribution margin ratio can be developed from the income statement for use in the break-even
analysis.

Margin of Safety

The margin of safety is the difference between budgeted (or actual) sales and break-even sales,
expressed as a percentage of budgeted sales. In equation form:

%Margin of safety = Budgeted (or actual) sales - break even sales

Budgeted sales

Assume in a company the actual sales are Rs. 60,000 and break-even sales are Rs.

48,000. Then the margin of safety is:

 = 60,000 – 48,000 x 100 % = 20 %
60,000

This means that if sales volume is 20% less than the actual sales volume, the firm would just
breakeven. Managers use the margin of safety as an indication of the risk inherent in a particular
sales goal. The simple presumption is that the greater the margin of safety, the lower the risk.

7.6.4 PROFIT-VOLUME GRAPH

A P/V graph is used in place of or along with a break-even chart. Profit and losses are given on a
vertical scale and units of products, sales revenue or percentage of activity are given on a horizontal
line. The horizontal line is drawn on the graph to separate profit from losses. The profit and losses
at various sales levels are plotted and connected by the profit line. The break-even point is measured
at the point where the profit line intersects

the horizontal line. P/V graph focuses entirely on the relationship between volume and profit. A P/V
graph is more useful than the break-even chart because it shows the profit or loss directly rather
than as the difference between the revenue and cost curves. However, the P/V graph does not
clearly show how costs vary with activity.

Example

Selling price per unit Rs. 40 Variable cost per unit Rs. 25 Total fixed costs Rs. 90,000

The total fixed expenses and break-even point can be used to construct the profit volume graph. The
total fixed expenses of Rs. 90,000 represent a Rs. 90,000 loss at zero sales volume. The break-even
point represents the unit sales volume at which there is no loss and no profit-(zero profits). As you
can see, the profit line begins where the fixed expenses is shown as a loss on the vertical axis and
moves upward and to the right at a rate equal to the contribution margin per unit, Rs. 15 per unit.
The contribution margin per unit is the slope 9f the profit line. The steeper the slope/starting at the
same fixed expenses of the profit line, the lower the break-even point.

Significance of Fixed Costs on Break-Even Point

The greater the fixed expenses, the higher will be the break-even point. In the short run, fixed costs
cannot be immediately reduced to meet declining customer demands. Certain fixed costs remain
fairly constant, such as taxes, insurance, rent or lease costs, depreciation, security and certain
aspects of administration (accounting, supervision, and marketing). Most of the fixed costs are
essential in order to maintain the facilities and environment of the organization. As sales revenue
decreases and fixed costs remain fairly constant, the earnings will naturally decline accordingly
because of the fixed cost impact. It is only logical to assume that an organization with greater fixed
expenses must have larger sales revenues to break even. If sales revenue increases, however, the
organization can increase its earnings position because the increased profit will more than offset the
fixed costs needs.

ASSUMPTIONS IN BREAK-EVEN ANALYSIS

The following are the important assumptions in break-even analysis and break-even charts.

1. The total revenues of the enterprise change in direct proportion to changes in unit sales
volume.

2. This is the same as assuming that the average selling price is constant.

3. The total expenses can be separated into variable expenses and fixed expenses per year.

4. The total variable expenses vary in direct proportion to changes in sales volume. This is the
same as assuming the variable expense per unit is constant.

5. The total fixed expenses, within a relevant range of volume, do not change as sales volume
changes.

6. For a multi-product firm, the sales mix remain constant for all volume levels under
consideration.

7. Production volume and sales volume are equal; in other words, inventory changes do no
effect profit.

ADVANTAGES OF BREAK-EVEN ANALYSIS

 Break-even analysis provides a useful tool in demonstrating the relationship and

interaction of cost, volume, and profit. If properly utilized, it aids in establishing realistic profit
objectives and operating budgets.

 It provides management with distinctive insight into the economic characteristics of

its business, not only in terms of the fixed and variable expenses at varying sales volumes, but also
of the break-even relationship and its effect on the firm due to changes in factors likely to have
impact on the profit of a business enterprise.
 The Manager can advantageously employ 'what if' question to determine the
anticipated results from contemplated managerial decisions. The break-even process may involve
such planning questions as plant expansion,‖ equipment modernization, change in product mix or
sales prices and the introduction of new product lines.

 Management is often confronted with the decision to increase sales volume with an
optimistic view towards enhancing profit. Profit enhancing is a possibility, provided costs are
controlled within prescribed limits. The break-even technique can be an important tool in
establishing expenditure constraints and control by adequate supervision.

 An important influence on profit is the product sales mix with variable gross
margins. The breakeven chart can highlight problem areas requiring connective management action.

DISADVANTAGES OF BREAK-EVEN ANALYSIS

 Break-even analysis is not a remedy for all problems faced by a business firm. It
cannot be used usefully without a thorough understanding of its concept and limitations.

 The break-even chart generally reflects a number of estimates and judgments, and the
resultant data developed and their implication can be misleading. For example, measuring costs and
sales volume at a particular output level may be an inaccurate method of assessment, particularly
when the volume approaches the break-even point, which can change depending on operating
circumstances.

 Usually, the break-even is developed at a point that represents a static position.

Changes in relationship factors should be conectly and logically reflected in a revised chart or a
series of charts.

 The improper understanding and usage of the charts can lead to inadequate decision
making, inaccurate planning assumptions and possibly detrimental control actions.

 Fixed and variable expenses may be inaccurately segregated with the resultant effect
on the break even position. Plotting sales as a function of production volume can be misleading, the
assumption that sales equals production may not necessarily be true because of the build up or
reduction of stocks of varying business cycles. Extreme care is needed in compiling homogenous
and compatible data for the break-even analysis.)
7.7 BUDGETARY CONTROL

One of the primary objectives of management accounting is to provide information to the

management for planning and control. Budgeting acts as a tool of both planning and control.
Budgeting is formal process of financial planning using estimated financial and accounting data.
The Institute of cost and Management Accountants (UK) define a budget as "a financial and/or
quantitative statemetment prepared and approved prior to a defined period of time, of the policy to
be pursued during that period for purpose of attaining a given objective. It may include income,
expenditure and the employment of capital.‖ The National Association of Accountants (USA)
defines budgeting as "the process of planning all flows of financial resources into, within, and from
an entity during some specified future period".

BUDGETING AND FORECASTING

Sometimes the terms 'budgeting' and 'forecasting' are used interchangeably. Both terms have some
similarities. For example, both relate to future events and involve prediction of something. The
basic difference between budgeting and forecasting lies in degree of sophistication involved in the
predictions used by them. According to the National Association of Accountants (USA),
"forecasting is a process of predicting or estimating a future happening ". Forecasting is an essential
part of the budgeting process. It pertains to estimating future events and their effects on the budget.
It comes to an end after mere estimating. Budgeting is a process of preparing budgets and further
control aspects are involved in its procedure Besides, forecasting can be made by a business for
purposes other than budgeting, such as a forecast of .general business conditions. Such forecasts are
sometimes not used in budgeting.

CONCEPT OF BUDGETARY CONTROL

Budgetary control is a control measure in which the actual state of affairs is compared with the
budget so that appropriate action may be taken with regard to any deviations before it is too late.
Budgeting is thus merely a part of budgetary control. The Institute of Cost and Management
Accountants (UK) defines budgetary controls as "the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and the continuous comparison of
actual with budgeted results either to secure by individual action the objective of that policy or to
provide a basis for its revision." Briefly, the use of a budget to control a firm‘s activities is known as
budgetary control. Budgetary control has the following main objectives.

1. To provide an organized procedure for planning. It provides a detailed plan of action for a
business over a definite period of time,
2. To coordinate all the activities of various departments of a business firm in such a manner
that the maximum profit will be achieved for the minimum use of resources.

3. To provide means of determining the responsibility for all deviations from the plan
(Budget), and to supply information on the basis of which necessary corrective action may be taken.
Thus budgetary control has the objective of controlling cost.

BUDGET PERIOD

The budget period is an important factor in developing comprehensive budgeting programmes. This
is the period for which forecasts can reasonably be made and budgets can be formulated. The length
of the budget period depends on the type of business, the length of the manufacturing cycle from
raw materials, finished products, the ease or difficulty of forecasting future market conditions and
other factors. However, a business enterprise generally prepares a short-range budget and a long-
range budget.

Short – Range Budget

Short-range budget may cover periods of three, six or twelve months depending upon the nature of
the business. Most manufacturing firms use one year as the planning period. Wholesale and retail
firms usually employ a six-month budget which is related to their selling seasons. In determining
the period of the short-range budget, the following factors should be considered:

o The budget period should be long enough to cover complete production of various products.

o For business of a seasonal nature, the budget period should cover at least one entire seasonal
cycle.

o The budget period should be long enough to allow for the financing of production well in
advance of actual needs. It should provide adequate time to arrange the funds for production and
other purposes.

o The budget period should coincide with the financial accounting period to compare actual
results with budget estimates and thus to facilitate better interpretation of the performances.

Long-range Budget

A long-range budget or planning is defined as a systematic and formalized process for purposefully
directing and controlling future operations towards a desired objective for periods extending beyond
one year. Long-range budgets or plans are neither described in precise terms, nor are they expected
to be completely coordinated future budgets. They cover specific areas such as, future sales, future
production, long-term capital expenditures, extensive research and development programmes,
financial requirements and profit forecast. They evaluate the future implications associated with
present decisions and help the management in making present decisions and select the most
profitable alternative. Long-range budgeting does not eliminate risk altogether; it only reduces the
risk to a level which does not hamper the production and achievement of company objectives. A
business enterprise through budgeting is prompted to take a greater but manageable risk.

7.7.1 FIXED AND FLEXIBLE BUDGETING Fixed Budgeting

The Institute of Costs and Management Accountants (UK) defines a fixed budget as the budget
which is designed to remain unchanged irrespective of the level of activity actually attained. It is
based on a single level of activity. A fixed budget performance report compares data from actual
operations with the single level of activity reflected in the budget. It is based on the assumption
that the company will work at some specified level of activity and that a stated production will be
achieved. It suggests that the budget is not adjusted. It acts as a target for the forthcoming period. It
represents a point fixed in advance with which actual results are compared. Fixed budgets do not
change when production level changes.

However, in practice, fixed budgeting is rarely used. The main reason is that actual output is often
significantly different from the budgeted output. In such a case, the budget cannot be used for the
purpose of cost control. The performance report may be misleading and will not contain very useful
information. For example, if actual production is 12,000 units in place of the budgeted 10,000 units,
the costs incurred cannot be compared with the budget which relates to different levels of activity.
Since, in fixed budgeting, units are overlooked, a cost to cost comparison without considering the
units may give misleading results, the performance report prepared under fixed budgeting merely
discloses whether actual costs were higher or lower than budgeted costs. Therefore, the fixed budget
is unable to provide useful information when actual output differs significantly from expected or
budgeted output. The fact that costs and expenses are affected by fluctuations in volume limits the
use of the fixed budget. If budgeted costs are compared with the actual costs at the end of the year,
it will be difficult to infer how successful a business firm has been in keeping expenses within the
allowed limits. Clearly, the idea of comparing performance at one activity level with a plan that was
developed at some other activity level is nonsense from the viewpoint of judging how efficiently the
manager has produced any given output.
Flexible Budgeting

A flexible budget is defined in the terminology of cost accounting, issued by the Institute of Cost
and Management Association (UK) as "a budget which by recognizing the difference between
fixed, semi-fixed and variable costs, is designed to change in relation to the level of activity
attained."

A flexible budget is a budget that is prepared for a range, i.e. for more than one level of activity. It
is a set of alternative budgets to different expected levels of activity. The flexible budget is also
known by other names, such as variable budget, dynamic budget, sliding scale budget, step budget,
expenses formula budget and expenses control budget. The underlying principle of a flexible budget
is that every business is dynamic, ever- changing and never static. Thus, a flexible budget might be
developed that would apply to a 'relevant range' of production, say 8,000 units to 12,000 units.
Under this approach, if actual production slips to 9,000 units from a projected 10,000 units, the
manager has a specific tool (i.e. the flexible budget) that can be used to determine budgeted cost at
9,000 units of output. The flexible budget provides a reliable basis for comparisons because it is
automatically geared to changes in a production activity.

A flexible budget provides information to managers for multiple levels of output in case actual
output is different from the expected level. The performance reports at the end of the accounting
period are compared with a budget based on the actual output attained during the period. A flexible
budget has the following important features:

(1) It covers a range of activity (output).

(2) It is flexible, i.e. easy to change with variation in production levels.

(3) It facilitates performance measurement and evaluation.

Steps in Flexible Budgeting

The following steps (stages) are involved in developing a flexible budget:

1. Decide the range of activity to which the budget is to be prepared.

2. Determining the cost behavior patterns (fixed, variable, semi-variable) for each element of
cost to be included in the budget.

3. Selecting the activity levels (generally in terms of production) to prepare budgets at those
levels.
4. Preparing the budget at each activity level selected by associating the activity level with
corresponding costs. The corresponding costs to be attached with each activity level are determined
in terms of their behavior, i.e. fixed, variable and semi- variable.)

7.7.2 TYPES OF BUDGETS

Budgets are the end product of the budgeting process. The numbers and types of budgets in a
business enterprise depend on the size and nature of the business. However, in a manufacturing
concern, the following budgets are generally prepared:

(A) Operating and Functional Budgets:

1. Sales budget

2. Production budget

3. Production cost budget

a. Direct materials budget

b. Direct labour budget

c. Factory overhead budget

4. Ending inventories budget

5. Cost of goods sold budget

6. Selling expense budget

7. Administrative expense budget

8. Budgeted income statement

(B) Financial Budgets

a. Capital expenditure budget

b. Research and development budget

c. Cash budget

d. Budgeted balance sheet

e. Budgeted statement of changes in financial position

Sales Budget

The most important budget, which all other budgets are contingent upon, is the sales budget. All
budgets, such as production budget, inventory budget, personnel budget, administration budget,
selling and distribution budget and others are all affected by the sales budget and are dependent
upon the revenue derived from sales. Therefore, the sales budget is the starting point in preparing
other functional budgets. Developing a sales budget requires forecasting future sales levels. Figure
27.1 presents a specimen of a sales budget.

ABC Company Ltd.

Table. 7.20 Sales Budget for the Year Ending December 31, 1999

Products Budgeted Budgeted sales price Total

sales units (Rs.) (Rs.)
A 70,000 80,000 56,00,000
B 80,000 1,20,000 96,00,000
1,50,000 1,52,00,000

Production Budget

After preparing the sales budget, the production budget is prepared. A production budget is stated in
physical units. It specifies the number of units of each product that must be produced to satisfy the
sales forecasts and to achieve the desired level of closing finished goods inventory. Essentially, the
production budget is the sales budget adjusted for inventory changes as follows:

Units to produce = Budgeted sales + Desired closing inventory of finished goods - Beginning
inventory of finished goods.

A specimen production budget is given in Fig. 27.2.

ABC Company

Table.7.21 Total Production Budget for the Month of December, 1999

Products
A B
Budgeted sales (units) 70,000 80,000
 Add: Desired closing finished goods inventory 20,000 30,000
90,000 1,10,000
Less: Beginning finished goods inventory 40,000 50,000
Units to be produced 50,000 60,000

The production budget deals with the scheduling of operations, the determination of volume and the
establishment of maximum and minimum quantities of raw materials and finished goods inventory.
Its summaries and details provide the basis for preparing the budgets of materials, labour and
factory overheads.

Production Cost Budget

A production cost budget summaries the materials budget, labour budget, the factory overhead
budget and may be expressed and analysed by departments and/or products. A production cost
budget, also known as a manufacturing budget is made up of three budgets: (i) materials, (ii) labour
and (iii) factory overhead.

Direct Materials Budget

A direct materials budget indicates the expected amount of direct materials required to produce the
budgeted units of finished goods. This budget specifies the cost of direct materials used and the cost
of the direct materials purchased. Figure 27.3 explains the calculation of the net direct materials
budget. The usage part of the direct materials budget determines the cost of purchases of direct
materials.

ABC Company

Table. 7.22 Direct Materials Budget for the Year Ending December, 1999

A. Usage Budget Products

A B Talal
Budgeted production in units 50.000 60,000
Direct materials requirements
Product A 5 kg per unit x5
Product B 8 per unit x8
Direct materials usage (kg) 2,50,000 4,80,000
Cost per kg Rs. 1.00 1.50
Cost of direct materials used Rs. 2,50,000 Rs. 7,20,000 Rs. 9,70.000
B. Purchase Budget
 Direct Materials (in kg) Total
A B
Direct material usage 2,50.000 4,80,000

Budgeted closing direct materials

inventory + 50,000 + 75,000
Total requirements 3,00,000 5,55,000
Beginning direct materials inventory 70,000 1,00,000
Purchase of direct materials 2,30,000 4,55,000
Cost per kg. x Rs. 1.00 x Rs. 1.50

Cost of purchase Rs. 2,30,000 Rs. 6,82,000 Rs. 9,12,000

The direct materials budget is useful in the following ways:

(1) It helps the purchasing department to prepare a schedule to ensure delivery of materials when
needed.

(2) It helps in fixing minimum and maximum levels of inventories in the stores department.

(3) It helps the finance manager to determine the financial requirements to meet production targets.

The materials budget usually deals with direct materials only. Supplies and indirect materials are
generally included in the factory overhead budget.

Direct Labour Budget

The labour budget estimates the labour, adequate in number and grades, to enable the production
budget to be achieved. It is generally preferable to prepare a separate direct labour budget and to
include indirect labour in the factory overhead budget. The labour budget for direct and indirect
labour helps the personnel or employment department in determining the number and types of
workers needed. If additional workers are not needed, the task of the personnel department is easy.
However, when workers are to be recruited, the personnel department has to make plans in advance.

ABC Company

Direct Labour Budget for the Year Ending December, 1999

Factory Overhead Budget

The factory overhead budget is prepared on the basis of the chart of accounts which reflects
different expenses accounts and which properly classifies expense accounts and details of the cost
centers or departments. Although expenses can be classified in a different manner such as natural
classification and variability, the preparation of the factory overhead budget requires that expenses
should be classified by departments since expenses are incurred by various departments. In this
way, departmental heads should be held accountable for expenses incurred by their departments.
Generally, the department heads prepare budgets for their respective departments for the budget
period. However, they need considerable help and advice from the budget director in order to
achieve production budget. After review by the budget committee, the departmental managers are
asked to review and comment on any revisions before the budget is made final.

The following depicts the factory overhead budget wherein overhead costs have been classified into
fixed and variable components.

ABC Company

Factory Overhead Budget for the Year Ending December, 1999

(Based on budgeted capacity of 2, 70,000 direct labour hours)

Items cost Direct labour Rate per direct Total

Hours (Rs.) labour hour (Rs)

A. Variable factory overhead:

(i) Suppliers 2, 70,000 1.00 2, 70,000
(ii) Repairs 2, 70,000 0.50 1, 35,000
(iii)Indirect 2, 70,000 1.00 2, 70,000
(iv)Others 2, 70,000 0.40 1, 08,000
 Total variable factory overhead cost 7, 83,000
B. Fixed factory overhead cost:

(i) Super vision 4, 00,000

(ii) Depreciation 5, 50,000
(iii)Property tax 2, 50,000
(iv) Others 1, 77,000
Total fixed factory overhead cost 13, 77,000

Total factory overhead cost 21, 60,000

Predetermined overhead rate = Rs.21, 60,000

2, 70,000 hours

= 8.00 per labour hour

Ending Inventories Budget

An inventory budget can be prepared to find out the values of direct materials and finished goods
inventory as shown below

ABC Company

Ending Inventory Budget for the Year Ending December, 1999

Rs.

Direct materials inventory

Product A 50,000 kg x Rs.1.00 per kg 50,000

Product B 75,000 kg x Rs.1.50 per kg 1, 12,000

1, 62,500

Finished goods inventory

Product A 20,000 kg x Rs.25.00 5, 00,000

Product B 30,000 kg x Rs.30.00 9, 00,000

14, 00,000
Cost of Goods sold Budget

After preparing direct materials, direct labour, factory overhead and ending inventory budgets, the
cost of goods sold budget can be prepared. The cost of goods sold budget summaries the entire
above budget as show in below

ABC Company

Cost of Goods sold Budget for the Year Ending December, 1999

Direct materials Rs Rs
Beginning inventory 2, 00,000
Purchases 9, 12,500
11, 12,500
Less: Closing inventory 1, 62,500
Cost of direct materials used 9, 50,000
Direct labour 13, 50,000
Factory overhead 21, 60,000
Total factory cost 44, 60,000
Beginning finished goods inventory 25, 00,000
Total goods available for sale 69, 60,000
Closing finished goods inventory 14, 00,000
Cost of goods sold 55, 60,000

Selling Expenses Budget

Closely related with the sales budget is the selling and distribution cost budget which shows
the budget costs of promoting sales for the budget period. It is also known as the marketing expense budget.
The selling cost budget is made up of a number of cost items, some of which are fixed and some variable.
The principal fixed expenses are salaries and depreciation; the principal variable expenses are commissions,
travel, advertising and bad debts. The variable expenses vary directly with sales. A selling expense budget
consists mainly of the following major items:

1. Sales representative (salaries, commissions, entertaining and traveling)

2. Sales office (office supplies, salaries, postage, telephone, rent and rates).

3. Publicity office (salaries, office costs, press, journals, televisions, cinema, samples,
sundries). (4) Warehousing, packing and dispatch (salaries, packing wages, drivers' wages, vehicle
costs, Sundries).
The following explain an annual selling expense budget classified according to fixed and variable
expenses. The annual budget should be broken down on a monthly basis so that actual expenses can
be compared with the budget monthly. Also, separate budgets for each of these expenses may be
prepared especially in the case of a large company.

ABC Company

Selling Expenses Budget for the Year Ending December 31, 1999

Items Cost (Rs.) Total cost (Rs.)

(A) Variable selling expense

(i) Sales Commission 35,000

(ii) Salary and wages 40,000

(iii) Advertising 15,000
(iv) Traveling 22,000 1, 12,000
(B) Total variable selling expenses
(i) Warehousing 60,000
(ii) Advertising 30,000
(iii) Marketing Manger‘s salary 60,000
(iv) Depreciation 27,000 1, 77,000
Total selling expenses 2, 89,000

Administrative Expense Budget

The administrative expense budget covers the administrative costs for non-manufacturing business
activities. Budgeting administrative expense is often difficult. Perhaps the first difficulty is in
classifying certain costs as production or administrative. For example, costs like purchasing,
engineering, personnel, research and development can be administrative as well as production.
Unless such and other expenses are properly classified, their proper budgeting and subsequent
control cannot be exercised. The second difficulty is in determining persons responsible for the
incurrence and control of these costs. However, in order to accomplish the purpose of cost control
in cost accounting, it is necessary that each item of cost -should be under the jurisdiction and
control of a responsible person who is accountable for incurring the cost.
 ABC Company

Administrative Expense Budget for the Year Ending December 31, 1999

Items Amount (Rs.) Amount (Rs)

(A) Variable administrative expenses

(i) Supplies 35,000

(ii) Clerical wages 60,000

Total variable administrative expenses 95,000

(B) Fixed administrative expenses Directors remuneration
1,20,000
(i) Legal charges 20,000
(ii) Depreciation 25,000
(iii) Salaries 30,000
(iv) Rent 60,000
(v) Postage, telephone etc 32,000
Total fixed administrative 2, 87,000
Total administrative expense 3, 82,000

Budget Income Statement

Budgeted income statement summaries all the individual budgets, i.e. sales budget, cost of goods
sold budget, selling budget and administrative expense budget. No new estimates are made; figures
are taken from budgets previously prepared. This budget determines income before taxes. If the tax
rate is available, net income after taxes can also be computed. The following exhibits a budgeted or
project income statement.

ABC Company

Budgeted Income Statement for the Year Ending December, 1999

Rs

Sales 1, 52, 00,000

Cost of goods sold 55, 00,000
Gross Margin 96, 40,000
 Selling expenses 2, 89,000
Administrative expenses 3, 82,000
6, 71,000
Income before taxes 89, 69,000
Income taxes (assuming 50%) 44, 84,500
Net Income 44, 84,500

Capital Expenditure Budget

The budgeting of capital expenditure is one of the most important areas of managerial decisions.
Large sums of money and long period of time are often involved in this budget which therefore
requires utmost care and sound judgment. Capital expenditures represent long-term commitments.
Also, the benefits of capital expenditure spread over a long period of time. Generally, capital
expenditures are relatively large in comparison with operating expenditures and have a long-term
impact on the organisation and the business firm. The capital expenditure budget aims at
minimizing errors while making capital expenditure decisions.

Capital expenditure budgets are prepared for both short and long-range projects depending on the
requirements of the business firm. Short-range projects are implemented during the current
accounting period; therefore, these provisions should be made in the current budget. Long-range
projects are not executed in the current period; they are expressed only in general terms. They
become budget commitments only when the time for their implementation approaches.

Cash Budgets

A cash budget contains detailed estimates of cash receipts' (cash inflows) and disbursement (cash
outflows) for the budget period or some other specific period. Cash budgeting is extremely
important since business operations require adequate cash to acquire materials and meet various
expense and loan obligations. Therefore, planning cash flow is very useful for all types of
organizations. The preparation of a cash budget has the following objectives:

o It indicates the effect on the cash position of seasonal requirements, large inventories,
unusual receipts and slowness in collecting receivables.

o It indicates the cash requirements needed for a plant or equipment expansion programme.

o It points the need for additional funds from sources such as bank or sale of securities and the
time factors involved. In this connection, it might also exert a cautionary influence on plans for plant
expansion leading to a modification of capital expenditure decisions.
o It indicates the availability of cash for taking advantage of discounts.

o It assists in planning the financial requirements of bond retirements, income tax installments
and payments to pension and retirement funds.

o It shows the availability of excess funds for short-term or long-term investments.

Budgeted or Projected Balance Sheet

A projected balance sheet represents the expected financial position at a particular date. The
projected balance sheet is prepared from the budgeted balance sheet at the beginning of the budget
period and the expected changes in the account balances reflected in the operating budgets, capital
expenditure budgets and cash budget. If any of the accounts or relationships among the accounts
appearing on the projected balance sheet are not according to the management‘s requirements and
objectives, the operating plan might have to be changed. For example, if a bank or financial
institution requires a business firm to maintain a certain minimum current ratio and debt-equity
ratio, the operating plan would have to be changed if these ratios are indeed too low. Furthermore,
unfavorable ratios may decrease the value of company shares in the stock exchange and lower the
credibility of the firm in the investment market. The projected balance sheet also automatically
determines the arithmetical accuracy of other budgets since they are used in preparing the forecasted
balance sheet.

Budgeted Statement of Changes in Financial Position

The projected statement of changes in financial position is usually prepared from data in the
budgeted income statement and changes between the project balance sheet at the beginning of the
budget period and projected balance sheet at the end of the budget period. This projected statement
is very useful to the management- in the financial planning process)

7.7.3 MASTER BUDGET (OR COMPREHENSIVE BUDGET)

A master budget sometimes called a comprehensive budget is the summary or total budget package
for a business firm. A comprehensive budget is a set of financial statements and other schedules
showing the expected or proforma results for a future period. A comprehensive budget normally
contains an income statement, a balance sheet, a statement of cash receipts and disbursements and
schedules of production, purchases and fixed asset acquisition. The budget packages might have
other components depending on the needs of the firm. A comprehensive budget is the end product
of the budget-making process. A master budget is a tool for coordinating all the individual budgets
of an organisation into an acceptable effective plan. It shows the budgeted profit and loss account
for the budget period and the budgeted balance sheet at the end of the period.

Whether a business firm prepares specific operating budgets or a complete master budget, the
depends on a number of factors. The primary reason is the need of the management at a particular
time. For example, management may be more concerned with a single or specific aspect at a time,
such as adequacy of the cash position. If the cash budget reveals that all is well, it may be the only
budget needed to be prepared for the management's use. If the cash budget reveals an inadequate or
poor cash position, then other budgets making up the master budget will have to be prepared. In this
situation, new budgets or forecasts will continue to be prepared, unless the management finds an
acceptable set of budgets

7.7.4 ZERO BASE BUDGETING (ZBB)

Zero Base Budgeting (ZBB) is a method of budgeting whereby all activities are evaluated each time
the budget is formulated and every item of expenditure in the budget is fully justified. That is, ZBB
involves starting from scratch or zero.

In traditional budgeting, departmental managers' need justify only increases over the prior year's
budget (known as incremental budgeting). This implies that what is already being spent is
automatically sanctioned. Under the ZBB concept, each department's functions are reviewed
completely and all expenditures, rather than only the increase, must be approved. Also, in some
departments, ascertainment of budgeted costs is easier than other departments. For example, in
production departments, it is easier to determine costs of inputs to achieve a level of budgeted
output. But, in other departments such as accounts, personnel, research and development, it is
difficult to even identify the output, and therefore equally greater difficult to determine the cost of
input to sustain (unidentifiable) output. Consequently, the budgets of the previous year tend to be
subjectively increased as the next year's budgeted expenditure. However, the previous year's
budgets may be inefficient and merely adjusting next year's budgets to the previous year's budget
may result in wastages. ZBB overcomes this problem, to a certain extent. ZBB rejects the traditional
view on annual budgeting as an incremental process which takes into account current expenditure
plus an estimate of next year's expenditure to arrive at the next budget. Instead, the projected
expenditure for existing programmes should start from base zero with each year's budgets being
compiled as if the programmes were being launched for the first time.

Application of ZBB

ZBB involves the following stages (steps):

a. Each separate activity of the organisation is identified and called a decision package. A
decision package is a document that identifies and describes a specific activity in such a manner that
the management can (i) evaluate it and ranks it against other activities competing for limited
resources, and (ii) decide whether to approve or disapprove it.

b. Each decision package must be justified, i.e., it should be enquired into whether a decision
package promotes the goals of an enterprise.

c. If justified, then the cost of minimum efforts needed to sustain each decision package is
determined.

d. Alternatives for each decision packages are considered in order to select better and cheaper
options for the package.

e. Incremental decision packages are also justified and coasted in the above manner. The
incremental packages describe the costs and benefits of additional work that could be done above
that required by the base package for the minimum amount of work needed to carry out the activity.

f. Managers rank their decisions package in order of priority for resource allocation.

g. Resources are allocated to the packages.

Advantages of ZBB

a. It represents a move towards allocation of resources by need and benefit and thus results in
more efficient allocation of resources.

b. It identifies and eliminates wastages and obsolete operations.

c. It ensures that the best possible methods of performing jobs are used and that new ideas
emerge.

d. It creates a questioning attitude rather than one which accepts that current practices represent
value for money.

e. It leads to increased staff involvement which may lead to improved motivation and greater
interest in the job.

f. It increases communication within the organisation.

g. Managers become more aware of the costs of inputs which help them to identify priorities.
h. The documentation of decision packages provides management with a deep, coordinated
knowledge of all organization‘s activities.

i. It is useful especially for service departments where it can be difficult to identify output.

Disadvantages of ZBB

a. The costs involved in preparing a vast number of decision packages in a large firm are very
high.

b. It is very time-consuming and a large amount of additional paper work is involved.

c. Managers develop fear and feel threatened by ZBB and therefore may oppose new ideas and
changes.

d. The ranking of decision packages and allocation of resources is subjective to certain degree,
which can result in departmental conflict

e. Administration and communication of ZBB process may become critical problems because
more managers become involved in this process than in most budgeting and planning procedures and these
problems are further compounded in large organizations

7.8 OVERVIEW OF FINANCIAL MANAGEMENT

Suppose you are planning to start your own business. No matter what the nature of your proposed
business is and how it is organized, you will have to address the following questions:

 What capital investments should you male? That is, what kinds of real estate, machineries, and
R&D programmes should you invest in?

 How will you raise money to pay for the proposed capital investments? That is, what will be the
mix of equity and debt in your financing plan?

 How will you handle the day-to-day financial activities like collecting your receivables and
paying your suppliers?

While these are not the only concerns of financial management, they are certainly the central ones.

FINANCIAL DECISIONS

As mentioned at the outset, there are three broad areas of financial decision making, viz. capital
budgeting, capital structure, and working capital management.

Capital Budgeting

The first and perhaps the most important decision that any firm has to make is to define the business
or businesses that it wants to be in. This decision has a significant bearing on how capital is
allocated in the firm.

Once the managers of a firm choose the business or businesses they want to be in, they have to
develop a plan to invest in buildings, machineries, equipments, research and development,
godowns, showrooms, distribution network, information infrastructure, brands, and other long-lived
assets. This is the capital budgeting process.

Considerable managerial time, attention, and energy is devoted to identify, evaluate, and implement
investment projects. When you look at an investment project from the financial point of view, you
should focus on the magnitude, timing, and riskiness of cash flows associated with it. In addition,
consider the option embedded in the investment projects.

Capital Structure

Once a firm has decided on the investment projects it wants to undertake, it has to figure out ways
and means of financing them. The key issues in capital structure decision are: What is the optimal
debt-equity ratio for the firm? Which specific instruments of equity and debt finance should the firm
employ? Which capital markets should the firm access? When should the firm raise finances? At
what price should the firm offer its securities?

An allied issue is the dividend decision of the firm. What is the optimal dividend payout ratio for
the firm? Should the firm buy back its own shares?

Capital structure and dividend decision should be guided by considerations of cost and flexibility, in
the main. The objective should be to minimize the cost of financing without impairing the ability of
the firm to raise finances required for value creating investment projects.

Working Capital Management

Working capital management, also referred to as short-term financial management, refers to the
day-to-day financial activities that deal with current assets (inventories, debtors, short-term holdings
of marketable securities, and cash) and current liabilities (short-term debt, trade creditors, accruals,
and provisions).
The key issues in working capital management are: What is the optimal level of inventory for the
operations of the firm? Should the firm grant credit to its customers and, if so, on what terms? How
much cash should the firm carry on hand? Where should the firm invest its temporary cash
surpluses? What sources of short-term finance are appropriate for the firm?

7.8.1 GOAL OF FINANCIAL MANAGEMENT

Finance theory rests on the premise that managers should manage their firm‘s resources with the
objective of enhancing the firm‘s market value.

You may ask why are we overlooking the interests of customers, employees, and suppliers. No
company can succeed unless it offers value for money to its customers, provides satisfactory
employment conditions to its employees, and treats its suppliers fairly. Hence the question of
neglecting the interests of these constituencies to promote the welfare of shareholders simply does
not arise. More value for shareholders does not imply less value for customers, employees, or
suppliers. On the contrary, only by focusing on creating value for its shareholders can a firm ensure
that it has durable and mutually beneficial relationships with their customers, employees, and
suppliers.

THE FUNDAMENTAL PRINCIPLE OF FINANCE

The key question that you have to ask before making a business decision is: Will the decision raise
the market value of the firm? To answer this question, let us look at the fundamental principle of
finance.

A business proposal- regardless of whether it is a new investment or acquisition of another company

or a restructuring initiative-raises the value of the firm only of the present value of the future stream
of net cash benefits expected from the proposal is greater than the initial cash outlay required to
implement the proposal.

The difference between the present value of future cash benefits and the initial outlay represents the
net present value or NPV of the proposal:

Net present value + Present value of future cash benefits – initial cash outlay

Note that the costs and benefits of a business proposal have to be measured in cash. As shown in fig
7.3, investors who finance a proposal invest cash and are hence interested only in cash returns.

Fig 7.3 Cash Alone matters

 Investors Shareholders, Investors provide the initial cash required to finance the business
The business proposal
Lender

The proposal generates

Cash returns to investors

o convert the expected cash returns from the proposal into a present value figure an appropriate
discount rate has to be applied. The discount rate reflects the riskiness of the proposal.

RISK-RETURN TRADEOFF

A firm has to choose between alternative courses of action. Should the firm set up a plant which has
a capacity of one million tons or two million tons? Should the debt-equity ratio of the firm be 2:1 or
1:1? Should the firm purpose a generous credit policy or niggardly credit policy? Should the firm
carry a large inventory or a small inventory?

The alternative courses of action typically have different risk-return implications. A large plant may
have a higher expected return and a higher risk exposure, whereas a small plant may have a lower
expected return and a lower risk exposure. A higher debt-equity ratio compared to a lower debt-
equity ratio may reduce the cost of capital but expose the firm to greater risk. A ‗hot‘ stock,
compared to a defensive stock, may offer a higher expected return but also a greater possibility of
loss.

In general, when you make a financial decision, you have to answer the following questions: what is
the expected return? What is the risk exposure? Given the risk-return characteristics of the decision,
how would it influence value? Fig 7.4 shows schematically the relationship between the key
financial decisions, return, risk, and market value.

Fig 7.4 Decisions, return, risk, and Market value

The Time Value of Money

Money has time value. A rupee today is more valuable than a rupee a year hence. Why? There are
several reasons:

 Individuals, in general, prefer current consumption to future consumption.

 Capital can be employed productively to generate positive returns. An investment of one rupee
today would grow to (1 + r) a year hence ( r is the rate of return earned on the investment)

 In an inflationary period, a rupee today represents a greater real purchasing power than a rupee
a year hence.

Many financial problems involve cash flows occurring at different points of time. For evaluating
such cash flows, an explicit consideration of time value of money is required.

FUTURE VALUE

Suppose you have Rs.1,000 today and you deposit ot with a financial institution which pays 1- per
cent interest compounded annually, for a period of 3 years. The deposit would grow as follows.

First year: Principal at the beginning 1,000

Interest for the year 100
(Rs.1,000x 0.10)
Principal at the end 1100
Second year: Principal at the beginning 1,100
Interest for the year 110
(Rs.1,100x 0.10)
Principal at the end 1,210
Third year: Principal at the beginning 1,210
interest for the year
(Rs.1,000x 0.10) 121
Principal at the end 1,331

Formula

The general formula for the future value of a single amount is:

Future Value = present Value (1 + r)n

Where r is the interest rate per year and n is the number of years over which compounding is done.
The factory (1 + r)n is called the future value factor, FVrn. It is very tedious to calculate this factor
unless you have a calculator. To reduce the tedium, tables are available. Table 7.23 gives the value
of this factor for several combinations of r and n. A comprehensive table is given in Appendix A at
the end of this book.

Table 7.23 Value of FVrn for various combinations of r and n

6% 8% 10% 12% 14%

n/r
2 1.124 1.166 1.210 1.254 1.300
4 1.262 1.361 1.464 1.574 1.689
6 1.419 1.587 1.772 1.974 2.195
8 1.594 1.851 2.144 2.476 2.853
10 1.791 2.518 2.594 3.106 3.707

Example If you deposit Rs.1000 today in a bank which pays 10 per cent interest,
compounded annually, how much will the deposit grow to after 8 years and 12 years?

The future value, 8 years hence will be Rs.1,000 (1.10)8 = Rs.1000 (2.144)

= Rs 2144

The future value, 12 years hence will be Rs 1000 (1.10)12 = Rs.1000 (3138)

= Rs.3138

Doubling Period

Investors commonly ask the question; how long would it take to double the amount at a given rate
of interest? To answer this question, we may look at the future value factor table. Looking at exhibit
10.1, we find that when the interest rate is 12 per cent, it takes about 6 years to double the amount,;
when the interest rate is 6 per cent, it takes about 12 years to double the amount, so on and so forth.
Is there a thumb rule which dispenses with the use of the future value interest factor table? Yes,
there is one and it is called the Rule of 72. According to this thumb rule, the doubling period is
obtained by dividing 72 by the interest rate. For example, if the interest rate is 8 per cent, the
doubling period is above 9 years (72/8). Likewise, if the interest rate is 4 per cent, the doubling
period is about 18 years (72/4). Though somewhat crude, it is a handy and useful thumb rule.
Shorter Compounding Periods

So far we have assumed that compounding is done annually. Now, consider the case where
compounding is done more frequently. Suppose you deposit Rs.1000 with a finance company,
which advertises that it pay 12 per cent interest semi-annually- this means that the interest is paid
every six months. Your deposit (if interest is not withdrawn) grows as follows:

First Six Months: Principal at the beginningRs.1000.0 Rs. 60.0

Interest for the 6 months
(Rs.1,000x 12/2) Rs 1,060.0
Principal at the end
Second Six Months: Principal at the beginningRs.1060.0 Rs. 63.6
Interest for the 6 months
(Rs.1,060x 12/2) Rs. 1,123.6
Principal at the end

Note that if the compounding is done annually, the principal at the end of one year would be
Rs.1000 (1.12) = Rs.1120.0. The difference of Rs.3.6 (between Rs.1123.6 under semi- annual
compounding interest for the second 6 months.

The general formula for the future vale of a single cash amount when compounding ios done more
frequently than annually is:

Future Value = present Vale (1 + r /m)m x n

Where r is the nominal annual interest rate, m is the number of times compounding is done in a
year, and n is the number of years over which compounding is done.

Example; How much does a deposit of Rs.5000 grow to at the end of 6 years, if the nominal rate of
interest is 12 per cent and the frequency of compounding is 4 times a year? The amount after 6
years will be Rs.5000 (1 + 0.12/4)4 x 6 = Rs.5000 (1.03) 24 = Rs.5000 x 2.0328 = Rs.10,164.

Effective versus nominal Rate

We have seen above that Rs.1000 grows to Rs.1123.6 at the end of the year if the nominal rate of
interest is 12 per cent and compounding is done semi-annually. This means that Rs1000 grows at
the rate 12.36 per cent per annum. The figure of 12.36 per cent is called the effective rate of
interest – the rate of interest under annual compounding, which produces the same results as that
produced by an interest rate of 12 per cent under semi-annual compounding.
The general relationship between the effective rate of interest and the nominal rate of interest is as
follows:

R = (1 + k/m)m – 1

Where r is the effective rate of interest, k is the nominal rate of interest, and m is the frequency of
compounding per year.

Example a bank offers 8 per cent nominal rate of interest with quarterly compounding. What is the
effective rate of interest? The effective rat of interest is: (1 + 0.08/4) 4 –1 = 0.0824 = 8.24 per cent.

Table 7.24 gives the relationship between the nominal and effective rates of interest for different
compounding periods. In general, the effect of increasing the frequency of compounding is not as
dramatic as some would believe it to be – the additional gains dwindle as the frequency of
compounding increases.

Table 7.24 Nominal and Effective Rates of Interest

Nominal rate % Effective Rate %

Annual Semi-annual Quarterly Monthly
Compounding Compounding Compounding Compounding
8 8.00 8.16 8.24 8.30
12 12.00 12.36 12.55 12.68

FUTURE VALUE OF ANNUITY

An annuity is a series of periodic cash flows (payments and receipts) of equal amounts. The
premium payments of a life insurance policy, for example, are an annuity. When the cash flows
occur at the end of each period, the annuity is called a regular annuity or a deferred annuity. When
the cash flows occur at the beginning of each period, the annuity is called an annuity due. Out
discussion here will focus on a regular annuity – the formulae of course can be applied, with some
modifications, to an annuity due.

Suppose you deposit Rs.1000 annually in a bank for 5 years and your deposits earn a compound
interest rate of 10 per cent. What will be the value of this series of deposits (an annuity) at the end
of 5 years? Assuming that each deposit occurs at the end of the year, the future value of thus
annuity will be:

= Rs.1000 (1.10)4 + Rs.1000 (1.10)3 + Rs.1000 (1.10)2 + Rs.1000 (1.10) + Rs 1000

= Rs.1000 (1.464) + Rs 1000 91.331) + Rs.1000 (1.21) + Rs.1000 (1.10) + Rs.1000

= Rs.6105.

The time line of this annuity is shown in Table 7.25

Table 7.25 Time Line for an Annuity

1 2 3 4 5
1000 1000 1000 1000 1000 (+)

1100 (+)

1210
(+)
1331
(+)

1464 (+)

Rs.6106

Formula

In general terms, the future value of an annuity is given by the formula:

Future value of an annuity = constant periodic flow (1 + r) n –1

r

where r is the interest rate per period and n, the duration of the annuity. The expression in the
bracket is the future value annuity factor, FVA r,n. Table 7.26 shows the value of this factor for
several combinations of r and n. A comprehensive table is given in appendix at the end of this book.

Table 7.26 Value of FVA r,n for various combinations of r and n

N/r 6% 8% 10% 12% 14%

2 2.060 2.080 2.100 2.120 2.140
4 4.375 4.507 4.641 4.779 4.921
6 6.975 7.336 7.716 8.115 8.536
8 9.897 10.636 11.436 12.299 12.232
 10 13.181 14.487 15.937 17.548 19.337
12 16.869 18.977 21.384 24.133 27.270

Example four equal annual payments of Rs.2000 are made into a deposit account that pays 8
percent interest year. What is the future value of this annuity at the end of 4 years? Rs.2000 (FVA
8%, 4yrs) = Rs 2000 (4.507) = Rs.9014.

PRESENT VALUE

Suppose someone promised to give you Rs 1000 three years hence. What is the present vale of this
amount if the interest rate is 10 per cent? The present value can be calculated by discounting
Rs.1000 to the present point of time as follows:

Value three years hence = Rs.1000

Value two years hence = Rs.1000 (1/1,10)
Value one year hence = Rs.1000 (1/1.10) x (1/1.10)
Value now (present value) = Rs.1000 (1/1.10) x (1/1.10) x (1/1.10)

Formula

The process of discounting, used for calculating the present value, is simply the inverse of
compounding. The present value formula can be readily obtained by manipulating the compounding
formula.

Future Value = Present Value (1+r)n

Dividing both the sides of the above equation by (1+r)n, we get,

Present value = Future value * 1/((1 + r) n

The factor 1/ (1+r)n, in the above equation is called the present value factor, PVr,n. Table

7.27 gives the value of this factor for several combinations of r and n. A comprehensive table is
given in appendix A. at the end of the book.

Example: Find the present vale of Rs.1000 receivable 6 years hence, if the rate of discount is 10 per
cent.

The present value is: Rs.1000 (PV 10%, 6) = Rs.1000 (0.564) = Rs.564

Table 7.27 Value of PV r, n for various combination of r and n

 n/r 6% 8% 10% 12% 14%
2 0.890 0.857 0.826 0.797 0.770
4 0.792 0.735 0.683 0.636 0.592
6 0.705 0.630 0.564 0.507 0.456
8 0.626 0.540 0.467 0.404 0.351
10 0.558 0.463 0.386 0.322 0.270
12 0.497 0.397 0.319 0.257 0.208

PRESENT VALUE OF ANNUITY

Suppose you expect to receive Rs.1000 annually for 3 years, each receipt occurring at the end of the
year. What is the present value of this stream of benefits if the discount rate is 10 per cent? The
present value of this annuity is simply the sum of the present values of all the inflows of this
annuity.

Rs.1000 (1/1.10) + Rs.1000 (1 /1.10)2 + Rs.1000 (1/1.10)3 Rs.1000 x 0.909 + Rs.1000 x 0.826 +
Rs.1000 x 0.751 = Rs.2486.

Table 7.28 Time Line of an Annuity

0 1 2 3
1000 1000 1000
909
826

751

Rs.2456 present value

Formula

In general term, the present value of an annuity is given by the formula.

Present value of an annuity = Constant periodic flow * 1- 1

(1+r)n
r

where r is the interest rate per periodic and n, the duration of the annuity. The expression in the
bracket is the present value annuity factor PVA r, n.

Table 7.29 shows the value of this factor for several combinations of r and n. A more
comprehensive table is given in Appendix A, at the end of this book.

Table 7.29 Value of PVA r,n for various combinations of r and n

N/r 6% 8% 10% 12% 14%

2 1.833 1.783 1.737 1.690 1.647
4 3.465 2.312 3.170 3.037 2.914
6 4.917 4.623 4.355 4.111 3.889
8 6.210 5.747 5.335 4.968 4.639
10 7.360 6.747 6.145 5.650 5.216
12 8.384 7.536 6.814 6.194 5.660

Example What is the present value of a 4 year annuity of Rs.10000 discounted at 10 per cent?

The PVA 10%, 4 is 3.170.

Hence, the present value of the annuity is Rs.10,000 (3.170) = Rs.31,700

Loan Amortisation Schedule

Most loans are repaid in equal periodic instalments (monthly, quarterly, or annually), which cover
interest as well as principal repayment. Such loans are referred to as amortised loans.

For an amortised loan we would like to know (a) the periodic installment payment‘ and

(b) the loan amortisation schedule showing the break-up of the periodic installment
payments between the interest component and the principal repayment component. To illustrate
how these are calculated, let us look at an example.

Suppose a firm borrows Rs.1,000,000 at an interest rate of 15 per cent and the loan is to be repaid in
5 equal installments payable at the end of each of the next 5 years. The annual installment payment
A is obtained by solving the following equation.

Loan amount = a x PVAn = 5, r = 15%

1,000,000 = A x 3.3522 Hence A = 298,312

The amortisation schedule is shown in Table 7.30. The interest component is the largest for year 1
and progressively declines as the outstanding loan amount decreases.

Table 7.30 Loan Amortisation Schedule

Year Beginning Annual Interest (3) Principal Remaining

Amount Instalment repayment Balance
(1) (2) (2)-(3) = (4) (10-(4) =(5)
1 1,000,000 298,312 150,000 148,312 851,688
2 851,688 298,312 127,753 170,559 681,129
3 681,129 298,312 102,169 196,143 484,986
4 484,986 298,312 727,482 225,564 259,422
5 259,422 298,312 38,913 259,399 23

a. Interest is calculated by multiplying the beginning loan balance by the interest rate.

b. Principal repayment is equal to annual instalment minus interest.

c. Due to rounding off error a small balance is shown.

d. Equated Monthly Installment

In the previous illustration we considered equated annual instalments. In many cases, such as
housing loans or car loans, however, the borrower has to repay the loan with interest in equated
monthly installments (EMIs). The calculation of the EMI is analogous to calculation of the equated
annual installment, except that the unit period is one month not one year. The calculation of EMI
may be illustrated with an example. Shyam takes a housing loan is to be repaid over 180 months
What is the EMI? The EMI is obtained by solving the following equation:

1,000,000 = A x PVA n = 180, r = 1.00%

1,000,000 = A x 1- 1
(1 + r) n
r

1,000,000 = A x 1- 1
(0.01) 180
.01

1,000,000 = A x 83.3217
 A = 1,000,000
83.3217 = 12,002

Present Value of a Perpetuity

A perpetuity is an annuity of infinite duration. In general terms:

Present value of a perpetuity = constant periodic flow/ r

where r is the discount rate. The expression in the bracket is the present value perpetuity factor. Put
in words, it means that the present value perpetuity factor is simply 1 divided by the interest rate
expressed in decimal form. Hence, the present value of a perpetuity is simply equal to the constant
annual payment divided by the interest rate. For example, the present value of a perpetuity of
Rs.10,000 if the interest rate is 10 per cent is equal to Rs.10000/0.10 = Rs.100,000. Intuitively, this
is quite convincing because an initial sum of Rs.100,000 would, if invested at the interest rate of 10
per cent, provide a constant annual income of Rs.10,000 forever, without any impairment of the
capital value.

14.0 Capital Budgeting

Capital budgeting is a complex process, which may be divided into the following phases:

 Identification of potential investment opportunities

 Assembling of proposals investment

 Decision making

 Preparation of capital budget and appropriations

 Implementation

 Performance review

7.9 PROJECT APPRAISAL

Project appraisal involves six broad steps as shown in Fig 7.5. A brief description of these steps are
as follows:

1. Forecast the costs and benefits A capital project involves costs and benefits extending
over a period of time. Typically, costs are incurred in the form of initial cash outlays on fixed assets
and net current assets. Benefits are derived in the form of cash inflows from the operations of the
project over its economic life, plus terminal cash inflow from the liquidation of the project at the
end of its economic life.

2. Apply suitable investment criteria The stream of costs and benefits of the project
has to be converted into a measure indicating how worthwhile is the project. For this purpose,
several investment criteria are used. They fall into two broad categories: discounted cash flow,
criteria and non-discounted cash flow criteria. While the former calls for discounting the future
benefits using an appropriate discount rate, the latter does not involve any discounting.

3. Assess the riskiness of the project Costs and benefits associated with a capital project
are almost invariably subject to risk. There may be a lot of variability characterizing factors like
project cost, sales quantity, selling price, material cost, energy cost, project life, and salvage value.
The actual values of these variables often turn out to be different from their forecast values.
Hence, you should try to get a handle over how the variability in these factors try to get a handle over
how the variability in these factors can affect the attractiveness of the project.

Fig 7.5 Key Steps in Project Appraisal

Forecast costs and benefits

Select appraisal criteria

Assess risk

Estimate the cost of capital

Value the options

Consider the overall corporate

perspective

4. Estimate the cost of capital The cost of capital is the discount rate used for evaluating
a capital project. Under appropriate conditions, it is measured as the weighted average cost of
different sources of capital employed for financing the project. The cost of a specific source of
finance is defined as the rate of discount that equates the present value of the expected post-tax
payments to that source of finance, with the net funds received from that source.

5. Value the options The traditional approach to project appraisal calls for judging a
project on the basis of its net present value, obtained by discounting the project cash flow stream
using an appropriate cost of capital. This approach, however, is incomplete, as it fails to capture the
value of real options embedded in the project. Hence, the traditional NPV analysis needs to be
expanded to include the value of real options inherent in the project.

6. Consider the overall corporate perspective

Capital investments in plant, machinery, buildings, research facilities, product development,

marketing programmes, and so on are tangible expressions of a company‘s strategy. Hence, capital
investment decision must be evaluated from the overall perspective of the firm. In such an
evaluation, due consideration should be given to general economic outlook, prospects of industries
in which the firm operates, and the competitive position and core competencies of the firm.

The following sections dwell at length on the issues involved in various steps of project appraisal.

7.10 COSTS AND BENEFITS

Capital expenditures typically involve current and near future costs that are expected to generate
benefits in the future.

Basic Principles

While measuring the costs and benefits of a capital expenditures proposal, you must bear in mind
the following guidelines:

Focus on Cash Flows: costs and benefits must be measured in terms of cash flows-costs are cash
outflows and benefits are cash inflows. Cash flows matter because they represent the purchasing
power.

Since accounting figures are based on the accrual principle, they have to be adjusted to derive the
cash flows. For example, depreciation and other non-cash charges, which are deducted in
computing profits from the accounting point of view, have to be added back as they do not entail
cash outflows.

Estimate cash flows on a post-tax basis. Some firms look at pretax cash flows and, to compensate
that, apply a discount rate greater than the cost of capital. However there is no reliable basis for
making such adjustments. Hence, as a rule, work with post tax cash flows.
Measures Cash flows on an Incremental Basis: The value of a project depends on its incremental
cash flows which are defied as the difference between ―Cash flows of the Firm with the project‖ and
―Cash flows of the firm without the project.‖

In estimating the incremental cash flows of a project, bear in mind the following sub- guidelines:

Consider all Incidental effects: In addition to its direct cash flows, a project may have incidental
effects on the rest of the firm. It may enhance the profitability of some of existing activities of the
firm as it has a complementary relationship with them; or it may detract from the profitability of
some of the existing activities as it has a competitive relationship with them- all these must be taken
into account.

Ignore sunk Costs: Sunk costs represents past outlays that cannot be recovered and, hence, are not
relevant for new investment decisions. Remember that ‗bygones are bygones‖.

Include Opportunity Costs: If a project requires the use of some resources already available with
the firm, the opportunity cost of these resources should be charged to the project. The opportunity
cost of a resource is the value of net cash flows that can be derived from it if it were put to its best
alternative use. Suppose a project requires a vacant piece of land within the factory premises of the
firm. The cost of this land represents a sunk cost and, hence, is not relevant for the new project. But
the project should be charged with the opportunity cost of this land which represents the benefit that
can be derived b by putting it to its best alternative use, which in this case may simply be leasing the
land to another firm.

Question the allocation of Overhead Costs: Accountants normally allocate organizational

overhead costs to various divisions or projects on some basis. Hence, when a project is proposed,
apportion of the organizational overhead costs is allocated to it. This may, however, have no
relationship with the incremental organizational overhead cost associated with. Remember that
what matters is the incremental overhead costs (along with other incremental costs), attributable
to the project and not the allocated overhead costs.

Do not forget Net Working Capital : Apart from investment in fixed assets like land, building,
machinery, and technical know-how, a project also requires investment in current assets like cash,
receivable (debtors), and inventories. A portion of current assets is supported by non-interest
bearing current liabilities like accounts payable (creditors) and provisions. The difference between
current assets and non-interest bearing current liabilities is the net working capital. It is financed by
equity, preference, and debt. While estimating the investment outlay of a project, do not forget the
investment in net working capital.
Exclude Financing Costs When you define project cash flows, exclude financing costs like interest
on debt and dividend on preference and equity. Why? The weighted average cost of capital used for
discounting the project cash flows reflects the cost of debt, preference and equity capital. Hence, if
interest on debt and dividend on preference and equity are deducted in estimating project cash
flows, cost of capital will be counted twice. Guard against this error.

Treat Inflation Consistently Interest rates are usually expressed in nominal terms, not real terms.
For example, if IDBI issues a debenture carrying an interest rate of say, 10 per cent, the 10 percent
rate is a nominal rate. This means that, if you buy a Rs.100 debenture you will get a nominal return
of 10 per cent. If the inflation rate happens to be, say 5 per cent, your real return will be
correspondingly less. To figure out your real return, use the following formula:

(1 + Real return) = ( 1+ Nominal return)

( 1 + Inflation rate)

applying this to the IDBI debenture, you get

(1 + Real return) = (1 + 0.10)

(1 + 0.05) = 1.048

Hence, the real return is 4.8 per cent.

Since discount rates are usually quoted in nominal terms, you should, for reasons of consistency,
estimate the project cash flows too in nominal terms. This means that, you must consider the trends
in prices and costs in nominal terms.

You can, of course, work with real cash flows (cash flows that abstract away the impact of
inflation). If you do so, make sure that the discount rate too is stated in real terms.

Components of the Cash flow Stream

The cash flow stream of a project may be divided into three parts a follows:

 Initial flows These represent the cash outflows associated with investment in various
project components. Initial flows are defined as:

Outlays on plant, machinery, and other fixed assets.

-
Tax shields relating to investment in plant, machinery, and other fixed asset
+
Outlays on net working capital
 Operational flows These are cash inflows expected during the operational phase
of the project. The operational cash inflow for a given year is equal to: Profit after tax +
Depreciation and other non cash charges.

 Terminal flows Cash flows expected from the disposal of assets when the project is
terminated are referred to as terminal flows. Terminal flows are defined as:

Post tax salvage value of fixed assets + Post tax salvage value of net working capital.

Illustration

Naveen Enterprises is considering a capital project about which the following information is
available:

 The investment outlay on the project will be Rs.100 million. This consists of Rs.80 million on
plant and machinery and Rs.20 million on net working capital. The entire outlay will be incurred at
the beginning of the project.

 The project will be financed with Rs.45 million of equity capital, Rs.5 million of preference
capital, and Rs.50 million of debt capital. Preference capital will

carry a dividend rate of 15 percent; debt capital will carry an interest rate of 15 percent.

 The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a
net salvage value of Rs.30 million whereas net working capital will be liquidated at its book value.

 The project is expected to increase the revenues of the firm by Rs.120 million per year. The
increase in costs on account of the project is expected to be Rs.80 million per year (This includes all
items of cost other than depreciation, interest, and tax). The effective tax rate will be 30 per cent.

 Plant and machinery will be depreciated at the rate of 25 per cent per year as per the written
down value method. Hence, the depreciation charges will be: First Year : Rs.20.00 million

Second Year: Rs.15.00 million

Third Year: Rs.11.25 million

Fourth Year: Rs.8.44 million

Fifth Year : Rs.6.33 million

Given the above details, the project cash flows are shown in Table 7.31.

Table 7.31 Project Cash Flows (Rs.in million)

0 1 2 3 4 5
A Fixed assets (80.00)
B Net working capital (20.00)
C Revenues 120 120 120 120 120
D Costs (other than 80 80 80 80 80
depreciation and interest
E Depreciation 20 15 11.25 8.44 6.33
F Profit after tax 14.0 17.5 20.12 22.09 23.57
G Tax 6 7.5 8.63 9.47 10.10
H Profit after tax 14.0 17.5 20.12 22.09 23.57
I Net salvage value of fixed 30.00
assets
J Recovery of net working 20.00
capital
K Initial outlay (100.00)
L Operating cash flow (H+E) 34.0 32.5 31.37 30.53 29.90
M Terminal cash flow (I+I) 50.0
N Net cash flow (K+L+M) (100.00) 34.0 32.5 31.37 30.53 79.90
Book value of investment 100 80 65 53.75 45.31

7.11 INVESTMENT CRITERIA

Once the stream of costs and benefits has been defined, it must be evaluated to determine whether
the project is worthwhile or not. Several criteria have been proposed for such evaluation, of which,
the important ones are:

 Payback period

 Average rate of return

 Net present value

 Internal rate of return.

Payback Period

The payback period is the length of the time required to recover the initial cash outlay on the
project. For example, a project involves a Cash outlay of Rs.600,000 and generates cash inflows of
Rs.100,000 rs.250,000, Rs.250,000, and Rs.2000,000 in the first, second, third and fourth years,
respectively. In this case, the payback period is 3 years because the sum of cash inflows during 3
years is equal to the initial outlay. When the annual cash inflow is a constant sum, the payback
period is simply the initial outlay divided by the annual cash inflow. For example, a project which
has an initial cash outlay of Rs.1, 000,000 and a constant annual cash inflow of Rs.300,000 has a
payback period of Rs.1,000,000/ Rs.300,000 = 31/3 years.

To figure out the payback period of Naveen Enterprise‘s capital project, let us look at the
cumulative cash flow, till it turns positive: (Rs. In million)
Year Cash flow Cumulative cash flow
0 -100.00 -100.00
1 34.00 -66.00
2 32.50 -33.50
3 31.37 -2.13
4 30.53 +28.40

Since the cumulative cash inflow is negative at the end of year 3 bit positive at the end of year 4, the
payback period I between 3 and 4 years.

According to the payback period criterion, the shorter the payback period, the more desirable the
project. Firms using this criterion generally specify the maximum acceptable payback period. If this
is n years, only projects with a payback period of n years or less are deemed worthwhile.

Evaluation A widely used investment criterion, the payback period, seems to offer the following
advantages:

 It is simply, both in concept and application. It does not use complicated concepts or tedious
calculations and has few hidden assumptions.

 It is a rough and ready method for dealing with risk. It favours projects which generate
substantial cash inflows in earlier years while discriminating against those which bring substantial
cash inflows in later years. Now, if risk trends to increase with futurity- and in general this may be
true- the payback criterion can be helpful in weeding out risky projects.
 Since it emphasizes earlier cash inflows, it is a sensible criterion when the firm is pressed with
problems of liquidity.

The limitations of payback criterion, however, are very serious:

 It falls to consider the time value of money. In the payback calculation, cash inflows are simply
added without suitable discounting. This violates the most basic principle of financial analysis,
which stipulates that cash flows occurring at different pints of time can be added or subtracted only
after suitable compounding or discounting.

 It ignores cash flows beyond the payback period. This lead to discrimination against projects,
which generate substantial cash inflows in later years.

 It is a measure of a project‘s capital recovery, not its profitability.

 Though it measures a project‘s liquidity, it does not indicate the liquidity position of the firm as
a whole, which is more important.

Average Rate of Return

The average rate of return, also called the accounting rate of return, defined as:

(Profit after tax/Book value of the investment)

The numerator of this ratio is the average annual post-tax profit over the life of the investment; the
denominator is the average book value of investment committed to the project. To illustrate the
calculation oif average rate of return, consider the data for the project of Naveen Enterprises.

(Rs.in million)
Year Book value of investment Profit after tax
1 100.00 14.00
2 80.00 17.5
3 65.00 20.12
4 53.75 22.09
5 45.31 23.57

The average rate of return is:

1/5 (14.0 + 17.5+20.12+22.09+23.57
1/5 (100+80+65+53.75+45.31) = 28.31 per cent.
Evaluation Traditionally, a popular investment appraisal criterion, the average rate of
return has the following virtues:

 It is simple to calculate.

 It is based on accounting information, which is readily available and familiar to businessmen.

 It considers benefits over the entire life of the project.

 Its shortcomings, however, seem to be considerable.

 It is based on accounting profit, not cash flow.

 It does not take into account the time value of money.

Net present Value

The net present value of a project is the sum of the present value of all the cash flows associated
with it. The cash flows are discounted at an appropriate discount rate (cost of capital). The net
present value of Naveen Enterprise‘s project is calculated below, using a discount rate of 15 per
cent which is the cost of capital applicable to this project. Fore details of how the cost of capital is
computed, refer to section 14.5.

Year Cash Flow Discount factor Present value

0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96

The decision rule associated with the net present value is: accept the project, if the net present value
is positive and reject the project, if the net present value is negative. A net present value of zero
suggests indifference.

Discount Rate and Net Present Value For projects that have cash outflows followed by cash
inflows- most projects are like this- the net present value declines as the discount rate increases.
Typically, the relationship between the discount rate and net present value is depicted in Fig 7.6.
Evaluation Conceptually sound, the net present value criterion has considerable merits:

 It takes into account the time value of money.

 It considers the cash flow stream in its entirety.

 It squares neatly with the financial objectives of maximization of the wealth of shareholders.
The net present value represents the contribution of the wealth of shareholders.

Fig 7.6 Discount Rate and Net Present Value

Discount rate

While this criterion has hardly any shortcoming, a problem regarding its use may be mentioned. The
net present value is an absolute measure and not a relative measure. Decision makers, however, are
generally more comfortable with a relative measure (like the accounting rate of return, or the
internal rate of return.)

Internal rate of Return

The internal rate of return of a project is the discount rate that makes its net present value equal to
zero. It is represented by the point of intersection in exhibit 13.3. Note the key differences between
net present value and internal rate of return.

Net Present Vale Internal Rate of return

 Assumes that the discount rate  Assumes that the net present
(cost of capital) is known value is zero.
 Calculates the net present value,  Figures out the discount rate that
given the discount rate. makes net present value zero.

To calculate the internal rate of return of a project, you have to try a few discount rates till you find
one that makes its net present value zero. In this iterative procedure, bear in mind the following
guidelines: If the net present value is positive, raise the discount rate to decrease the net present
value; on the other hand, if the net present value is negative, lower the discount rate to increase the
net present value. Remember the objective is to drive down the net present value to zero.
To illustrate the calculation of internal rate of return, let us work with the project of Naveen
Enterprises and initially try a discount rate of 20 per cent. The net present value at this discount rate
works out to Rs.15.88 million, as shown in exhibit 13.4. Since the net present value is positive, we
raise the discount rate to 24 per cent in the next iteration. The net present value drops to Rs.5.13
million, as shown in exhibit 13.4. Since it is still positive, we try a higher discount rate, viz 28 per
cent. At this discount rate, the net present value becomes Rs.4.02 million as shown in the last
column of Table 7.32. Thus, we know that the internal rate of return lies between 24 per cent and 28
per cent. If we resort to linear interpolation in this range the internal rate of return is calculated as
follows:

Table 7.32 How the Discount Rate Impacts on the Net Present Value

Year Cash flow Discounting rate Discounting rate Discounting rate

20% 24% 28%
Discount Present Discount Present Discount Present
factor value factor value factor value
0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00
1 34.00 0.833 28.3332 0.806 27.40 0.781 26.55
2 32.50 0.694 22.56 0.650 21.13 0.610 19.55
3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
4 39.53 0.482 14.72 0.423 12.91 0.373 11.39
5 79.90 0.402 32.12 0.341 27.25 0.291 23.25
NPV = 15.88 NPV = 5.13 NPV =4.02

Smaller discount rate + NPV at the smaller rate

Sum of the absolute values of x The NPV at the smaller
and the Bigger discount rates

(Bigger discount rate – smaller discount rate)

24% + 5.13 (28% - 24%) = 26.24 per cent

5.13 + 4.02

Evaluation A popular discounted cash flow method, the internal rate of return criterion has several
virtues:
 It takes into account the time value of money.

 It considers the cash flow stream in it entirety.

 It makes sense to businessmen who are wonted to think in terms of rate of return ad find an
absolute quantity such as net present value, somewhat difficult to work with.

The internal rate of return criterion, however, has its own limitations:

 There may be multiple rates of return. If the cash flow stream of a project has more than one
change in sign, there is possibility of multiple rates of return.

 The internal rate of return criterion can be misleading when the choice is between mutually
exclusive projects that have substantially different outlays. Consider projects P and Q.

Cash flow Internal rate of Net present

0 | 1 return value (at 12%)
P - 10,000 +20,000 100% 7857
Q - 50,000 +75,000 50% 16,964

Both the projects are good, but Q with its higher net present value contributes more to the wealth of
the shareholders. Yet, from an internal rate of return point of view, P looks better than Q. Hence, the
internal rate of return criterion seems unsuitable for ranking projects of different scales.

COST OF CAPITAL

The cost of capital of any investment (project, business, or company) is the rate of return the
supplier of capital would expect to receive if the capital were invested elsewhere in an investment
(project, business or company) of comparable risk. Before discussing the technical details of how
the cost of capital is computed, let us reiterate two points.

 The cost of capital reflects expected returns, not historical returns.

 The cost of capital represents an opportunity cost. It reflects the returns investors expect from
investments of similar risk.

To illustrate the calculation of the marginal cost of capital, let us look at the financing plan for the
project of Naveen Enterprises.
 Equity capital Rs.45 million
(2 million equity shares are proposed to be issued to
fetch a net price of Rs.22.5. while the issue price will be
Rs.25 per share, the issue expenses will be 10 per cent.
The expected dividend per share for the following year is
Rs.1.8)
Preference capital Rs.5 million
(50,000 preference shares of Rs.100 each are proposed to
be issued to an institutional investor at part. The
preference shares will carry a dividend of 15 per cent)
Debt capital Rs.50 million
(0.5 million non-convertible debentures of Rs.100 each
will be privately placed with a mutual fund. The
debentures will carry an interest rate of 15 per cent)

For our present discussion we assume that the risk of the project of Naveen Enterprises is
comparable to the risk of the firm as a whole; further, the financing pattern of the project is
comparable to the financing pattern of the firm as a whole.

Cost of Debt

The cost of debt is the return required by the creditors of the firm on new borrowings. You can
observe the cost of debt, directly or indirectly. Since it is the interest rate the firm must pay on its
new borrowings, you can estimate it by looking at the interest rates prevailing in the financial
markets. For example, if the firm has outstanding bonds, you can use the yield to maturity on these
bonds as a proxy for the cost of new borrowings. Alternatively, if you know that the new bonds of
the firm would have a rating of say, AAA, you can look at the interest rate on recently issued AAA
bonds. While figuring out the cost of debt, remember that the coupon rate on the firm‘s outstanding
debt is irrelevant. It merely represents a historical cost, not the current cost of debt. What matters is
the cost of debt today and this is reflected in the yield prevailing in today‘s market. The return
required by the suppliers of debt capital to Naveen enterprises is 15 per cent. Hence, this represents
the pre-tax cost of debt. Since the interest paid on debt capital is a tax deductible expense, the post
tax cost of debt is equal to:

Pre-tax cost of debt (1-tax rate) = 15% (1-.3) = 10.5%.

Cost of preference

Since preference capital carries a fixed rate of dividend, the cost of preference capital can be
determined fairly easily. It is the dividend rate the firm must pay on a new issue of preference
capital. Alternatively, it can be estimated by looking at the yields on outstanding preference shares
that are similarly rated. The cost of preference capital for Naveen Enterprises is 15 per cent. Note
that the preference dividend, unlike the interest on debt, is not a tax deductible payment. Hence,
there is no tax adjustment here.

Cost of Equity

Theoretically, the cost of equity is the return expected by capital providers from investments of
similar risk. So you can argue that the cost of equity can be found out by asking equity investors
how much return they expect. This is not feasible because the number of equity shareholders for
most companies is fairly large, sometimes running into hundreds of thousands. Further, even if you
could ask them, they may not be able to define their expectation the way seasoned bankers or
investors do. Many of them may simply say ― I want a high return‖. This is not helpful in arriving at
a concrete estimate of the cost of equity. Given the practical difficulties in directly ascertaining the
return expected by equity shareholders, financial analysts try to deduce investor expectation by
indirect ways. Three methods are commonly employed in practice.

 CAPM approach

 Bond yield plus risk premium approach

 Dividend discount model approach.

CAPM Approach according to the capital asset pricing model (which was introduced in chapter
11), risk and return are related as follows:

E( R ) = Rf M)-R]

In words, Expected return = risk-free

On a risky asset rate return

Beta of (Expected return Risk-free rate

The asset on market portfolio of return

To illustrate the CAPM approach, let us assume that Rf= 10 per cent and E (RM) = 18 per cent. The
expected return on equity stocks of companies with different betas is given below.

Beta Expected return = Rf M)-R]

0.5 10+0.5 (18-10) = 14%

1.0 10 + 1.0 (18-10) = 18%
1.5 10 + 1.5 (18-10) = 22%

To apply the CAPM approach, the following inputs are required: Rf, the risk-free rate [E(RM) –Rf],

While there is a disagreement among finance practitioners as to how these inputs have to be
estimated, for our purposes the following will suffice:

 The risk-free rate may be estimated as the yield on a long-term government bond that has a
maturity of 10 years or more.

 The market risk premium may be estimated as the difference between the average return on the
market portfolio and the average risk-free rate over the past 10 to 30 years- the longer the period,
the better it is.

 The beta of the stock may be calculated by regressing the monthly returns on the stock over the
monthly returns on the market index over the past 60 months or more.

The CAPM is regarded by many as a fairly rigorous and objective approach to determine the
required return on equity. This approach, however, is based on the assumption that investors
eliminate unsystematic risk by efficient diversification and hence require compensation only for
systematic risk which is reflected in beta. Market imperfections may impede efficient diversification
by investors, exposing them to unsystematic risk. When this occurs, investors will require
compensation for unsystematic risk, a factor which is not found in the standard CAPM relationship.
Another shortcoming of the CAPM relates to the instability of the betas of individual securities.
Studies have shown that individual securities have unstable betas. This makes the use of a historical
beta as a proxy for the future beta somewhat questionable. Notwithstanding, these shortcomings, the
CAPM approach is a useful approach for estimating the required rate of return of equity stocks.

Bond Yield Plus risk Premium Approach Analyst who do not have faith in the CAPM approach
often resort to a subjective procedure to eliminate the cost of equity. They add a judgmental risk
premium to the observed yield on the long-term bonds of the firm to get the cost of equity:
Cost of equity = Yield on long-term bonds + Risk premium.

The logic of this approach is fairly simple. Firms that have risky and consequently high cost debt
will also have risky and consequently high cost equity. So it makes sense to base the cost of equity
on a readily observable cost of debt.

The problem with this approach is how to determine the risk premium. Should it be 2 per cent, 4 per
cent, or n per cent? There seems to be no objective way of determining it. Most analysts look at the
operating and financial risks of the business and arrive at a subjectively determined risk premium
that normally ranges between 2 per cent and 6 per cent. While this approach may not produce a
precise cost of equity, it will give a reasonable ballpark estimate.

Dividend discount Model Approach In chapter 10 we learnt that the price of an equity share is
equal to the present vale of the dividends expected from it. If we assume that the dividend per share
grows at a constant rate , the price of the equity share is:

P0 = D1/ (r-g)

where P0 is price, D1 is the dividend expected a year from now, r is the return expected by
shareholders, and g is the growth rate in dividends. Solving the above equation for r, we get.

r= D1
+g
P0

Thus, the expected return of shareholders, which in equilibrium is also the required return, is equal
to the dividend yield plus the expected growth rate. For a publicity traded company, it is fairly easy
to determine the dividend yield. However, estimating the expected growth rate, g, is difficult. You
can estimate g by using the following methods.

1. You can get a handle over g by relying on analysts forecasts for the future growth rates.
Analysts‘ forecasts may be available from a variety of sources. Since different sources are likely to
give different estimates, s simple approach may be to obtain multiple estimates and then average
them.

2. you can look at dividends for the preceding 5-10 years, calculate the annual growth rates, and
average them. Suppose you observe the following divides for some stock.
 Year Dividend Rupee Growth 1
change
1 Rs.3.00 ------ ------
2 Rs.3.50 Rs.0.50 16.7
3 Rs.4.00 Rs.0.50 14.3
4 Rs.4.25 Rs.0.25 6.3
5 Rs.4.75 Rs.0.50 11.8

If you average the four growth rates, the result is 12.3 per cent, so you can use this as an estimate of
the expected growth rate.

3. You can use the retention growth rate method. Here, you first forecast the firm‘s average
retention rate (this is simply 1 minus the dividend payout rate) and then multiply it by the firm‘s
expected future return on equity (ROE).

g = (Retention rate) (Return on equity)

For example, if the forecasted retention rate and return on equity are 0.60 and 15 per cent, the
expected growth rate is:

g = (0.6) (15%) = 9 per cent.

The dividend growth model is simple. It is easy to understand and easy to apply. However, there are
some problems associated with it.

 First, it cannot be applied to companies that do not pay dividend or to companies that are not
listed on the stock market. Even for companies that pay dividends, the assumption that dividends
will grow at a constant rate may not be valid.

 Second, it does not explicitly consider risk. There is no direct adjustment for the risk associated
with the estimated growth. Of course, there is an implicit adjustment for risk as the current stock
price is used.

Average Cost of Capital

Once the specific costs of debt, preference, and equity capital are determined, the average cost of
capital is calculated as the weighted arithmetic average of these specific costs.

For Naveen Enterprises, the weights applicable to the various sources of finance are as follows:
 > Equity capital 45/100
> Preference capital 5/100

. Debt capital 50/100

The average cost of capital is calculated as follows:

Source of finance Component cost (per Weight ‗Product of

cent) component cost
and weight
Equity capital 20.00 0.45 9.00
Preference capital 15.00 0.05 0.75
Debt capital 10.50 0.50 5.25
15.00

FINANCING STRATEGY

7.12 CAPITAL STRUCTURE

The two broad sources of finance available to a firm are: shareholders‘ funds and loan funds.
Shareholders‘ funds come mainly in the form of equity capital and retained earnings and
secondarily in the form of preference capital. Loan funds come in a variety of ways like debenture
capital, term loans, deferred credit, fixed deposit, and working capital advance. Ignoring preference
capital (which is of minor significance) the basic differences between shareholders‘ funds (referred
to as equity) and loan funds (referred to as debt) are as follow:

Equity Debt
 equity shareholders have a residual Lenders have affixed claim in the
claim on the income and wealth of the firm. form of interest and principal amount.
 Dividend paid to equity shareholders Interest paid to lenders is a tax
is not a tax deductible deductible payment.
payment.

What are the key considerations in determining the debt equity ratio (the capital structure) of the
firm? The important considerations in planning the capital structure are:

 Earnings per share

 Risk

 Control

 Flexibility

 Nature of assets

Earnings per Share

Earnings per share, which is simply equity earnings divided by the number of outstanding equity
shares, is regarded as an important financial number that firms would like to improve. Hence we
need to understand how sensitive is earning per share (EPS) to changes in profit before interest and
tax (PBIT) under different financing alternatives.

To illustrate the relationship between PBIT and EPS under alternative financing plans, let us
consider the following data for Falcon Limited.

Existing capital structure: 10 million equity shares, per value Rs.10 each

Tax rate 50 per cent

Falcon Limited plans to raise additional capital of Rs.100 million for financing an expansion
project. In this context, it is evaluating two alternatives financing plans; (i) issue of equity shares
(10 million equity shares of Rs.10 per share), and (ii) issue of debentures carrying 14 per cent
interest.

What will be the EPS under the two alternative financing plans for two levels for PBIT, say Rs.20
million and rs.40 million? Table 7.33 shows the value of EPS at these two levels of PBIT under the
alternative financing plans.

Table 7.33 Earnings per Earnings per Share under alternative Financing Plans

Equity Financing Debt Financing

PBIT PBIT PBIT PBIT

20,000,000 40,000,000 20,000,000 40,000,000

Interest 14,000,000 14,000,000
Profit before 20,000,000 40,000,000 6,000,000 26,000,000
tax
 Tax 10,000,000 20,000,000 3,000,000 13,000,000
Profit after tax 10,000,000 20,000,000 3,000,000 13,000,000
No. of equity 20,000,000 20,000,000 10,000,000 10,000,000
shares
EPS 0.50 1.00 0.30 1.30

In general, the relationship between profit before interest and taxes and earnings per share is as
follows:

Earnings per share + [ PBIT – interest] (1-Tax rate) – Preference dividend

Number of equity shares

The break-even PBIT for the two alternative financing plans is the level of PBIT at which EPS is
the same under both the financing plans. It can be graphically obtained by plotting the relationship
between PBIT and EPS under the two alternatives and nothing the point of intersection. This is
shown in Fig 7.7 for the example of Falcon limited. From this figure we find that the break-even
level of PBIT is Rs.28 million. If PBIT is below Rs 28 million equity financing is preferable to
debenture financing; if PBIT is higher than Rs.28 million, the opposite holds.

Risk

The two principal sources of risk in a firm are business risk and financial risk.

Fig 7.7 Break-even PBIT Level

EPS (Rs)

7- PBIT (Rs in million)

28

Business risk refers to the variability of profit before interest and taxes. It is influenced, inter alia,
by the following factors.

 Demand Variability Other things being equal, the higher the variability of demand for the
products manufactured by the firm, the higher is its business risk.
 Price Variability A firm which is exposed to a higher degree of cterised by a higher degree
of business risk in comparison with similar firms which are exposed to lesser volatility for the
prices of their products.

 Variability of Input Prices When input prices are highly variable; business risk tends to be
high.

 Proportion of Fixed Costs If fixed costs represent a substantial proportion of total costs,
other being equal, business risk is likely to be high. This is because when fixed costs are high, PBIT
is more sensitive to variations in demand.

Financial risk represents the risk emanating from financial leverage. When a firm employs a high
proportion of debt in its capital structure, i.e. when it has a high degree of financial leverage, it
carries a high burden of fixed financial commitment. Equity shareholders, who have a residual
interest in the income and wealth of the firm, are naturally exposed to the risk arising from such
fixed commitments. Equity shareholders face this risk, also referred to as financial risk, in addition
to business risk.Generally, the affairs of the firm are, or should be, managed in such a way that the
total risk borne by equity shareholders, which consists of business risk plus financial risk, is not
unduly high. This implies that if the firm is exposed to a high degree of business risk, its financial
risk should be kept low. On the other hand, if the firm has a low business risk profile, it can assume
more financial risk.

Control

Consider the case of a firm which presently has an equity capital of 1000 owned entirely by the
original promoters. If the firm wants to raise additional capital, say another 1000, it may go for debt
finance, or a rights issue of equity capital, or a public issue of equity capital, or a combination of
two or more of these. The pros and cons of the three basic ways of raising additional finance are
shown below:

Pros Cons
Rights issue of equity No dilution of control Severe limits on financing
capital
Debt capital No financial risk Higher cost Financial risk
No dilution of control Lower
cost
 Public issue of equity No financial risk Dilution of control Higher
capital cost

Since the rights issue option severely limits the financing ability of the firm – the present owners
may lack resources or inclination or both – the options which may merit serious considerations are
debt capital and public issue of equity capital. In evaluating these options, among other things, the
issue of control is important.

Flexibility

Flexibility refers to the ability of a firm to raise capital from any source it wishes to tap. It provides
manipulability to the finance manager. Generally, if the return earned on equity is satisfactory, the
firm can raise further equity capital as there is no restriction on the amount of equity capital a firm
can raise. However, as the debt equity ratio is normally not permitted to exceed a certain level
(which may be specified by some regulatory authority, or determined by financial institutions, or
indicated by the capital market), the firm cannot presume that it can always raise further capital by
issuing debt securities. Hence, flexibility for practical purposes may mean that the firm does not
exhaust fully its debt capacity. Put differently, it implies that the firm maintains reserve-borrowing
power to enable it to raise debt capital to fund unforeseen needs.

Nature of Assets

The nature of a firm‘s assets has an important bearing on its capital structure. If the assets are
primarily tangible (plant and machinery and buildings), debt finance is used more. For example,
electric utility companies use more debt because their assets are mainly tangible, physical in nature.
On the other hand, if the assets are primarily intangible (brands and technical know-how) debt
finance is used less. For example, software companies use very little debt as their assets are mainly
intangible. What explains the link between the nature of assets and the use of debt finance? The
major explanation is that lenders are more willing to lend against tangible assets and less inclined to
lend against intangible assets.

A Checklist

When should the firm use more equity and when should the firm use more debt. Here is a checklist:

Use more equity when Use more debt when

  The corporate tax rate applicable to  The corporate tax rate applicable to
the firm is negligible the firm is high.
 Business risk exposure is high  Business risk exposure is low.
 Dilution of control is not an  Dilution of control is an important
important issue. issue.
 The assets of the firm are mostly  The assets of the firm are mostly
intangible. tangible.
 The firm has many valuable growth  The firm has few growth options.
options.

FINANCING INSTRUMENTS

Equity and debt come in a variety of forms and are raised in different ways. The important forms
are given in Fig 7.8 which shows the menu of financing available to a firm. The various forms of
financing have been discussed in greater detail in the following chapter.

Public and Private Sources of Capital

A firm can raise equity and debt capital from both public and private sources. Capital raised from
public sources is in the form of securities offered to public through an offer document filed with the
Securities Exchange Board of India. These securities can be traded on public secondary markets like
the national Stock Exchange or the Bombay Stock Exchange, which are recognized stock exchanges
that facilitate the trading of public securities. Private capital comes either in the form of loans given
by banks and financial institutions or in the form of securities like equity shares, preference shares,
and debentures which are privately placed with a small group of sophisticated inventors like venture
capital firms, financial institutions, insurance companies, mutual funds, and wealthy individuals.
Fig 7.8 Menu of Financing

The Typical Pattern of Financing

When a company is formed, it first issues equity shares to the promoters (founders) and also, in
most cases, raises loans from banks, financial institutions, and other sources. As the need for
financing increases the company may issue shares and debentures privately to promoters‘ relatives,
friends, business partners, employees, financial institutions, banks, mutual funds, venture capital
funds, and others-venture capital funds are likely to be an important source of finance for a nascent
venture. Such investors are specific and small in number.As the company grows further, it may
have to raise capital from the public. Once the company decides to go public, its options, in terms of
markets, widen. It can access the domestic market, international market, and foreign market. Apart
from equity shares, a firm may issue preference shares and debentures to the general investment
public through a public issue.

METHODS FOR RAISING FINANCES

The market for financial securities may be divided into two segments: the primary market and the
secondary market. New issues are made in the primary market whereas outstanding issues are
traded in the secondary market. There are three ways in which a company may raise finances in the
primary market:

(a) public issue,

(b) rights issue, and

(c) private placement or preferential allotment.

Public Issue

A public issue involves sale of securities to the members of the public. The first public offering of
equity shares of a company, which is followed by a listing of its shares on the stock market, is
called the initial public offering (IPO). Subsequent offerings are called seasonal offerings.

Initial Public offering: The decision to go public ( or more precisely the decision to make an
IPO so that the securities of the company are listed on the stock market and publicity traded) is a
very important decision which calls for carefully weighing the benefits against costs.

Benefits Costs
 Access to a larger pool of capital  Dilution
 Respectability  Loss of flexibility
 Lower cost of capital compared to  Disclosures and accountability
private placement  Periodic costs
 Liquidity

Eligibility for IPOs An Indian company, excluding certain banks, and infrastructure
companies can, make an IPO if it satisfies the following conditions:

 The company has a certain track profitability and a certain minimum net worth.

 The securities are compulsorily listed on a recognized stock exchange, which means
that a certain minimum percent of each class of securities is offered to the public.

 The promoter group (promoters, directors, friends, relatives, associates, etc) is

required to make a certain minimum contribution to the post-issue capital.

 The promoters‘ contribution to equity is subject to a certain lock-in period.

Principal steps in an IPO: A public issue involves sale of securities to the members of the public. It
entails a fairly elaborate process involving the following steps after the proposed issue is approved
by the board of directors and shareholders:

 Appoint the lead manager / s.

 Appoint other intermediaries like co-managers, underwriters, bankers, brokers, and

registrars.

 Prepare the prospectus and file the same with the Registrar of Companies and SEBI.

 Print the prospectus and dispatch the same to brokers.

 Make the statutory announcements.

 Collect and process the applications.

 Establish the liability of underwriters.

 Allot shares.

 Get the issue listed.

Cost The cost of an IPO is normally between 6 and 12 per cent depending on the size of the issue
and the level of marketing effort. The important expenses incurred for public issue are: underwriting
expenses, brokerage, fees for the managers and registrars, printing and postage expenses,
advertising and publicity expenses, listing fees, and stamp duty.

Seasoned Offering For most companies their IPO is seldom their last public issue. As companies
grow, they are likely to make further trips to the capital market with issues of debt and equity.
These issues are likely to be public issues offered to investors at large or rights issues or private
placement or preferential allotment.

The procedure for a public issue by a listed company (seasoned offering) is similar to that of an
IPO. Hence all the steps involved in an IPO are applicable to a public issue by a listed company.
However, a public issue by a listed company is subject of fewer regulations when compared to an
IPO (expect when the post-issue net worth grows to more than five times the pre-issue net worth).
This is evident from the following:

 A public issue by a company which has been listed on a stock exchange for at least
three years and has a track record of dividend payment for at least three immediate preceding years
does not require the promoters‘ contribution, provided the relevant information is disclosed in the
offer document.

Rights Issue

A rights issue involves selling securities in the primary market by issuing rights to the existing
shareholders. When a company issues additional equity capital, it has to be offered in the first
instance to the existing shareholders on a pro-rata basis. This is required under section 81 of the
Companies Act, 1956. The shareholders, however, may by a special resolution forfeit this right,
partially or fully, to enable a company to issue additional capital to the public.

Procedure for Rights Issue A company making a rights issue sends a letter of offer along with a
composite application form consisting of four forms (A, B, C and D) to the shareholders. Form A is
meant for the acceptance of the rights and application of additional shares. This form also shows the
number of rights shares the shareholder is entitled to. It also has a column through which a request
for additional shares may be made. Form B is to be used if the shareholder wants to renounce the
rights in favour of someone else. Form C is meant for application by the renounces in whose favour
the rights have been renounced, by the original allottee, through Form B. Form D is to be issued to
make a request for split forms. The composite application form must be mailed to the company
within a specific period, which is usually 30 days.

Private Placement or Preferential Allotment

In a private placement, funds are raised in the primary market by issuing securities privately to
some investors without resorting to underwriting. The investors in this case may be financial
institutions, commercial banks, other companies, and shareholders of promoting companies, and
friends and associates of the promoters. The merits of private placement are: (a) The process of
raising funds is fairly simple. The elaborate procedure required in the case of a public issue is more
or less bypassed. (b) The issue cost is minimal. (c) In the case of a debenture issue, negotiated
directly between the issuing company and the few investors, there may be greater flexibility with
respect to terms and conditions. The disadvantages of private placement are: (a) The quantum of
funds that can be raised may be rather limited. (b) The cost of capital of funds raised by way of
private placement may be somewhat higher.

Private Placement of Debentures Private placement of debentures has become very popular in
recent years. The principal buyers of such debentures have been mutual funds, insurance companies,
and financial institutions. Army group Insurance, Navy Group insurance, Air Group Insurance, and
so on. The phenomenal growth of private placement of debentures may be attributed to the
following factors:

Accessibility Almost every company can use the private placement route. There is no need for
credit rating.

Flexibility In a private placement, there is greater flexibility in working out the terms of issue.

Speed A private placement requires much less time than a public issue.

Lower issue costs: The issue costs of a private placement are substantially less.

How Do the Three Methods compare

How do the three methods compare broadly in terms of the amount that can be raised, the cost of
issue, dilution of control, degree of under-pricing, and market perception. Table

7.34 presents a summary comparison for equity issue. As far as a debt issue is concerned,
dilution of control is a non-issue and the market perception is positive under all the methods.

Table 7.34 Summary comparison of the Three Methods

Public issue Rights Issue Private Placement

Amount that can be Large Moderate Moderate
raised
Cost of issue High Negligible Negligible
Dilution of control Yes No Yes
Degree of under Large Irrelevant Small
pricing
Market Perception Negative Neutral Neutral

MARKETS

A firm planning to raise finances may tap one or more of the following capital markets:

Indian capital Market A firm accessing the Indian capital market has to conform to the
regulations of the Securities and Exchange Board of India (SEBI).

Euro Capital market The euro capital market is a global market beyond the purview of any
national regulatory body. Many firms in India have accessed this market since the early 1990s using
instruments like Global depository Receipts (GDRs) and Euro Convertible Bonds (ECBs). Firms
interested in accessing this market have to take the approvals of Ministry of Finance, foreign
Investment Promotion Board, and Reserve bank of India.

Foreign domestic Capital Market Some Indian firms have accessed or are in the process of
accessing the domestic capital market of US (through instruments like Yankee bonds and American
Depository Receipts), U.K, and Japan. Obviously, an Indian firm interested in accessing a foreign
domestic capital market has to obtain clearances from Indian authorities as well as the regulatory
bodies of the foreign country.

How do the three markets compare in terms of access, market size, cost of issue, disclosure and
transparency requirements, and prices/rates? Table 7.35 provides a summary comparison of the
three markets.

Table 7.35 A Summary Comparison of the Three Markets

Indian Capital Euro Capital Market Foreign Domestic

Market market
Access Easy Restricted Highly restricted
Market Small Large Large
Cost of Issue High Low Low
Disclosure and Less onerous Onerous Highly onerous
transparency
Prices / Rates Not so attractive Attractive More attractive

PRICING AND TIMING

Along with the choice of instrument, market, and mode, the firm has to determine when and at what
price should its issue be made. Since pricing and timing are closely inter- related they may be
discussed together.

If the capital market is efficient in the sense that the market price is always equal to the intrinsic
value, the simple guideline with respect to pricing and timing would be: ― Raise finances whenever
they are required by issuing securities at prevailing market prices‖.

Since the market price and intrinsic value may diverge in real life situations, pricing and timing are
important issues. Bear in mind the following guidelines while resolving these issues.

Decouple Financing and Investment Decisions Opportunities for smart moves on investment and
financing side of the business often do not synchronies. Hence financing decisions should be
decoupled from investment decisions, As Warren Buffett says: ―Therefore, we simply borrow when
conditions seem non-oppressive and hope that we will later find intelligent expansion or acquisition
opportunities, which as we have said are more likely to pop up when conditions in the debt market
are clearly oppressive. Out basic principle ins that if you want to shoot rare, fast moving, elephants,
you should always carry a loaded gun‖.

Never Be Greedy If present conditions are favourable for a certain type of financing, take
advantage of it. Driven by greed, do not wait for an even better possible tomorrow. The advice of
Bernard Baruch formulated for the stock market investor applies equally well to the participant in
financial market: ―Leave the first 1p per cent and the last 10 per cent of someone else.‖

Ensure Inter-generational Fairness Tapping the equity market when it is buoyant does not mean
that the firm should price its equity issue far above its intrinsic value. If it does so, existing
shareholders will benefit at the expense of new shareholders. While it may appear alluring in the
short run, it may not be advisable in the long run. Firms which succumb to such a temptation for
immediate gains may eventually alienate new investors and lose credibility in the capital market. To
ensure inter-generational fairness among equity shareholders, the firm should price its issue at more
or less the intrinsic value and to more or less guarantee an encouraging response to its issue, the
firm should approach the market when it feels that the market price is higher than the intrinsic value
by a margin of say 20 per cent.

DIVIDEND POLICY

Very broadly, the distribution policy is concerned with issues like how much of its earnings should
a firm pay by way of dividends, what are the implications of bonus issues and stock-splits, and
when does it make sense to buy back shares.

Key Considerations Influencing Dividend Policy

The key considerations influencing a firm‘s dividend policy are as follows:

Earnings Prospects If the firm expects its earnings to grow in future it may be inclined to pay more
by way of dividends. On the other hand, if it is uncertain about its earnings prospects it may pay less
by way of dividends.

Funding Requirements An important factor influencing the payout ratio of a firm is its
requirement for funds in the foreseeable future. This is usually assessed with the help of financial
forecasts prepared in the context of long range planning. Generally, firms which have substantial
investment opportunities and consequently considerable funding needs tend to keep the dividend
payout ratio low to conserve resources for growth.

Dividend Record The past dividend record of a firm has a bearing on its current dividend
payment. Firms generally pursue a policy of gradually varying (this mostly implies increasing but
occasionally means decreasing) the rupee level of dividend over time.

Liquidity Position Dividends entail cash payment. Hence, the liquidity position of the firm has a
bearing on its dividend decision. A firm may be unable to distribute more than a small fraction of its
earnings, despite its desire to do so, if it is hard pressed for liquidity.

Shareholder Preference The preference of shareholders may influence the dividend payout ratio of
the firm. When equity shareholders have greater interest in current dividend vis-à-vis capital gains,
the firm may be inclined to follow a liberal dividend payout policy. On the other hand, if equity
shareholders have a strong preference for capital gains, the firm may plough back a larger
proportion of its earnings.

Control External financing, unless it is through a rights issue, involves dilution of control. If
external finances are raised through a public issue of equity capital, the existing shareholders will
have to share control with the new shareholders. Internal financing by way of retained earnings, on
the other hand, leads to no dilution of control. Hence, if the shareholders and management of the
firm are averse to dilution of control, the firm should rely more on retained earnings.

Bonus Shares

Share issued to existing shareholders as a result of the capitalization of reserves are called bonus
shares. Table 7.36 illustrates the nature of this capitalization.
Table 7.36 Effect of a Bonus issue on the Equity Portion of the Balance Sheet

Part A: Equity Portion before the Bonus Issue

Paid up Share Capital Rs.10,000,000

(1,000,000 shares of Rs.10 each fully paid)

Reserves and Surplus Rs.30,000,000

Part B: Equity Portion after the Bonus Issue in the Ratio 1:1

Paid up Share Capital Rs.20,000,000

(2,000,000 shares of Rs.10 each fully paid)

Reserves and Surplus Rs.20,000,000

In the wake of the bonus issue:

 The shareholders‘ proportional ownership remains uncharged.

 The book value per share, the earnings per share, and the market price per share
decrease, but the number of shares increases.

From the above it appears that the issue of bonus shares is more or less a financial gimmick without
any real impact of the welfare of equity shareholders. Yet, firms do issue bonus shares and
shareholders eagerly look forward to such issues. Why? The primary reason is that shareholders
regard a bonus issue as a firm indication that the prospects of the company have brightened.
Further, they feel reassured that the management is investor friendly. A secondary reason is that
the bonus issue brings the price of the share in a more popular trading range.

Stock Splits

In a stock split, the par value per share is reduced and the number of shares is increased
proportionately. Table 7.37 illustrates the nature of this change.

Table 7.37 Effects of a Stock Split on the Equity Portion of the Balance Sheet.

Part A: Equity Portion of the Balance Sheet

Paid up Share Capital Rs.5,000,000

(1,000,000 shares of Rs.50 each fully paid)

Reserves and Surplus Rs.10,000,000

Part B: Equity Portion after Stock Split in the Ratio 5:1

Paid up Share Capital Rs.5,000,000

(5,000,000 shares of Rs.10 each fully paid)

Reserves and Surplus Rs.10,000,000

Comparison between Bonus Issue and Stock Split

A comparison between a bonus issue and a stock split given below:

Bonus Issue Stock Split

 The par value of the stock remains  The par value of the stock is reduced.
constant.  There is no capitalization of reserves.
 A part of reserves is capitalized.  The shareholders‘ proportional
 The shareholders‘ proportional ownership remains unchanged.
ownership remains unchanged.  The book value per share, the
 The book value per share, the earnings per share, and market price per
earnings per share, and the market price per share decline.
share decline.  The market price per share is
 The market price per share is brought within a more popular trading
brought within a more popular trading range.
range.
SUMMARY

Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by users of the information. Nowadays, Profit and loss
account, Balance Sheet, and Statement of Changes in Financial Position are important in the
accounting process. Accounting, especially, cost accounting, as a tool of management, is an integral
part of the management process. Cost accounting records relevant date from production and other
activities on a regular basis and reports these data to management for managing the undertaking.
Cost accounting is the processing and evaluation of monetary and non-monetary data to provide
information for internal planning, control of business operations, managerial decisions and special
analysis, external reporting. Economic Order Quantity and Re order level make ease accountants
and financial managers in the process of placing an order with the answer of questions when and
how many.

The two types of inventory systems, perpetual inventory method requires a continuous record of
additions to or reductions in materials, work-in-progress, and cost of good sold on a day-to-day
basis and the stock-taking task which is long and costly is avoided under this method; Under the
periodic method, the entire book inventory is verified at a given date by an actual count of
materials on hand and this physical inventory is usually taken near the end of the accounting period.
The difference between Cost accounting and Managerial accounting makes clear its usages. Cost
accounting largely uses data about production, sales, wages, and overhead services. Managerial
accounting utilizes the same (and also additional) data to prepare budgets, performance reports, and
control reports and data analyses for decision-making purposes. Cost- Volume-Profit (CVP)
analysis is an important tool that provides the management with useful information for managerial
planning and decision-making. A break-even analysis is performed to identify the level of
operations at which the .entity has covered all costs but has not yet earned any profit. The break-
even point identifies the volume of activity at which total revenues equal total costs. This is an
important point to the management because it represents a minimum acceptable level of operations
and it indicates that profitable operations can only result when the level of activity exceeds the
break-even point.
 CHAPTER 8

PROJECT MANAGEMENT
SCOPE OF THE COURSE

After reading chapter 8, you should be able to:

 Understand the basic needs for project planning

 Explain the characteristics of project planning

 Understand Critical Path Method

 Understand PERT

INTRODUCTION

8.1 WHAT IS A PROJECT?

―A project is a temporary endeavor undertaken to achieve a particular aim. Every project has a
definite beginning and a definite end.‖

From the Project Management Institute

What is Project Management?

Project management is the application of knowledge, skills, tools and techniques … in order to meet
the requirements of the particular project.

8.2 WHAT IS PROJECT PLANNING

Project Planning in general can best be described as the function of selecting the enterprise
objectives and establishing the policies, procedures and programs necessary for achieving them.

Characteristics of Project Planning

 Project Planning must be systematic,flexible, enough to handle unique activities,

disciplined through reviews and controls and capable of accepting multifunctional inputs.

 Task is required to be well understood prior to being performed, much of the work
can be preplanned

 During the actual task execution more knowledge is learned that in turn leads to
changes in resources allocations schedules and priorities.

 The more uncertain the task the greater the amount of information that must be
processed in order to ensure effective performance.

Poor Project Planning

 Project initiation

 Wild Enthusiasm

 Chaos

 Search for the guilty

 Punishment of the innocent

 Promotion of the nonparticipants

 Unclear definition of the requirements

Basic need for Project Planning

 To eliminate or reduce uncertainty

 To improve efficiency of the operation

 To obtain better understanding of the objectives

 To provide a basis for monitoring and controlling work

 The competitive situation in the area like

 Marketing, Research and Development

 Production, Financing and Personnel

 Management Structure etc.

 Agreement on purpose
 Assignment and acceptance of individual responsibilities

 Coordination of work activities

 Increased commitmen to group goals

 Lateral Communications

 Assignment and acceptance of group responsibilities

The statement of work (SOW)

 The SOW is a narrative description of the work required for the project. It includes
the objectives of the project A brief description of the work the funding constraint if one exists and
the specifications and schedule.

 It includes: Start date, End Date, Major Milestones,Written reports (data items).

 Common causes of misinterpretation:

 Mixing tasks, specifications, approvals and special instructions

 Using imprecise language (nearly, optimum, approximately etc.)

 No pattern,structure or chronological order

 Wide variation in size of tasks

 Wide variation in how to describe details of the work

 Failing to get third –party review

The project manager or his designees should review the document that authorize the project and
define its objectives. As a convenience a related studies should be prepared together with samples
of any Similar SOW‘S and related coding should be used. A copy of the Work Breakdown Structure
(WBS) should be obtained. Coordination between Contract work breakdown structure (CWBS)
elements and the SOW should commence. Each task element of the preliminary CWBS should be
explained in SOW. The project manager should establish a SOW preparation team consisting of
personnel from he deems appropriate.

Or experts in the area of technical, financial fabrication test, logistic, configuration management
operations safety, reliability and quality assurance. Before work has start on SOW, project manager
should brief CWBS and the nature of the contemplated SOW. This Is the baseline to proceed
further. The identified tasks may be assigned to team members. Team members should develop
specifications and Technical requirements documentation that may apply to various elements of the
proposed procurement.

Checklist for SOW Preparation:

 Is the SOW specific enough to permit a contractor to Make a tabulation and

summary of manpower and resources needed to accomplish each SOW task element.

 Are specific duties of the contractor stated so he will know what is required?

 Are all parts of the SOW so written that it is clear to both the parties.

 Is proper reference of document is described?

 Are any specifications or exhibits applicable in whole or in part? If so are they cited
and referred to the appropriate SOW element.

 Are directions clearly distinguishable from general information.

 Is there a time–phased data requirement for each deliverable item? If elapsed time is
used does it specify calender or work days?

 Are proper quantities shown?Have headings been checked for format and grammer?
Are subheadings are comparable?

 Have appropriate portions of procurement regulations been followed?

 Can SOW task or /contract line items and configuration item breakouts at lower level
so they can be summarized to CWBS elements.

 Have all requirements for data been specified separately in a data requirements
appendix or its equivalent? Have all extraneous data requirements been eliminated?

 Are security requirements adequately covered if required?

 Has its availablity to contractors been specified.

 Finally, there should be management review of the SOW preparation and

interpretation

8.3 WORK BREAKDOWN STRUCTURE (WBS)

The project manager must structure the work into small elements that are:

 Manageable, in that specific authority and responsibility can be assigned

 Independent or with minimum interfacing with and dependence on other ongoing

elements.

 Integratable, so that the total package can be seen

 Measurable in terms of progress

The first major step in the planning process after project requirements definition is the development
of the work breakdown structure(WBS). The WBS is the single most important element because it
provides a common framework from which:

• The total program can be described as a summation of subdivided elements

• Planning can be performed

• Costs and budgets can be established

• Time,cost and performance can be tracked

• Objectives can be linked to company

• resources in a logical manner

• Schedules and status-reporting procedures can be established

• Network construction and control planning can be initiated

• The responsibility assignments for each element can be established.

• A copy of the WBS should be obtained .

• Coordination between CWBS elements and the sow should commence.

• Each task element of the preliminary CWBS should be explained in SOW.

• The project manager should establish a SOW preparation team consisting of
personnel from he deems appropriate.

Check List for Effective Work Breakdown Structure (WBS)

• Has WBS developed by subdividing the total effort into discrete and logical supplements.

• Check the proposed WBS satisfies both functional engineering-manufacturing- test)and

program / project (hardware,services etc.) requirements including recurring and nonrecurring costs.

• Check to determine if the WBS provides for logical subdivision of all project work.

• Establish assignment of responsibilities for all identified effort to specific organizations.

PROJECT SPECIFICATIONS

Project specification is a part of statement of work. Specifications are used for man-hour, equipment
and material estimates. Small changes in a specification can cause large cost overrun. It avoids
surprises for the customer downstream. The specifications must be most current revision. It is not
uncommon for a customer to hire outside agencies to evaluate the specifications. Specifications are
in fact standards for pricing out a proposal

MILESTONE SCHEDULES

Milestone schedules contain such information as:

 Project start date

 Project end date

 Other major milestones

 Data items

8.4 ESTIMATING PROJECTS

There will be higher degree of uncertainity and more inputs to the estimates have to be treated as
variable rather then constants.

The changes that have the greatest effects can be discussed in terms of the systems model of project
activities.
 Rough/finger-in- Much uncertainty Early check on +or-25
the air/ballpark As what is involved feasibility of
brief

As-buts As was carried out With an + or

previously with appropriate - 15
Some Amendment contingency
factor
Detailed Some solid initial work proposals +or-10
Estimates is carried out

NAME NATURE ROLE ACCURACY

To finish At ending stage Additional +or-

fund 5

COSTING PROPOSAL

There are two types of approaches to the preparation of costing:

1.Ground –up-costing

2.Top-down-Costing.

Ground-up-Costing: The estimate of each level in the work breakdown structure are compiled and
added together by each level of supervision in the project hierarchy

Top-down-costing: The amount of money is allocated to complete the project activities and this has
to be split between the sub-projects. The allocation is either based on senior management estimates
or through the use of target costing.

Top Down Ground-up

Project Manager Project manager collects Estimates.

Allocates budgets

To sub projects
TYPES OF ESTIMATES

 Definitive

 Capital Cost

 Appropriation(with capital cost)

 Appropriation

 Feasibility

 Order of magnitude

ACTIVITY LEVEL COST

Time: The direct input of labor into activities

Materials: Consumables and other items used in the process

Capital Equipment

Indirect Expenses: Transportation, Training

Overheads: Provision of an office financial and legal support and staff cost.

TECHNIQUES FOR TIME DETERMINATION

1. DIRECT WORK MEASUREMENT

2. WORK SAMPLING

3. SYNTHETIC ESTIMATION

4. LEARNING CURVE CALCULATIONS

ELEMENTS OF COST

Price =direct material+ direct labour + projects overheads + general overheads + profit

BUDGET

A written statement of money: where it is drawn from, its amount how it is to be spent
-Collins English Dictionary Category of Budgets: Labour, materials, consumables, capital
expenditure, travel - Subsitance, etc.

Resource Analysis

-Crashing

-Resource allocation and smoothing

CRASHING

It is part of the project how to carried out the project in less time .Shortening one or more project
activities.

-Provide an incentive for work to be completed early eg. road work.

- Add additional resources such as extra people or machine capacity provide over time
additional contract etc.

- Parallel activities

- Reduce the level of technological change

- Compromise in terms of time or specifications or to commit extra resource

How to do ?

-Personal supervision of one or more activities which ensures an early completion

- Find out absolute latest time required

- -Discussion with the members of the projects

8.5 RESOURCE ALLOCATION AND SMOOTHING

-Resources are to be properly utilized

-Use responsibility matrix and responsibility matrix with resource loading

CPM/PERT

Critical Path Method (CPM)

 Designed to provide intense micro-control

 The system is dynamic; it continues to provide periodic reports as the project

progresses

 It involves three Basic Steps:

 It defines the job to be done

 It integrates them in a logical sequence

 It controls the progress of project plan.

Manager’s View of CPM

 Activity

– A task or a certain amount of work required in the project

– Requires time to complete

– Represented by an arrow

 Parallel activity

– Activities that start after a particular activity and progresses along with it but finishes only after
that activity is over.(E.g. Construction of a wall and Plastering)

 Dummy Activity

– Indicates only precedence relationships

– Does not require any time of effort

 Event

– Signals the beginning or ending of an activity

– Designates a point in time

– Represented by a circle (node)

 Network
– Shows the sequential relationships among activities using nodes and arrows

 Loops and Dangling

– Looping:Avoid looping by checking the precedence relationship of activities

by numbering them in logical order(Non Cyclic)

– Dangling: activities other then initial and final don‘t have successor events.

CPM Terminology

 Path

– A connected sequence of activities leading from the starting event to the ending event

 Critical Path

– The longest path (time);

– determines the project duration

– Sequence of activities along which there is no free time.

 Critical Activities

– All of the activities that make up the critical path

 Earliest Start (ES)

– The earliest that an activity can begin; assumes all preceding activities have been completed

 Earliest Finish (EF)

– ES + activity time

 Latest Finish (LF)

– The latest that an activity can finish and not change the project completion time

 Latest Start (LS)

– LF – activity time

Steps in CPM Analysis

 Draw the CPM network

– A graphic view of the relationships among the required activities

 Analyze the paths through the network

– Determine the length of each path (the time required to complete each path)

– Starting at the beginning of the network and working toward the end (from left to right),
determine the ES and the EF for each activity

 Path analysis (continued)

– Identify the critical path(s) (the longest path[s] through the network)

– The critical path(s) determines how long the project will take

 Determine the slack for each activity

– Working from the end of the project network (from right to left), find the LF and the LS for
each activity

– Compute the activity‘s slack

slack = LS – ES = LF – EF

– Slack is the maximum amount of time that this activity can be delay in its completion before
it becomes a critical activity, i.e., delays completion of the project

CPM Network

f, 15

g, 17 h, 9
a, 6
i, 6

b, 8
d , 13 j, 12

c, 5
e, 9

 Paths Enumerated

Path Length of Path

a-f-h 6 + 15 + 9 = 30

a-g-I 6 + 17 + 6 = 29
b-d-j 8 + 13 + 12 = 33*

c-e-j 5 + 9 + 12 = 26

*Critical path

 ES and EF Times

f, 15
6 21
g, 17 h, 9
a, 6
6 21 30
0 6 i6

b, 8 29 23
d-13 j, 12
8 21 21
c, 5 33
0 5 e, 9 Project’s EF = 33
5 14

Program Evaluation and Review Technique (PERT)

 The technique is based on the assumption that an activity‘s duration follows a

probability distribution instead of being a single value.

 The probabilistic information about the activities is translated into probabilistic

information about the project.

 Three time estimates are required to compute the parameters of an activity‘s duration
distribution:

– pessimistic time (tp ) – the time the activity would take if things did not go well

– most likely time (tm ) – the consensus best estimate of the activity‘s duration

– optimistic time (to ) – the time the activity would take if things did go well
Steps in PERT Analysis

 Draw the network.

 Analyze the paths through the network and find the critical path.

 The length of the critical path is the mean of the project duration probability
distribution which is assumed to be normal.

 The standard deviation of the project duration probability distribution is computed by

adding the variances of the critical activities (all of the activities that make up the critical path) and
taking the square root of that sum

 Probability computations can now be made using the normal distribution table.

PERT Example

Immed. Optimistic Most Likely Pessimistic

Activity Predec. Time (Hr.) Time (Hr.) Time (Hr.)
A -- 4 6 8
B -- 1 4.5 5
C A 3 3 3
D A 4 5 6
E A 0.5 1 1.5
F B,C 3 4 5
G B,C 1 1.5 5
H E,F 5 6 7
I E,F2 5 8
J D,H2.5 2.75 4.5
K G,I 3 5 7

Activity Cost-Time Tradeoffs

 Project managers may have the option or requirement to crash the project, or
accelerate the completion of the project.

 This is accomplished by reducing the length of the critical path(s).

 The length of the critical path is reduced by reducing the duration of the activities on
the critical path.
Cost-Time Tradeoffs

 If each activity requires the expenditure of an amount of money to reduce its duration
by one unit of time, then the project manager selects the least cost critical activity, reduces it by one
time unit, and traces that change through the remainder of the network.

 As a result of a reduction in an activity‘s time, a new critical path may be created.

 When there is more than one critical path, each of the critical paths must be reduced.

 If the length of the project needs to be reduced further, the process is repeated.

8.6 COMPUTER SOFTWARE FOR PROJECT MANAGEMENT

 Artemis Views (Artemis Management Systems)

 FastTrack Schedule (AEC Software)

 Microsoft Project (Microsoft Corp.)

 Oracle Projects (Oracle Corp.)

 PowerProject (ASTA Development)

 Primavera Project Planner (Primavera Systems)SuperProject (Computer Associates

international)

 Turbo Project (IMSI)

Evaluation of CPM/PERT

 Activities are assumed to be independent.

 It is assumed that there is a precise breaking point where one activity ends and another
begins.

 Initially-critical activities might not receive the attention they deserve until it is too late.

 Activity time estimates might be biased.

 The cost of CPM/PERT might not be justified by the value of the information it provides.

 Personnel might not understand the statistical underpinnings of PERT.

Wrap-Up: World-Class Practice

 The project organizations are flexible enough to respond aggressively to business

opportunities.

 Personnel are selected and trained to be flexible in moving from department to department
and project to project as needed.

 Scheduling and control charts are frequently used because of their simplicity, flexibility ,
low cost, and effectiveness as communication devices.

 CPM, PERT, and PERT/Cost are also used to provide computerized activity-by- activity
planning and control.

Project Feasibility Study

According to P Gopal Krishnan and VE RAma Moorthy The project feasibility study is to be
conceived of following point to avoid incomplete and inadequate preparation.

1. Executive Summary

2. project background and history

3. Demand and Market Study

4. Demand Projections

5. Forecasting Techniques

6. Export Projections

7. Market Penetration

8. Sensitivity Analysis

9. Sales forecast and Marketing

10. Production program

11. Plant Capacity

12. Materials and Inputs

13. Supply Program

14. Project Location

15. Plant Site within the location

16. Local Conditions

17. Layout and Physical Coverage of project

18. Technology and Equipment

19. Civil Engineering

20. Plant Organizations

21. Overhead Costs

22. Labor

23. Staff

24. Implementation Scheduling

25. Financial Evaluation

26. Economic Evaluation

Technical Feasibility :

1. Technology Considered and rationale for the ultimate choice of Technology

2. The cost of technology in terms of investment or lump sum payment of technology fees or
royalty or annualized payments have to be determined and detailed.

3. Equipments have to be categorized as belonging to the production infrastructure or other

categories the basis of their choice elaborated and their cost estimated with appropriate details of
quantities and rates.

Economic and Commercial evaluation:

1. The nature of project should contribute to the national economy.

2. Raising of aggregate consumption could be one of the basic objectives in project evaluation.

3. Prepare comparative Return Analysis and defined return analysis

4. Estimate total investment

5. Direct Capital Investment

6. Offsite facilities and Supporting Utilities

7. transfer of existing Capital item,Preliminary Project engineering expenses, Working Capital

Return on Investment

8. General Facities

Project Risk Analysis

1. Identifying Critical Sources of Risk

2. Measuring the quantum of risk

3. Incorporating risk in decision making

Project Monitoring and Controlling Process

1. Monitoring the Progress of Project Activities

2. Monitoring Consumption of Resources

3. Revision/Updating Of A Project Schedule

4. Reallocate (Addition/Shifting) Resources Among Activities.

 Three Types of Time Based Control

1. Establishes Standards to Prevent Problems

2. Measures Activities When Performed

3. Measures Final Activity Control of Major Constraints

• Time

• Cost

• Quality

• Environmental

• HR management

• Risk management

Time Management

• Purpose: Create a realistic schedule with the team

• Identify the activities (tasks)

– Activities are action steps (HOW) and different from deliverables that are tangible results
(WHAT)

– Use the WBS and scope statement

• Develop activity lists and revise the WBS Sequence activities

– Consider dependencies

• Estimate durations (time)

– Top down, bottom up estimates, Monte Carlo simulations

– Estimating formulae (PERT estimates)

– Expert opinion

– Consider resource capabilities

– Look at similar projects

• Develop the schedule (Gantt chart)

– Document assumptions and decisions

– Use project management scheduling software e.g. MS Project

• Control the schedule

– Performance reports, change requests, time management plan, corrective

action, lessons learned

• E.g. baseline Gantt chart and then update

– Frequency

– Roles and responsibilities

– Control techniques e.g. meetings.

Cost Management

• Plan resources (people, equipment, materials)

– Consider WBS, scope statement, organizational policies, staff pool

– Identify resource requirements

• Cost centers at Your company?

– Time is money

• Cost budgeting

– Resource leveling

– Cost baseline

• Control costs

– Performance reports, change requests, cost management plan, corrective action, lessons
learned

• e.g. budgeted, actual, variance (with explanation)

Cost Variance = ACWP-BCWP

• ACWP= Actual cost of work performed

• BCWP= Budgeted cost of work performed

• ECAC= Total Budget +Cost Variance.

• ECAC= Estimated cost at completion.

BUDGETARY CONTROL

• Cost Standards

• Master Budget

• Production Budgets

• Project Budgets

• Human Resources Budget

• Financial Ratios
Cash Budget

• Estimates and reports cash flow on a daily or weekly basis to ensure that the company has
sufficient cash.

Capital Budget

• Lists planned investments in major assets.

• Not only have a large impact on future expenses, they are investments designed to enhance
profits.

Quality

The totality of features and characteristics of a product or services which bear on its ability to
satisfy a stated or implied need‖

Objective:

To provide a formalized system within the project system which ensures that the needs of the
customer or the stated objectives of the system are continually being met.

The process of implementing quality system

• Establishing the reason for wanting a system

• Train people and prepare for documentation

• Create documentation

• System for internal audit

• System for external audit

Quality Management

• Plan for quality

– Quality product and quality project management practices

– Quality standards

• Conform to specifications (project produces what it said it would)

• Fitness for use (satisfy needs)

• Prevention vs. inspection

• Plan, do, check, act

• Benchmark, checklists, flow charts, cause/effect diagrams

• Quality management plan

– Organizational structure, processes, resources, procedures, responsibilities to ensure quality

plan is implemented

– Quality metrics

• Checklists

• Quality Assurance

– Follow the quality management plan, audits, improvements

• Quality control

– Process and product results

– Control charts, Pareto diagrams, trend analysis Quality Tips

• Start with a clear view of quality in mind

• What is quality?

• Implications for ALL knowledge areas

Total Quality Management (TQM)

• Commitment to infusing quality into every activity.

• Focuses on teamwork, increasing customer satisfaction, and lowering costs.

• Means a shift from a bureaucratic to a decentralized approach to control.

• Has a target of zero defects.

Most companies that have adopted TQM have incorporated.

• Quality

• Empowerment

• Benchmarking

• Outsourcing

• Standard for reduced cycle time

• Continuous improvement

Statistical Quality Control Steps

1. Define the characteristics of a high-quality output.

2. Breakdown work activities into separate elements required for producing a high-quality
output.

3. Have current and reasonable standards.

4. Discuss specific performance expectations for every job with workers.

5. Make check sheets and collect data for each task.

6. Evaluate employee progress at frequent intervals.

Requirements of environmental systems

• Commitment

• Environmental policy

• Environmental review

• Authority and responsibility

• Maintaining of relevant records

• Objectives and goals

• Plan of action

Drafting a Detailed Project Report.

While drafting a Detailed Project Report following points are to be considered:

1. Product, Capacity and Applications

2. Market, Competition and Demand – Supply estimate

3. Production Process and Technical Arrangement

4. Plant and Machinery, Capacity and Cost, Equipments, the suppliers of machinery, price
delivery.

5. Land and Building

6. Electricity, fuel, water and steam are required to produce at full capacity, cost to arrange for
supply of these in the first instance and later for consuming these.

7. Project entail liquid effluent or air-pollution? What is the type of equipment to be installed
and process to be carried out to cope with the problem?

8. Location

9. Raw material, Working Capital, Manpower

10. Project Cost, Financial Incentives

11. What re the various sources from which money will be raised to meet the project cost? How
much money will be raised from each source?

12. Capacity Utilization, Income Expenditure and Profitability Projection.

13. Cash flow Projection, Debt Service.

14. What is the break-even level of operation –level at which enterprise will make neither profit
nor loss?

15. What will happen to profitability if some critical assumptions do not come true?

16. What will be a realistic time schedule for carrying out individual tasks pertaining to project-
implementation (setting up of enterprise)?
17. What will be the total time frame for implementation?

18. What are the important statutory formalities, which the enterprise must fulfill prior to
commencement of production?

19. What are the major factors, which will determine the enterprise performance?

20. What are the requirements of information to establish implement commission and
run the project? Where are they available? How are you going to manage these inputs of
information?

Guidelines for micro/mini/small hydro electric power projects Component of the Project

The nature of projects can be reservoir, run of river or canal based. The projects can be divided in
two parts civil and Electrical. The civil projects include various activities such as construction of
Dam/Diversion weir, reservoir, and power channel. In-take tank, feeder channel, Fore bay
Spillways, Pen Stroke and Tail race channel etc. Electrical Components covers turbine, Alternate
controls, Transformation, Evaluation of Power etc.

Project Design

A small Hydro Power generating project design is based on availability of hydro potential and
sufficient head to utilize potential energy which is used to generate electricity.

Design criteria further requires survey and investigation for selection of Land /site on topographical
/geological and Hydrological grounds.

Details required for Mini/Micro/Small Power Generation projects.

1. Brief proposal indicating type of plant, availability of rate of flow of water and head i.e. Run
off river based or stored water type.

2. Availability of Land

3. Environmental and Rehabilitation Constraints, if any

4. Economics of Power generation

5. Peak Load existing and in Horizon Year

6. Connected Load
7. Demand Factor

8. Load Factor

9. Utilization Factor

10. Plant Factor

11. Whether proposed plant is of base load plant or stand by reserved plant

12. Proximity of load

13. Generation Voltage and Frequency

14. Transmission/distribution voltage and frequency

15. Specifications of equipments

16. Selection of Type and Turbine and alternator/with techno –commercial reasons

17. Tariff Calculations and Market (consumers)

18. Present Tariff Structure and expected increase in horizon year

The Broad Guidelines for Power Projects are provided by NABARD.

SUMMARY

Project Planning in general can best be described as the function of selecting the enterprise
objectives and establishing the policies, procedures and programs necessary for achieving them.
Characteristics of Project Planning are: project planning must be systematic, flexible, enough to
handle unique activities, disciplined through reviews and controls and capable of accepting
multifunctional inputs; task is required to be well understood prior to being performed, much of the
work can be preplanned; during the actual task execution more knowledge is learned that in turn
leads to changes in resources allocations schedules and priorities. PERT is the technique based on
the assumption that an activity‘s duration follows a probability distribution instead of being a single
value, the probabilistic information about the activities is translated into probabilistic information
about the project, and three time estimates are required to compute the parameters of an activity‘s
duration distribution: