UNIT II Cost determination and Balance sheet Cost-Definition An amount that has to be paid or given up in order to get something.

. In business, cost is usually a monetary valuation of (1) Effort, (2) Material, (3) Resources, (4) Time and utilities consumed, (5) Risks incurred, and (6) Opportunity forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred in acquisition of an incomegenerating asset) are expenses.

Types of costs:

Fixed costs:

Costs that don't change over a period of time and don't vary with output. E.g. salaries, rent, tax, insurance, heating and lighting. Fixed costs can also be called indirect costs as they are not directly associated with the final product. Fixed costs have to be paid even if the company is not producing any goods.

Variable costs:

Costs that vary directly with output so when output increases, variable costs also increase. E.g. raw materials, electricity. Variable costs can also be called direct costs as they are directly associated with production.

Semi-variable costs:

These costs have fixed and variable elements. E.g. a person working for the company may have a fixed salary but may also earn commission on sales. Total costs are calculated by adding together fixed, variable and semi-variable costs.

The other types of costs:

opportunity cost

accounting cost or historical costs transaction cost sunk cost marginal cost

Opportunity cost: The opportunities forgone in the choice of one expenditure over others. For a consumer with a fixed income, the opportunity cost of buying a new dishwasher might be the value of a vacation trip never taken. The concept of opportunity cost allows economists to examine the relative monetary values of various goods and services.

Accounting cost or historical costs: A measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company.

Transaction cost It is a cost incurred in making an economic exchange (the cost of participating in a market). For example, most people, when buying or selling a stock must pay a commission to their broker.

Sunk cost Costs already incurred in a project that cannot be changed by present or future actions. For example, if a company bought a piece of machinery five years ago, that amount of money has already been spent and cannot be recovered. It should also not affect the companys decision on whether or not to buy a new piece of machinery if the five-year old machinery has worn out.

Marginal cost It is a cost of producing an additional unit of that product. Let the cost of producing 20 units of a product be Rs.10,000 and the cost of producing 21 units of the same product to be Rs.10045. then the marginal cost of producing the 21st unit is Rs.45.

Balance Sheet

What Does Balance Sheet Mean? A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders. The balance sheet must follow the following formula: Assets = Liabilities + Owners / Shareholders' Equity

Format a balance sheet: Liabilities Assets

Capital: Share capital Preference capital Debentures Long term loan Reserves & Surplus

Fixed Assets: Plant & Machinery Land & Building Furniture Goodwill Current Assets: Cash in hand

Current Liabilities: Creditors Mortgage loan Bills Payable Outstanding expenses

Cash at bank Debtors Closing stock Bills receivables Prepaid expenses

Note: Capital: Permanent fixed requirement of a business Current Liability: The short term obligation which need to be honored within a year Fixed Assets: the permanent asset of the company, which cannot be dispersed easily Current Assets: The asset which can be converted into liquid cash within a year.

Time Value of Money The value of money receive today is greater than the value of the same amount receivable after 5 or 10 years. Reasons for Time preference for money: Uncertainity: Future is uncertain People like to receive money today itself rather than waiting for the future.

Preference for consumption: The money may be need to meet urgent current needs. People prefer to receive money as early as possible. Investment Opportunities: Receive the money today and immediately invest the same to other alternatives. We will get high return. Techniques of time value of money: Compounding value of a lump sum: Yearly calculations. Multiple Compounding Periods: Yearly, half-yearly or even monthly. Doubling Period: Investment doubling after some year. Example: Indra vikas Patra doubled in 5 years. Examples: Compounding value of a lump sum: Mr.Ram deposits Rs 10,000 for 3 years at 10% interest. What is the compound value of his deposit? FV = P(1+i)n

Where FV = Future Value P = Principal i = Rate of interest n = Number of Years FV = 10,000(1+10%)3 FV = 10,000 (1.331) FV = 13,310. Multiple Compounding Periods: Mano deposits Rs 20,000 for 2 years at 10%. Calculate the maturity value of the deposit (FV) if the interest is compounded half yearly. FV = p (1+i/m)m*n Where FV = Future Value P = Principal i = Rate of interest n = Number of Years m = Frequency of compounding in a year. FV = 20,000 (1 + 10%/2)2*2 FV = 20,000 (1 + 0.05)4 FV = 20,000 (1.2155) FV = Rs 24,310.

Doubling period: The doubling period can be found approximately by following the rule of thumb methods, popularly known as rule of 72 and rule of 69. Rule 72: Doubling period = 72 / Rate of interest If the rate of interest is 12%, doubling period is 72/12 =6 years. If the rate of interest is 18% , doubling period is 72/18 = 4 years. If the doubling period is 6 years , the rate of interest 72/6 = 12%. Rule 69: It gives a more accurate result. Doubling period = .35 +69/interest rate 10% Interest rate = .35 +69/10 = 7.25 years 12 % interest rate = .35 +69/12 = 6.10 years. Time Value of Money (TVM) can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. Example: TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1.

Key concepts of TVM: A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples. Interest

Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period of time.

Simple Compound

Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date. Compound interest is always assumed in TVM problems.

Number of Periods

Periods are evenly-spaced intervals of time. They are intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM applications, payments must represent all outflows (negative amount) or all inflows (positive amount).

Present Value

Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been discounted by an

Single Amount Annuity

appropriate interest rate. The future amount can be a single sum that will be received at the end of the last period, as a series of equally-spaced payments (an annuity), or both. Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it.

Future Value

Future Value is the amount of money that an investment with a fixed, compounded interest rate will grow to by some future date.

Single Amount Annuity

The investment can be a single sum deposited at the beginning of the first period, a series of equally-spaced payments (an annuity), or both. Since money has time value, we naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate.

Loan Amortization

A method for repaying a loan in equal installments. Part of each payment goes toward interest and any remainder is used to reduce the principal. As the balance of the loan is gradually reduced, a progressively larger portion of each payment goes toward reducing principal.

Cash Flow Diagram

A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflows along a time line. It can help you to

visualize a problem and to determine if it can be solved by TVM methods. Cost benefit Analysis It is a widely used technique for deciding whether to make any change or implement a project. A business firm may introduce a new product only if it finds i.e commercially viable Eg: When government propose a project such as linking rivers across the country , the decisions are not necessarily based on commercial viability and profit motive. They are evaluated based on CBA. CBA It is a technique for estimating and aggregating the equivalent monetary value of the benefits and costs to the community projects to decide whether they can be taken up or not. Eg: Highways, Dams. To assess the welfare or net social benefits that will accrue to the nation from these projects. It is considering on long term view of the sponsoring body. It is an economic accounting tool.

Principles: Common unit of measurement: It should compute all aspects of the project , both positive and negative, common unit is money. All the benefits and cost of a project should be measured in terms of their money value at a particular point of time. Money has time value.

Actual behavior of the procedures / consumers be the basis for valuation: The benefits and costs under CBA should be valued based on the preferences revealed by the choices of consumers/producers.

Eg: Higher/lower rent for a house in polluted area. Measure the benefits based on value of human life: Implementation of community projects require a thorough evaluation of the effect on human lifes. Alternative scenerios need to be worked out: What was the scenario when the project was not implemented? Does the implementation of the project create an impact in terms of increased benefits in relation to the costs. Eg: Compare government and private engineering colleges.

Choice of a specific study area: The impact of a project in terms of benefits and costs is dependant on the choice of the specific study area , whether it is a city/ town/state/nation as a whole. Avoid double counting of benefits/costs: The impact of the project may be measured at times in more than one method. Under such circumstances , confine to only one method and thus avoid double counting.

Decision criteria for projects: More than one mutually exclusive projects , they need to be ranked based on the net present value. Payback period also may be employed to arrive at decision.

DEPRECIATION It is the distribution in value of a fixed assets due to use and/or the passage of time. Depreciation is a gradual decrease in the value of an asset from any cause.

OBJECTIVES 1. 2. 3. Ascertainment of True profits. Presentation of True Financial Position. Replacement of assets.

METHODS OF DEPRECIATION 1. Straight line or equal installment method. It is the simplest and most commonly used depreciation method. Straight line depreciation is calculated by taking the cost or acquisition price of an asset subtracted by the scrap value divided by the total productive years the asset can be reasonably expected to benefit the company (called "useful life" in accounting jargon). Straight line depreciation is based on the assumption that the assets usefulness declines evenly over time. Cost of the asset - scrap value. Annual Depreciation = Estimated economic life

2.

The Diminishing Balance Method: or written down Diminishing balance method is also known as written down value method or reducing installment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation. It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

where :

n s c r

= = = =

the economic life in years the residual value the cost of asset rate of depreciation to be applied.

3.

Sinking Fund Method: The straight line method has equal annual depreciation for every year. There are other methods which has more depreciation allocated to the earlier years like Written-Down Value (WDV) method in which depreciation is charged at fixed rate (%) on the reducing balance (i.e. cost less depreciation) every year. The sinking fund method allocates more depreciation to the later years. The depreciation for the first year equals the annual deposit needed for a sinking fund to accumulate at the given rate to an amount that equals the depreciation base. For each consecutive year, the annual depreciation equals the annual sinking fund deposit plus the interest earned on the fund up to that year. Rate of depreciation
I (C S ) (1 I )( N 1)

4.

Insurance policy method This is similar to the sinking fund method but, instead & investing the money in securities, the amount is used is paying premium on a policy the out with an insurance company. The policy should make immediately after the expiry of the useful life of the asset.

5. Sum of the years digit method This is a method of providing depreciation on annual machine hours in use with total anticipated machine hours over the life of the asset. Here it is necessary to estimate the total effective marking hours during the whole life of the machine and to divide this into the net cont of the machine and this arriving at an homely rate of depreciation No of years life remaining Depreciation = ----------------------------------- x (cost sales) Some of the years Digits

E.g.: If the estimate life of an asset is 5 years, the sum of the years digit is 1+2+3+4+5 = 15. Taking n as estimated useful life. Sum of years Digit =
n(n 1) 5(5 1) 15 2 2

Problem If the cost of the machine is Rs.46,000 and scrap value after 5 years is Rs.1,000 the amount of depreciation to be charged in different years will be. I year = 5 /15 x (46000 - 1000) = 5/15 x 45000 = 15000 II years = 4/15 x (46000 - 1000) = 4/15 x 45000 = 12000 III years = 3/15 x (46000 - 1000) = 3/15 x 45000 = 9000 IV year = 2/15 x (46000 - 1000) = 2/15 x 45000 = 6000 6. The Annuity Method To consider the time value of money. Under this method, total amount of deprecations written off during the life of the asset equals the net cost of the asset plus interest calculated on the reducing balance.
(C (1 I ) n S )(1 (1 I )) R.O.D = (1 (1 I ) n )

Where, C = Cost of asset n = numbers of years of economic life. s = scrap value, I = Interest Rate

Ex: The cost of the machine is Rs.6000 and its scrap value after 4 years is Rs.3000. Assuring an interest rate of 4% per year, find depreciation rate per year. C = Rs.6000 S = Rs.3000 N = 4 years I = 4% = 0.04
C (1 I ) N S )(1 (1 I )) (1 (1 I ) n )

R.O.D =

(6000(1 0.04I )4 3000)(1 (1 0.04)) (1 (1 0.04) 4 )

= Rs.946

Under this method, depreciation is calculated by dividing the value of the asset by the estimated numbers of units to be produced delivery it's life time. Cost of the machine - scrap value R.O.D = per unit = Total effective working hours

50 ,000 10 ,000 Rs.2. 20 ,000

(ii) Machine - Hour Rate Method This is a method of providing depreciations an annual machine hours in the with total anticipated machine hours over the life of the asset.

Eg. Cost of machine Rs.50, 000 Scrap value Rs.10, 000 Expected working hours Rs.20, 000

Cost of the machine - scrap value Machine -hour rate = Total effective working hours

50 ,000 10 ,000 Rs.2. 20 ,000

8. Revaluation Method Here the assets are valued at their currency market values and the depreciations is calculated by finding out the difference between written -down value and the revaluations figure : usually the revaluations method concerned with the recovery of original. 9. Depletion Method This method is an according for natural resources rather than accounting for depreciation wasting assets such as mines, quarries etc., Eg : A coal mine can be considered as an underground inventory of coal. But such inventory cannot be considered as one of the current assets. Therefore, this method is applied to wasting assets such as minor, quarries etc., where the output for each year depends on the quantity extracted. Here, dept is calculated first by making an estimates in advance of the total quantity to be extracted over it's and then the cost of asset is apportionment over the periods of the assets in proportion to the rate of extractions.

Sources of Finance The need for finance may be for long-term, medium-term or for short-term. Financial requirements with regard to fixed and working capital vary from organization to other

organization. To meet out these requirements, funds need to be raised from various sources. Some sources like issue of shares and debentures provide money for a longer period. These are therefore known as long- term finance. On the other hand sources like cash credit, trade credit, overdraft, bank loan etc which make money available for shorter period of time are called short term sources of finance. Once if the costs are estimated, then they should find the gap between his own resources and the requirement of additional funds. Next step is to identify various sources from which he can raise funds.

Sources of finance

Internal Sources

External sources

Long t Long term

Short term

Long term finance: Finance required for a long period say 3 years and above. E.g.: purchase of fixed assets such as land and buildings, plant and machinery etc. Own Capital: Irrespective of sole trader, partnership, the owners of the business have to invest their own finance to start with. Money invested by the owners is permanent and will stay with the business , throughout the life. Share capital: Capital is raised by issue of shares. The capital so raised is called share capital. Liability of the shareholder is limited to the extent of his contribution to the share capital The shareholder is entitled to dividend if the company makes profit. Directors announce dividend formally in the general body meeting. Preference Share Capital: Capital rose through issue of preference shares. Preference share capital enjoys two rights over equity shareholders. Right to receive fixed rate of dividend. Right to return of capital

After settling the claims of outsiders, preference shareholders are the first to get their dividend and then the balance to the equity shareholders. They do not have any voting rights in the annual general meeting of the company.

Equity share capital: Capital rose through issue of equity share. It is also called ordinary share Equity shareholder is vice-versa to preference shareholder Entitled to voting rights as many as the number of shares he holds. Real risk bearers They are the first to suffer losses. At the same time, they are entitled for the whole surplus of the profits after payment of dividend to preference shareholders, Therefore, the rate of dividend on equity shares is not fixed. Retained Profits: They are the profits remaining after all the claims Retained profits form good source of working capital Particularly in times of growth and expansion, retained profits can be advantageously utilized. Long term loans: The promoters should be able to offer assets of the business as security to avail of this source. Debentures: They are the loans taken by the company A certificate/letter issued by the company under its common seal acknowledging the receipt of loan

 Entitled to a fixed rate of interest on the debenture amount. The company may raise loans through debentures It is an additional source of long term finance. Medium term finance: It refers to such sources of finance where the repayment is normally over one year and less than three years. E.g.: To buy motor vehicles, computer equipment/machinery whose life is less than three years. Hire purchase & leasing: These are financing schemes used by entrepreneurs to buy assets like land and machinery. In hire purchase, the contract provides for the transfer of ownership of an asset at the end of the stipulated period. Under leasing owner of the asset is lesser and the one who obtains the asset is lessee. In operating lease , the ownership rests with the lessor and the lessee only pays lease rent for usage In financial lease the ownership is transferred at the point of time greed between the parties Venture capital : Venture capital is a form of financing, especially designed for funding high technology, high risk and perceived high reward projects. E.g.: ICICI venture Fund, IFCI Venture Fund, and SIDBI Venture Fund etc.

Short term finance: Finance which is available for a period of less than one year. Commercial Paper: They are used to finance current transactions and seasonal and interim needs for funds. Eg: Reliance industries is one of the early companys which issue commercial paper. It is a new money market instrument introduced in India. Cash Credit: It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit Initially this limit is granted for one year This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years Rate of interest varies depending upon the amount of limit Banks ask for collateral security for the grant of cash credit the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit.

Bank Credit: Commercial banks grant short term finance to business firms which is known as bank credit

 When bank credit is granted , the borrower gets a right to draw the amount of credit at one time or in installments as and when needed It may be granted by way of loans, cash credit, overdraft and discounted bills. Bank Overdraft: When a bank allows its depositors or account holders to withdraw the money in excess of the balance in his account up to a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit worthiness of the borrower Banks generally gives the limit up to Rs 20,000 Interest is charged on a day to day basis on the actual amount overdrawn Rate of interest in case of overdraft is less than the rate charged under the cash credit To meet temporary shortage of funds. Trade credit: Credit granted to manufacturers and traders by the supply of raw materials, finished goods etc Usually business enterprises buy supplies on a 30-90 days credit This means that the goods are delivered but the payments are not made until the expiry of period of credit This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment This is a quite popular sources of finance E.g.: Traders buy materials from suppliers on credit basis.

Loans: When a certain amount is advanced by a bank repayable after a specified period , it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets Customers Advances: Sometimes businessmen insist on their customers to make some advance payment It is generally asked when the value of order is quite large or things ordered are very costly Customers advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods A firm can meet its short-term requirements with the help of customers advances. Installment credit: Installment credit is now-a-days a popular source of finance for goods like television, refrigerators as well as for industrial goods Only a small amount of money is paid at the time of delivery of such articles The balance is paid in a number of instilments. The supplier charges interest for extending credit.

 The amount of interest is included while deciding on the amount of installment Another comparable system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last installment. Sometimes commercial banks also grant installment credit if they have suitable arrangements with the suppliers.

Factoring and bill discounting The factor or the agent is one takes up the responsibilities of collection of debts. He charges commission for the service rendered. Three parties involved in this agreement : factor financial institution client-business concern customer

Financial Institutions Financial institutions comprise of six All India Development Banks (AIDBs), two Specialized Financial Institutions (SFIs), three investment institutions , eighteen State Finance Corporation and twenty eight State Industrial Development Corporations (SIDCs).

IFCI Expansion: Industrial Finance Corporation of India Ltd Establishment: It was set up in 1948 under the IFCI Act and was brought under the Companies Act, 1956. Purpose: It extends financial assistance to the industrial sector through rupee and foreign currency loans.

Raising of funds: Finance is raised through share capital, bonds, debentures and other borrowings. Shareholders of IFCI: IDBI, scheduled banks, insurance companies, investment trusts and cooperative banks. New promotional schemes: Schemes such as Interest fee subsidy scheme for women entrepreneurs Consultancy fee subsidy scheme for providing assistance to SSI Control of pollution in small and medium industries. Setting up management development institute for providing management training Promoting research for the development of industries.

IDBI Expansion: Industrial Development Bank of India Establishment: It was established in 1964 under an act of parliament as the principal financial institution in the country. Initially it was a wholly owned subsidiary of RBI. Purpose: It provides assistance to SSI through the scheme of refinance. Objects of IDBI: In 1976, IDBI was made as an autonomous institution with the following objects: Promoting rapid and balanced industrial growth in the country. Providing technical guidance and administrative assistance in promotion of industries. Undertaking marketing and investment research for development of industries.

Small industries development fund has set up in 1986, to facilitate the development of small scale industries. In 1988, it launched National equity fund scheme for providing support to tiny and small scale industries. The scheme is administered by the IDBI through nationalized banks.

Functions: The functions of IDBI were: Direct finance Indirect finance Special assistance & General assistance.

ICICI Expansion: Industrial Credit and Investment Corporation of India Ltd Establishment: In 1955 Primary objective: Developing small and medium industries in the private sector. Objectives: Assisting in the creation, expansion and modernization of private sector Encouraging and promoting private capital participation. Encouraging and promoting private industrial investment.

IIBI Expansion: Industrial Development Bank of India Ltd Formerly known as Industrial Reconstruction Bank of India (IRBI) Establishment: In 1971

Objectives: Mainly to look after the special problems of sick units and provide assistance for their speedy reconstruction and rehabilitation.

SFC Expansion: State Finance Corporation Establishment: 18 SFCs were established under State Finance Corporation Act, 1951. Objectives: Providing long term loans to small and medium scale industries. Promoting tiny sector, village and cottage industries. Providing infrastructure facility by promoting industrial estates. Providing seed capital. Consultancy.

SIDBI Expansion: Small Industries Development Bank of India Establishment: In 1989 Objectives: Schemes of refinance assistance Direct assistance scheme Project Financing Equity assistance.

LIC

Expansion: Life Insurance Corporation of India Establishment: In 1956, wholly owned by Government of India. Functions: It gives various insurance policies, assistance to corporate sector and financial institutions in the form of term loans, underwriting, direct subscription to shares and debentures.