TYBCOM -Financial Management-munotes

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CAPITAL BUDGETING
Unit Structure :
1.0 Objective
1.1 Introduction
1.2 Meaning
1.3 Evaluation Techniques
1.4 Pay Back Period Technique
1.5 Discounted Cash Flow Technique
1.6 Profitability Index / Benifit Cost Ratio
1.7 Internal Ra te of Return Method
1.8 Problems and solutions
1.0 OBJECTIVES
 To Introduce the topic.
 To Understand the meaning and importance of Capital Budgeting.
 To Explain the techniques of capital budgeting.
 To Explain the Merits and Demerits of the techniques.
 To Know the calculation procedure of the techniques.
 To Illustrate the Evaluating techniques namely NPV and Payback
Method.
1.1 INTRODUCTION
Budget is the term especially used in the Government department Budget
means to plan for future. Durin g the early years Budgetary Control has
become a very popular technique of cost control. Now a day it exists in
almost all the organization in various forms. Capital Budget is one of the
forms.
1.2 MEANING
The final Objective of each organization is to e arn more and more profit.
Thatswhy to plan and control the capital expenditure to achieve the profit
goal is the vital part of every business unit. The capital expenditures mean
the expenditures incurred on acquiring or for extension of the long-term munotes.in

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Financial Mangement
2 asset. Capital Asset or a Long -term asset may be a new building, a new
machinery or a new project. Capital Budget relates to the investment in
capital expenditures. Capital expenditure decisions include current outlays
but are beneficial over a period of time longer than one year. The term
capital budget is used interchangeable with Capital Expenditure Decision,
Long Term Investments Decision. Capital Budget means long term
investment decisions and management of fixed assets. Capital Budget is
the decisi on whet her or not the money should be invested in long term
project. Capital Budgeting involves the preparation of cost and revenue
estimates for all the possible projects, an examination of the merits and
demerits of each and every possibility and finally select ion of the project
giving the highest return on investment. The Capital Budget includes the
planning and utilization of available capital to increase the profitability of
the business organization.
The Capital expenditure decisions are of two types:
1. Inve stment Decisions which increases Revenues: It means here the
decision have been taken for adding New Capital Assets or New Plant
or Introducing New Product Line which increase the production and
finally brings additional revenue.
2. Investment Decisions whic h reduces Cost : Here the decisions have
been taken for Replacement of Old Asset or Old Plant with New One,
which reduces cost.
Importance of Capital Budgeting :
According to Joe Dean, “Today’s capital expenditure makes the bed that
comp any must lie in to morrow. The capital expenditure budget embraces a
company’s plans for replacing, improving and adding to its capital
equipment.” These words show that capital budgeting is a vital function of
management. Capital Budgeting is very impor tant for survival an d growth
of the organization as it is related to the decisions of long-term investment.
Following points explain the importance of capital budgeting: -
1) For Careful Investment Decisions : -
As the capital investment is a long term investment therefore if onc e the
decision has been taken it becomes very difficult to reverse from it. Even
any modification or alternations are also become impossible.
Capital budgeting helps in taking careful capital expenditure decisions.
2) To avoid ov er and under investment :-
Capital budgeting includes the decisions about Acquisition of assets and
an estimation of earnings during the life time of such assets. An incorrect
decision in this matter leads to over or under investment. Both the
situation s are risky from the pr ofitability point of view. Hence proper
planning of capital expenditure is essential. munotes.in

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Capital Budgeting
3 3) To avoid unessential blocking : -
Ensure the proper timin g of assets acquisition, is the main feature of
Capital budgeting. If the assets are not a cquired on proper time, it is the
unessential blocking of funds. It results into loss of revenue.
4) To arrange for the necessary finance in time : -
Capital budgeting means the Estimation of capital investment decisions.
Therefore it enables the organizati on to arrange for the necessary funds
in time for long term investment.
5) To look into the various aspects and alternatives : -
Deep study of various proposals and their various aspects is a vital stage
in the process of capital budgeting. It ensures that the investment wil l be
made in the most profitable proposal. It increases the productivity of the
concern and finally the overall economy of the country.
6) To investigate and evaluate the technological changes : -
For facing cut throat competition inve stigation of technologi cal changes is
needful. To investigate and evaluate the technological changes is the
important function of capital budgeting. Thorough investigation,
evaluation and application of advanced techniques decreases the cost of
production and increases the proba bility which enables the business ready
for facing the cut throat computation.
1.3 EVALUATION TECHNIQUES
The technique used in capital budgeting for the appraisal or reappraisal of
an investment proposal is termed as Evaluation Technique. While taking
long term investment decisions the comparison among the various
investment proposals is needful. After comparison and evaluation of all
the proposals one proposal should be selected for investment which gives
the best results.
Types of Evaluation Techniques






The main Techniques are discussed below : -
Traditional Techniques
Techniques Time Adjusted/Discounted
Cash Flow
1) Average Rate of Return 1) Net Present Value Method
2) Payback Period Method 2) Internal Rate of Return Method
3) Pr ofitabili ty Index munotes.in

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Financial Mangement
4 1.4 PAY BACK PERIOD TECHNIQUE
it is the tr aditional technique of Capital Budgeting. Here the period is
calculated within which the cost of the project will be completely
recovered. Such period is termed as Pay Back Period.
Advantages :
1) This method is easy to calculate
2) It is simple to understand
3) Here investment recover y period is calculated therefore business unit
can know about the period within which the funds will remain tied up.
4) The project having short pay - back period are accepted here this
method is more suitable to the industries where risk of obsolescence is
high.
Disadvantages :
1) This method completely ignores all cash inflows after the pay - back
period. This can be very misleading as it does not consider the total
benefits occurring from the project.
2) It ignores the time value of money. I n this method money recei ved
now and receivable in future are considered as of equal value.
3) This method does not take into consideration the entire life of the
project. As a result, project with large cash inflows in the latter part of
payback period and less cash inflows in the earlier years may be
rejected.
4) This method ignores residual value. in spite of the se limitations the
industries having high risk of obsolescence prefer this method. Like
wise where, quick return to recover the investment is the p rimary goal
this method i s preferred.
The terms used in this method :
 Cash outflows : It means the original cost of proposal or investment
 Cash inflows : It means the profits before depreciation but after tax.
Procedure :
1) If the cash inflows are un iform :
Pay Back Period = _Cash Outflow
Cash Inflow

For e.g. An investment of Rs. 32,000 in a machine is expected to yield Rs.
8,000 for a period of 10 years, here the munotes.in

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Capital Budgeting
5 Pay Back Period = 32000
8000
= 4 years
2) If the cash inflows are not uniform :
A) Prepare the column for cumulative cash inflows
B) Here the pay back period is the time when the cumulative cash inflows
become equal to the original cost of proposal.
For e.g.
When an i nvestment of Rs. 70,000 in a machine is expected to yield
earnings of Rs. 6,000, Rs. 12,000, Rs. 17,000, Rs. 20,000, Rs. 20,000 and
Rs. 25,000 in 6 years are estimated calculate the pay back period.
Solution :
YEAR Annual earnings
Rs. Cumulative
earnings
Rs.
1
2
3
4
5
6 6,000
12,000
17,000
20,000
20,000
25,000 6,000
18,000
35,000
55,000
75,000
1,00,000

Here , the Cash Out flow = Rs. 70,000
Pay Back Period lies between the 4th and the 5th year
Pay Back P eriod = 4 years + Part of the 5th year to cover the cost of the
Machine Rs. 70,000 which is calculated as below
Pay Back Period =
= 4 Years + (Cash Outflows – Cumulative earnings of the 4th year)
Annual earnings of 5th year
= 4 years + ___(70,000 -55,000)____
20,000
= 4 years and __ 15,000___
20,000
= 4years and ¾ months

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Financial Mangement
6 Pay Back Period = 4 Years and 9 months
Accept or re ject criterion : -
The project having lower pay back period will be accepted.
1.5 DISCOUNTED CASH FLOW TECHNIQUE
This t echnique takes into consi deration the time value of money while
evaluating the project. The meaning of Time Value of money is that the
sum received today is worth more than the same to be received tomorrow.
For e.g. if Rs.1,000/ - are invested at @ 15% Rs 1,150 will be received
after a year It means Rs.1,150/ - to be received in the next year has a
present value of Rs. 150/ - represents the ti me value of money.
The main features of this technique are :
1) This technique takes into consideration the time value of the money.
2) Here all th e benefits and costs occurring during the entire life of the
project are taken into account.
3) Here the cash in flow s are discounted at certain rate.
4) The Discounted Cash Flow Technique is sub divided as :
 Net Present Value method
 Internal Rate of Return Method
 Profitability Index 1.6 PROFITABILITY INDEX / BENEFIT COST RATI O
It represents a ration of the present value of future cost benefit at the
required rate of return to the initial cash outflow of the investme nt. It is
similar to the Net Present Value approach.
Merits:
1) This method is helpful in comparing the project hav ing different
amounts of investment therefore it is superior to Net Present Value
method.
2) It considers the time value of money.
3) It considers all cash inflows.
Demerits:
1) It is difficult to understand and to calculate.
2) In case of mutually exclusive nature investment the Present Va lue
Method is superior than of this method. munotes.in

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Capital Budgeting
7 Procedure :
1) Calculate Cash Out Flows and its present value.
2) Calculate the pr esent value of Cash Inflows.
3) Calculate the ratio of present value of cash in flows to the present
value of c ash outflows. This ratio is called as profitability index.
Sum of Present Value of Cash Inflows /Discounted Cash Inflows
Formula -
Present Value of Cash Outflows/ Discounted Cash Outflows

Accept / Reject :
The selection of project has based on ranking i.e. the project with the
highest Profitability Index is given the first rank followed by others.
1.7 INTE RNAL RATE OF RETURN METHOD
It is also a Discounted Cash Flow Technique. It is also known as Yield on
Invest ment Technique, Marginal Efficiency of Capital, Marginal
Productivity of capital, Time Adjusted Rate of Return. Here the
discounted rate of return is calculated by picking up the estimated rates.
This process is continued up to the time one can get the est imated rate
which equaliz e the cash inflows and out flows. This Discounted Rate is
known as Internal Rate of Return. It means the Internal Rate of Re turn is
the interest rate at which present values of cash inflows and cash out flows
are equal. The interna l rate of return is usual ly the rate of return that a
project earns. It is defined as, “ The Discounted Rate which equates the
aggregate present value of the net cash inflows with the aggregate present
value of cash out flows.” In other words , it is the r ate which gives the
proje ct Net Present Value ZERO.
Merits :
1) It considers the Time Value of money.
2) It takes into account the total cash inflows and out flows.
3) It does not use the required rate of return or the cost of capital.
Therefore , calculations for cost of capital are not necessary. It provides
a separate rate of return which indicates the profitability of the
proposal.
Demerits :
1. This method is diff icult to understand and to calculate.
2. It is based on future earnings as the estimates of future ear nings
cannot be made cor rectly.
3. It provides the multiple rates which can be confusing. munotes.in

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Financial Mangement
8 Accept / Reject criterion :
While taking the decision for accept or r eject of the project the Internal
Rate of Return is compared with the Required Rate of Return. If the
Internal Rate of Retu rn exceeds the required rate the project would be
accepted.
1.8 PROBLEMS AND SOLUTIONS
1.8.1 The initial outlay of the project is Rs. 50,000 and it generates cash
inflows of Rs. 25,000, Rs. 20,000, Rs. 15,000 and Rs. 10,000 in the fou r
years of its life span. Your are required to calculate the Net Present Value
of the project assuming 10% rate of discount. The present value of Re. 1 a t
10% discount rate is as follows:
Year: 1st 2nd 3rd 4th
Present Value: 0.909 0.826 0.751 0.683
You are required to calculate the Net Present Value of the project.
SOLUTIO N:
Year Cash Inflows Rs. Discounted Factor
At 10% Present Value Rs.

1
2
3
4
25,000
20,000
15,000
10,000
0.909
0.826
0.751
0.683

Less: Cash outflows

Net Present Value
22,725
16,520
11,265
_____ 6,830
57,340
_____ 50,000

7,340

1.8.2 Given below is the information regarding two machines A and B
each costing Rs. 1,00,000. In com paring the profitability of the
machines, a discount rate of 9% is to be used. Earnings after
taxation are expected to be as f ollows:
Cash Inflows
YEAR Machine A Machine B
1
2
3
4
5 30,000
40,000
50,000
30,000
20,000 10,000
30,000
40,000
60,000
40,000
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Capital Budgeting
9 Indicate which machine would be more profitable investment under the :
1) Pay Back Period Method
2) Net Present Value Method
3) Calculate the Pay Back Profitability
The Present Value of Rs. 1 at 9% discount rate is as follows :
YEAR: 1st 2nd 3rd 4th 5th
PRESENT VALUE: 0.92 0.84 0.77 0.71 0.65
SOLUTION:
Pay Back Period Method :
Year Machine A Machine B
Cash Inflows Rs. Cumulative
Cash Inflows
Rs. Cash
Inflows
Rs. Cumulative
Cash Inflows
Rs.
1
2
3
4
5 30,000
40,000
50,000
30,000
20,000 30,000
70,000
1,20,000
1,50,000
1,70,000 10,000
30,000
40,000
60,000
40,000 10,000
40,000
80,000
1,40,000
1,80,000

Pay Back Period of Machine A :
Cash Outflow/ cost of Machine A = Rs. 1,00,000
i.e. The Pay Back Period lies between 2nd and 3rd year
Pay Back Period = 2 Years and __ 1,00,000 – 70,000__
50,000

Pay Back Period = 2 Years and __ 30,000__
50,000

Pay Back Period of Machine A = 2 and 3/5 Years i.e. 2.6 Years.
Pay Back Peri od of Machine B
Cash Outflow / cost of Machine B = 1,00,000
i.e. The Pay Back Period of Machine B lies between 3rd and 4th year munotes.in

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Financial Mangement
10 Pay Back Period = 3 Years and ___ 1,00,00 0 -80,000___
60,000
= 3 Years and _ _20,000___
60,000

Pay Back Period of Machine B = 3 and 1/3 Years i.e. 3 Ye ars and 4
months
As the Pay Back Period of Machine A is less than of Machine B ther efore
the investment in Machine A is more profitable as per the Pay Back Period
Method.
Pay Back Profitability

Particulars Machine A Mahcine B
Total Cash Inflows 1,70,000 1,80,000 Less: Total Cash
Outflows / Cost of the
Machine
1,00,000
1,00,000 Pay Back Profitability 70,000 80,000
Net Present Value Method :
Profitability statement (at 9% Discount Factor)
YEAR Present
Value
Factor at
9%
Discount Machine A Machine B
Cash
inflow
Rs. Present
value Rs. Cash
inflow
Rs. Present
Value Rs.

1
2
3
4
5
0.92
0.84
0.77
0.71
0.65
30,000
40,000
50,000
30,000
20,000

Less
:Cash
outflow
Net
Present
Value
27,600
33,600
38,500
21,300
_____13,000
1,34,000

___1,00,000
34,000
10,000
30,000
40,000
60,000
40,000

Less:
Cash
outflow
Net
Present
Value
9,200
25,200
30,800
42,600
_____ 26,000
1,33,800

___1,00,000
33,800 munotes.in

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Capital Budgeting
11
As per the Net Present Value Method the investment in Machine A is
profitable as its Net Present Value is more than Machine B.
1.8.3 A limited company considering to purchase a new mac hine which
will carry out some operations performed by labour. X and Y are
alternative models. From the following information, you are required
to prepare a profitability statement and work out the Pay Back Period
in respect of each assets :
Particulars Machine X Machine Y
Estimated life of machine ( years )

Cost of machine
Cost of indirect materials
Estimated savings in scrap
Additional cost of maintenance
Estimated savings in direct wages :
Employees not required
Wages per employee 5
Rs
15,000
3,000
5,000
9,500

75
300 5
Rs.
25,000
4,000
7,500
13,500

100
300

Taxation is to be regarded as 50% of profit (ignore depreciatio n for
calculation of tax).
SOLUTION :
Calculation of annual Cash Inflows
Particulars Machine X Mach ine Y
Saving per annum :
Labour
Scrap
TOTAL SAVINGS
Less: Additional cost per
annum
Indirect Material
Maintenance
Profit before Tax and
Depreciation
Tax @ 50%
Depreciation

Net increase in Savings
ANNUAL CASH
INFLOWS =
Net increase in savings
+Dep reciation
300x75



3,000
9,500


15,000 /
5



4,500
3,000
22,500
______5,000 27,500


___12,500
15,000
7,500
3,000
_______
4,500
7,500
300x100



4,000
13,500


25,000 /5



5,000
5,000
30,000
7,500
37,500


____17,500
20,000
10,000
5,000
_________
5,000
10,000


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Financial Mangement
12 PAY BACK PERIOD = ____ Cost of Machine____
Annual Cash Inflows

Pay Back Period of Machine X = __ 15,000__
7,500
= 2 years
Pay Back Period of Machine Y = 25,000
10,000
= 25 yesrs



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13 2
WORKING CAPITAL
Unit Structure:
2.0 Objective
2.1 Introduction
2.2 Importance of Working Capital:
2.3 Components of Working Capital:
2.4 Operating Cycle
2.5 Classification of Working Capital
2.6 Factors Affeting Working Capital
2.7 Management of Working Capital
2.8 Strategies in Working Capital Management
2.9 Working Capital Policies
2.10 Working Capital Ratios
2.11 Working Capital Leverage
2.12 Estimation of Working Capital
2.13 Steps in Determination of Working Capital
2.0 OBJECTIVE
The basic objectives of working capital management are as follows:
 By optimizing the investment in current assets and by reducing the
level of current liabilities the company can reduce the locking up of
funds in working capital thereby, its fan improves the return on capital
employed in the business.
 The second important objective of working capital management is that
the company should always be a position to meet its current obligations
which should properly be supported by the current assets available with
the firm. But maintaining excess funds in working capital means
locking of funds without return.
 The firm should manage its current assets in such away that the
marginal return on investment in these assets is not less than the cost of
capital employed t o finance the current assets. munotes.in

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Financial Mangement
14  The firm should maintain proper balance between current assets and
current liabilities to enable the firm to meet its day to day financial
obligations.
2.1 INTODUCTION
Working capital can be defined as the difference between the current
assets and liabilities.
The difference received after deducting the current liabilities from the
current assets is known as the net working capital of the business.
Working Capital is the measure of a venture's liquidity. It also denotes the
operational efficiency of a venture. The better the working capital, the
better is the business’ short -term financial health.
2.2 IMPORTANCES OF WORKING CAPITAL
Working capital management is a significant in Financial Management
due to the fact that it pla ys a pivotal role in keeping the wheels of a
business enterprise running. Working Capital Management is concerned
with short term financial decisions. Shortage of funds for working capital
has caused many business to fail and in many cases, has retarded their
growth Lack of efficient and effective utilization of working capital leads
to earn low rate of return o capital employed or even compels to sustain
losses. The need for skilled working capital management has thus become
greater in recent years. A firm invests a part of its permanent capital in
fixed assets and keeps a part of it for working capital i.e. for meeting the
day to day requirements. We will hardly find a firm which does not
require any amount of working capital for its normal operations . The
requirement of working capital varies from firm to firm depending upon
the nature of business, production policy market conditions seasonality of
operations, conditions of supply et. Working capital to a company is like
the blood to human body. It is the most vital ingredient of a business.
Working capital management if carried out effectively, efficiently and
consistently will ensure the health of an organization. A company invests
its funds for log term purposes and for short -term operations. That portion
of a company’s capital, invested in a short term or current assets to carry
on its day to day operations smoothly is called the “ working capital”.
Working capital refers to a firm’s investment in short term assets viz. cash,
short term securi ties amounts receivables and inventories of raw materials
work in progress and finished goods. It refers to all aspects of current
assets and current liabilities. The management of working capital is no
less important than the management of long -term fi nancial investment.
Sufficient liquidity is necessary and must be achieved and maintained to
provide that funds to pay off obligation as they arise or mature. The
adequacy of ash and other current assets together with their efficient
handling virtually d etermine the survival of the company. The efficient
working capital management is necessary to maintain a balance of
liquidity and profitability If the funds are tied up in idle current assets
represent proper and in efficient working capital management wh ich
affects the firm’s liquidity as sell as profitability. munotes.in

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Working Capital
15 Working capital is defined as “the excess of current assets over current
liabilities”. All elements of working capital are quick moving in nature
and therefore require constant monitoring for pro per management. For
proper management of working capital, it is required that a proper
assessment of its requirement is made. Working capital is also known as
circulating capital, fluctuating capital and revolving capital. The
magnitude and composition keep on changing continuously in the course
of business. If the working capital level is not properly maintained and
managed then it may result in unnecessary blockage of scarce resources of
the company. Therefore, the Finance Managers should give utmost care in
management of working capital.
Working capital at the beginning **
Source of Funds:
- Funds generated from Operations issue of
Shares and debentures
- Raising of term loans
- Sale of fixed assets
- Sale of investments
- Non operating income etc.

**
**
**
**
**
Application of Funds:
- Loss from operations
- dividend paid
- taxes paid
- purchase of fixed assets
- repayment of term loans
- redemption of preference shares debentures etc.
- Increase /decrease in Working capital

**
**
**
**
**
**
**
Workin g capital at the end **
FLOW OF FUNDS AND WORKING CAPITAL CHANGES
2.3 COMPONENTS OF WORKING CAPITAL:
 Current Assets: Current assets are those asserts which are convertible
into cash within a period of one year and are those which re required to
meet the d ay to day operations of the business. The working capital
management, to be more precise is the management of current assts.
The current assets are cash or near cash resources. They are:
(a) Cash and Bank balances
(b) Temporary investments
(c) Short t erm advances
(d) Prepaid expenses
(e) Receivables
(f) Inventory of raw materials stores and spares munotes.in

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Financial Mangement
16 (g) Inventory of work -in-progress
(h) Inventory of finished goods
 Current Liabilities: Current liabilities are those claims of outsiders
which ar e expected to mature for payment within an accounting year
these include:
(a) Creditors for goods purchased
(b) Outstanding expenses
(c) Short term borrowings
(d) Advances received against sales
(e) Taxes and dividends payable
(f) Other liabilities maturi ng within a year
2.4 OPERATING CYCLE
CASH CYCLE


2.5 CLASSIFICATION OF WORKING CAPITAL
2.5.1 GROSS AND NET WORKING CAPITAL:
Generally the working capital has its significance in two perspectives.
These are gross working capital and net working capital are called Balance
sheet approach” of working capital. munotes.in

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Working Capital
17 2.5.1.1 Gross Working Capital:
The terms gross working capital refers to the firm’s investment in current
assets. According to this concept working capital refers to a firm’s
investment in cur rent assets. The amount or current liabilities is not
deducted from the total of current assets. The concept of gross working
capital is advocated for the following reasons
 Profits of the firm are earned by making investment of its funds in fixed
and curr ent assets. This suggests the part of the earning relate to
investment in current assets. Therefore, aggregate of current assets
should be taken to mean the working capital.
 The management is more concerned with the total current assets as they
constitute the total funds available for operating purposes than with the
sources from which the founds come.
 An increase in the overall investment in the enterprise also brings in
increase in the working capital.
2.5.1.2 Net Working Capital:
The term net working c apital refers to the excess of current assets over
current liabilities. It refers to the difference between current assets and
current liabilities. The net working capital is a qualitative concept which
indicates the liquidity position of a firm and the extent to which working
capital needs may be financed by permanent source of funds. The concept
looks into the angle of judicious mix of long term and short -term funds for
financing current assets. A portion of et working Capital should be
financed with permanent sources of funds. the gross and net working
Capital are ascertained as shown below “
Current assets
Raw material stock xxx Work in process stock xxx Finished goods stock xxx Sundry debtors xxx Bills receivable xxx Short term investments xxx Cash and bank balances xxx Gross Working capital
(Total Current Assets) xxx Less: Current liabilities Credit ors for materials xxx munotes.in

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Financial Mangement
18
Creditors for expenses xxx Bills payable xxx Tax liability xxx Short term loans xxx Net working capital xxx
2.5.2 PERMANENT AND VARIABLE WORKING CAPITAL
Considering time as the basis of classification, there are two types of
working capital viz. Permanent and temporary”
The management of working capital is concerned with maximum the
return to share holders within the accepted risk constraints carried by the
participants in the company. Just as excessive long -term debt puts a
company at risk, so an inordinate quantity of short -term debt also
increases the risk to a company by straining its solvency. The suppliers of
permanent working capital look for long term return on funds invested
whereas the suppliers of temporary workin g capital will look for
immediate return and the cost of such financing will also be costlier than
the cost of permanent funds used for working capital.
2.5.2.1 Permanent Working Capital:
The magnitude of investment in working capital may increase or decre ase
over a period of time according to the level of production. But, there is a
need for minimum level of working capital to carry its business
irrespective of change in level of production. Such minimum level of
working capital is called permanent worki ng capital or fixed working
capital. It is the irreducible minimum amount necessary for maintaining
the circulation of current assets. The minimum level of investment in
current assets is permanently locked up in business and it is also referred
to as re gular working capital. It represents the assets required on
continuing basis over the entire year. The permanent component current
assets which are required throughout the year will, generally, be financed
from long term debt and equity. Tandon committe e has referred to this
type of working capital as core curre3nt assets, Core current assets are
those required by the firm to e4nsure the continuity of operations which
represents the minimum level of various items or current assets viz. Stock
of raw mater ials stock of work in process stock of finished goods debtors’
balances ash and bank etc. This minimum level of current assets will be
financed by the long -term sources and any fluctuations over the minimum
level of curr3ent assets will be financed by the short -term financing.

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Working Capital
19 2.5.2.2 Variable Working Capital:
It is also known as “fluctuating working capital”. It depends upon the
changes in production and sales, over and above the permanent working
capital. It is the extra working capital needed to sup port the changing
business activities. It represents additional assets required at different
items during the operation of the year. A firm will finance its seasonal
and current fluctuations in business operations through short term debt
financing. For example, in peak seasons, more raw materials to be
purchased more manufacturing expenses to be incurred, more funds will
be locked in debtors balances etc. In such times excess requirement of
working capital would be financed from short term financing sou rces
2.5.3 POSITIVE AND NEGATIVE WORKING CAPITAL:
The net working capital of a firm may be positive or negative “
 The positive net working capital represents the excess of current assets
over current liabilities.
 Sometimes the net working capital turn to be negative when current
liabilities are exceeding the current assets. The negative working
capital position will adversely affect the operations of the firm and its
profitability. The chronic negative working capital situation will lead
to closure of bu siness and the enterprise is said to be technically
insolvent.
Disadvantages of Negative Working Capital: The disadvantages
suffered by a company with negative working capital are as follows:
 The company is unable to take advantage of new opportunities or adopt
to changes
 Fixed assets cannot be used effectively in situation of working capital
shortage
 The operating pans cannot be achieved and will reduce the profitability
of the firm.
 It will stagnate the growth of the firm.
 Employee morale will be lowered due to financial difficulties
 The operating inefficiencies will creep into daily activities
 Trade discounts are lost. A company with ample working capital is able
to finance large stocks and can, therefore, place large orders.
 Cash discounts are lost. Some companies will try to persuade their
debtors to pay early by offering them a cash discount, off the price
owed.
 The advantage of being able to offer a credit line to customers are
foregone.
 Financial reputation is lost result in non cooperation from trade
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Financial Mangement
20  There may be concerned action by creditors and will apply to court for
winding up.
 It would be difficult to get adequate working capital finance from
banks, financial institutions.
2.6 FACTORS AFFETING WORKING CAPITAL
Factors Determining Working Capital Requirement:
There is no set of universally applicable rules to ascertain working capital
needs of a business organisation. The factors which influence the need
level are discussed below:
1. Nature of Business:
If we look at the balance sheet of any trading organisation, find major part
of the resources are deployed on current assets, particularly stock -in-
trade.
Whereas in case of a transport organization major part of funds would be
locked up in fixed asserts like moto r vehicles spares and work shed etc.
and the working capital component would be negligible.
The service organizations will require lesser working capital than trading
and financial organizations. Therefore, the requirement of working capital
depends upo n the nature of business carried by the organization.
Manufacturing Time span required for conversion of raw materials
cycle to finished goods is a block period. The period in reality, extends a
little before and after the WIP. This cycle determines the Need of working
Capital. In case of industries with long manufacturing processor
production cycle, more funds are required for working capital. The
industries involved in quick conversion of raw materials into finished units
or having lesser production cy cle requires lesser amount of working
capital.
In case of labour intensive Industries more working Process capital is
needed, but in case of capital -intensive Industries the production process is
faster and it requires lesser amount of working capital due to lesser
conversion costs.
2. Business Cycle:
This is another factor which determines the need level. Barring
exceptional cases, there are variations in the demand for goods/services
handled by any organization. Economic boom or recession etc. have their
influence on the transactions and consequently on the quantum of working
capital required. More working capital is needed during peak or boom
conditions. But in case of economic recession or low inflationary
conditions, the company requires low or moderate working capital.
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Working Capital
21 3. Seasonal Variations:
Variation apart seasonality factor creates production and even storage
problem. Mustard and many other oil seeds are Rabbi Crops. These are to
be purchased in a season to ensure continuous operation of oil plant.
Further there are woolen garments which have demand during winter only.
But manufacturing operation has to be conducted during the whole year
resulting in working capital blockage during off season.
4. Scale of Operations:
Operational level determines workin g capital demand during a given
period. Higher the sale, higher will be the need for working capital.
However, pace of sales turnover (quick or slow) is another factor. Quick
turnover calls for lesser investment in inventory, while low turn over rate
necessitates larger investment.
5. Inventory Policy:
The traditional production systems generate more stocks of finished goods
and high levels of raw materials and WIP stocks are maintained and the
stock holding period is also more. In such cases more working capital is
needed. The adoption of JIT supply chain management, vendor
management will drastically reduce the levels of raw materials, WIP and
finished goods stocks and therefore less amount of funds are invested in
inventory.
6. Credit Policy:
Credit policy of the business organization includes to whom, when and to
what extent credit may be allowed. Amount of money locked up in
account receivables has its impact on working capital. The liberal credit
period and follow up proceedings will increase the inves tment in debtors
balances and simultaneously increased the working capital requirement
than concerns resorting to strict credit and collection procedures
7. Accessibility to Credit
Credit worthiness is the precondition for assured accessibility to credit.
Accessibility in banks depends on the flow of credit i.e. the level of
working capital.
8. Business Standing:
In case of newly established concerns the materials are required to be
purchased in cash and the sales are to be made on credit basis. Such new
concer ns require high levels of working capital. But the established
companies can negotiate for credit terms with suppliers and sell the
products at lesser credit period to customers. Therefore, it requires less
working capital than concerns with lesser busin ess standing.

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Financial Mangement
22 9. Growth of Business:
Growth and diversification of business call for larger amount of working
capital. The need for increased working capital does not follow the
growth of business operations but precedes it. Working capital need is in
fact assessed in advance in reference to the business plan.
10. Market Conditions:
In a buyers market i.e. the market with fierce competition, the companies
are forced to sell on credit with liberal credit and collection policies. This
increases the level of inv estment on working capital due to increased
debtors balances and its administration costs. But if the sellers market
prevails the quick disposal of stocks, high percentage of cash sales, strict
credit and collection policies etc. reduces the need for work ing capital.
11. Supply situations:
In easy and stable supply situation no contingency plan is necessary and
precautionary steps in inventory investment can be avoided. But in case
of supply uncertainties, lead time, may be longer necessitating larger basic
inventory, higher carrying cost and working capital need for the purpose.
Aggressive approach cannot be adopted in such situation.
12. Environment Factors:
Political stability brings in stability in money market and trading world
Things mostly go smooth. Ri sk ventures are possible with enhanced need
for working capital finance. Similarly, availability of local infrastructural
facilities like road, transport, storage and market etc. influence business
and working capital need as well.
2.7 MANAGEMENT OF WORK ING CAPITAL
Symptoms of Poor Working Capital Management:
The following cases are seen in inefficient management of working
capital.
 Excessive carriage of inventory ogerth4e normal levels
required for the business will result in more balance i n trade creditors
accounts. More creditors balances will cause strain on the management
in management of cash.
 Working capital problems will arise when there is a slow down in the
collection of debtors.
 Sometimes capital goods will be purchased from the f unds available for
working capital. This will result in shortage of working capital and its
impact is on operations of the company.
 Unplanned production schedules will cause excessive stocks of finished
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Working Capital
23  More funds kept in the form of cash will not generate any profit for the
business.
 Inefficiency in using pot3ntial trade credit require more funds for
financing working capital.
 Overtrading will cause shortage of working capital and its ultimate
effects on th e operations of the company.
 Dependence on short term sources for financing permanent working
capital cause lesser profitability and will increase strain on the
management in managing working capital.
 Inefficiency in cash management cause embezzlement of c ash.
 Inability to get working capital limits will cause serious concern to the
company and sometimes may turnout to be sick.
2.8 STRATEGIES IN WORKING CAPITAL
MANAGEMENT
So far, the banks were the sole source of funds for working capital needs
of busines s sector. At present more finance options are available to a
finance Manager to see the operations of his firm go smoothly.
Depending on the risk exposure of business, the following strategies re
evolved to manage the working capital.
2.8.1 Conservative Appro ach:
A conservative strategy suggests not to take any risk in working capital
management and to carry high levels of current assets in relation to sales.
Surplus current assets enable the firm to absorb sudden variations in sales,
production plans and pro curement time without disrupting production
plans. It requires to maintain a high level of working capital and it should
be financed by long term funds like share capital or long term debt.
Availability of sufficient working capital will enable the smoot h
operational activities of the firm and there would be no stoppages of
production for want of raw materials, consumables. Sufficient quantity of
finished goods are maintained to met the market fluctuations. The higher
liquidity levels reduce the risk of insolvency. But lower risk translates
into lower return. Large investments in current assets lead to higher
interest and carrying costs and encouragement for inefficiency. But lower
risk translates into lower return. Large investments in current asse ts lead
to higher interest and carrying costs and encouragement for inefficiency.
But conservative oily will enable the firm to absurd day to day business
risks. It assures continuous flow of operations and eliminates worry about
recurring obligations. Under this strategy long term financing covers
more than the total requirement for working capital. The excess cash is
invested in short term marketable securities and in need, these securities
are sold off in the market in meet the urgent requirements of working
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24 Financing Strategy
Long term funds = Fixed assets + Total permanent current
assets + Part of temporary current assets.
Short -term funds = Part of temporary current assets.

2.8.2 Aggres sive Approach:
Under this approach current assets are maintained just to meet the current
liabilities without keeping any cushion for the variations in working
capital needs. The core working capital is financed by long term sources
of capital and seasona l variations are met through short term borrowings.
Adoption of this strategy will minimize the investment in net working
capital and ultimately it lowers the cost of fining working capital. The
maintenance drawbacks of this strategy are that if necessit ates frequent
financing and also increases risk as the firm is vulnerable to sudden
shocks. A conservative current asset financing strategy would go for more
long-term finance which reduces the risk of uncertainty associated with
frequent refinancing. The price of this strategy is higher financing costs
since long term rates will normally exceed short term rates. But when
aggressive strategy is adopted, sometimes the firm runs into mismatches
and defaults. It is the cardinal principle of corporate financ e that long
terms assets should be financed by long term sources and short -term assets
by a mix of long - and short -term sources.
Financing Strategy
Long term funds = Fixed assets + Part of permanent current assets
Short term funds = Part of permanen t current assets + Total
temporary current assets.
2.8.3 Matching Approach:
Under matching approach to financing working capital requirements of a
firm, each asset in the balance sheet assets side would be offer with a
financing instrument of the same approxi mate maturity. The basic
objective of this method of financing is that the permanent component of
current assets, and fixed assets would be met with long term funds and the
short term or seasonal variations in current assets would be financed with
short t erm debt. If the long term funds are used for short term needs of the
firm, it can identify and take steps to correct the mismatch in financing.
Efficient working capital management techniques are thus that impress the
operating cycle. The length of the operating cycles is equal to the sum or
the lengths of the inventory period and the receivables period. Just in time
inventory management technique reduce carrying costs by slashing the
time that goods are parked as inventories. To shorten the receivabl es
period without necessarily reducing the credit period, corporate can offer
trade discounts for prompt payment. This strategy is also called as
“hedging approach”.
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Working Capital
25 Financing Strategy:
Long term funds = Fixed assets + Total permanent current
assets
Short term funds = Total temporary current assets
2.8.4 Zero Working Capital Approach:
This is one of the latest trends in working capital management. The idea
is to have zero working capital i.e. at all tim es the current assets shall
equal the current liabilities. Excess investment in current assets is avoided
and firm meets its current liabilities out of the matching current assets. As
current ratio is1 and the quick ratio below l. there may be apprehensi ons
about the liquidity, but if all current assets are performing and are
accounted at their realisable values, these fears are misplaced. The firm
saves opportunity cost on excess investments in current assets and as bank
cash credit limits are linked to the inventory levels interest costs are also
saved. There would be a self imposed financial discipline on the firm to
manage their activities within their current liabilities are current assets ad
there may not be a tendency to over borrow or divert fund s. Zero working
capital also ensure a smooth and uninterrupted working capital cycle and it
would pressure the finance Managers to improve the quality of the current
asses at all times, to keep them 100% realizable. There would also be a
constant displac ement in the current liabilities and the possibility of
having over dues may diminish. The tendency to postpone current
liability payments has to be curbed and working capital always maintained
at zero. Zero working capital would call for a fine balancin g act in
Financial Management and the success in the Endeavour would get
reflected in healthier bottom lines.
Financing Strategy:
Total Current Assets = Total current Liabilities
Or
Total current Asset s – Total Current Liabilities = Zero

2.9 WORKING CAPITAL POLICIES:
The degree of current assets that a company employs for achieving a
desired level of sales is manifested in working capital policy. In practice,
the business concerns follow three forms of working Capital policies
which are discussed in brief as follows:
1. Restricted Policy:
It involves the rigid estimation of working capital to the requirements of
the concern and then forcing it to adhere to the estimate. Deviations from
the estimate are not allowed and the estimate will not provide for any
contingencies or for any unexpected events.
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Financial Mangement
26 2. Relaxed Policy:
It involves the allowing of sufficient cushion for fluctuations in funds
requirement for financing various items of working capital. The e stimate
is made after taking into account the provision for contingencies and
unexpected events.
3. Moderate Policy:
The working capital level estimated in between the two extremes i.e.
restricted and relaxed policies. The relationship of sales and correspond ing
levels of investment current assets is show in Figure below:
Current Assets
C1 Related policy
C1 Moderate Policy
C Restricted policy
______________
Sales (Rs.)
Figure: Level of Current Assets Indifferent Policies
When the company adopts restrict ed policy for a sales level of ‘S’ It
maintains the current assets level of ‘C’ Under this policy the company
maintains lower investments incurrent assets, represents aggressive
approach, intend to yield high return and accepting higher risk. The
managem ent is ready to counter any financial difficulties arising out of
restricted policy. Under relaxed policy, the company maintains current
assets up to the level of ‘C’ , for the same level of sales (S) as in restricted
policy.
This policy represents conser vative approach. It allows the company to
have sufficient cushion for uncertainties contingencies seasonal
fluctuations, changes in activity, levels changes in sales etc. The level of
investment in current assets is high which results in lesser return, bu t the
risk level is also reduced. In moderate policy, the investment in currents
lies in between C and C2 With this policy, the expected profitability and
risk levels fall between relaxed policy and restricted policy. The higher
the level of investment in current assets represents the liberal working
capital policy in which the risk level is less and also the marginal return is
also lesser. In restricted policy the level of investment in current assets
lesser and high risk is perceived for increase of marginal return on
investment. The determination of level of investment in currents is
dependent on risk return perception of the management.
Illustration 2.1
The financing pattern, current ratio, profitability net working capital
position is explained und er conservative moderate and aggressive working
capital policies are explained by way of hypothetical figures as follows :

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Working Capital
27 Particulars Working Capital Policy
Conservative Moderate Aggressive
Fixed assets 40 40 40 Current assets 40 35 30 ----- ----- ----- Total assets 80 75 70 ---- ----- ---- Share Capital 40 35 30 Debentures (@ 12%) 30 25 20 Current liabilities (short -term
Loan @ 8%) 10 15 20 ---- ---- ---- 80 75 70 ----- ---- ----- Current assets 40 35 30 Less: Current liabi lities 10 15 20 ----- ---- ---- Net working capital 30 20 10 ---- --- ---- Current assets financed by: Short term sources 10 15 20 Long term sources 30 20 10 ---- --- ---- 40 35 30
Current ratio (current assets/
current/liabilities) (times ) 4.0
2.33

1.5 Sales 180 180 180 ----- ---- ---- EBIT (15% on sales) 27.00 27.00 27.00 Less : Interest Interest on Debentures (@ 12%) 3.60
3.00
2.40 Interest on short term Loans (@ 8%) 0.80 1.20 1.60 ----- ----- ----- 22.60 22.80 23.00 Less : Tax @ 40% 9.04 9.12 9.20 ----- ----- ---- EAT 13.56 13.68 13.80 ----- ---- ----- Return on investment
(Eat/Total assets) x 100 16.95 % 18.24% 19.71%
Analysis – We can observe from the above analysis that current ratio i s 4
times if conservative policy is followed, it has dropped to 1.5 in
management of working capital under aggressive policy. However, the
return on investment has increased from 16.95% to 19.71%, if aggressive
approach is adopted Higher risk is attached with the higher return, under munotes.in

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Financial Mangement
28 aggressive policy. In conservative approach majority of current assets are
financed from long term sources of finance. When it comes to financing
current asserts under aggressive approach, majority of current assets are
financed from short term sources. The moderate policy stands in between
two extremes of conservative and aggressive financing approaches.
Majority of the corporates follow the moderate policy of working capital
financing which enables to avoid higher risk and to earn moderate profit
margin on additional investments in current assets.
Illustration – 2.2
The Balaji Company is attempting to establish a current assets policy.
Fixed assets are Rs. 6 lakhs and the firm plan to maintain a 50% debt -to-
assets ratio . The interest rate is 10% on all debts. Three alternative
current assets policies are under consideration. - 40%, 50% and 60% of
projected sales. The company expects to earn 15% before interest and
taxes on sales or Rs.30 lakhs. Calgary’s effective ta x rate is 40%. What is
the expected return on equity under each alternative? (C.S. Final Dec.
1908).
Balance sheets Under Different Current Assets Policies
Particulars Restricted
Policy
(40%of sales) Moderate Policy
(50% of sales) Relaxed Policy
(60% of sales)
Current assets 12,00,000 15,00,000 18,00,000 Fixed assets 6,00,000 6,00,000 6,00,000 ________ ________ ________ Total Assets 18,00,000 21,00,000 24,00,000 ________ ________ ________ 10% Debt (50%
of total Assets) 9,00,000 10,50,00 0 12,00,000 Equity 9,00,000 10,50,000 12,00,000 ________ ________ _________ Total Claims 18,00,000 21,00,000 24,00,000





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Working Capital
29 Income Statement Under Different Current Assets Policies
Particulars
Policy Restricted
Policy
(aggressive) Moderate
Policy
Relaxed Policy

(conservative)
Sales 30,00,000 30,00,000 30,00,000 ________ ________ ________ EBIT (15% OF
SALES) 4,50,000 4,50,000 4,50,000 Interest (10%) 90,000 1,05,000 1,20,000 ________ ________ _________ EBT 3,60,000 3,45,000 3,30,000 Taxes (4 0%) 1,44,000 1,38,000 1,32,000 ------------ ------------- ------------- Net Income 2,16,000 2,07,000 1,98,000 _______ ________ ________ Return on
Equity (ROE) 24% 19.71% 16.50% 2,16,000 * 100 9,00,000 2,07,000 * 100 10,50,000 1,98,000 * 100 12,00,000

2.10 WORKING CAPITAL RATIOS
Working capital ratios indicate the ability of a business concern in meeting
its current obligations as well as its efficiency in managing the current
assets for generation of sales. These ratios are applied to evaluate the
efficiency with which the firm managers and utilises its current assets.
The following three categories of ratios are used for efficient management
of working capital
(1) Efficiency ratios
(2) Liquidity ratios
(3) Structural health rati os.

2.10.1 EFFICIENCY RATIOS:
2.10.1.1 Working Capital to Sales Ratio:
This ratio is computed by dividing sales by working capital. this ratio
helps to measure the efficiency of the utilization of net working capital. It
signifies that for an amount o f sales, a relative amount of working Capital
is needed. If any increase in sales is contemplated working capital should
be adequate and thus the ratio helps management to maintain the adequate
level of working Capital. This ratio measures the efficiency with which
the working capital is being used by a firm. A high ratio indicates munotes.in

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Financial Mangement
30 efficient utilization of working capital. But a very high ratio is not a good
indication for any firm, which may be due to overtrading.
Sales
= ----------------- ----------
Working Capital

2.10.1.2 Inventory Turnover Ratio :
The ratio establishes relationship between the sales with average stock. It
measures the velocity of converting stock into sales. This ratio indicates
the ef fectiveness and efficiency of the inventory management. The ratio
shows how speedily the inventory is turned into accounts receivable
through sales. The higher the ratio, the more efficiency the inventory is
said to be managed and vice versa. A high rat io indicates efficient
management of inventory because more frequently the stocks are sold, the
lesser amount of money is requi5edto finance the inventory. A low ratio
indicates an inefficient management of inventory over investment in
inventory. Sluggish business poor quality of goods and lower profit as
compared to total investment.
Sales
= ----------------------------
Inventory

2.10.1.3 Current Assets Turnover Ratio :
This ratio indicates the efficiency with which current assets turn into
sales. A higher ratio implies by and large a more efficient use of funs.
Thus, a high turn over rate indicates reduced lock up of funds in current
assets. An analysis of this ratio over a period of time reflects working
capital management of a firm.
Sales
= -------------------
Current Assets

2.10.2 LIQUIDITY RATIOS:
2.10.2.1 Current Ratio
The current ratio is calculated by dividing current assets to current
liabilities. The current ratio is a measure of firm’s short term solvency. It
indicates the availability of current asserts in rupees for every one rupee of
current liability. This ratio indicates the extent of the soundness of the
current finan cial position of an undertaking and the degree of safety
provided to the creditors. The higher the current ratio, the larger amount
of rupee available per rupee of current liability, the more the firm’s ability
to meet current obligations and the greater safety of funds of short term
creditors current assets are those assets which an be converted into cash
within a year. Current liabilities and provisions are those liabilities that munotes.in

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Working Capital
31 are payable within a year. A current ratio of 2:1 indicates a highly sol vent
position. A current ratio of 1.33: 1 is considered by banks as minimum
acceptable level for providing working capital finance. The constituents
of the current assets are as important as the current assets themselves for
evaluation of company’s solve ncy position.
Current Assets, Loans & Advances
= -----------------------------------------------
Current Liabilities & Provisions

2.10.2.2 Quick Ratio/Liquid ratio/ Acid test ratio:
Quick ratio expresses the relationship between quick (current) assets and
quick (current) liabilities. While calculating of quick ratio, inventories are
excluded from current assets, sine inventories cannot be converted in to
cash in short time without loss of value. This ratio is a more refined tool
to measure the liquidity of an organization. It is a better test of financial
strength than the current ratio because it excludes very slow moving
inventories and the items of current assets which cannot b e converted into
cash easily. This ratio shows the extent of cushion of protection provided
from the quick assets to the current creditors. A quick ratio of 1:1 is
usually considered satisfactory though it is again a rule of thumb only.
Current Assets , Loans and Advances – Inventories
= -------------------------------------------------------------------
Current Liabilities & Provisions – Bank Overdraft

2.10.2.3 Absolute Liquid Ratio:
Even though debtors and bills receivable are considered as more liquid
than inventories, it cannot be converted into cash immediately or in time.
Therefore, while calculation of absolute liquid ratio, only the absolute
liquid assets like cash in hand, cash at bank, short term marketable
securities are taken into cons ideration, to measure the ability of company
in meeting short term financial obligations. An ideal ratio is 0.5:1:
Absolute Liquid Assets
= ------------------------------
Current Liabilities

2.10.3 STRUCTURAL HEALTH RATIOS:
2.10.3.1 Curre nt Assets to Total Net Assets:
This ratio explains the relationship between current assets and total
investment in assets. A business enterprise should use its current assets
effectively and economically because it is out of the management of these
assets that profits accrue. A business will end up in losses if there is any
lacuna in managing the asserts to the advantage of business.
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32 Total Net Assets
= ----------------------
Current Assets
Composition of Current Assets:
An analy sis of current assets component enables one to examine in which
component the working capital funds are locked up. A large tie up of
funds in inventories effects profitability of the business adversely owing to
carry over costs. In addition, losses are l ikely to occur by way of
depreciation, decay, obsolescence, evaporation and so on. Receivables,
constituting another component of current assets. If the major portion of
current asserts are made up of cash alone, the profitability will be
decreased becau se cash is a non earning asset. If the portion of cash
balance is excessive, then it can be said that management is not efficient to
employ the surplus cash.
2.10.3.2 Debtors Turnover Ratio:
This ratio shows the extent of trade credit granted and the e fficiency in the
collection of debts. Thus, it is an indicative of efficiency of the credit
management. The lower the debtors to sales ratio, the better the trade
credit management and better the quality (liquidity) of debts. The lower
debtors mean promp t payment by customers. An excessively long
collection period, on the other hand, indicates a very liberal, ineffective
and inefficient credit and collection policy.
Credit Sales
= ----------------
Debtors

2.10.3.3 Debt ors Collection Period (In days)
This ratio measures how long it takes to collect amounts from debtors.
The ratio represents the average number of days, for which a firm has to
wait before their receivables are converted into cash. It measures the
quality of debtors. The shorter average collection period is considered the
high-quality debtors. A higher collection period implies inefficiency in
collection of debtors, which in turn adversely affects the liquidity or short -
term paying capacity of the fir m. The longer the average collection period
higher the chances for turning into bad debts. The actual collection period
can be compared with the stated credit terms of the company. If it is loner
than those terms, then this indicates some insufficiency in the procedures
for collecting debts.
Debtors
= --------------- x 365
Credit Sales

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Working Capital
33 2.10.3.4 Bad Debts to Sales
This ratio indicates the efficiency of the control procedures of the
company. The actual ratio is compared with the target or norm to decide
whether or not it is acceptable.
Bad Debts
= --------------
Sales

2.10.3.5 Creditors Payment Period (In days)
The measurement of the credit or payment period shows the average time
taken to pay for goods and services purchased by the company. In
generally the longer of the credit period achieved the better because delays
in payment mean that the operations of the company are being financed
interest free by suppliers’ funds. But there will be a point beyond which,
if they are operating in a seller’s market, may harm the company. If too
long a period is taken to pay creditors, the credit rating of the company
may suffer, thereby making it more difficult to obtain suppliers credit in
the future.
Creditors
= ---------------- ------ x 365
Credit Purchasers

Illustration 2.3
Bajaj Ltd. manufacturer water filters. The current ratio at the end of the
last year was 3:1 which appeared to be comfortable. However, the cash
flow position, in reality, is rather weak and the company finds it difficult
to effect payments to the suppliers and workers on time. The composition
of working capital as per the last balance sheet is provided hereto.
Mention specific possibilities of what might be causing cash flow
diffic ulties in this context. Suggest any better ratios which the company
might use to gauge its liquidity in future.
(Rs)
Current Assets: Inventories 18,00,000 Receivables 12,00,000 Cash and bank balances 1,00,000 Loans and advances 20,00,000
------------- Total Current Assets 51,00,000 ------------- Current Liabilities 17,00,000 munotes.in

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34 Solution:
Current Assets : Rs Inventories 18,00,000 Receivables 12,00,000 Cash and Bank balances 1,00,000 ------------- (i) Total Current Assets 51,00,000 ------------- (ii) Current Liabilities 17,00,000 ------------- Working Capital (i) - (ii) 34,00,000 Analysis
(a) Current Ratio
Current assets, loans and advances 51,00,000
----------------------------------- ------------ = ------------- = 3 : 1
Current liabilities 17,00,000

The current ratio is satisfactory, since it is above the ideal current ratio of 2
: 1
(b) Quick Ratio
Current assets, loans and advances – Stock - Prepaid Expenses
-----------------------------------------------------------------------------
Current liabilities – Bank Overdraft
51,00,000 – 18,00,000
= ------------------------------ = 1.94 : 1
17,00,000

The quick ratio is also satisfactory, since the desired quick ratio is
1 : 1 but the actual quick ratio is 1.94 : 1. the company is in a position to
meet its short term financial obligations :

(c) Super Quick R atio
Cash and marketable securities 1,00,000
------------------------------------------- = ----------- ---- = 0.06 : 1
Current liabilities 17,00,000

The Company’s cash and bank balances ar e grossly insufficient to meet
the day to day financial needs and contingencies.
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35 (d) Composition of Current Assets
Current assets Rs. Proportion (%)
Inventories 18,00,000 35.29
Receivables 12,00,000 23.53
Cash ad bank 1,00,000 1.96
Loans and advan ces 20,00,000 39.22
------------ ---------
51,00,000 100%
The analysis of composition of current assets indicate the following
 Excess investments in inventories could be held. Dormant and non -
moving stock may also include in inventories.
 The receiv ables should be further classified into good doubtful and bad
amounts.
 Cash and bank balances may not be sufficient to meet the4 day to day
obligation.
 Substantial amount of working capital is locked up in loans and
advances which may not relate to the bus iness.
(e) Stock turn over ratio, Receivables turnover ratio, debtors, collection
period, Creditors payment period, working capital turnover ratio,
current assets to total assets ratio should also be calculated for the
ascertainment or efficiency in workin g capital management.
2.11 WORKING CAPITAL LEVERAGE
One of the important objectives of working capital management is by
maintaining the optimum levels of investment in current assets and by
reducing the levels of current liabilities, the company can minim ize the
investments in working capital thereby improvement in return on capital
employed is achieved. The term working capital leverage, refers a to the
impact of level of working capital on company’s profitability. The
working capital management s hould improve the productivity of
investments in current assets ad ultimately it will increase the return on
capital employed. Higher levels of investment in current assets than is
actually required mean increase ion the cost of interest charges on the
short-term loans and working capital finance raised from banks etc. and
will result in lower return on capital employed and vice versa. Working
capital leverage measures the responsiveness of ROCE for changes in
current assets. It is measured by applying th e following formula: munotes.in

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36 % change in ROCE
Working Capital Leverage = -------------------------------------
% change in Current Assets

Return on Capital Earnings Befor e Interest and Taxes
Employed (ROCE) = -----------------------------------------------
Total Assets

The working capital leverage reflects the sensitivity of the return on
capital employed to the changes in level of current assets. Working
capital leverage would be less in the case of capital -intensive units, even
though total capital employed is same. Working Capital leverage
expresses the relation of efficiency of worki ng Capital management with
the profitability of the company.
CA
Working Capital Leverage = -------------
T.A. - C.A.
Where C.A. = Current As sets
T.A = Total Assets (i.e. Net Fixed
Assets + Current Assets)
C.A = Changes in Current Assets
Illustration 2.4
From the following information calculate the res ponsiveness of ROCE for
changes in current assets:
Particulars Company A Company B
Fixed assets 300 200
Current assets 200 300
Total Assets 500 500
EBT 90 90
ROCE 18% 18%

Calculation of responsiveness of ROCE if the current assets decline by
20% ove r the existing level is calculate Working Capital Leverage
Solution:
C.A
Working Capital Leverage = -------------
T.A. - C.A.

Rs.200 lakhs
Company A = --------------------------------- = 0.435
Rs. 500 lakhs – Rs.40 lakhs munotes.in

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37
Rs.300 lakhs
Company B = --------- ---------------- ------------ = 0.682
Rs.500 lakhs – Rs.60 lakhs

Analysis - From the above analysis it is observed that working capital
leverage is higher for Company B and therefore it is more responsive
as compa red to Company A

Illustration 2.5
Following information is given of Stars Ltd. (Rs. Lakhs)
Fixed assets 300
Current assets 200
-----
Total assets 500
The entire current assets are being financed by the bank fiancé @ 16% p.a.
The earnings before t ax (EBT) of the company is Rs.100 lakhs. The
company is planning to reduce its level of investments in current assets by
Rs.100 lakhs with an efficient working capital management. Show the
impact of change in working capital on the Company’s Return on
Investment (ROI).
Solution:
(i) Calculation of ROI prior to Reduction in current Assets
EBT Rs.100 lakhs
ROI = --------------- X 100 = ------------------ x 100 = 20%
Total assets Rs.500 lakhs

(ii) Calculations of ROI after Reduction of current Assets to Rs.100 lakhs
EBT 100
Add: Savings in interest charges due to reduction
In investment in current assets
16
______
Total EBT 116
Rs.116 lakhs
Revised ROI = -------- ------------ x 1 -- = 29%
Rs.400 lakhs

Analysis: With the efficient management of working capital, by reducing
the level of investments in current assets the company can improve its
return on investment from 20% to 29% munotes.in

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38 2.12 ESTIMATION OF WORKING CAPITAL
There are three methods for estimating the working capital requirements
of a firm :
(i) Percentage of sales method
(ii) Regression analysis method
(iii) Operating cycle method.
2.12.1 Percentage of Sales Method:
It is a traditi onal and simple method of determining the level of working
capital and its components. In this method, working capital is determined
on the basis of past experience. If, over the years, the relationship
between sales and working capital is found to be st able then this
relationship may be taken as a base for determining the working capital for
future. This method is simple, easy to understand ad useful for projecting
relatively short t4rm changes in working capital. However, this method
cannot be recomme nded for universal application because the assumption
of linear relationship between sales and working capital may not hold
good in all cases.
Illustration 2.6
ABC Ltd. has achieved a turn over of Rs.85 Crores for the accounting
year 2006 -07. It is anti cipated that the turnover of the company will reach
rs.110 crores for the year 2007 -08. The financial position of the company
as o 31satMarch, 2005 as follows
(Rs. in Crores)
Liabilities Rs. Assets Rs. Equity share capital 10 Land and Build ings 4 Reserves and surplus 4 Plant and machinery 5 Secured loans 5 Inventories 11 Unsecured loans 3 Receivables 7 Sundry creditors 6 Cash and bank 3 Provision for taxation 2 30 30
Estimate the working capital requirement for the year 2007 -08?

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39 Solution:
Estimation of Working Capital Requirement for 2007 -08

Particulars Actuals % to sales Estimate
2006 -07 2006 -07 200 7-08
(Rs.crores) (Rs.Crores)

Sales 85 100 110
------- ------- -------
Current Assets

Inventories 11 12.9 14.19

Receivables 7 8.2 9.02

Cash in bank 3 3.5 3.85
------------ --------- -------
(a) 21 24.6 27.06
------------ --------- --------

Current Liabilities

Sundry creditors 6 7.1 7.81
Provision for taxation 2 2.4 2.64
------- -------- --------
(b) 8 9.5 10.45
--------- --------- --------
Working capital (a) -(b) 13 15.01 16.61


2.13 STEPS IN DETERMINATION OF WORKING
CAPITAL
The individual components method of estimation of working capital
involves the f ollowing steps:
Step 1 Identify the various items of current assets and
current liabilities which consist in determination of working
capital. The4 current assets include inventory of raw
materials, WIP and finished goods, sundry debtors , pre-paid
expenses desired cash balance etc. The current liabilities
include, creditors for raw materials stores and consumables,
creditors for wages creditors for expenses etc.

Step 2 (a) Estimate the holding period of each item stock
i.e. raw m aterials, WIP and finished goods.

(b) Estimate the collection period of sundry debtors
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Financial Mangement
40 (c) Estimate the desired cash balance for meeting the
requirements of day to day operations.

(d) Estimate the desired cash balance for meeting the
requireme nts of day to day operations.

(e) Estimate the lag in payment of wages and
expenses

Step 3 (i) Determine the raw material, labour and overheads cost
per unit

(ii) Determine the operating level.

(iii) Determine the percentage of conver sion cost incurred
on WIP

(iv) Determine the cost of sale and selling price
per unit.

Step 4 Ascertain the value of each item of current assets and
current liabilities taking into account the information in
step (2) and step (3)

Step 5 Put the values of current assets and current liabilities in a
statement form and ascertain the net working capital (i.e.
current assets – current liabilities) after adding up the
desired cashbalance and amount needed for meeting
contingencies.

Illustration 2.7
The Board of Directors of INDIGO Ltd. requests you to prepare a
statement showing the working capital requirements forecast for a level of
activity of 1,56,000 units of production. The following information is
available for your calculation:

Raw materials 90
Direct labour 40
Overheads 75
----
205
Profit 60
-----
Selling price per unit 265

(a) Raw materials are in stock on average one mo nth.
(b) Materials are in process on average 2 weeks
(c) Finished goods are in stock on average one month munotes.in

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Working Capital
41 (d) Credit allowed by suppliers one month.
(e) Time lag in payment from debtors – 2 months
(f) Lag in payment of wages - 1½ weeks
(g) Lag in payment of overheads – one month
20% of the out put is sold against ash. Cash in hand and at bank is
expected to be Rs.60,000. It is to be assumed that production is carried on
evenly throughout the year. Wages and overheads accrue similarly and a
time period o f 4 weeks is equivalent to a month
Solution:
Working Notes
1,56,000 units
(1) Raw Material = ------------------- x 4 weeks x Rs.90 = 52 weeks
Rs.10,80,000

1,56,000 units
(2) Work in progress = ------------------ x 2 weeks = Rs.6, 0 00 units
52 weeks


Raw materials (6,000 units @ Rs.90) 5,40,000

Wages (6,000 units @ Rs.40 x ½) 1,20,000

Overheads (6,000 units @ Rs.75 x ½) 2,25,000
------------
Total value of WIP 8,85,000
1,56.000
(3) Finished Goods = ------------ x 4 weeks x Rs.205
52 weeks
= Rs.24,60,000

1,56,000 units 80
(4) Debtors = ------------------ x 8 weeks x Rs.205 x ---
52 weeks 100
= Rs. 39,36,000

1,56,000 units
(5) Creditors = ------------------- x 4 weeks x Rs.90 = Rs. 10,80,000
52 weeks

1,56,000
(6) Wages = ------------------- x 1.5 weeks x rs.40 = Rs. 1,80,000
52 weeks


1,56,000 units
(7) Expenses = --------------------- x 4 weeks x Rs.75 = Rs. 9,00,000
52 weeks munotes.in

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42

Statement of Working Capital Required (Rs)


Current Assets :

Cash in hand and cash at bank 60,000

Stock in hand :
Raw materials 10,80,000
Work in process 8,85,000
Finished goods 24,60,000
------------- 44,25,000

Sundry deb tors 39,36,000
--------------
(a) 84,24,000

Current liabilities

Sundry creditors 10,80,000

Wages payable 1,80,000

Expenses payable 9,00,000
------------
(b) 21,60,000
-----------
Net working capital employed (a) - (b) 61,61,000

Illustration 2.8
From the following details you are required to make an assessment of the
average amount of working capital requirement of HINDALCO Ltd.

Particulars Average period Estimate for the
of credit 1st year (Rs)

Purchase of material 6 weeks 26,00,000

Wages 1½ weeks 19,50,000

Overheads :

Rent rates etc. 6 months 1,00,000

Salaries 1 month 8,00,000

Other overheads 2 months 7,50,000
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Working Capital
43 Sale cash 2,00,000

Credit s ales 2 months 60,00,000


Average amount of stocks and work in progress 4,00,000

Average amount of un drawn pro 3,00,000


It is to be assumed that all expenses and income were made at even rate
for the year.
Soluti on:

Assessment of average amount of Working capital requirement

Current Assets

Stock and work in progress 4,00,000

Debtors (Rs.60,00,000 x 2/12) 10,00,000
-------------
(a) 14,00,000
-------------
Current Liabilities :

Lag in payments :

Purchases (Rs.26,00,000 x 6/52) 3,00,000

Wages (Rs.19,50,000 x 15/52) 56,250

Rent (Rs.1,00,000 x 6/12) 50,000
Salaries (Rs.8,00,000 x 1/12) 66,667

Other overheads (Rs.7,50,000 x 2/12) 1,25,000
------------
(b) 5,97,917
-----------
Total Working Capital Requirements (a) - (b) 8,02,083

Less : Average amount of undrawn profit 3,00,000
------------
Working Capital Required 5,02,083



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44 3
RECEIVABLE MANAGEMENT
Unit Structure:
3.1 Meaning And Importance
3.2 Obje ctive o f Receivables Management
3.3 Aspects o f Receivable Management
3.4 Credit Policies
3.5 Credit Terms
3.6 Control o f Accounts Receivables
3.1 MEANING AND IMPORTANCE
The term ‘receivables’ is defined as ‘debt’ owed to the firm by customers
arising from sale of goods or services in the ordinary course of business.
When a firm makes an ordinar y sale of goods or services and does not
receive payment, the firm grants trade credit and creates accounts
receivable which could be collected in the future. Receivables
management is also called “Trade credit management ”. Thus, accounts
receivable repr esents an extension of credit of customers, allowing them a
reasonable period of time which to pay for the goods received.
The sale of goods on credit is an essential part of the modern competitive
economic systems. In fact, credit sales and therefore, re ceivables are
treated as a marketing tool to aid the sale of goods. The credit sales are
generally made to open account in the sense that there are no formal
acknowledgements of debt obligations through a financial instrument. As
a marketing tool, they ar e intended to promote sales and thereby profits.
However, extension of credit involves risk and cost Management should
weight the benefits as well as cost to determine the goal of receivables
management.
3.2 OBJE CTIVE OF RECEIVABLES MANAGEMENT
The obj ective of receivables management is “to promote sales and profits
until that point is reached where the return on investment in further
funding receivables is less than the cost of funds raised to finance that
additional credit (i.e. cost of capital).
3.3 ASPECTS OF RECEIVABLE MANAGEMENT
The specific costs and benefits which are relevant to the determination of
the objectives of receivables management are examined below. munotes.in

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45 3.3.1 COSTS
The major categories of costs associated with the extension of credit and
accounts receivable are:
(i) Collection cost,
(ii) Capital cost
(iii) Delinquency cost and
(iv) Default cost.
3.3.1.1 Collection Cost
Collection costs are administrative costs incurred in collecting the
receivables from the customers to whom credit sales have been made.
Included in this category of costs are (a) additional expenses on the
creation and maintenance of a credit department with staff, accounting
records, stationery postage and other related items, (b) expenses involved
in acquiring credit information either through outside specialist agencies
or by the staff of the firm itself. These expenses would n ot be incurred if
the firm does not sell in credit.
3.3.1.2 Capital Cost
The increased level of accounts receivable is an investment in assets.
They have to be financed thereby involving a cost. There is a time lag
between the sale of goods to, and paym ent by, the customers. Meanwhile,
the firm has to pay employees and suppliers of raw materials, there by
implying that the firm should arrange for additional funds to meet its own
obligations while waiting for payment from its customers. The cost on the
use of additional capital to support credit sales, which alternatively could
be profitably employed elsewhere, is therefore, a part of the cost of
extending credit or receivables.
3.3.1.3 Delinquency Cost
This cost arises out of the failure of the customer s to met their obligations
when payment on credit sales become due after the expiry of the credit
period. Such costs are called delinquency costs. The important
components of this cost are: (i) blocking up of funds for an extended
period (ii) cost associ ated with steps that have to be initiated to collect the
over dues, such as reminders and other collection efforts, legal charges,
where necessary, and so on.
3.3.1.4 Default Cost
Finally, the firm may not be able to recover the overdoes because of the
inability of the customers. Such debts are treated as bad debts and have to
be written off as they cannot be realised. Such costs re known as default
costs associated with credit sales and accounts receivable.
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46 3.3.2 BENEFITS
Apart from the costs, another f actor that has a bearing on accounts
receivable management is the benefit emanating from credit sales. The
benefits are the increased sales and anticipated profits because of a more
liberal policy. When firms extend trade credit, that is, invest in
recei vables, they intend to increase the sales. The impact of a liberal trade
credit policy is likely to take two forms. First, it is oriented to sales
expansion. In other words, a firm may grant trade credit either to in crease
sales to existing customers or attract new customers. This motive for
investment in receivables is growth oriented. Secondly the firm may
extend credit to protect its current sales against emerging competition.
Here, the motive is sales retention. As a result of increased sales, th e
profits of the firm will increase
From the above discussion, it is clear that investments in receivables
involve both benefits and costs. The extension of trade credit has a major
impact on sales, costs and profitability. Other things being equal, a
relatively liberal policy and, therefore, higher investments in receivables,
will produce larger sales. However, costs will be higher with liberal
policies than with more stringent measures. Therefore, accounts
receivable management should aim to a trade o ff between profit (benefit)
and risk (cost). That is to say, the decision to commit funds to receivables
(or the decision to grant credit) will be based on a comparison of the
benefits and costs involved, while determining the optimum level of
receivables . The costs and benefits to be compared are marginal costs
and benefits. The firm should only consider the incremental (additional)
benefits and costs that result from a change in their receivables or trade
credit policy.
While it is true that general ec onomic conditions and industry practices
have a strong impact on the level of receivables, a firm’s investments in
this type of current asses is also greatly affected by its internal policy. A
firm has little or no control over environmental factors, such as economic
conditions and industry practices. But it can improve its profitability
through a property conceived trade credit policy or receivables
management.
3.4 CREDIT POLICIES
In the preceding discussions it has been clearly shows that the firm’s
objective with respect to receivables management is not merely to collect
receivables quickly, but attention should also be given to the benefit -cost
trade -off involved in the various areas of accounts receivable
management. The first decision area is credi t policies.
The credit policy of a firm provides the framework to determine (a)
whether or not to extend credit to a customer and (b) how much credit to
extend. The credit policy decision of a firm has two broad dimensions: (i)
Credit standards and (ii) C redit analysis. A firm has to establish and use
standards in making credit decisions, develop appropriate sources of credit munotes.in

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47 information and methods of credit analysis. We illustrate below how these
two aspects are relevant to the account’s receivable man agement of a firm.
3.4.1 CREDIT STANDARDS
The term ‘ credit standards’ Represents the basic criteria for the extension
of credit to customers. The quantitative basis of establishing credit
standards are factors such as credit ratings, credit references, a verage
payment period and certain financial ratios. Since we are interested in
illustrating the trade off between benefit and cost to the firm as a whole,
we do not consider here these individual components of credit standards.
To illustrate the effect, we have divided the overall standards into (a) tight
or restrictive and (b) liberal or non restrictive. That is to say, our aim is to
show what happens to the trade off when standards are relaxed or
alternatively tightened.
The trade off with reference to credit standards covers
(i) the collection cost,
(ii) The average collection period/cost of investment in accounts
receivable
(iii) level of bad debt losses and
(iv) level of sales.
These factors should be considered while deciding whether to
relax credit standards or not. If standards are relaxed, it means
more credit will be extended while if standards are tightened,
less credit will be extended . The implications of the four
factor s are elaborated below.
(i) Collection Costs
The implications of relaxed credit are (i) more credit, (ii)
a large credit department to service accounts receivable and
related matters, (iii) increase in collection costs. The effect of
tightening of credit sta ndards will be exactly the opposite.
These costs are likely to be semi variable. This is because up to
a certain point the existing staff will he able to carry on the
increased work load, but beyond that, additional staff would be
required. These are ass umed to be included in the variable cost
per unit and need not be separately identified.
(ii) Investments in Receivables or the Average Collection Period.
The investment in accounts receivable involves, a capital cost
as funds have to be arranged by the fir m to fiancé them till
customers make payments. Moreover, the higher the average
accounts receivable, the higher is the capital or carrying cost.
A change in the credit standards relaxation or tightening leads
to a change in the level of accounts receivab le either through a
change in (a) sales or (b) collections.
A relaxation in credit standards, as already stated, implies an
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48 accounts receivable. Further, relaxed standards would mean
that credit is extended liberally so that it is available to even
less creditworthy customers who will take a longer period to
pay overdue. The extension of trade credit to slow paying
customers would result in a higher level of accounts receivable.
In contrast, a t ightening of credit stands would signify (i) a
decrease in sales and lower average accounts receivable ad(ii)
an extension of credit limited to more credit worthy customers
who a promptly pay their bills and thus, a lower average level
of accounts receivab le.
Thus, a change in sales and change in collection period
together with a relaxation in standards would produce a higher
carying cost while changes in sales and collection period result
in lower costs when credit standards are tightened. These basic
reactions also occur when changes in credit terms or collection
procedures are made. We have discussed these in the
subsequent sections of this chapter.
(iii) Bad Debt Expenses
Bad Debt is another factor which is expected to be affected by
changes in the credit st andards is bad debt (default) expenses.
They can be expected to increase with relaxation in credit
standards and decrease if credit standards become more
restrictive.
(iv) Sales Volume
Changing credit standards can also be expected to change the
volume of sale s. As standards are relaxed, sales are expected
to increase; conversely, a tightening is expected to cause a
decline in sales.
The basic changes and effects on profits arising from a
relaxation of credit standards are summarized in the following
paragrap hs. If the credit standards are tightened, the opposite
effects, as shown in the brackets would follow:
Effect of Relaxation of Standards

Item Direction of Effect on
Change (Increase = 1 Profits (Positive +
Decrease = D) Negative -)

1. Sales Volume 1(D) +(-)
2. Average Collection Period 1(D) -(+)
3. Bad Debt 1(D) -(+)


The effect of alternative credit standards is illustrated in the following
example. munotes.in

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Receivable Management
49 Illustration 3.1
A firm is currently selling a product @ Rs.10 per unit. The most recent
annual sal es (all credit) were 30,000 units. The variable cost per unit is
rs.6 and the average cost per Unit, given a sales volume of 30,000 units, is
Rs.8. the total fixed cost is Rs.60,000. the average collection period may
be assumed to be 30 days.
The firm i s contemplating a relaxation of credit standards that is expected
to result in a 15 per cent increase in units’ sales, the average collection
period would increase to 45 days with no change in bad debt expenses. It
is also expecte4d that increased sales w ill result in additional net working
capital to the extent of rs.10,000. the increase in collection expenses may
be assumed to be eligible. The required return on investment is 15 per
cent.
Should the firm relax the credit standard?
Solution :
The dec ision to put the proposed relaxation in the credit standards into
effect should be based on a comparison of (i) additional profits on sales
and (ii) cost of the incremental investments in receivables. If the former
exceeds the latter, the proposal should be implemented, otherwise not.
(i) Profit on Incremental Sales – This can be computed in two ways:
(a) long approach and ( b) short cut method.
(a) Long Approach : According to this approach, the costs and
profits on both the present and the proposed sales level are
calculated and the difference in profit at the two levels will be
the incremental profit as shown below.
Long Method to Calculate Marginal Profits : A) Proposed Plan:
1. Sales Revenue (34,500 units * Rs. 10)
2. Less: Costs
(a) Variable Cost (34,500 units * Rs.6)
(b) Fixed Cost
3. Profit from Proposed sales 2,07,000 60,000 3,45,000 2,67,000 78,000 B) Current Plan:
1. Sales Revenue (30,000 units * Rs. 10)
2. Less: Costs
(a) Variable Cost (30,000 units * Rs.6)
(b) Fixed Cost
3. Profit from Current sales 1,80,000 60,000 3,00,000 2,40,000 60,000 C) Marginal profits with new plan (I – II) 18,000 Short Cut Method munotes.in

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Financial Mangement
50 The profits on sales will increase by an amount equal to the product of the
additional units sold and additional profit p er unit. Since the 30,000 units
representing the current level of sales absorb all the fixed costs, any
additional units sold will cost only the variable cost per unit. The
marginal profit per unit will be equal to the difference between the sales
price p er unit (Rs.10) and the variable cost per unit (Rs.6). The marginal
profit/contribution margin per unit would therefore, be Rs.4. The total
additional (marginal) profits from incremental sales will be Rs.18,000
(Rs.4,500 x Rs.4).
(ii) Cost of Marginal/Incremental Investment in Receivables – The
second variable relevant to the decision to relax credit standards is
the cost of marginal investment in accounts receivable. This cost
can be computed by finding the difference between the cost of
carrying receivables before and after the proposed relaxation in
credit standards. It can be calculated as follows:
(i) Turnover of accounts receivable:
Proposed Plan = Number of days in the year = 360 = 8
Average collection period 45

Present Plan = Number of days in the year = 360 = 12
Average collection period 30

(ii) Total cost of sales:
Present Plan = Number of units x cost per unit
= 30,000 units x Rs.8 = Rs.2,40,000
Proposed Plan = (30,000 units x Rs.8) + (4,500 x Rs.6)
= Rs.2,67,000
(iii) Average investment in accounts receivable:
Present Plan = Rs.2,40,000/12 = Rs.2 0,000
Proposed Plan = Rs.2,67,000/8 = Rs.33,375
(iv) The cost of marginal investments in accounts receivable:
This is the difference between the average investments in accounts
receivable under (i) the proposed plan and (ii) under the present
plan. It is calculated as follow:
Average investment with proposed Plan Rs. 33,375
Less: Average investment with present plan Rs. 20,000
-------------
Marginal investments Rs. 13,375
-------------
Marginal investments represent the amount of additional funds
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51 to relax the credit standards is implemented. The additional cost of
Rs.13,375 is the cost of margi nal investment in accounts
receivable.
Given 15 per cent as required return Rs.13,375 x 15
on the Investments, the cost = -------------------
100
= Rs.2,006.25

This is an opportunity cost in that the firm would earn this amount
from alternative uses if the funds are not tied up in additional
accounts receivable.
(v) Cost of working capital:
Rs.10,000 x 0.15 = Rs.1,500
In the above above illustration, since the additional profits on increased
sales as a result of relaxed credit standards (Rs.18,000) is considerably
more than the cost of incremental investments in accounts receivable
(Rs.2,006. 25) and working capital (Rs.1,500), the firm should relax its
credit standards. Such an action would lead to an overall increase in the
profits a of the firm by Rs.14,493.75 (Rs.18,000) –
Rs.2,006.25 – Rs.1,500).
The effect of tigh tening credit standards would be just the opposite and
can be illustrated on the above lines.
3.4.2 CREDIT EVALUATION
In addition to establishing Credit standards, a firm should develop
procedures for evaluating credit applicants. The second aspect of credit
policies of a firm is credit analysis and investigation. Two basic steps are
involved in the credit investigation process: (a) obtaining credit
information and (b) analysis of credit information It is on the basis of
credit analysis that the decisi ons to grant credit to a customer as well as
the quantum of credit would be taken.
(a) Obtaining Credit Information
The first step in credit analysis is obtaining credit information on which to
base the evaluation of a customer. The sources of information, broadly
speaking, are (i) internal and (ii) external.
(i) Internal : Usually firms require their customers to fill var ious forms
and documents giving details about financial operations. They are also
required to furnish trade reference with whom the firms can have
contacts to judge the suitability of the customer for credit. This type of
information is obtained from int ernal sources of credit information.
Another internal source of credit information is derived from the
records of the firms contemplating an extension of credit. It is likely
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52 the pa st. In that case, the firm would have information on the
behaviour of the applicant(s) in terms of the historical payment
pattern. This type of information may not be adequate and may,
therefore, have to be supplemented by information from other sources.
(ii) External : The availability of information from external sources to
assess the credit -worthiness of customers depends upon the
development of institutional facilities and industry practices. In India,
the external sources of credit information are not a s developed as in
the industrially advanced countries of the world. Depending upon the
availability, the following external sources may be employed to collect
information.
 Financial Statements One external source of credit information is
the published f inancial statements, that is, the balance sheet and the
profit and loss account. The financial statements contain very useful
information. They throw light on an applicant’s financial, viability,
liquidity, profitability and debt capacity. Although the final statements
do not directly reveal the past payment record of the applicant, they
are very useful in assessing the over all financial position of a firm,
which significantly determines its credit standing.
 Bank References Another useful source of cr edit information is the
bank of the firm which is contemplating the extension of credit. The
modus operandi here is that the firm’s banker collects the necessary
information from the applicant’s bank. Alternatively, the applicant
may be required to ask h is banker to provide the necessary information
either directly to the firm or to its bank.
 Trade References These refer to the collection of information from
firms with whom the applicant has dealings and who on the basis of
their experience would vouch for the applicant.
 Credit Bureau Reports Finally, specialist credit bureau reports from
organizations specializing in supplying credit information can also be
utilized.
(b) Analysis of Credit Information Once the credit information has
been collected from d ifferent sources, it should be analysed to
determine the credit worthiness of the applicant. Although there are
no established procedures to analyse the information, the firm should
devices one to suit its needs. The analysis should over two aspects (i)
quantitative, and (ii) qualitative.
(i) Quantitative : The assessment of the quantitative aspects is based
on the factual information available from the financial statements, the
past records of the firm and so on. The first step involved in this type
of asse ssment is to prepare an Aging Schedule of the accounts payable
of the applicant as well as calculate the average age of the accounts
payable. This exercise will give an insight into the past payment
pattern of the customer. Another step in analyzing the credit
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53 debt capacity of the applicant. These ratios should be compared with
the industry average. Moreover, trend analysis over a period of time
would reveal the financial streng th of the customer.
(ii) Qualitative: The quantitative assessment should be supplemented by
a qualitative/subjective interpretation of the applicant’s
creditworthiness. The subjective judgment would cover aspects
relating to the quality of management. Here, t he references from other
suppliers, bank references and specialist bureau reports would form the
basis for the conclusions to be drawn. In the ultimate analysis
therefore the decision whether to extend credit to the applicant and
what amount to extend wil l depend upon the subjective interpretation
of his credit standing.
3.5 CREDIT TERMS
The second decision area in accounts receivable management is the credit
terms. After the credit standards have been established and the
creditworthiness of the custom ers has been assessed, the management of a
firm must determine the terms and conditions on which trade credit will be
made available. The stipulations under which goods are sold on credit
referred to as credit terms. These relate to the repayment of the a mount
under the credit sale. Thus, credit terms specify the repayment terms of
receivables.
Credit terms have three components : (i) credit period, in terms of the
duration of time for which trade credit is extended – during this period the
overdue amount must be paid by the customer (b) cash discount, if any,
which the customer can take advantage of that is, the over due amount will
be reduced by this amount, and (c) cash discount period, which refers to
the duration during which the discount can be avail ed of. These terms are
usually written in abbreviations, for instance, 2/10 net 30. The three
numerals are explained below:
 2 signifies the rate of cash discount (2 per cent) which will be available
to the customers if they pay the overdue within the stipulated time;
 10 represents the time duration (10 days) within which a customer must
pay to be entitled to the discount;
 30 me ans the maximum period for which credit is available and the
amount must be paid in any case before the expiry of 30 days.
In other words, the abbreviation 2/10 net 30 means that the customer is
entitled to 2 per cent cash discount (discount rate) if he pa ys within 10
days (discount period) after the beginning of the credit period (30 days).
If, however, he does not want to take advantage of the discount, he may
pay within 30 days. If the payment is not made within a maximum period
of 30 days, the custome r would be deemed to have defaulted.
The credit terms, like the credit standards, affect the profitability as well as
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54 cost benefit trade off. We illustrate below how the three co mponents of
credit terms, namely, rate of discount period of discount and the credit
period, affect the trade off. It should be noted that our focus in analysis
the credit terms is from the view point of suppliers of trade credit and not
the recipients fo r whom it is a source of financing.
Cash Discount
The cash discount has implications for the sales volumes, average
collection period/average investment in receivables, bad debt expenses
and profit per unit. In taking a decision regarding the grant of cash
discount, the management has to see what happens to these factors if it
initiates increase or decrease in the discount rate. The changes in the
discount rate would have both positive and negative effects. The
implications of increasing or initiating cas h discount are as follows:
1. The sales volume will increase. The grant of discount implies reduced
prices. If the demand for the products is elastic, reduction in prides will
result in higher sales volume.
2. Since the customers to take advantage of the discount, would like to
pay within the discount period, the average collection period would be
reduced. The reduction in the collection period would lead to a
reduction in the investment in receivables as also the cost. The
decrease in the average colle ction period would also cause a fall in bad
debt expenses. As a result, profits would increase.
3. The discount would have a negative effect on the profits. This is
because the decrease in prices would affect the profit margin per unit of
sale.
The effec ts of increase in the cash discount are summarized in a Table
below. The effect of decrease in cash discount will be exactly opposite.
Effects of Increase in Cash Discount

Item Direction of change Effect on P rofits
(1=increase D=Decrease) (Positive or Negative)

Sales volume 1 +
Average Colle ction Period D +
Bad Debt Expens es D +
Profit Per Unit D -

The cash discount decision is illustrated in the following examp le.
Illustration 3.2
Assume that the firm in our Example is contemplating to allow 2 per cent
discount for payment within 10 days after accredit purchase. It is
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55 and the average col lection period will drop to 15 days. Assume bad debt
expenses will not be affected return on investment expected by the firm is
15 peer cent 60 per cent of the total sales will be on discount should the
firm implement the proposals?
Solution
(i) Profit on sales.
= (sale of additional units multiplied by the difference between the
sales price and the variable cost per unit )
= 4,500 (Rs.10 – Rs/6) = 4,500 x Rs.4 = Rs.18,000
(ii) Saving on average collection period.
This sing is what would have been earned on the reduced
investments in accounts receivable as a result of the cash
discount.

Cost of sales
Average investment in accounts receiv able = -------------------- ------
Receivables turn over


(30,000 xRs.8)

(a) Present plan (without discount) = ------------------- = Rs.20,000
12 (i.e.360/30)

(30,000 x Rs.8) + (4500 x Rs.6)
(b) Proposed plan (with discount) = ------------------------------------------
24 (i.e. 360/15 )

Rs.2,67,000
= ---------------- = Rs.11,125
24
Thus, if cash discount i s allowed, the average investments in receivable
will decline by Rs.8,875 (i.e. Rs.20,000 – Rs.11,125)
Given a 15 per cent rate of return, the firm could earn Rs.1,331,25 on
Rs.8,875. Thus, the saving resulting from a drop in the average collection
period is Rs.1331.25
(iii) The total benefits associated with the cash discount –

Profit on additional sale Rs.18,000.00
Saving in cost Rs. 1,331. 25
-------------------
Total Rs. 19,331.25
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56 (iv) Cash discount:
The cost involved in the cash discount on credit sales i.e, 2 per cent of
credit sales = 0.02 x Rs.2,07,000 (i.e. 0.60 x Rs.3,45 ,000) = Rs.4,140
Thus against a cost of Rs.4,140 the benefit from initiating cash discount is
Rs.19 ,331.25 i.e, there is a net gain of Rs.15,191.25 (Rs.19,331.25 –
Rs.4,140). The firm should, therefore, implement the proposal to allow 2
per cent cash disc ount for payment within 10 days of the credit purchase
by the customers.
A similar type of analysis can be made to illustrate the effect of either
reduction or elimination of cash discount.
Credit Period
The second component of credit terms is the credit p eriod. The expected
effect of an increase in the credit period is summarized bellow.
Effect of Increase in Credit Period

Item Direction of change Effect on Profits
(1=increase D=Decrease) (Positive or Negative)

Sales volume 1 +
Average Colle ction Period 1 -
Bad Debt Expenses 1 -

A reduction in the credit period is likely to have an opposite effect. The
credit period decision is explained through the following example.
Illustration 3.3
Suppose, a firm contemplating an increas e in the credit period from 30 to
60 days. The average collection period which is at present 45 says is
expected to increase to 75 days. It is also likely that he bad debt expenses
will increase from the current level of 1 per cent to 3 per cent of sale.
Total sales are expected o increase from the level of 30,000 units to
34,500 units. The present average cost per unit is rs.8, the variable cost
and sales per unit is rs.6 and Rs.10 per unit respectively. Assume the firm
expects a rate of returns of 15 per cent.
Should the firm extend the credit period ?
Solution
(i) Profit on additional sales = (Rs.4 x 4,500) = Rs.18,000
(ii) Cost of additional investments in receivables = Average investments
with the proposed credit period less

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57 Cost of sales (Rs.8 x 30,000) + Rs..6 x 4,500
Proposed plan = __________ _____ ______________
Turn over of receivalues 360 + 75

= Rs.55,625

(Rs.8 x 30,000)
Present Plan = -------------------- = Rs.30,000
360 + 45

Additional investment in accounts receivable = Rs.55,625 – Rs.30,000
= Rs.25,625

Cost of additional investment at 15 per cent
= 0.15 x Rs.25,625 = Rs.3,843.75
(iii) Additional bad debt expenses:
This is the difference between the bad debt expenses with the
proposed and present credit periods.
Bad debt with proposed credit period = 0.03 x Rs.3,45,000 = Rs.10,350
Bad debt with present Credit period = 0.01 x Rs.3,00,000 = Rs.3,000
Additional bad debt expense = (Rs.10,350 – Rs.3,000) = Rs.7,350
3.6 CONTROL OF ACCOUNTS RECEIVABLES
The third area involved in the accounts receivable management is
collection policies. They refer to the procedures followed to collect
accounts receivable when, after the expiry of the credit period, they
become due. These policies cover two aspects: (i) degree of effort to
collect the over dues and (ii) type of collection efforts.
(i) Degree of Collection Effort
To illustrate the effect of the collection effort, the credit policies of a firm
may be categorized into (i) strict/light, and (ii) lenient. The collection
policy would be tight if very rigorous procedures are followed. A tight
collection policy has impl ications which involve benefits a well as costs.
The management has to consider a trade off between them. Likewise, a
lenient collection effort also affects the cost benefit trade off. The effect
of tightening the collection is discussed below.
In the f irst place, the bad debt expenses (default cost) would decline.
Moreover, the average collection period will be reduced. As a result of
these two effects, the firm will benefit and its profits will increase. But
there would be a negative effect also. A very rigorous collection strategy
would involve increased collection costs. Yet another negative effect may
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58 some customers may not like the pressure and intense efforts initiated by
the firm, and may switch to other firms.
Basic Trade -off from Tight Collection Effort

Item Direction of change Effect on Profits
(1=increase D=Decrease) (Positive or Neg ative)

Bad Debt Expenses D +
Average Colle ction Period D +
Sales volume D -
Collection Expenditure 1 -


The effect of the lenient policy will be just the opposite.
Illustration 3.4
A firm is contemplating stricter collection policies. The following details
are a vailable.
1. At present, the firm is selling 36,000 units on credit at a price of Rs.32
each; the variable cost per unit is Rs.25 while the average cost per unit
is Rs.29; average collection period is 58 days’ and collection expenses
amount to Rs.10,000; b ad debts are 3 per cent;
2. If the collection procedures are tightened additional collection charges,
amounting to Rs.20,000 would be required, bad debts will be 1 per
cent, the collection period will be 40 days; sales volume is likely to
decline by 500 un its;
Assuming a 20 per cent rate of return on investment, what would be your
recommendation? Should the firm implement the decision?
Solution
(i) Bad debt expenses:
(a) Present plan: (0.03 x Rs.11,52,000) Rs. 34,560
(b) Proposed Plan : (0.01 x Rs.11,36,000) Rs. 11,360
-------------
Savings in bad debt expenses (a-b) Rs. 23,200
-------------
(ii) Average collection period/average investment in receivables
36,000 x Rs.29 x 58days
(a) Present Plan = -------------------- -----------
360
= Rs. 1,68,200

((36,000 x Rs.29) – (500 x Rs.25) ) x 40 days
(b) Proposed Plan = ----------------------- --------------------- -------------
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59 = Rs. 1,14,611
Savings in average investments (a – b 53,589
---------------
Assuming a 20 per cent return, the firm will be able to Earn Rs.10,718 on
this saving.
(iii) Sales volume: Since the sales volume will decline
by 500 units, there would be a loss of
Rs.3,500 (500 x Rs.7)
(iv) Additional collection charges = Rs.20,000
Thus, the total benefits from a tightening of the collection policy will be
Rs.33,918 (Rs.23,200 + Rs.10,718) and the total cost will be Rs.23,500
(Rs.3,500 + Rs.20,000). Therefore, there would be a net gain of
Rs.10,418 (Rs.33,918 – Rs.23,500). The firm should, therefore,
implement the proposed strategy.
Illustration 3.5
Super Sports, dealing in sports goods, has an annual sale of Rs.50 lakhs
and currently extending 30 days credit to the dealers. It is felt that salers
can pick up considerably if the dealers are willing to carry increased
stocks, but the dealers have difficulty in financing their inventory. The
firm is, therefore, considering shifts in credit policy. The following
information is available.

The average collection period now is 30 days
Variable costs, 80 per cent of sales.
Fixed costs, Rs.6 lakh per annum
Required (pre -tax) return on investment: 20 per cent

Credit Policy Average collection Annual Sales (Rs lakh)
period (days)

A 45 56
B 60 60
C 75 62
D 90 63





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60 Solution
Evaluation of P roposed Credit Policies

Particulars Present Proposed (number of days)
-----------------------------------------------
(30) A(45) B(60) C(75) D(9)

(a) Sales revenue 50 56 60 62 63
Less: Variable costs
(80% of sales) 40 44.8 48 49.6 50.4

Total contribution 10 11.2 12 12.4 12.6
---------- ------ ---- ---------- ---------- ------------
Less : Fixed costs 6 6 6 6 6
Profit 4 5.2 6 6.4 6.6
---------- ---------- --------- ---------- -----------
Increase in profits due
To increase in total
Contribution (20% of
Sales) compared to
Present profits --- 1.2 2 2.4 2.6
--------- --------- -------- ---------- ------
(b) Investment in debt s:
Total cost (VC+FC) 46 50.8 54 55.6 56.4

Debtors turnover (DT)
(360 days collection
period) 12 8 6 4.8 4

Average investment
(total cost + DT) 3.83 6.35 9 11.58 14.10

Additional Investment
Compared to present
Level - 2.52 5.17 7.75 10.27

Cost of additional
Investment - 0.50 1.03 1.55 2.05
---------- ------ -------- -------- -------
(c) Incremental
profit (a – b) - 0.70 0.97 0.85 0.55





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61 Illustration 3.6
ABC Corporation is considering relaxing its present credit policy and is in
the process of evaluating two alternative policies. Cur rently the firm has
annual credit sales of Rs.50 lakh and accounts receivable turnover ratio of
4 times a year. The current level of loss due to bad debts is Rs.1,50,000.
the firm is required to give a return of 25 per cent on the investment in
new accou nts receivable. The company’s variable costs ate 70 percent of
the selling price. Given the following information, which is a better
option?
Particular Present policy Policy option I Policy option II

Annual credit sales Rs.50,00,000 Rs.60,00,000 Rs.67,50,000
Accounts receivable
Turnover ratio 4 3 2.4
Bad debt losses 1,50,000 3,00,000 4,50,000


Solution
Relative Suitability of Policy Options
Particulars Present policy Policy option -I Policy option II
Sales revenue Rs.50,00,000 Rs.60,00,000 Rs.67,50,000
Less: Variable cost
(70%) 35,00,000 42,00,000 47,25,000
------------------ ----------------- -------------------
Contribution margin
(manufacturing) 15,00,000 18,00,000 20,25,000
Less: Other relevant
Costs:
Bad debt losses 1,50,000 3,00,000 4,50,000
Investment cost
(see working notes) 2,18,750 3,5 0,000 4,92,187.,50
----------------- ----------------- -----------------
Contribution margin
(final) 11,31,250 11,50,000 10,82,812.50

Working notes
Strictly speaking, investment in accounts receivable should be determined
with reference to total cost of goods sold on credit. However, fixed costs
re not given. It is assumed that there are no fixed costs and investment in
debtors/ receivables i s determined with reference to variable costs only.
Rs.35,00,000
Present policy : ----------------- = Rs.8,75,000 x 0.25 = Rs.2,18,750
4

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62 Rs.42,00,000
Polic y option I: ------------------ = Rs.14,00,000 x 0.25 = Rs.3,50,000
3

Rs.47,25,000
Policy option II : ------------------ = Rs.19,68,750 x 0.25 = Rs.4,92,187.5
2.4

(ii) Types of Collection Efforts
Another aspect of collection policy relates to the steps that should be taken
to collect over dues from the cust0mers. A well -established collection
policy should have clear cut guidelines as to the sequence of collection
efforts. After the credit period is over and payment remains due the firm
should initiate measures to collect them. The effort should in the
beginning be polite but with the passé of time, it should gradually become
strict. The steps usually taken are (i) letters, including reminders t o
expedite payment (ii) telephone calls for personal contact; (iii) personal
visits; (iv) help of collection agencies and finally, (v) legal action. The
firm should take recourse to very stringent measures like legal action only
after all other avenues ha ve been fully exhausted. They not only involve a
cost but also affect the relationship with the customers. The aim should be
to collect as early as possible genuine difficulties of the customers should
be given due consideration.









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63 4
MANAGEMENT OF CASH AND
MARKETABLE SECURITI ES
Unit Structure :
4.1 Introduction
4.2 Motives Of Holding Cash
4.3 Objectives Of Cash Management
4.4 Factors Determining Cash Needs
4.5 Determining Cash Need
4.6 Cash Budget: Management Tool
4.7 Elements/Preparation Of Cash Budget
4.8 Operating Cash Flows
4.9 Financial Cash Flows
4.10 Cash Management Models
4.11 Cash Management Techniques/Processes
4.12 Marketable Securities
4.1 INTRODUCTION
Cash Management is one of the key areas of working capital management.
Apart from the fact that it is the most liquid current asset, cash is the
common denominator to which all current assets can be reduced because
the other major liquid assts, that is, r eceivable and inent ory get eventually
converted into cash. This underlines the significance of cash management.
The present Chapter gives a detailed account of the problems involved in
managing cash. The first Section outlines the motives for holding cas h
followed by the objectives of cash management in Section two. Section 3
presents a discussion of the factors determining cash needs. The
approaches to derive optimal cash balances, namely, cash management
models and cash budgets are examined in depth i n section 4. the basic
strategies for efficient management of cash are the subject matter of
Section 5. we have explained specific techniques to manage cash
subsequently. The remainder of the chapter is devoted to the discussion of
marketable securities . the Chapter concludes with a summary of the major
points.
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64 4.2 MOTIVES OF HOLDING CASH
The term ‘ cash’ with reference to cash management is used in two senses.
In a narrow sense, it it used broadly to cover currency and generally
accepted equivalents of cash, such as cheques, drafts and demand deposits
in banks. The Broadview of cash also includes near cash assets, such as
marketable securities and time deposits in banks. The maintenance
characteristics of these is that they can be readily sold and con verted into
cash. They serve as a reserve pool of liquidity that provides cash quickly
when needed. They also provide a short -term investment outlet for
exceeds cash and are also useful for meeting planned outflow of funds.
Here, the term cash managemen t is employed in the broader sense.
Irrespective of the form in which it is held, a distinguishing feature of cash
as an asset is that it has no earning poser . If cash does not earn any return,
why is it held?
There are four primary motives for maintai ning cash balances:
(i) Transaction motive;
(ii) Precautionary motive;
(iii) Speculative motive and
(iv) compensating motive.
4.2.1 Transaction Motive :
An important reason for maintaining cash balances is the transaction
motive. This refers to the holding of cash to meet routine cash
requirements to finance the transactions which a firm carries on in the
ordinary course of bus iness. A firm enters into a variety of transactions to
accomplish its objectives which have to be paid for in the form of cash.
For Illustration , cash payments have to be made for purchases, wages
operating expenses, financial charges like interest, taxe s, dividends and so
on. Similarly, there is a regular inflow of cash to the firm from sales
operations, returns on outside investments and so on. These receipts and
payments constitute a continuous two -way flow of cash. But the inflows
(receipts) and ou tflows (disbursements) do not perfectly coincide or
synchronize. At times, receipts exceed outflows while, at other times,
payments exceed inflows. To ensure that the firm can meet its obligations
when payments become due in a situation in which disburse ments are in
excess of the current receipts, it must have an adequate cash balance. The
requirement of cash balances to meet routine cash needs is known as the
transaction motive and such motive refers to the holding of cash to meet
anticipated obligation s whose timing is not perfectly synchronized with
cash receipts. If the receipts of cash and its disbursements could exactly
coincide in the normal course of operations, a firm would not need cash
for transaction purposes. Although a major part of transa ction balances
are held in cash, a part may also be in such marketable securities whose
maturity conforms to the timing of the anticipated payments, such as
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65 4.2.2 Precautionary Motive :
In addition to the non synchr onization of anticipated cash inflows and
outflows in the ordinary course of business, a firm may have to pay cash
for purposes which cannot be predicted or anticipated. The unexpected
cash need at short notice may be the result of:
 Floods, strikes and failure of important customers;
 Bills may be presented for settlement earlier than expected;
 Unexpected slow down in collection of accounts receivable;
 Cancellation of some order for goods as the customer is not satisfied;
and
 Sharp inc rease in cost of raw materials.
The cash balances held in reserve for such random and unforeseen
fluctuations in cash flows are called as precautionary balances. In other
words, precautionary motive of holding cash implies the need to hold cash
to meet u npredictable obligations. Thus, precautionary cash balance
serves to provide a cushion to meet unexpected contingencies. The
more unpredictable are the cash flows, the larger is the need for such
balances.
Another factor which has a bearing on the level of such cash balances is
the availability of short -term credit. If a firm can borrow at short notice to
pay for unforeseen obligations, it will need to maintain a relatively small
balance and vice versa.
Such cash balances are usually held in the form of marketable securities so
that they earn a return.
4.2.3 Speculative Motive :
It refers to the desire of a firm to take advantage of opporttnities which
present themselves unexpected moments and which re typically outside
the normal course of business. Whi le the precautionary motive is
defensive in nature in that firms must make provisions to tide over
unexpected contingencies, the speculative motive represents a positive and
aggressive approach. Firms aim to exploit profitable opportunities and
keep cash in reserve to do so. The speculative motive helps to take
advantage of :
 An opportunity to purchase raw materials at a reduced price on
payment of immediate cash;
 A chance to speculate on interest rate movements by buying securities
when interest rates ar e expected to decline;
 Delay purchase of raw materials on the anticipation of decline in prices;
and
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66 4.2.4 Compensating Motive :
Yet another motive to hold cash balance is to compensate banks for
providing certain servic es and loans.
Banks provide a variety of services to business firms, such as clearance of
cheque, supply of credit information, transfer of funds, and so on. While
for some of these services banks charge a commission or fee, for others
they seek indirect compensation. Usually clients are required to maintain
a minimum balance of cash at the bank. Since this balance cannot be
utilized by the firms for transaction purposes, the banks themselves can
use the amount to earn a return. Such balances are compen sating
balances.
Compensating balances are also required by some loan agreements
between a bank and its customers. During periods when the supply of
credit is restricted and interest rates are rising, banks require a burrower to
maintain a minimum balance in his account as a condition precedent to the
grant of loan. This is presumably to compensate the bank for a rise in the
interest rate during the period when the loan will be pending.
The compensating cash balances can take either of two forms (i) an
absolute minimum, say, Rs.5 lakh, below which the actual bank balance
will never fall;(ii) a minimum average balance, say, Rs.5 lakh over the
month. The first alternative is more restrictive as the average amount of
cash held during the month must be above Rs.5 lakh by the amount of the
transaction balance. From the firm’s view point, this is obviously dead
money. Under the second alternative the balance could fall to zero one
day provided it was Rs.10 lakh some other day with the average working
to Rs.5 l akh. of the four primary motives of the holding cash balances, the
two most important are the transactions motive and the compensation
motive. Business firms normally do not speculate and need not have
speculative balances. The requirement of precautiona ry balances can be
met out of short -term borrowings.
4.3 OBJECTIVES OF CASH MANAGEMENT:
The basic objectives of cash management are two -fold (a) to meet the cash
disbursement needs (payment schedule); and (b) to minimize funds
committed to cash balance. These are conflicting and mutually
contradictory and the task of cash management is to rec oncile them.
4.3.1 Meeting Payments Schedule
In the normal course of business, firms have to make payments of cash on
a continuous and regular basis to suppliers of goods, employees and so on.
At the same time, there is a constant inflow of cash through collections
from debtors. Cash is, therefore, aptly described as the oil to lubricate the
ever-turning wheels of business, without it the process grinds to a stop. A
basic objective of cash management is to me the payment schedule, that is,
to have suffi cient cash to met the cash disbursement needs of a firm. munotes.in

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67 The importance of sufficient cash to meet the payment schedule can
hardly be overemphasized. The advantages of adequate cash are : (i) it
prevents insolvency or bankruptcy arising out of the inabi lity of a firm to
meet its obligations; (ii) the relationship with the bank is not strained; (iii)
it helps in fostering good relations with trade creditors and suppliers of
raw materials, as prompt payment may help their own cash management;
(iv) a cash d iscount can be availed of if payment is made within the due
date. For Illustration , a firm is entitled to 2 percent discount for a
payment made within 10 days when the entire payment is to be made
within 30 days. Since the net amount is due in 30 days , failure to take the
discount means paying an extra 2 per cent for using the money for an
additional 20 days. If a firm were to pay 2 per cent for every 20 days
period over a year, there would be 18 such periods (360 days + 20 days).
This represents an annual interest rate of 36 per cent. (v) it leads to a
strong credit rating which enables the firm to purchase goods on
favourable terms and to maintain its line of credit with banks and other
sources of credit, (vi) to take advantage of favourable busine ss
opportunities that may be available periodically and finally, (vii) the firm
can meet unanticipated cash expenditure with a minimum or strain during
emergencies such as strikes fires or a new marketing campaign by
competitors. Keeping large cash balanc es, however, implies a high cost.
The advantage of prompt payment of cash can well be realized by
sufficient and not excessive cash.
4.3.2 Minimising Funds Committed to cash Balances
The second objective of cash management is to minimize cash balance. In
minimizing the cash balances, two conflicting aspects have to be
reconciled. A high level of cash balances will, as shown above, ensure
prompt payment together with all the advantages. But it also implies that
large funds will remain idle, as cash is ano n earning asst and the firm will
have to forgo profits. A low level of cash balances, on the other hand,
may mean failure to met the payment schedule. The aim of cash
management therefore should be to have an optimal amount of cash
balances.
Keeping in v iew these conflicting aspects of cash management, we
propose to discuss the planning/determination of the need for cash
balances. There are two aspects involved in cash planning : first an
examination of those factors which have a bearing on the firm’s re quired
cash balance; second, a review of the approaches to achieve optimum cash
balances.
4.4 FACTORS DETERMINING CASH NEEDS
The factors that determine the required cash balances are: (i)
synchronization of cash flows, (ii) short costs , (iii) excess cash balance ,
(iv) procurement and management , and (v) uncertainty.

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68 4.4.1 Synchronization of Cash Flows
The need for maintaining cash balances arises from the non -
synchronization of the inflows and outflows of cash, if the receipts and
payments of cash perfect ly coincide or balance each other, there would be
no need for cash balances. The first consideration in determining the cash
need is, therefore, the extent of non -synchronization of cash receipts and
disbursements. For this purpose, the inflows and outfl ows have to be
forecast over a period of time, depending upon the planning horizon which
is typically a one -year period with each of the 12 months being a sub -
period. The technique adopted is a cash budget. The preparation of a cash
budget is discussed i n the next section of this chapter. A property
prepared budget will pinpoint the months/period when the firm will have
an excess or a shortage of cash.
4.4.2 Short Costs
Another general factor to be considered in determining cash needs is the
cost associ ated with a shortfall in the cash needs. The cash forecast
presented in the cash budget would reveal periods of cash shortage. In
addition, there may be some unexpected shortfall. Every shortage of cash
whether expected or unexpected involves a cost dep ending upon the
severity, duration and frequency of the shortfall and how the shortage is
covered. Expenses incurred as a result of shortfall are called short costs .
Cost i ncluded in the short costs are the following:
(i) Transaction costs associated with raising cash to tide over the
shortage. This is usually the brokerageincu55red in relation to the
sale of some short term near cash assets such as marketable securities;
(ii) Borrowing costs associated with borrowing to cover the shortage.
These include items such as interest on loan, commitment charges and
other expenses relating to the loan;
(iii) Loss of cash discount, that is, a substantial loss because of a
temporary shortage of cash.
(iv) Cost associated with deterioration of the credit rating whic h is
reflected in higher bank charges on loans, stoppage of supplies,
demands for cash payment, refusal to sell, loss of image and the
attendant decline in sales and profits.
(v) Penalty rates by banks to meet a shortfall in compensating balances.
4.4.3 Excess Cash Balance Costs :
The cost of having excessively large cash balances is known as the excess
cash balance cost. If large funds are idle, the implication is that the firm
has missed opportunities to invest those funds and has thereby lost interest
which it would otherwise have earned. This loss of interest is primarily
the excess cost.
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69 4.4.4 Procurement and Management :
These are the costs associated with establishing and operating cash
management staff and activities. They are generally fixed and are mainly
accounted for by salary, storage handling of securities and so on.
4.4.5 Uncertainty and Cash Management :
Finally, the impact of uncertainty on cash management strategy is also
relevant as cash flows cannot be predicted with complete accuracy. The
first requirement is a precautionary cushion to cope with irregularities in
cash flows, unexpected delays in collections and disbursements defaults
and unexpected cash needs.
The impact of uncertainty on cash management can, however be mitigated
through (i) improved forecasting of tax payments capital expenditure,
dividends and soon and (ii) increased ability to borrow through overdraft
facility.
4.5 DETERMINING CASH NEED
After the examination of the pertinent considerations and cost that
determine cash needs, the next aspect relates to the determination of cash
needs.
There are two approaches to derive an optimal cash balance, namely,
(a) minimizing cost cash m odels and (b) cash budget.
4.6 CASH BUDGET: MANAGEMENT TOOL
A firm is well advised to hold adequate cash balances but should avoid
excessive balances. The firm has, therefore, to assess its need for cash
properly. The cash budget is probably th e most important tool in cash
management. It is a device to help a firm to plan and control the use of
cash. It is a statement showing the estimated cash inflows and cash
outflows over the planning horizon. In other words, the net cash position
(surplus or deficiency) of a firm as it moves from one budgeting sub
period to another is highlighted by the cash budget.
The various purposes of cash budgets are:
(i) to coordinate the timings of cash needs. It identifies the period(s)
when there might either be a shortage of cash or a abnormally large
cash requirements;
(ii) It pinpoints the period(s) when there is likely to be excess cash;
(iii) It enables a firm which has sufficient cash to take advantage of cash
discounts on its accounts payable, to pay obligations when due, to
formulate dividend policy, to plan financing of capital expansion
and to help unify the production schedule during the year so that
the firm can smooth out costly seasonal fluctuations, finally, munotes.in

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70 (iv) It helps to arrange needed funds on the most favour able terms and
prevents the accumulation of excess funds. With adequate time to
study his needs, the finance manager can select the best alternative,
in contrast a firm which does not budget its cash requirements,
may suddenly find itself short of funds. With pressing needs and
little time to explore alternative avenues of financing, the
management would be forced to accept the best terms offered in a
difficult situation. These terms will not be as favourable, since the
lack of planning indicates to the lender, that there is an
organizational deficiency. The firm therefore represents a higher
risk.
4.7 ELEMENTS/PREPARATION OF CASH BUDGET
Thus, the principal aim of the cash budget, as a tool to predict cash flows
over a given period of time, is to ascerta in whether at any point of time
there is likely to be an excess or shortage of cash. The preparation of a
cash budget involves various steps, these may be described as the elements
of the cash budgeting system.
The first element of a cash budget is the se lection of the period of time to
be covered by the budget, it is referred to as the planning horizon. The
planning horizon means the time span and the sub -periods within that time
span over which the cash flows are to be projected. There was no fixed
rule. The coverage of a cash budget will differ from firm to firm
depending upon its nature and the degree of accuracy with which the
estimate can be made. As a general rule, the period selected should be
neither too long nor too short. If it is too long, it is likely that the
estimates will be inaccurate. If, on the other hand, the time span is too
small, many important events which lie just beyond the period cannot be
accounted for and the work associated with the preparation of the budget
becomes excess ive.
The planning horizon of a cash budget should be determined in the light of
the circumstances and requirements of a particular case. For instance, if
the flows are expected to be stable and dependable, such a firm may
prepare a cash budget covering a long period, say, a year and divide it into
quarterly intervals. In the case of a firm whose flows are uncertain, a
quarterly budget, divided into monthly intervals may be appropriate.
Where flows are affected by seasonal variations, monthly budgets,
subdivided on a weekly or even a daily basis may be necessary. the flows
are subject to extreme fluctuations, even a daily budget may be called for.
The idea behind subdividing the budgeting period into smaller intervals is
to highlight the movement of cash from one sub period to another. The
sub-division will provide information on the fluctuations in the cash
reservoir level during the time span covered by the budget.
The second element of the cash budget is the selection of the factors that
have bearing on cash flows. The items included in the cash budget are
only dash items, non cash items such as depreciation and amortization are
excluded. The facts that generate cash flows are generally divided, for munotes.in

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71 purposes of the construction of cash budget into tw o broad categories (a)
operating and (b) financial This two -fold classification of cash budget
items is based on their nature. While the former category includes cash,
flows generated by the operations of the firms and are known as
Operating cash flows . The latter consists of Financial cash flows.
4.8 OPERATING CASH FLOWS
The main operating factors/items which generate cash outflows and
inflows over the time span of a cash budget are tabulated in Exhibit -1.
Exhibit -1 Operating Cash Flow items

Inflow /cash receipts Outflow/Disbursements

1. Cash sales 1. Accounts payable/Payable payments

2. Collection of 2. Purchase of raw materials.
Accounts receivable

3. Disposal of fixed 3. Wages and salary (payroll)
assets
4. Factory expenses

5. Administrative and selling expenses

6. Maintenance expenses

7. Purchase of fixed assets


Among the operating factors affecting cash flows, are the collection of
accounts receivable (inflows) and accounts payable (outflows). The terms
of credit and the speed with which the customers pay would determine the
lag between the creation of the accounts receivable and their collection.
Also, discounts and allowances for early payments, returns from
customers and bad debts affected cash inflows. Similarly, in the case of
accounts payable relating to credit purchase cash outflow are affected by
the purchase terms.
The calculation of the collection on credit sales and payments on credit
purchases, is g enerally done in the form of a statement known as the
worksheet.
Illustration 4.1
A firm sells goods on credit and allows a cash discount for payments made
within 20 days. If the discount is not availed of the buyer must pay the
full amount in 40 days. However, the firm finds that some of its
customers delay payments up to 90 days. The experience has been that on
20 per cent of sales payment is made during the month in which the sale is munotes.in

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72 made, on 70 per cent of the sales payment is made during the first month
after sale and on 10 per cent of sales payment is made during the second
month after sale .
The raw materials and other supplies required for production amount to 70
per cent of sales and are bought in the month before the firm expects to
sell its fin ished products. Its purchase terms allow the firm to delay
payment on its purchases for one month.
The credit sales of the firm are: (Rs. Lakhs)
------------------------------------------------------------------------------------------
May 10 August 30 November 20

June 10 September 40 December 10

July 20 October 20 January 10

Prepare a worksheet, showing the anticipated cash inflows on account of
collection of receivables and disbursement of payables.
Solution :
The expected cash inflows t hrough collection of receivables and the
anticipated outflows on account of accounts payable are presented in
Table 1 in the form of a worksheet.
Work Sheet (Rs.in Lakhs) Particluars May Jun Jul Aug Sep Oct Nov Dec Jan 1. Credit Sales 10 10 20 30 40 20 20 10 10 2. Collections: During month Of sale @ 20% 2 2 4 6 8 4 4 2 2 During 1st month after sale @ 70% 0 7 7 14 21 28 14 14 7 During 2nd month after sale
@ 10% 0 0 1 1 2 3 4 2 2 Total Collections 2 9 12 21 31 35 22 18 11 3. Credit purchase @ 70% of next months sale 7 14 21 28 14 14 7 7 0 munotes.in

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73 Payment (1 month lag) 0 7 14 21 28 14 14 7 7 Total payments 0 7 14 21 28 14 14 7 7

4.9 FINANCIAL CASH FLO WS
The major financial factors/items affecting the generation of cash
flows are explained below.

Financial Cash Flow Items

Cash Inflow/Receipts Cash
Outflow/Payments

1. Loans/Borrowings 1. Income -tax/Tax P ayments

2. Sales of securities 2. Redemption of loan

3. Interest received 3. Repurchase of shares

4. Dividend received 4. Interest paid

5. Rent received 5. Dividends paid

6. Refund of tax

7. Issue of new shares and
securities

Preparation of Cash Budget :
After the time span of the cash budget has been decided and pertinent
operating and financial factors have been identified, the final step is the
construction of the as budget. The preparation of a cash budget is
illustrated in Illustration -4.2 and 4.3.
Illustration 4.2
A firm adopts a six -monthly time span, subdivided into monthly intervals
for its cash budget.
(A) The following information is available in respect of its operations:

Particulars Months
-------------------------------------------------------------------
1 2 3 4 5 6

1. Sales 40 50 60 60 60 60
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74 2. Purchases 1 1.50 2 2 2 1

3. Direct labour 6 7 8 8 8 6

4. Manufacturing overheads 13 13.50 14 14 14 13

5. Administrative expenses 2 2 2 2 2 2

6. Distribution expenses 2 3 4 4 4 2


7. Raw materials (30 days credit) 14 15 16 16 16 15



(B) Assume the foll owing financial flows during the period

(a) Inflows 1. Interest received in month 1 and
month 6 Rs.1 lakh each

2. Dividend received during months 3 and 6, Rs.2
lakhs each

3. Sales of shares in month 6 Rs.160 lakh s

(b) Outflows 1. Interest paid during month 1, Rs.0.4 lakhs

2 Dividends paid during months 1 and 4 Rs.2 lakh s
each

3. Instalment payment on machine in month 6,
Rs. 20 lakhs

4. Repayment of loan in montjh 6, Rs.80 lakh s

(c) Assume that 10 per cent of each month’s sales are for cash; the
balance 90 Per cent are on credit. The terms and Credit experience of the
firm are;

1. No cash discount

2. 1 per cent of credit sales is returned by the
customers.

3. 1 per cent of total accou nts receivable is bad debt;

4. 50 per cent of all accounts that are going to pay, do
so within 30 days
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75 5. 100 percent of all accounts that are going to pay,
do so within 60 days

Using the above information prepare a cash budget.

Solution -
The cash Budget is constructed as shown below.

Cash Budget for Six Months Particluars 1 2 3 4 5 6 Sales 40 50 60 60 60 60 (A) Cash inflows
1. cash sales
(10% of Sales) 4.00 5.00 6.00 6.00 6.00 6.00
2. Receivables
collection 0.00 17.64 39.69 48.51 52.92 52.92 3. Interest received 1.00 0.00 0.00 0.00 0.00 1.00
4. Dividends
received 0.00 0.00 2.00 0.00 0.00 2.00 5. Sale of shares 0.00 0.00 0.00 0.00 0.00 160.00 Total (A) 5.00 22.64 47.69 54.51 58.92 221.92 (B) Cash outflows
1. Purchases 1.00 1.50 2.00 2.00 2.00 1.00
2. Labour 6.00 7.00 8.00 8.00 8.00 6.00 3. Manufacturing
overheads 13.00 13.50 14.00 14.00 14.00 13.00 4. Administrative
expe nses 2.00 2.00 2.00 2.00 2.00 2.00
5. Distribution
charges 2.00 3.00 4.00 4.00 4.00 2.00 munotes.in

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76 6. Raw materials (30
days Credit) 0.00 14.00 15.00 16.00 16.00 16.00
7. Interest 0.40 0.00 0.00 0.00 0.00 0.00 8. Dividend paid 2.00 0.00 0.00 2.00 0.00 0.00
9. Instalment
of machine 0.00 0.00 0.00 0.00 0.00 20.00 10. Repayment of loan 0.00 0.00 0.00 0.00 0.00 80.00
Total (B) 26.40 41.00 45.00 48.00 46.00 140.00 (C) Net Receipt or Payment (A
- B) -
21.40 -
18.36 2.69 6.51 12.92 81.92
It can be seen from the above calculations that the cash budget helps to
reconcile the need for cash with the financing arrangement. For instance,
in the first two months, the cash receipts fall below the disbursements and
the firm obviously needs tempo rary financing which it will be able to pay
in the subsequent months. In month 6, it has, in fact, excess cash for
which temporary investment will have to be made until the funds can be
employed in business.

Illustration 4.3

The following information is available in respect of a firm.

(A) Balance Sheet as on March 31

Liabi lities Amount Assets Amount

Accrued salaries 500 Cash 3000

Other liabilities 2500 Inventory 8000

Capital 65000 Other assets 70,000
Less :
Depreciation 13,000
---------------- 57000
------------ ---------------
68,000 68,000 munotes.in

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Management of Cash and Marketable Securities
77

(B) Sales Forecast

April 10,000 July 50,000

May 20,000 August 40,000

June 30,000 September 20,000

October 5,000

(C) Salary Expenses B udget


April Rs.1,500 July Rs. 4,000

May 2,000 August 3,000

June 2,500 September 2,000


(D) The firm is expected to operate on the following lines:

 Other expenses approximate 12 per cent of sales (paid in the same
month)

 Sales will be 80 per cent dash and 20 percent credit. The all credit sales
will be collected on the following month and no had debts are expected.

 All inventory purchases will be paid for during the month in which they
are made.

 A basic inventory of Rs.2,000 (at cost) will be maintained. The firm
will follow a policy of purchasing additional inventory each month to
cover the following month’s sale.

 A minimum cash balance of Rs.3,000 will be maintained.

 New orders for equipment amounting to s.20,000 scheduled for May1
delivery and Rs.10,000 for June 1 delivery have been made Payment
will be made at the time of delivery.

 Accrued salaries and other liabilities will remain unchanged

 Gross profit margin is 40 per cent of sales.


Prepare a Cash budget for 6 months (April to September) Borrowings are
made in thousands of rupees. Ignore interest. munotes.in

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78 Solution :

Cash Budget (Amount in 000 rupees) Particluars Apr May Jun Jul Aug Sep Sales 10 20 30 50 40 20 (A) Cash inflows 1. cash sales (80%) 8.00 16.00 24.00 40.00 32.00 16.00 2. Receivables
collection 0.00 2.00 4.00 6.00 10.00 8.00 Total (A) 8.00 18.00 28.00 46.00 42.00 24.00 (B) Cash outflows
1. Inventory 12.00 18.00 30.00 24.00 12.00 3.00
2. Salary 1.50 2.00 2.50 4.00 3.00 2.00
3. Expenses 1.20 2.40 3.60 6.00 4.60 2.40 4. Equipment 0.00 20.00 10.00 0.00 0.00 0.00
Total (B) 14.70 42.40 46.10 34.00 19.60 7.40 (C) Net Receipt or
Payment (A
- B) (6.70) (24.40) (18.10) 12.00 22.40 16.60 Cumulative cash gain or
Loss by end
of month (6.70) (31.10) (49.20) (37.20) (14.80) 1.80 Cumulative borrowing
(month end) 6.70 31.10 49.20 37.20 14.80 0.00
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79 4.10 CASH MANAGEMENT MODELS
The cash budget, as a cash management tool, would throw on the net cash
position of a firm. After knowing the cash position, the management
should work out the basic strategies to be employed to manage its cash.
The present section attempts to outline th e basic strategies of cash
management.
The broad cash management strategies are essentially related to the cash
turnover process, that is the cash cycle together with the cash turnover.
The cash cycle refers to the process by which cash is used to purchas e
materials from which are produced goods, which re then sold to
customers, who later pay the bills. The firm receives cash from customers
and the cycle repast itself. The cash turnover means the umber of times
cash is used during each year. The cash cy cle involves several steps along
the way as funds flow from the firm’s account, as shown in Exhibit 3.
Details of Cash Cycle

A B C D E F G H I


A = Materials ordered, B = Materials received

C = Payment s D = Cheque clearance

E = Goods sold F = Customer mails payments

G = Payment received H = Cheques deposited,

I = Funds collected.


In addressing the issue of cash management strategies, we are concerned
with the time periods involved in stages B, C, D and F, G. H. I. a firm has
no control over the time involved between stages A and B. the lag
between D and E is determined by the production process and inventory
policy. The time period between stages E and F is determined by credit
terms and the payments policy of customers.
The cash cycles and cash turnover are illustrated in the following
Illustration :
Illustration 4.4
A firm which purchases raw materials on credit is required by the credit
terms to make payments within 30dsays on its side, the firm allows its
credit buyers to pay within 60 days. Its experience has been that it takes,
on an average,35 days to pay its accounts payable and 70 days to collect
its accounts receivable Moreover 85 days elapse between the purchase of munotes.in

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Financial Mangement
80 raw materials and the sale of finished goods, that is to say, the average age
of inventory is 85 days. What is the firm’s cash cycle? Al so estimate the
Cash turnover.
Solution:
The cash cycle of the firm can be calculated by finding the average
number of days that elapse between the cash outflows associated with
paying accounts payable and the cash inflows associated with collecting
accounts receivable:
(i) Cash cycle = 85 days + 70 days – 35 days = 120 days
(ii) cash turn over = the assumed number of days in a year
divided by the cash cycle = 365/120 = 3
Minimum Operating Cash :
The higher the cash turnover, the less is the cash a firm requires. A firm
should therefore, try to maximize the cash turnover. But it must maintain
a minim um amount of operating cash balance so that it does not run out of
cash. The minimum level of operating cash is determined by dividing the
total operating annual outlays by the cash turnover rate. If, for Illustration ,
the total operating annual outlay o f a firm is Rs.240 lakh, its minimum
cash requirement is Rs.80 lakh (i.e. Rs.240 lakh + 3) . The operational
implication of the minimum operating cash requirement is that if the firm
has opening cash balance of Rs.80 lakh, it would be able to meet its
obligation when they become due. In other words, it would not have to
borrow anything. But the minimum operating cash involves a cost in
terms the earnings forgone from investing it temporarily, that is to say,
there is a opportunity cost. Assuming 10 per cent return on riskless
investment (or retirement of a debt carrying 10 per cent interest), the cost
of the minimum cash balance of Rs.60 lakhs works out to Rs.8 lakhs.
Cash Management strategies are intended to minimize the operating cash
balance require ment. The basic strategies that can be employed to do the
needful me as follows:
(a) Stretching Accounts Payable.
(b) Efficient Inventory – Production Management
(c) Speedy Collection of accounts Receivable, and
(d) Combined cash Management Strategies
We spelt out the implications of these strategies to the minimum cash
balance and the associated cost with the underlying assumption that a firm
should adopt such cash management strategies as we will lead to the
minimizing of the operating casjh requirement. In other words, efficient
cash management implies minimum cash balance consistent with the need
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81 a. Stretching Accounts Payable :
One basic strategy of efficient cash management is to stretch the accounts
payable. In other words, a firm should pay its accounts payable as late as
possible without damaging its credit standing. It should, however take
advantage of the cash discount ava ilable on prompt payment
If the firm, in our Illustration can stretch is accounts payable from the
current level of 35 days to 45 days, its cash cycle will be 110 days (i.e.
reduced by 10 days a from the original 120 days). The reduction in cash
cycle by 10 days as a result of the stretching of the accounts payable by 10
days will increase the dash turn over from 3 (initially) to 3.27 (360 + 110).
This will lead to a decrease in the minimum cash requirement from Rs.80
lakhs to Rs.73.40 lakh (Rs.240 lakh + 3.27). \that is, the requirement has
been reduced by Rs.6.60 lakh. Assuming a 10 per cent rate of interest,
there will be a saving in cost to the firm to the extent of Rs.0.66 lakh.
b. Efficient Inventory Production Management :
Another strategy is to incre ase the inventory turnover, avoiding stock
outs, that is, shortage of stock. This can be done in the following ways
(1) Increasing the raw materials turnover by using more efficient
inventory control techniques
(2) Decreasing the production cycle through bette r production planning,
scheduling and control techniques, it will lead to an increase in the
work in progress inventory turnover.
(3) Increasing the finished goods turn over through better forecasting of
demand and a better planning of production.
Assume that the firm in our Illustration is able to reduce the average age of
its inventory from 85 to 70 that is by 15 days. As a result, the cash cycle
will decline by 15 days from 120 days to 105 days. The cash turn over
will increase to 3.43 (360 + 105) from the original level of 3. The effect
of an increase in the cash turn over will be to reduce the minimum cash
requirement from Rs.80 lakh to Rs.70 lakh (Rs.240 lakh+ 3.43). the
saving in cost on Rs.10 lakh will Rs.1 lakh (Rs.10 lakh x 0.10). thus,
efficient inventory and production management causes a decline in the
operating cash requirement and hence, a saving in cash operating cost.
c. Speeding Collection of Accounts Receivable :
Yet another strategy for efficient cash management is to collect accounts
receiv able as quickly as possible without losing future sales because of
high pressure collection techniques. The average collection period of
receivables can be reduced by charges in (i) credit terms, (ii) credit
standards and (iii) collection policies. These are elaborated in the next
chapter. In brief, credit standards represent the criteria for determining
to whom credit should be extended. The collection policies determine the
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Financial Mangement
82 If the firm in our above Illustration manages to reduce the average age of
its accounts receivable from the current level of 70 days to 60 days, the
cash cycle will be reduced to 100 days from 120 days (decline by 20
days). The cash turn over will increase in consequence to 3.60 (360 +
100) from the original level of 34. the operating cash requirement will fall
from rs.80 lakhs to approximately Rs.66.67 lakh (Rs.240 + 3.60). the
reduction in cash balance of aboutnRs.233.33 lakh will lead to a saving in
cost amounting to Rs. 1.33 lakh (o.10 x Rs.13.33 lakh). Thus a reduction
in the average collection period by 20 days releases funds equivalent to
rs.13.33 lakh and leads to saving in cash operating cost of Rs.1.33 lakh)
d. Combined Cash Management Strategies
We have shown the e ffect of individual strategies on the efficiency of cash
management. Each one of them has a favourable effect on the operating
cash requirement. We now illustrate their combined effect, as firm will be
well advised to use a combination of these strategie s.
Assume the firm in our Illustration , simultaneously (i) increases the
average accounts payable by 10days; (ii) reduces the average age of
inventory by 15 days; (iii) speeds up the collection of accounts receivable
by 20 days. Now, the cash cycle will b e 75 days (120 days – 10 days – 15
days – 20 days); the cash turnover will increase to 4.8 (360 + 75), the
minimum operating cash requirement will go down to Rw.50 lakh, that is
a reduction of Rs.30 lakh, assuming a 10 percent rate of interest the saving
in cash 0perating cost will be Rs.3 lakh.
The foregoing discussion clearly shows that the three basic strategies of
cash management, related to (1) accounts payable, (2) inventory and (3)
accounts receivable, lead to a reduction in the cash balance. But th ey
imply certain problems for the management. First, if the accounts payable
are postponed too long, the credit standing of the firm may be adversely
affected. Secondly, a low level of inventory may lead to a stoppage of
production as sufficient raw mate rials may not be available for
uninterrupted production, of the firm may be short or enough stock to met
the demand for its product that is stock out finally restrictive credit
standards credit terms and collection policies may jeopardize sales. These
implications should be constantly kept in view while working out cash
management strategies.
4.11 CASH MANAGEMENT TECHNIQUES/PROCESSES
The basic strategies of cash management have been outlines in the
preceding section. It has been shown that the strategic aspects of efficient
cash management are : (i) efficient inventory management (ii) speedy
collection of accounts receivable and (iii) delaying payments on accounts
payable. There are some specific techniques and process for speedy
collection of receivables from customers and slowing disbursement.
(i) Speedy Cash Collections : munotes.in

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Management of Cash and Marketable Securities
83 In managing cash efficiently, the dash inflow process can be ac celerated
through systematic planning and refined techniques. There are two broad
approaches to do this. In the first place, the customers should be
encouraged to pay as quickly as possible. Secondly, the payment from
customers should be converted into cash without any delay.
(ii) Prompt Payment by Customers:
One way to ensure prompt payment by customers is prompt billing. What
the customer has to pay and the period of payment should be notified
accurately and in advance. The use of mechanical derives for billing
along with the enclosure of self -addressed ret urn envelope will speed up
payment by customers, is the practice of offering cash discounts. The
availability of discount implies considerable saving to the Customers to
avail of the facility the customers would be eager to make payment early.
Early Con version of Payments into Cash Once the customer makes the
payment by issuing a cheque in favour of the firm, the collection can be
expedited by prompt encashment of the cheque. There is lag between the
time a cheque is prepared and mailed by the customer and the time the
funds are included in the cash reserve of the firm.
The collection of accounts receivable can be considerably accelerated by
reducing transit, processing and collection time. An important cash
management technique is reduction in deposit float. This is possible if a
firm adopts a policy of decentralized collections. we discuss below some
of the important processes that ensure decentralised collection so as to
reduce (i) the amount of time that elapses between the mailing of a
payment by a customer and (ii) the point the funds become available to the
firm for use. The principal methods of establishing a decentralised
collection network are (a) Concentration Banking and (b) Lock box
System.
(a) Concentration Banking :
In this system of de centralized collection of accounts receivable, large
firms which have a large number of branches at different places, select
some of the strategically located branches as collection centres for
receiving p[payment from customers Instead of all the paymen ts being
collected at the head office of the firm, the cheques for a certain
geographical area are collected at a specified local collection centre.
Under this arrangement, the customers are required to send their payments
(cheque) to the collection centr e covering the area in which they live and
these are deposited in the local account of the concerned collection centre,
after meeting local expenses, if any. Funds beyond a predetermined
minimum are transferred daily to a central or disbursing of concentr ation
bank or account. A concentration bank is one with which the firm has a
major account usually a disbursement account. Hence, this arrangement is
referred to as concentration banking.
Concentration banking, as a system of decentralized billing and multiple
collection points, is a useful technique to expedite the collection of munotes.in

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84 accounts receivable. It reduces the time needed to the collection process
by reducing the mailing time. Since the collection centres are near the
customers, the time invo lved in sending the bill to the customer is reduced.
Moreover, the time lag between the dispatch of the cheque by the
customer and its receipt by the firm is also reduced. Mailing time is saved
both in respect of sending the bill to the customers as well as in the receipt
of payment. The second reason why deposit float is reduced by
concentration banking is that the banks of the firm as well as the
customers may be in a close proximity. Thus, the arrangement of multiple
collection centres with concentra tion banking results in a saving of time in
both mailing and clearance of customer payments and leads to a reduction
in the operating cash requirements. Another advantage is that
concentration permits the firm to ‘store’ its cash more efficiently. This i s
so mainly because by pooling funds for disbursement in a single account,
the aggregate requirement for cash balance is lower than it would be if
balances are maintained at each branch office.
(b) Lock -Box Syst em:
The concentration banking arrangement is instrumental in reducing the
time involved in mailing and collection. But with this system of collection
of accounts receivable, processing for purpose of internal accounting is
involved, that is, some time elapses before a cheque is deposited by the
local collection centre in its account. The lock box system takes care of
this kind of problem, apart from effecting ec0nomy in mailing and
clearance times. Under this arrangement, firms hire a post office lock box
at important collection centres. The customers are required to remit
payments to the post office lock box. The local banks of the firm, at the
respective places, are authorized to open the box and pick up the
remittances (cheques) received from the custome rs. Usually, the
authorized banks pick up the cheques several times a day and deposit them
in the firm’s accounts. After crediting the account of the firm, the banks
send a deposit slip along with the list of payments and other enclosures if
any, to the firm by way of proof and record of the collection.
Thus, the lock box system is like concentration banking in that the
collection is decentralized and is done at the branch level. But they differ
in one very important respect. While the custome sends the cheques under
the concentration banking arrangement to the collection centre, he sends
them to a post office box under the lock box system. The cheques are
directly received by the bank which empties the box and not from the firm
or its local branch.
In a way, the lock box arrangement is an improvement over the
concentration banking system. Its superiority arises from the fact that one
step-in the collection process is eliminated with the use of lock box, the
receipt and deposit of cheques by the firm. In other words, the processing
time within the firm before depositing a cheque in the bank is eliminated.
Also, some extra saving 9n mailing timing is provided by the lock box
system as the cheques received in the post office box are not delivered munotes.in

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Management of Cash and Marketable Securities
85 either by the post office or the firm itself to the bank, rather, the bank itself
picks them up oat the post office.
Thus, the lock box system as a method of collection of receivables, has a
two fold advantage : (i) the bank performs the clerical task of handling t he
remittances prior to deposits services which the bank may be able to
perform at lower cost (ii) the process of collection through the banking
system begins immediately upon the receipt of the cheque/remittance and
does not have to wait until the firm co mpletes its processing for internal
accounting purposes. In terms of the steps involves in the cash cycle, as
shown in Exhibit 3. GH and HI would take place sim8ultaneously. As a
result, the time lag between payment by a customer and the availability of
funds to the firm for use would be reduced and thereby the collection of
receivables would be accelerated.
Although the use of concentration banking and lock box systems
accelerate the collection of receivables they involve a cost. While in the
case of the former, the cost is in terms of the maintenance of multiple
collection centres, compensation to the hank for services represents the
cost associated with the latter. the justification for the use or otherwise of
these special cash management techniques would be based on a
comparison of the cost with the return generated on the released funds. If
the income exceeds the cost the system is profitable and should be used,
otherwise not. For this reason, these techniques can be pressed into
service only by l arge firms which receive a large number of cheques from
a wide geographical area.
Illustration 4.5
A firm uses a continuous billing system that results in an average daily
receipt of Rs.40,00,000. It is contemplating the institution of concentration
bankin g, instead of the current system of centralized billing and collection.
It is estimated that such a system would reduce the collection period of
accounts receivable by 2 days.
Concentration banking would cost Rs.75,000 annually and 8 per cent can
be earne d by the firm on its investments. It is also found that a lock box
system could reduce its over all collection time by four days and could
cost annually Rs.1,20,000
(i) How much cash would be freed by lock box system?
(ii) How much money can be saved due to reduction in the collection
period by 2 days? should the firm institute the concentration banking
system?
(iii) How much cash would be freed by lock box system, which is better?
(iv) Between concentration banking and lock box system, which is better?
Solution :
(i) Cash released by the concentration banking system munotes.in

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86 = Rs.40,00,000 x 2 days = Rs.80,00,000
(ii) Saving = 0.08 x Rs.80,00,000 = Rs.6,40,000

The firm should institute the concentration banking system. It costs only
Rs.75,000 while the savings expected areras.Rs.6,40,000
(iii) Cash released by the lock box system
= Rs.40,00,000 x 4 days = Rs.1,60,000
(iv) Saving in lock box system = Rs.1,60,000 = Rs.12,80,000
Lock box system is better. Its net savings rs.11,60,000 (Rs.12.80,000 –
Rs.1,20,00 0) are higher than that of concentration banking.
(iii) Slowing Disbursements :
Apart from speedy collection of accounts receivable, The operating cash
requirement can be reduced by slow disbursements of accounts payable.
In fact, slow disbursements represent a source of funds requiring no
interest payments. There are several tec hniques to delay payment of
accounts payable namely ( a) avoidance of early payments ( b) centralized
disbursements ( c) floats and ( d) accruals.
(a) Avoidance of Early Payments :
One way to delay payments is to avoid early payments. According to the
terms of cre dit, a firm is a required to make a payment within a stipulated
period. It entitles a firm to cash discounts. If, however, payments are
delayed beyond the due date, the credit standing may be adversely affected
so that the firms would fid it difficult to secure trade credit later. But if
the firm pays its accounts payable before the due date it has no special
advantages. Thus, a firm would be well advised not to make payments
early, that is, before the due date.
(b) Centralised Disbursements :
Another method to slow down disbursements is to have centralized
disbursements. All the payments should be made by the head office from
a centralized disbursement account. Such an arrangement would enable a
firm to delay payments and conserve ash for several reasons. Firstly, it
involves increase in the transit time. The remittance from the head office
to the customers in distant places would involve more mailing time than a
decentralised payment by the local branch. The second reason for
reduction in operating cash requirement is that since the firm has a
centralized bank account, a relatively smaller total cash balance will be
needed. In the case of a decentralised arrangement a minimum cash
balance will have to be maintained at each branch which will add to large
operating cash balance. Finally, schedules can be tightly controlled and
disbursements made exactly on the right day.
(c) Float munotes.in

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Management of Cash and Marketable Securities
87 A very important technique of slow disbursements is float. The term float
refers to the amount of money tied up in cheques that have been written
but have yet to be collected and encashed. Alternatively, float represents
the difference between the bank balance and book balance of cash of a
firm. The difference between the balance as shown by the firm’s record
and the actual bank balance is due to transit and processing delays. There
is a time lag between the issue of a cheque by the firm and its presentation
to its bank by the customer’s bank for payment. The implication is that
although the cheque has been issued cash would be required later when the
cheque is presented for encashment Therefore, a firm can send remittances
although it does not have cash in its bank at the time of issuance of the
cheque. Meanwhile, funds can be arranged to make payment when the
cheque is present ed for collection after a few days. Float used in this
sense is called as cheque kiting. There are two ways of doing it ( i) paying
from a distant bank ( ii) scientific cheque cashing analysis.
(i) Paying from a Distant Bank :
The firm may issue a cheque on bank s away from the creditor’s bank.
This would involve relatively longer transit time for the creditor’s bank to
get payment and, thus, enable the firm to use its funds longer.
(ii) Cheque -encashment Analysis :
Another way to make use of float is to analyse, on th e basis of past
experience, the time lag in the issue of cheques and their encashment. For
instance, cheques issued to pay wages and salary may not be encashed
immediately, it may be spread over a few days, say, 25 per cent on one
day, 50 per cent on the second day and the balance on the third day. It
would mean that the firm should keep in the bank not the entire amount of
a payroll but only a fraction represented by the actual withdrawal each
day. This strategy would enable the firm to save operating c ash.
(d) Accruals
Finally, a potential tool for stretching accounts payable is accruals which
are defined as current liabilities that represent service or goods received by
a firm but not yet paid for. For instance, payroll, that is, remuneration to
employees who render se rvice in advance and receive payment later. In a
way, they extend credit to the firm for a period at the end of which they
are paid say, a week or a month. The longer the period after which
payment is made, the greater is the amount of free financing con sequently
and the smaller is the amount of cash balances required. Thus, less
frequent payrolls, that is, weekly as compared to monthly are an important
source of accrual. They can be manipulated to slow down disbursements.
Other Illustration s of accrua l are rent to lessors and taxes to government.
But these can be utilized only to a limited extent as there are legal
constraints beyond which such payments cannot be extended.

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88 4.12 MARKETABLE SECURITIES:
This section presents a brief description of th e marketable securities.
Attention is focused on the meaning and characteristics of marketable
securities the general selection criterion and the basis types of such
securities.
4.12.1 Meaning and characteristics :
Once the optimum level of cash balance o f a firm has been determined the
residual of its liquid assets is invested in marketable securities. Such
securities are short -term investment instruments to obtain a return on
temporarily idle funds. In other words, they are securities which can be
conv erted into cash in a short period of time typically a few days. The
basic characteristics of marketable securities affect the degree of their
marketability/liquidity. To be liquid a security must have two basic
characteristics; a ready market and safety of principal. Ready
marketability minimize the amount of time required to convert a security
into cash. A ready market should have both breadth in the sense of a large
number of participants scattered over a wide geographical area as well as
depth as det ermined by its ability to absorb the purchase/sale of large
amounts of securities.
The second determinant of liquidity is that there should be little or no loss
in the value of a marketable security over time. Only those securities that
an be easily conve rted into cash without any reduction in the principal
amount qualify for short -term investments. A firm would be better off
leaving the balances in cash if the alternative were to risk a significant
reduction in principal.
4.12.2 Selection Criterion :
A m ajor decision confronting the financial managers involves the
determination of the mix of cash and marketable securities. Some of the
quantitative models for determining the optimum amounts of marketable
securities to hold in certain circumstances have be en outlines in an earlier
section. In general, the choice of the mix is based on a trade off between
the opportunity to earn a return on idle funds (cash) during the holding
period, and the brokerage costs associated with the purchase and sale of
marketab le securities. For Illustration , take the case of a firm paying
Rs.350 as brokerage costs to purchase and sell Rs.45,000 worth of
marketable securities yielding an annual return of 8 per cent and held for
one month. The interest earned on the securities works out a Rs.300 (1/12
x -08 x Rs.45,000). Since this amount is less than the cost of the
transaction (Rs.350) it is not advisable for the firm to make the
investments. This trade off between interest returns and brokerage costs is
a key factor in dete rmining what proportion of liquid assts should be held
in the form of marketable securities.
There are three motives for maintaining liquidity (cash as well as
marketable securities) and, therefore, for holding marketable securities,
transaction motive, sa fety/precautionary motive and speculative motive. munotes.in

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Management of Cash and Marketable Securities
89 Each motive is based on the premise that a firm should attempt to earn a
return on temporarily idle funds. The type of marketable security
purchased will depe3nd on the motive for the purchase. An assess ment of
certain criteria can provide the financial manager with a useful framework
for selecting a proper marketable securities mix.
These considerations include evaluation of (i) financial risk (ii) interest
rate risk (iii) taxability (iv) liquidity and (v) yield among different
financial assets.
(i) Financial/Default Risk :
It refers to the uncertainty of expected returns from a security attributable
to possible changes in the financial capacity of the security issuer to make
future payments to the security owner. If the change of default on the
terms of the investment is hi gh (low) then the financial risk is said to be
high (low). As the marketable securities portfolio is designed to provide a
return on funds that would be otherwise tied up in ideal cash held for
transaction or precautionary purposes, the financial manager will not
usually be willing to assume such financial/default risk in the hope of
greater return within the make up of the portfolio.
(ii) Interest Rate Risk :
The uncertainty that is associated with the expected returns from a
financial instrument attributable to changes in interest rate is known as
interest rate risk. Of particular concern to the corporate financial manager
is the price volatility associated w ith instruments that have long, as
opposed to short terms to maturity.
If prevailing interest rates rise compared with the date of purchase, the
market price of the securities will fall to bring their yield to maturity in
line with what financial managers could obtain by buying a new issue of a
given instrument, for instance, treasury bills. The longer the maturity of
the instrument t, the larger will be the fall in prices. To hedge against the
price volatility caused by interest rat3e risk, the market se curities portfolio
will tend to be4 composed of instruments that mature over short periods.
(iii) Taxability :
Another factor affecting observed difference in market yields is the
differential impact of taxes. Securities income on which is tax exempt sell
in the market at lower yields to maturity than other securities 0f the same
maturity. A differential impact on yields arises also because interest
income is taxes at the ordinary tax rate while capital gains are taxes at a
lower rate. As a result fixed interes t securities that sell at discount because
of low coupon rate in relation to the prevailing yields are attractive to
taxable investors. The reason is that part of the yield to maturity is a
capital gain. Owing to the desirability of discount on low inter est fixed
income securities their yield to maturity tends to be lower than the yield
on comparable securities with higher coupon rates. The greater the
discount the greater is the capital gains attraction and the loser is its yield munotes.in

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90 relative to what it wou ld be if the coupon rate were such that the security
was sold at par.
(iv) Liquidity :
With reference to marketable securities portfolio, liquidity refers to the
ability to trans form a security into ash. Should an unforeseen event
require that a significant a mount of cash be immediately available, a
sizeable portion of the portfolio might have to be sold. The financial
manager will want the cash quickly and will not want to accept a large
price reduction in order to convert the securities. Thus, in the formu lation
of preferences for the inclusion of particular instruments in the portfolio,
consideration will be given to (i) the time period needed to sell the
security and (ii) the likelihood that the security can be sold at or near its
prevailing market price. The later element, here means that ‘thin’ market,
where relatively few transactions take place or where traders are
accomplished only with large price changes between transaction, should
be avoided.
(v) Yield :
The final selection criterion is the yields that are available on the different
financial assets suitable for inclusion in the marketable/near cash portfolio.
All the four factors factors listed above, financial risk, interest rate risk
liquidity and taxability influence the available yields on financi al
instruments. Therefore the yield criterion involves a weighing of the risks
and benefits inherent in these facts. If a given risk is assumed, such as
lack of liquidity, then a higher yield may be expected on the instrument
lacking the liquidity charac teristics.
4.12.3 Marketable Security Alternatives :
We describe below briefly the more prominent marketable/near cash
securities available for investment. Our concern is with money market
instruments.
(i) Treasury Bills :
There are obligations of the governm ent. They are sold on a discount
basis. The investor does not receive an actual interest payment. The
return is the difference between the purchase price and the face (par) value
of the bill.
The treasury bills are issued only in bearer form. They are purchased,
therefore, without the investors’ name upon them. This attribute makes
them easily transferable from one investor to another. Ay active
secondary market exists for these bills. The secondary market for bills not
only makes them highly liqui d but also allows purchase of bills with very
short maturities. As the bills have the full financial backing of the
government, they are, for all practical purposes, risk free. The negligible
financial risk and the big degree of liquidity makes their yie ld lower than
those on the other marketable securities. Due to their virtually risk free munotes.in

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Management of Cash and Marketable Securities
91 nature and because of active secondary market for them, treasury bills are
one of the most popular marketable securities even though the yield on
them is loser.
(ii) Negot iable Certificates of Deposit (CDs) :
These are marketable receipts for funds that have been deposited in a bank
for a fixed period of time. The deposited funds earn a fixed rate of
interest. The denomination and maturities are tailored to the investors’
need. The CDs are offered by banks on a basis different from treasury
bills, that is, they are not sold at a discount . Rather when the certificates
mature, the owner receives the full amount deposited plus the earned
interest. A secondary market exists for the CDs. While CDs may be
issued in either registered or bearer form the latter facilitates transactions
in the secondary market and thus, is the most common. The default risk is
that of the bank failure, a possibility that is low in most cases.
(iii) Comm ercial Paper :
It refers to short term unsecured promissory note sold by large business
firms to raise cash. AS they arte unsecured the issuing side of the market
is dominated by large companies which typically maintain sound credit
ratings. Commercial papers (CPs) can be sold either directly or through
dealers. Companies with high credit rating can sell directly to investors.
The denominations in which they can be bought vary over a wide range.
They can be purchased similarly with varying maturitie s. These papers
are generally sold on discount basis in bearer form although at times
commercial papers can be issued carrying interest and made payable to the
order of the investor. For all practical purposes, there is no active trading
in secondary mar ket for commercial paper although direct sellers of CPs
often repurchase it on request. This feature distinguished CPs from all of
the previously discussed short term investment vehicles. When, therefore
a financial manager evaluates these for possible i nclusion in marketable
securities portfolio he should plan to hold it to maturity. Owing to its lack
of marketability. CPs provide a yield advantage over other near cash
assets of comparable maturity.
(iv) Bankers Acceptances :
These are drafts(order to pay) d rawn on a specific bank by an exporter in
order to obtain payment for goods he has shipped to a customer who
maintains an account with that specific bank. They can also be used in
financing domestic trade. The draft guarantee payment by the accepting
bank at a specific point of time. The Seller who hold such acceptance may
sell it at a discount to get immediate funds. Thus, the acceptance becomes
a marketable security. Since acceptances are used to finance the
acquisition of goods by one –arty, the doc ument is not issued in
specialized denominations, its size/denomination is determined by the cost
of goods being purchased. They serve a wide range of maturities and are
sold on a discount basis, payable to the bearer. A secondary market for
the acceptan ce of large banks does exist. Owing to their greater financial
risk and lesser liquidity, acceptances provide investors a yield advantage munotes.in

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92 over treasury bills of like maturity. In fact, the acceptance of major banks
are a very safe investment, making the yield advantages over treasury bills
worth looking for marketable securities portfolio.
(v) Repurchase (Repo) Agreements :
These are legal contracts that involve the actual sale of securities by a
borrower to the lender with a commitment on the part of the former to
repurchase the securities at the current price; us a stated interest charge.
The securities involved are gover nment securities and other money market
instruments. The borrower is either a financial institution or security
dealer.
There are two major reasons why a firm with excess cash prefers to buy
repurchase agreements rather than a marketable security. First, the
original maturities of the instrument being sold can, in effect, be adjusted
to suit the particular needs of the investing firm. Therefore, funds
available for a very short period, that is, one/two days can be employed to
earn a return. Closely rela ted to the first is the second reason, namely,
since the contract price of the securities that make up the arrangement is
fixed for the duration of the transaction, the firm buying the repurchase
agreement is protected against market fluctuations throughou t the contract
period. This makes it a sound alternative investment for funds that are
surplus for only short periods.
(vi) Units :
The units of mutual funds offer a reasonably convenient alternative avenue
for investing surplus liquidity as (i) there is a very active secondary market
for them, (ii) the income from units is tax exempt up to a specified amount
and (iii) the units appreciate in a fairly predictable manner.
(vii) Intercorporate Deposits :
Intercorporate deposits, that is, short -term deposits with other co mpanies
is a fairly attractive form of investment of short term funds in terms of rate
of return which currently ranges between 12 and 15 per cent. However,
apart from the fact that one month’s time is required to convert them into
cash, inter corporate d eposits suffer from high degree of risk.
(viii) Bills Discounting :
Surplus funds may be deployed to purchase/discount bills. Bills of
exchange are drawn by seller (drawer) on the buyer (drawee) for the value
of goods delivered to him. During the pendency of th e hill i9fthe seller is
in need of funds, he may get it discounted. On maturity, the bill should be
presented to the drawee for payment. A bill of exchange is a self
liquidating instrument. Bill discounting is superior to intercorporate
deposits for inv esting surplus funds. While parking surplus funds in bills
discounting, it should be ensured that the bills are trade bills arising out of
genuine commercial transaction and, as far as possible they should be munotes.in

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Management of Cash and Marketable Securities
93 backed by letter of credit/acceptance by banks to ensure absolute safety of
funds.
(ix) Money Market Mutual Funds/Liquid Funds:
are professionally managed portfolios of marketable securities. They
provide instant liquidity. Due to high liquidity, competitive yields and
low transactions, these funds h ave achieved significant growth in size and
popularity in recent years.
Illustration 4.6
The following information is available in respect of a trading firm.
(i) On an average debtor are collected after 45 days inventories have an
average holding period of 75 days and creditors payment period on an
average is 30 days.
(ii) The firm spends a total of Rs.120 lakh annually at a constant rate.
(iii) It can earn 10 per cent on investments.
From the above information compute: (a) the cash cycle and cash turnove r
(b) minimum amounts of cash to be maintained to meet payments as they
become due(c) savings by reducing the average inventory holding period
by 30 days.
Solution
(a) (i) Cash cycle = 45 days + 75 days – 30days = 90 days (3 months)
(ii) Cash turnover = 12 months (360 days) 3 months (90 days) = 4

(b) The firm spends a total of Rs.120 lakh annually at a constant rate

(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months)
Cash turnover = 12 months (360 days)/2 months (60 days) = 6
Minimum ope rating cash = Rs.120 lakh/6 = Rs.20 lakh
Reduction in investments = Rs.30 lakh – Rs.20 lakh = Rs.10 lakh
Savings = 0.10 x Rs.10 lak = Rs.1 lakh

Illustration 4.7
A firm has been offered, a cash management service by a bank for
Rs.1,00,000 per year. It is estimated that such a service would not only
eliminate “excess” cash on deposits (Rs.8,00,000) but also reduce its
administration and other costs to the tune of Rs.5,000 per month.
Assuming the cost of capital of 15 percent, is it worthwhile for the f irm to
engage the cash management service?

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94 Solution :

Benefits (annual)

Savings in interest(Rs.8,00,000 x 0.15) Rs.1,20,000

Reducti0n in administration and other costs
(Rs.5,000 x 120 ) Rs. 60,000
-----------------
Total Rs.1,80,000

Less: Cost (annual)

Bank service charges Rs.1,00,000
-----------------

Net annual benefits Rs. 80,000


Recommendation: It is worthwhile to engage the bank services.
Illustration 4.8
METR IT Industries feels a lock box system can shorten its accounts
receivable collection period by 3 days credit sales are estimated at Rs.365
lakh per year billed on a continuous basis. The firm’s opportunity cost of
funds is `15 per cent. The cost of lock box system is Rs.50,000
(a) Will you advise “METRIT” to go for lock box system?
(b) Will your answer be different if accounts receivable collection period is
reduced by 5 days?
Solution

(a) Cash released by lock box system
(Rs.365 lakh/365 days =
Rs.Rs.1 lakh x 3 days Rs.3,00,000

(i) Savings (Rs.3 lakh x 0.15) 45,000

(ii) Less: Cos t of lock box system (50,000)
------------
Net loss (i-ii) (5,000)

The firm is advised not to go for the lock box system



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95 (b) Cash released Rs.1 lakh x 5 days Rs.5,00,000
(i) Savings (Rs.5 lakh x 0.15) 75,000
(ii) Less : Cost of lock box system (50,000 )
----------------
Net savings (i – ii) 25,000

The firm should go for the lock box system.
Illustration 4.9
EXCEL Industries sells ts products through widely dispersed distributors
in Nor hern India. It currently takes on an average 8 days for cash receipt
cheques to become available to the firm from the data they are mailed.
The firm is contemplating the institution of c0ncentration banking to
reduce this period. It is estimated that su ch a system would reduce the
collection period of accounts receivable by 3 days. The daily cheque
receipts currently average Rs.10,00,000.
The concentration banking would cost rs.1,50,000 annually and the cost of
funds is 15 per cent.
(a) Advise EXCEL whe ther it should introduce concentration banking
system.
(b) Will your answer be different, if it is estimated that a lock box system
can reduce the collection time by 45 days and its annual cost would be
Rs.2,00,000?
Solution


(a) Cash released by concentr ation banking
system (Rs.10 lakh x 3 = Rs.30 lakh)
(i) Savings (Rs.30 lakh X 0.15) Rs,4,50,000

(ii) Less: Costs (1,50,000 )
----------------
Net savings (i – ii) 3,00,000
The firm should introduce concentration banking system


(b) cash released by lock system (Rs.10 lakh x 4 =
Rs..40 lakh)
(i) Savings (Rs.40 lakh x 0.15) 6,00,000
(ii) Less : C osts 2,00,000
-------- ---
Net Savings (i – ii) 4,00,000

The lock box system is better

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96 Illustration 4.10

The following results are expected by AMERSONS Ltd. by quarters next
year, in thousands of rupees.


Particulars Quarter
----------------------------------------------------
1 2 3 4

Sales 7,500 10,500 18,000 10,500

Cash payments

Production costs 7,000 10,000 8,000 8,500

Selling ad ministrative
And other costs 1,000 2,000 2,900 1,600

Purchases of plant and
Other fixed assets 100 1,100 2,100 2,100


The debtors at the end of a quarter are one third of sales for the quarter.
The opening balance of debtors is Rs .30,00,000 cash on hand at the
beginning of the year is Rs.6,50,000 and the desired minimum balance is
Rs.5,00,000. Borrowings are made at the beginning of quarters in which
the need will occur in multiplies of Rs.10,000 and are repaid at the end of
quarters Interest charges maybe ignored . You are required to prepare:
(a) a cash budget by quarters for the year and
(b) state the amount of loan outstanding at the end of the year

Solution
1 2 3 4 Total A) Cash inflows Collection from debtors (i) From prior quarter (1/3 of sales) 2500 3500 6000 3500 15500 (ii) From current quarter (2/3 of sales) 5000 7000 12000 7000 31000 munotes.in

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97 Total 7500 10500 18000 10500 46500 (B) Cash outflows Production costs 7000 10000 8000 8500 33500 Selling, administration and other costs 1000 2000 2900 1600 7500 Plant and other fixed Assets
purchased 100 1100 2100 2100 5400 Total 8100 13100 13000 12200 46400 (C) Surplus (deficiency) -600 -2600 5000 -1700 100 Beginning balance 650 500 500 2450 650 Ending balance (indicated) 50 -2100 5500 750 750 Borrowings required 450 2600 0 0 3050 (deficiency + min cash required) Repayment made 0 0 3050 0 3050 (balance – min cash required) Ending balance (actually now
Estimated) 500 500 2450 750 750
(b) Loan outstanding = Rs.30,50,000 – Rs.30,50,000 = Nil
Illustration 4.11
From the following information prepare cash budget of a business firm for
the month of April
(a) The firm makes 20 per cent cash sales. Credit sales are collected
40,30 and 25 per cent in the month of sales month after and second munotes.in

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Financial Mangement
98 month after sales respectively. The remaining 5 per cent becomes bad
debts.
(b) The firm has a policy of buying enough goods each month to maintain
its inventory at two - and one -half times the following month’s
budgeted sales.
(c) The firm is enti5tled to 2 per cent discount on all its purchases if bills
are paid within 15 days and the firm avails of all such discounts.
Monthly purc hases are made in two equal lots on fortnightly basis.
(d) Cost of goods sold, without considering the 2 per cent discount, is 50
per cent of selling prices. The firm records inventory net of discount.
(e) Other data is :
Sales
------ ------------------------- --------------------------------------------------
January (actual) Rs.1,00,000
February (actual) 1,20,000
March (actual) 1,50,000
April (budgeted) 1,70,000
May (budgeted) 1,40,000
---------------------- --------------------------------------------------------------------
Inventory on March 31, Rs.2,25,400
Cash on March 31, Rs.30,000
Gross purchasers in March Rs.1,00,000
Selling, general and administrative expenses budgeted for April
Rs.45,00 0 (includes rs.10,000 depreciation)
Solution

Cash Budget for the month of April
Particulars Amount
(a) Cash inflows
Balance in the beginning April 1 Rs.30,000
Collection from sales
Cash sales 10.20 x Rs.1,70,0 00 34,000
Collection from debtors :
For February sales Rs.(0.25 x Rs.96,000) 24,000
For March sales (0.30 x 1,20,000) 36,000
For April sales (0.40 x 1,36,000) 54,400
---------------
Total 1,78,400

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99


(b) Cash outflows
Payment for purchase
March (Rs.1,00,000 x 0.98 x ½) 49,000
April (Rs.29,400 x ½) (see purchase budget) 14,700
Selling general and administrative expenses
(Rs.45,000 – Rs.10,000) 35,000
----------
Total 98,700
---------
(c) Budgeted cash balance at end of April (a – b)
Working notes
Particular budget (April) Gross Net
Desired ending inventory -gross
(Rs.1,40,000 x 0.50 x 2.5) Rs.1,75,000 Rs.1,71,500
Add: Cost of sales in April -gross
(Rs.1,70,000 x 0.50) 85,000 83,300
------------------ ----------------
Total requirements 2,60,000 2,54,800
Less Beginning inventory – gross
(Rs.2,25,400 x 100/98) 2,30,000 2,25,400
------------------- -----------------
Required purchases 30,000 29,400



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100 5
BASIC PRINCIPLES OF COST
ACCOUNTING
Unit Structure :

5.0 Objectives
5.1 Introduction
5.2 Meaning of Cost Accounting
5.3 Definition of Cost Accounting
5.4 Scope of Cost Accounting
5.5 Difference Between Financial Accounting and Cost Accounting
5.6 Concept of Cost Centre and Cost Unit
5.7 Classification of Cost
5.8 Determination of Tot al Cost
5.9 Elements of Cost
5.10 Cost Sheet / Statement of Cost
5.0 OBJECTIVES
 To Introduce the topic
 To Know about the Meaning and Definitions of Cost Accounting
 To Explain the relationship between Financial Accounting and
Cost Accounting
 To clear the concept s ost Centre and Cost Unit
 To Explain the Classification of cost and Elements of cost
 To Unable the students to prepare the Cost Sheet
5.1 INTRODUCTION
In the modern age of business the managem ent needs much more
information th an supplied by the Financial Accounting. Usually
Financial Accounting provides only the information related to the
profits or losses of the business activities for a particular period and
the financia l position of the business on t he particular date. This
information is insufficient to take various managerial decisions. Here
the new branch of accounting emerged namely Cost Accounting. Thus
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Basic Principles of Cost
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101 it started as a branch of Financial Accounting but now it has been
developed as a special profession due to its scope and importance. Now
It is used in profit and non profit organisations engaged in
manufacturing and non manufacturin g organisations.
In the primary stages Cost Accounting largely used for - recording the
expenditures, determining factory cost, inventory valuation, pricing and
profit determination. Now it has become so wide t hat it includes
administration, sel ling and distribution expenses and covers the areas
like cost control, cost analysis, budgeting etc., which are useful for taking
various managerial decisions.
5.2 MEANING OF COST ACCOUNTING
The term Costing and Cost Accounting are often used interchangeably.
But there is a technical difference between the two. Costing is simply
Cost finding by using the various techniques and processes. On the other
hand Cost Accounting includes the formal accounting mech anism by
means of which various expenses are recorded and costs are ascertained.
Cost Accounting relates to the collection, classification, ascertainment of
cost , its accounting the control of cost.
5.3 DEFINITION OF COST ACCOUNTING
Definitions Of Cost Accounting :
“ Cost Accounting is the p rocess of accounting for cost from the point
at which expenditure is incurred or committed to the establishment of its
ultimate relationship with cost centres and cost units. In its widest usage, it
embrac es the preparation of statistical data, the applic ation of cost control
methods and ascertainment of profitability of activities carried out or
planned.”
Chartered Institute of Management :
“ Cost Accounting is a set of procedures for determining the cos t of a
product and various activities involved in its manufacture and sale and for
planning and measuring performance.”
Gillespie
The Costing Accounting is a formal mechanism by means of which the
cost of a product or a service is ascertained and controlle d.The above
definitions of Cost Accounting explain s that Cost Accounting is the
technique applied for classifying, recording and appropriate allocation of
expenditures for the determination of the cost of products or services, and
for the presentation of s uitably arranged data for purpose of control and
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102 5.4 SCOPE OF COST ACCOUNTING
The meaning of the term Scope is the areas covered.To know about the
scope of Cost Accounting the opinion of Kohler is very important, he
says, “Cost Acc ounting includes the design and operation of cost system
and procedures, the determination of cost by departments functions,
responsibilities, activities, products, territories, period and other units of
forecast, future costs and standard costs, as well as historical costs ; the
comparison of cost of d ifferent periods, of actual with estimated standard
cost, the presentation and interpretation of cost data as an aid to
management in controlling current and future operations.” After analysing
the definiti ons of Costing Accounting it can be said that Cost Accounting
covers the following areas :
 Cost ascertainment :
Cost Accounting collects the cost data from various sources under
appropriate heads of accounts and then analyse the costs under the various
elements of cost. Then various statements are prepar ed where the elements
of cost are recorded systematically. Making use of the relative information
included in the respective statements Cost Accounting ascertains the cost
for particular product, job or pro cess.
 Cost Control :
Cost Accounting includes var ious techniques like Standard Costing,
Budgetary Control which are useful for cost control. Here the costs are
pre-determined and such estimated costs are compared with the actual
costs. Then various state ments are prepared to analyse the difference for
e.g. Variances analyses, Idle time analyses etc. Such statements are useful
for cost control.
 Decision Making :
Cost Accounting technique like Marginal Costing is useful for price
fixation and taking variou s decisions such as accept or reject the increased
demand, make or buy the product, increase the profits or not etc.
 Cost Audit :
The purpose of Cost Audit is to ensure that the costing books are
arithmetically accurate as well as to see that the principl es and rules have
been applied correctly. Cost Acc ounting includes Cost Audit also.
5.5 DIFFERENCE BETWEEN FINANCIAL
ACCOUNTING AND COST ACCOUNTING
FINANCIAL ACCOUNTING COST ACCOUNTING 1. OBJECT
To provide the information about
the profit or l oss and the financial
position of the business to the To p rovide detailed cost
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proper planning, control and munotes.in

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Basic Principles of Cost
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103 owners and ot her outside parties.
decision making purpose.

2. STATEMENTS PREPARED
To fulfil the above objective
statements as Profit and Loss
Account and Balance Sheet are
prepared here. To fulfil the object the statement as Cost Sheet, Loss of Material
Report, Idle Time Report, Variance
Report etc., are prepared here.

3. PREPARATION PERIOD
The above statements are usually prepared at the end of the year. Here th e various statements and reports are prepared as and when desired by management.

4. STATUTORY REQUIRE MENT
These accounts are kept obligatory
to meet the requirement of
Companies Act and Income Tax
Act.
These accounts are kept voluntarily
to meet the requirements of
management. But now Companies
Act has made it obligatory to keep
cost records in some manufacturing
industri es.

5. CONTROL ASPECT
It gives importance to recording the
financial transactio ns. Control
aspect is ignored here
The control aspect is very important
here. For controlling purpose it provides techniques like Budgetary control, Standard costing etc.

6. NATURE OF TRANSACTION
The transactions included here are
based on actual facts a nd figures.
Only the commercial transactions
are included here.
The transactions included here are
based partly on facts and partly on
estimates. Commercial as well as
interna l transactions i.e. internal
transfers etc., are also recorded
here.

7. ANALYSIS OF COST AND PROFIT It shows the profits or losses of the whole business for a particular period. It shows the detailed cost data as
well as profits for each product,
department, process etc.,
individually as and desired.


5.6 CONCEPT OF COST CENTRE A ND COST UNIT

The total cost s hould be determined by applying different methods
of costing. But for allocation and ascertainment purpose it becomes
necessary to break up or separate the cost. For this purpose to study about
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Financial Mangement
104 5.6.1 COST CENTRE:
Cost centres are set up to allocate the cost on each centre, thereby cost
control should be possible. Chartered Institute of Management and
Accountants London defines Cost Centres as,” A location, person or it em
of equipment (or group of the se), for which cost may be ascertained an
used for the purpose of control.”
 Main Features of Cost Centres:
1. It is the section or sub section of business to which the costs can be
allocated.

2. It may be a location, i.e. a dep artment, a sales area etc., o n which the
costs can be charged.

3. It may be an item of equipment i.e. a machine, a vehicle etc., to
which the cost can be allocated.

4. It may be a person or group of persons i.e. a sales man, a machine
operator etc. On whi ch the cost may be allocated.

 Cost centres are divided as :
1. Personal Cost Centre – If includes a person or a group of person
for e.g. a sales man, Machine Operator, group of Machine operator
operating one Machine

2. Impersonal Cost Centres – It includes a location, an equipment or
group of these.

3. Production Cost Centres - It includes the Cost Centre where the
production work take place for e.g. Melting department, Welding,
Finishing department etc. Cost incurred by these centres ca n be
charged directly to a particular product.

4. Service Cost Centre – It includes ancillary departments which are
rendering services to production and other departments in the business.
The cost incurred by these centres are of indirect nature for e.g .
Canteen, Tool room, Powe r house etc.
The Cost Centres are set up to ascertain the cost of that centre and to
control the cost. Suppose if Sales man is a cost centre all the costs
related to this centre i.e. his salary, commission, training expenses,
allowances etc., are charged to it. Thus , the total cost of that centre is
ascertained. Cost control is the main objective to ascertain the cost of
the centre. The person in charge of that centre is held responsible for
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Basic Principles of Cost
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105 The number and s ize of cost centres depend upon the expenditures
involved and the requirements of management for the purpose of cost
control.
5.6.2 COST UNIT :
Cost Unit is a device where the costs are further divided into smaller sub
divisions than in the cost centres. Cost centre is the step where the total
cost is allocated to allocation or an equipment or a person or group of
these. On the other hand, cost unit is the step where the above allocated
cost is subdivided into smaller subdivisions thereby the cost of sale able
products or services can be ascertained.
Chartered Institute of Management London defines Cost Unit as, “ It is a
unit of product, service or time in relation to which the cost may be
ascertained or expressed.” For e.g. cost per tonne in case of Min es, cost
per metre in case of Textile Industries etc. Here a tonne, a metre are the
units to measure the coal, cloth to determine the cost for selling purpose.
 Main features of Cost Unit
1. It is the measurement of cost to be stated in the terms of number i. e.
weight, length, area, vol ume etc.

2. It must be clearly defined and selected before the process of cost
determination.

3. It must not be too big or too small. It means the cost unit must be
applicable to the circumstances under consideration for e.g. cost for
1000 bricks not 1 brick, here 1000 bricks is the appropriate cost unit
which is applicable in wholesale and retail transactions.

 Cost Units are divided as :
 Units of production :- Which are generally decided for production
industries for e.g. in cas e of Mines Tonne of coal , in case of Printing
Press Thousand copies, in case of Bricks Thousand Bricks.

 Units of Services : - Which are generally decided for service rendering
industries, for e.g. Transport Service - Per Passenger Per Mile , Hotel
Service – Room Per Day, Electricity Service - Kilowatt Hour etc.
5.7 CLASSIFICATION OF COST
For proper control and taking managerial decisions classification process
is very essential. It is the systematic process where the costs are grouped
accord ing to their comm on characteristics
Cost are generally classified as below to achieve different objectives :
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Financial Mangement
106 5.7.1 On the basic of Identifiability :

1. Direct Cost : - These are the costs which can be directly charged to a
particular cost centre or cost unit. It include s Direct material, Direct
labour and Direct expenses.

2. Indirect cost : - These are the costs which are incurred for the benefit
of a number of cost centres and cost units therefore cannot be charged
to a particular cost centre or cost unit. These a re of a general nature and
incurred for the organisation as a whole. All the factory overheads,
office and administration overheads, selling and distribution overheads
are included in indirect cost.

5.7.2 On the basic of Behaviour : -

1. Fixed Cost : - These co sts rema in constant in ‘total’ amount and not
related to the volume of production. For e.g. rent, insurance of building,
managerial salaries, bank charges, office expenses etc. These costs do
not increase or decrease in ‘total’ when the volume of producti on
chang es but fixed cost ‘per unit’ increases when volume of production
decreases, and vice versa.

2. Variable Cost : - These costs vary in ‘total’ amount in direct
proportion to the volume of production but the variable cost per unit
remains fixed. For e.g. dir ect material, direct labour, power etc.

3. Semi variable cost : - These costs include both a fixed and a variable
component. These are partly variable and partly fixed. For e.g.
telephone expenses include a fixed portion of annul charges plus
variabl e charge according to calls.

5.7.3 On the basic of time

1. Historical Cost : -These costs are ascertained after they have been
incurred. These are the actual costs. These costs are available only after
the completion of the manufacturing activity.

2. Pre-determin ed Cost :- These costs are estimated costs which are
ascertained in advance for the planning and control purpose.

5.7.4 On the basic of Controllability : -

1. Controllable Cost : - The costs within the control of management are
controllable costs. Variable cost s are ge nerally controllable costs which
are controlled by department heads. For e.g. raw material cost.

2. Non-controllable Costs : - These are the costs on which management
can have no control. These costs cannot be influenced by the action of
a specified member o f an organisation. For e.g. factory rent ,
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Basic Principles of Cost
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107
5.7.5 On the basic of Normality : -

1. Normal cost : - It is the cost which is normally incurred on expected
lines at a given level of output. This cost is the pa rt of Cost of
Production.

2. Abnormal cost : - It is the cost which is not normally incurred at a
given level of output. This cost is not incurred normally but incurred
only in certain cases. Such cost is over and above the normal cost and is
not treated a s a part of the Cost of Production and charged to Costing
Profit and Loss Account.
5.8 DETERMINATION OF TOTAL COST
A Cost is the composition of three elements i.e. material, labour and
expenses. While determining the total cost it becom es nece ssary to
study about these three elements thoroughly for proper control and
managerial decisions. It is very important to analyse the total cost by
elements of cost i. e. Material, Labour and Expenses.
There are Three elements of cost :
1] Materia l
2] Labour
3] Expenses
These elements further divided as : -
1] Direct material and Indirect material
2] Direct labour and Indirect labour
3] Direct Expenses and Indirect expenses [Overheads]
The degree of ease and feasibility with whi ch the el ements of cost can be
charged to the finished product will determine what is to be treated as
Direct and what is to be Indirect
5.9 E LEMENTS OF COST
DIRECT COST: INDIRECT COST/ OVER HEADS/ ON - COST
 Direct ma terial / Indirect ma terial
 Direct labour / Indirect labour
 Direct expenses / Indirect expenses

(i) Direct material : These are the material which can be conveniently
measured and direct charged to a particular product. For e.g. timber in
Furniture making, bricks, cement, st eel used in Building, leather used in
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Financial Mangement
108
(ii) Direct Labour : It includes the wages paid to those employees who
directly operate the manufacturing machinery and equipments. These
wages can conveniently identified with a particul ar product , job or
process.

(iii) Direct Expenses : These are the expenses which can be identified
with and allocated to cost centres or cost units. It includes all the expenses
other than direct material and direct labour that are specially incurred fo r a
partic ular product, job or process. For e.g., Cost of patent right, Royalty on
production, Experimental expenses, Depreciation or Hire of special plant
or equipment for a particular job, Architect or Surveyor’s fees etc.

(iv) Indirect Material : These are the mater ials which cannot be
conveniently identified with a particular product, job or process. It
includes the materials which form part of the product but minor in
importance and relatively inexpensive. For e.g. nails used in furniture,
thread used in stitching garments, etc. Those items of materials which do
not become a part of the finished products are also included here for e.g.
coal, lubricating oil and grease, sand paper used in polishing etc.

(v) Indirect Labour : These are the labours which are no t directl y
engaged in the production operations but only assist in the production
operations. For e.g. Time keeper’s wages, wages of factory clerk etc

(vi) Indirect Expenses : These are the expenses which cannot be
directly identified with a particular produc t, job or process. These are so
general in nature.

This group of expenses is sub divided as :

a. Factory overheads / Production overheads /Works overheads/
Manufacturing overheads: It includes all the expenses related to
factory. It includes indirect mater ial, i ndirect labour and indirect
expenses in producing goods and services. For e.g. factory rent, taxes,
insurance, depreciation and repairs of factory building, plant &
machinery, factory lighting, power etc.

b. Office and Administration overheads : It inc ludes all the expenses
related to general administrative function i.e., planning, organising,
decision making, controlling, directing and motivating the personnel
such as office staff salaries, depreciation and repairs of office
building, furniture, offic e rent , rates, taxes, insurance, printing and
stationery etc.

c. Selling and Distribution overheads : The cost of promoting sales
and retaining customers is termed as Selling expenses, for e.g.
advertisement. Samples and free gifts, salaries and commissi on to
salesmen etc.
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Basic Principles of Cost
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109 Distribution overheads are those which incurred f rom the time the
production is completed until it reaches to the final consumer for e.g.
carriage and freight outward, delivery van expenses, ware housing,
insurance of goods in transit etc.
Following are the steps to Determine the total cost
1. PRIME COST
= Direct Material + Direct Labour + Direct Expenses

2. WORKS COST / FACTORY COST
= Prime cost + Factory Overheads

3 COST OF PRODUCTION
= Works cost + Office / Admini stration Overheads

4 COST OF SALES / TOTAL COST
= Cost of Production + Selling and Distribution Over heads.

5 SELLING PRICE = Total cost + Profit

 Non- Cost Items :
There are some items which are excluded from cost accounts. The
expenses w hich are related to capital assets, capital losses, payments by
way of distribution of profits and purely financial items are excluded
from cost. The examples are – Income Tax, dividends, debenture interest
loan interest donations and Expenses not rel ated to business, abnormal
wastage of material, abnormal idle time and all capital Expenditures,
cash discount, appropriation of profits( transfer to various reserves for e.g.
general reserve, reserve for doubt full debts etc.), profit or loss on sale o f
asset s, miscellaneous expense written off in the form of Discount on
redemption of debentures, preliminary expenses, goodwill etc., written
off, under writing commission. Such items are excluded while preparing
the Cost Sheet.
5.10 COST SHEET / STATEME NT OF COST:
Cost Sheet is detailed analysis of the different elements of cost of a
particular output for a particular accounting period. It shows the detailed
cost of a product. It should be prepared at weekly, monthly, or other
convenient interva ls. The re is no fixed form for preparing the cost sheet
but generally it is prepared in columnar form where the columns would
depend upon the requirement of management Generally there are three
columns viz. Particulars, Total cost and Unit cost.
A specimen o f Cost Sheet is given below : -
PARTICULARS Total cost
Rs. Cost P er
Unit Rs.
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110 Direct Materials :
Opening stock
+Purchases...
+Carriage inwards...
Less: Closing stock...
.
Direct materials consumed
+Direct wages
+Direct expenses
PRIME COST
Add : Works or Factory Overhead s
(All expenses relating to Factory such as :
Indirect materials
Indirect wages
Factory Rent, Rates, Taxes,
Insurance
Lighting and heating
Power and Fuel, Hauling cha rges
Depreciation, Repairs, Insurance
etc., of Factory Machinery,
Building etc.
Time Keeper’s, Store Keeper’s
Wages
Drawing office expenses
Loose Tools written of f
Factory stores
Works Manager’s salary etc
.
Total Factory Overheads
Add : Opening Balance of Work -in-
Progress
Less: Closing Balance of Work - in-
Progress
Less : Sale of Scrap

WORKS OR FACTORY COST

Add : Office and Administrative
Overh eads

All expenses relating to Office such
as
Office Rent, Rates, Taxes,
Insurance
Depreciation, Repairs etc., of office building, furniture, equipments etc.
Printing an d stationary
Postage and telegrams
Counting house salary
Legal expenses munotes.in

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111
Illustration 5.1
Prepare a Cost Sheet from the details given below :
Inventories (opening)
Finished Stock 40,000
Raw Materials 70,000
Work -in-Process 1, 00,000
Office Appliances 8,000
Plant & Machinery 2, 30,000
Building 1, 00,000
Raw Materials Purchased 1, 60,000
Freight Inward 8,000
Purchases Returns 2,400
Sales 3, 84,000
Sales Returns 7,000
Direct Wag es 80,000
Indirect Wages 9,000
Factory Supervision 5,000
Repairs and upkeep -Factory 7,000
Heat, Light, and Power 32,500
Rate & Taxes 3,000 Bank charges etc.

COST OF PRODUCTION

Add : Opening stock of finished goods
Less : Closing stock of finished goods

COST OF GO ODS SOLD

Add : Selling and Distribution
Overheads
Showroom rent and rates
Salesman’s salary, commission, travelling expenses
Advertising
Bad debts
Depreciatio n and expenses of
delivery van
Carriage and freight outward
Sample and other free gifts etc.

TOTAL COST OF SALES

Add : Net Profit

SALES

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112 Sundry Factory Expenses 9,500
Sales Commission 10,800
Sales Travelling 5,500
Sales pr omotion 11,250
Distribution Dept . - Salaries & Expenses 9,000
Office Salaries & Expenses 4,300
Income Tax paid 2,700
Dividend Paid 2,500
Closing Inventories
Finished Goods 57,500
Raw Materials 90,000
Work -in-Progress 96,000
Accrued Expense s
Indirect Labour 600

Depreciation t o be provided as under :
Office Appliances @ 5% ; Plant & Machinery @ 10% and Building @4%.
Distribute the following costs:
- Heat, Light and Power to Factory, Office and Distribution in the
ratio 6 : 2 : 2
- Rates a nd Taxes to Factory an d Office in the ratio 2 : 1.
- Depreciation on building to Factory, Office and Selling in the ratio
6 : 2: 2.
Solution :

COST SHEET
Particulars Rs. Rs.
Opening Stock of Raw Materials 70,000 Add: Purcha ses of RM 1,60,000 Less : Purchases Returns 2,400 1,57,600 Add : Freight Inward 8,000 2,35,600 Less : Closing Stock of Raw Materials 90,000 MATERIALS CONSUMED 1,45,600 Add: Direc t wages 80,000 PRIME COST 2,25,600 Add : Works Overheads / Factory Overheads munotes.in

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113 IndirectWages 9,000 Add: Accrued Indirect Labour 600 9,600 Factory S upervision 5,000 Repairs and Upkeep - Factory 7,000 Depreciation of Plant & Machinery 23,000 Depreciation of Building ( 4,000 × 3/5 ) 2,400 Heat, Light, Water ( 32,500 × 3/5 ) 19,500 Rates & Taxes (3,000 × 2/3 ) 2,000 Sundry factory expenses 9,500 78,000 Add : Opening Work - in- Progress 1,00,000 4,03,600 Less : Closing Work -in-Progress 96,000 WORKS COST / FACTORY COST 3,07,600 Add : Administrative & Office Overheads Office Salaries and Expenses 4,300 Heat, Light and Power ( 32,500 × 1/5 ) 6,500 Rates & Taxes ( 3,000 × 1/3 ) 1,000 Depreciation of Building ( 4,000 × 1/5 ) 800 Depreciation of Office Appliances 400 13,000 COSST OF PRODUCTION 3,20,600 Add : Opening Stock of Finished Goods 40,000 3,60,600 Less : Closing Stock of Finished Goods 57,500 COST OF GOODS SOLD 3,03,100 Add : Selling and Distribution Overheads Sales Commission 10,800 Saes Travelling munotes.in

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114 5,500 Sales Promotion 11,250 Depreciation of Building (4,000 × 1/5 ) 800 Distribution Dept. - Salaries & Expenses 9,000 Heat, Light & Power ( 32,500 × 1/5 ) 6,500 43,850 TOTAL COST 3,46,950 Add : Profit 30,050 SALES 3,77,000 ( PROFIT = SALES -- TOTAL COST )
NOTE : - Income Tax Paid, Dividend Paid are the Non Cost items
therefore excluded from Cost sheet. Office Applianc es, Plant &
Machinery, Building are the Assets hence only the depreciation is taken
into account.
Illustration 5.2
The following is the Profi t and Loss Account for the year ending 31st
March, 2007 for a manufacturer of Table Fans. They manufactured and
sold 2,000 fans dur ing the year.
Partic ulars Rs. Particulars Rs.
To Materials Consumed
To Wages
To Manufacturing Expenses
To Gross Profit c/d


To Rent, Rates, Taxes
To General Expenses
To Management Expenses
To Sales & Distribution
To Net Profit 1,20,000 1,80,000 75,000 2,25,000 6,00,000 15,000 30,000 90,000 45,000 __45,000 2,25,000 By Sales





By Gross Profit 6,00,000 ________ _6,00 ,000 2,25,000 ________ _2,25,000
Their estimate for the next year ending 31st March, 2008 are as und er:
1. The production a nd sales would increase to 3,000 fans

2. The price of materials per fan would increase by 20%.

3. The labour cost per fan would go up by 10%. munotes.in

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115
4. The manufacturing expenses would remain in the same proportion to
combined cost of material co nsumed and wages as in the previous
year.

5. Selling and distribution expenses per fan would remain unchanged.

6. Other expenses would remain unaffected on account of increase in
production.
Prepare a statement of cost and profit per fan and total cost, total profit
for the y ears 2006 - 07 and 2007 -08.
Solution
STATE MENT OF COST AND PROFIT
For the year ending 31st March 2007
Manufacture and sale of 2,0 00 fans
Particulars Total cost
Rs. Cost per
fan Rs.
Material Consumed
+ Direct Wages
PRIME COST
+ Ma nufacturing Expenses
WORKS COST
+ Office and Administration expenses
Rent, rates, taxes 15,000 General Expenses 30,000 Management Expenses 90,000_
COST OF PRODUCTION
+ Sales and Distribution Expenses
TOTAL COST
+ Profit
SALES
1,20,000 ____1,80,000 3,00,000 ______75,000 3,75,000 ____1,35,000 5,10,000 _____45,000 5,55,000 _____45,000 ____6,00 ,000 60.00 ____90.00 150.00 _____37.50 187.50 _____67.50 255.00 _____22.50 277.50 _____22.50 300.00
STATE MENT OF COST AND PROFIT
For the year ending 31st March 2008
Manufacture and sale of 3,000 fans
Particulars Total cost
Rs. Cost Per
Unit Rs.
Material consumed
+ Direct Wa ges
PRIME COST
+ Manufacturing expenses
(25% of Prime Cost 2,16,000 __2,97,000 5,13,000 __1,28,250 72.00 ____99.00 171.00 _____42.75 munotes.in

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116 i.e. 25% of Rs. 5,13,000 )
WORKS COST
+Office and Administration expenses
Rent, rates, taxes 15,000
General Expenses 30,000
Management Expenses 90,000
COST OF PRODUCTION
+Sale and Distribution Expenses
(Rs.22.50 per fan × 3,000 fans )
TOTAL COST


+PROFIT
SALES ( Selling price R s. 300 per fan ×
3,000 fans )

Note : It is assumed that the selling price
per unit has remained the same 6,41,250 _1,35,000 7,76,250 ___67,500 8,43,750 ___56,250 __9,00,000 213.75 ___45.00 258.75 ____22.50 281.25 _____18.75 __300.00
WORKING NOTES :
 Calculation of Material Consumed :
Rs.
Materia l Cost per fan 60
+ 20% increase in per unit cost 12
Material consumed per unit 72

 Calculation of Labour Cost

Labour cost per unit 90
+10 % increase in per u nit cost 9_
Labour cost per unit 99

 Calculation of Manufacturing Expenses in the proportion of PRIME
COST

75,000 × 100 = 25%
3, 00,000





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117 6
MARGINAL COSTING
Unit Structure :
6.1 Marginal Costing Meaning & Definition
6.2 Fetures of Marginal Costing
6.3 Advantages of Marginal Costing
6.4 Limitations of Marginal Costing
6.5 Marginal Costing
6.6 Short Term (Tact ical) Decisions
6.7 Marginal Cost and Product Pricing
6.8 Cost Volume Profit Analysis
6.9 Break ­Even Sales
6.10 Margin of Safety
6.1 MARGINAL COSTING MEANING & DEFINITION
Marginal cost is defined as “The variable cost of one unit of a product or
service, i.e. a cost which can be avoided if the unit was not produced or
provide (CIMA, Official Terminology)
As already discussed, under marginal costing system products are barged
with only those costs which vary directly with the change in the volume of
production. In other words, under this system only prime cost (the total of
direct material cost, direct labour cost and direct expenses) and variable
factory over head are treated as product cost while fixed factory overhead
along with selling and distrib ution overhead and administration overhead
is treated as period cost.
Variable costing and Direct costing are synonyms of marginal costing.
6.2 FETURES OF MARGINAL COSTING
(i) This technique is used to ascertain the marginal cost and to know the
impact of variable costs on the volume of output.
(ii) All costs are classified on the basis of variability into fixed cost and
variable cost. Semi ­variable costs are segregated into fixed and variable
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118 (iii) Marginal (i.e., variable) costs are treated as t he cost of the product or
service. Fixed costs are charged to Costing Profit and Loss Account of the
period in which they are incurred.
(iv) Stock of finished goods and work ­in­progress are valued on the basis
of marginal costs.
(v) Selling price is based on marginal cost ­plus contribution.
(vi) Profit is calculated in the usual manner. When marginal cost is
deducted from sales it gives rise to contribution. When fixed cost is
deducted from contribution it results in profit.
(vii) Break ­even analysis and co st­volume profit analysis are integral parts
of this tech­nique.
(viii) The relative profitability of products or departments is based on the
contribution made available by each department or product.
6.3 ADVANTAGES OF MARGINAL COSTING
(i) The technique i s simple to understand and easy to operate because it
avoids the complexities of apportionment of fixed costs which, is really,
arbitrary.
(ii) It also avoids the carry forward of a portion of the current period’s
fixed overhead to the subsequent period. A s such cost and profit are not
vitiated. Cost comparisons become more meaningful.
(iii) The technique provides useful data for managerial decision ­making.
(iv) There is no problem of over or under ­absorption of overheads.
(v) The impact of profit on sales fluctuations are clearly shown under
marginal costing.
(vi) The technique can be used along with other techniques such as
budgetary control and standard costing.
(vii) It establishes a clear relationship between cost, sales and volume of
output and break­e ven analysis.
(viii) It shows the relative contributions to profit which are made by each
of a number of products, and shows where the sales effort should be
concentrated.
(ix) Stock of finished goods and work ­in­progress are valued at marginal
cost, which is uniform.


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119 6.4 LIMITATIONS OF MARGINAL COSTING
Marginal costing suffers from the following limitations:
(i) Segregation of costs into fixed and variable elements involves
considerable technical difficulty.
(ii) The linear relationship between output and variable costs may not be
true at different levels of activity. In reality, neither the fixed costs remain
constant nor do the variable costs vary in proportion to the level of
activity.
(iii) The value of stock cannot be accepted by taxation authoriti es since it
deflates profit.
(iv) This technique cannot be applied in the case of contract costing where
the value of work ­in­progress will always be high.
(v) This technique also cannot be used in the case of cost plus contracts
unless fixed costs and pro fits are considered.
(vi) Pricing decisions cannot be based on contribution alone.
(vii) The elimination of fixed costs renders cost comparison of jobs
difficult.
(viii) The distinction between fixed and variable costs holds good only in
the short run. In the long run, however, all costs are variable.
(ix) With the increased use of automatic machinery, the proportion of
fixed costs increases. A system which ignores fixed costs is, therefore, less
effective.
(x) The technique need not be considered to be uni que from the point of
cost control.
6.5 MARGINAL COSTING
Sales
Less: Variable Cost
­ Variable manufacturing costs :
 Direct material
 Direct expenses
­ Variable factory overhead
­ Variable Selling and distribution overhead
­ Variable administration overhead
Contri bution
Less: Fixed cost
 Fixed Manufacturing overhead
 Fixed Selling & Distribution overhead
 Fixed Administration overhead
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120 6.5.1 NET INCOME
The contribution margin figure, which is determined at the first step i n
matching cost with revenue in the marginal costing income statement is
very useful for forecasting and reporting income for internal management
purposes. The underlying principle in income forecasting and decisions
making using contribution margin is th at the fixed costs remain unchanged
over a relevant period and within the relevant range of activity and
therefore, variable costs which vary in direct proportion to the changes in
the activity level are the only RELEVANT COSTS when decisions
variables lie within the relevant range and decisions over the relevant
period.
One of the greatest advantages of marginal costing income statement is
that it focuses on the impact that period costs (synonym of fixed costs)
have on profits. This makes marginal costing income statement very
useful for internal reporting.
6.5.2 Contribution as an Indicator of Profitability
The following diagram reflects how individual products contribute
towards over all profit of the firm.
PRODUCT X PROUCT Y PRODUCT Z
Total Sales V alue Total Sales Value Total Sales Value
Minus Minus Minus
Marginal cost of Marginal cost of Marginal cost of
Goods sold goods sold goods sold
Yields Yields Yields
Contribution margin Contribution Margin Contribution Margin
Contribution Fund
Minus
Fixed Cost
Leaves
Profit

The above diagram reflects that contribution from each product towards
fixed cost and profit determines the profit of the firm as a whole. Fixed
cost being a constant factor, overall prof it depends 0on the size of the
contribution fund. Management endeavours to maximize the contribution
fund by selecting between various alternatives. Short term decisions
(often termed as tactical decisions) make extensive use of the marginal
costing conc ept.
Contribution per unit is taken as the profitability index for each product.
Profit per unit (i.e. selling price per unit minus average cost of sales per
unit) may lead to wrong decisions. To illustrate the point, let us consider
the following exampl e.

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121 Illustration 6.1
Management is considering utilization of spare capacity by introducing a
new product A which has the following cost structure
Variable manufacturing cost per unit Rs.80
Allocated average fixed factory overhead per unitrs.20
There is no additional expenditure on selling and distribution.
The product is expected to be sold at Rs.95 per unit.
Solution:
Prima facie it may appear that the new product is unprofitable because the
selling price of Rs.95 per unit is lover than the cost o f sales of Rs.100
However, if we compare marginal cost per unit of Rs.80 with the selling
price of Rs.95 we find that the product will contribute towards fixed cost
and profit at the rate of Rs.15 per unit and therefore it is advisable to
introduce the pr oduct. Allocated fixed cost is irrelevant for the decisions
became total fixed cost will not be affected by the decision.
6.5.3 Contribution Per Unit of Limiting Factor :
Limiting factor has been defined as “The factor in the activities of an
undertaking which at a particular point of time or over a particular period
will limit the volume of out put. Limiting factor restricts the number of
Units they can be produced or sold. Typical examples of limiting factor
are:
(i) Demand in quantity;
(ii) Demand in value
(iii) Availability of material
(iv) Availability of Labour
(v) Plant capacity in terms of available machine hours.
More than one limiting factor may opera at a particular point of time.
Under such a situation the factor which keeps the activity leve l at the
minimum should be considered as the key factor. However, the impact of
other factors should also be considered in arriving at the final decision.
Maximum contribution fund can be achieved by manufacturing and selling
that product which best utili zes the limiting factor. Profitability index, in
such a situation, is contribution per unit of the limiting factor. The
following example further clarifies the point.

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122 Illustration 6.2
A firm can produce two products ‘X’ and ‘Y’. the following are the cost
structures :
Per Unit (Rs)
X Y
Selling price 20 22
Variable manufacturing cost 5 6
Variable selling expenses 3 2
Labour hours 2 3

Total available labour hours is 1,200 per week. There is no other limiting
factor in operation. Which of the products should be manufactured and
sold?
Solution:
Contribution Statement:
X Y
Rs. Rs.
(i) Selling price 20 22
­­­­­­ ­­­­­­
(ii) Variable manufacturing cost 5 6
Variabl e selling expenses 3 2
­­­­­­­ ­­­­­­
Total Variable cost 8 8
­­­­­­­ ­­­­­­
(iii) Contribution per unit ( i – ii) 12 14
­­­­­­­ ­­­­­
(iv) Contribution per labour hour 2 3
- Rs.6 - Rs.4.67
If we take contribution per unit as profitability index, product Y is
considered to be more profitable as compared to X because contribution
per unit of Y is higher as compared to the Contribution per unit of X
However, in the given situation this profitability index misleads the
decision maker. Let us verify:
Total available labour hours are 1,200
Maximum number of units, that can be produced and sold
1,200 hours
X ­­­­­­­­­­­­­­­ i.e. 600 units
2 hrs

1,200 hrs.
Y ­­­­­­­­­­­­­­ i.e. 400 units
3 hrs.

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123 Maximum contribution:
X = 600 units x Rs.12 per unit i.e. Rs.7,200
Y = 400 units x Rs.14 per unit i.e. Rs.5,600
From the above it is clear that total contribution from product a is mo re as
compared to the contribution from product Y, hence, product a should be
selected to maximize the total contribution. This is contrary to that
indicated by the Profitability Index if contribution per unit is used to
measure profitability.
The decisio n maker would be guided correctly if Contribution per unit of
limiting factor is used as Profitability Index. Contribution per labour hour
is more for X as compared to that for Y and therefore, X is more
profitable. This leads to the selection of a which makes the best utilization
of the available labour hours the limiting factor.
The Maximum contribution from each product may be worked out as
follows:
Maximum contribution – Available hours contribution per hour
Maximum contribution from A = 1.200 x Rs.6 = Rs.7,200
Maximum contribution from B = 1.200 x Rs.4.67 = Rs.5,600
Determination of the limit9ing factor poses problems because it changes
rapidly. A detailed study of the economic environment and the supply
market of various resources as well as a study of the internal factors is
necessary to identify the potential limiting factors. This is important for
performance planning. The determination of limiting factor is
comparatively simple when only one product is produced or when more
than one produ ct is produced using the same raw material labour and other
resources and through the same process. However, it becomes very
complex when a number of products are manufactured from a variety of
materials with different types of labour using different type s of machines
or applying different processes.
6.6 SHORT TERM (TACTICAL) DECISIONS
Marginal costing technique is frequently used by managers for short term
decision making in the following paragraphs we shall discuss the
applications of the technique in de cision making. However, we must keep
in mind that the basic assumption of linear relationship between cost and
revenue does not hold good beyond the relevant range and this limits the
precision and reliability of decisions based on marginal costing. Sim ilarly
in practice, it is difficult to segregate the total cost into fixed and variable
elements accurately Inspite of these limitations, marginal costing
t4chnique has emerged as an important management tool.
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124 6.6.1 Determination of the Most Profitable P roducts Mix
In determining the most profitable product mix, the short term profitability
of products is assessed by measuring contribution per unit when no
limiting factor is in operation and by measuring contribution per unit of
the limiting factor when a limiting factor is in operation. The most
profitable product is the one which has the highest contribution as unit or
the highest contribution per unit of the limiting factor as the case may be.
The products are to be ranked accordingly for profitabilit y.
Illustration 6.3
(a) The following particulars are extracted from the records of a
company
Product X Product Y
Sales (per unit) 100 120
Consumption of material 2kg 3kg
Material cost Rs.10 Rs.15
Direct wages cost Rs.15 Rs.10
Direct Expenses Rs.5 Rs.6
Machine hours used 3 2
Overhead expenses:
Fixed Rs.5 Rs.10
Variable Rs.15 Rs.20

Direct wage per hours is Rs.5. Comment on the profitability of each
product (both use the same raw material) when
(i) Total sales potential is units is limited
(ii) Total sales potential in value is limited;
(iii) Raw material is in short supply
(iv) Production capacity (in terms of machine hours) is the limiting
favor
(b) Assuming Raw – material is the key factor – availability of which is
10,000 kg. and maximum sales potential of each product being 3,500
units, find the product mix which will yield the maximum profit.
Solution –
Per Unit
Product X Product Y
Rs. Rs.
(i) Sales 100 100
(ii) Variable cost:
Direct material 10 15
Direct wages 15 10
Direct expenses 5 6 munotes.in

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125 Variable overhead 15 20
­­­­­­­ ­­­­­­
Total variable cost 45 51
­­­­­­­ ­­­­­
(iii) Contribution per unit ( i – ii) 55 69
­­­­­­ ­­­­­­
(a) Ranking of Products in terms of Profitability –
(i) Total sales potential in units is limited
Basis : Contribution per unit : Product X Rs.55
Product Y Rs.69
Ranking 1st Product X
2nd Product Y

(ii) Total sales potential is value is limited:
Basis Contribution per rupee of sales value i.e.
Contribution per unit
­­­­­­­­­­­­­­­­­­­­­­­­­­­
Selling price per unit


Rs.55
Product X ­­­­­­­­ = Rs.0.55
Rs.100

Rs.69
Product Y ­­­­­­­ = Rs.0.575
120

Ranking: 1st Product Y
2nd Product X

(iii) Raw material is in short supply
Basis : Contribution per unit of raw material consumption
Contribution per unit
i.e. ­­­­­­­­­­­­­ ­­­­­­­­­­­­ ­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­
Material consumption (in quantity) per unit

Rs.55
Product X ­­­­­­­­ = Rs.27.50 per kg.
2 kg

Rs.69
Product Y ­­­­­­­ = Rs.23.00 per kg.
3 kg
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126 Ranking 1st Product X
2nd Product Y

(iv) Production capacity (in terms of machine hours) is the limiting factor)
Basis: Contribution per unit of machine hour.
Contribution per unit
i.e ­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­
Machine hours used per unit

Rs.55
Product X ­­­­­­­­ = Rs.18.33 per hour
3 hrs.

Rs.69
Product Y ­­­­­­­ = Rs.34.50 per hour
2 hrs.

Ranking: 1st Product B
2nd Product A

(b) When raw material is the key factor, our ranking is Product X – 1st
and Product Y – 2nd Management would, therefore, intend to
produce Product X which best utilize the available raw material.
However, there is another limiting factor in operation, that is, maximum
sales potential. This factor will set the limit for production of product X.
The following will be the allotment of avai lable raw material between
Product X and Product Y.
Available raw material 10,000 kg.
Maximum Sales potential for
Product X (ranked 1st) 3,500 units
Raw material required for X 3 ,500 x 2 kg. (7,000 kg)
­­­­­­­­­­­­­­
Balance available for Product Y 3,000 kg
­­­­­­­­­­­­

Maximum number of Product Y that
Can be produced with available

3,000
Raw­material ­­­­­­­­ kg. i.e. 1,000 units
3

Product mix which will yield the maximum profit:
Product X 3,500 units
Product Y 1,000 units

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127 Total contribution:

Product X 3,500 x Rs.55 = 1,92,500
Product Y 1,000 x Rs.69 69,000
­­­­­­­­­­­­
Total Rs. 2,61,500
Total Fixed cost:
Product X 3,500 x Rs.5 = Rs.17,500
Product Y 1,000 x Rs.10 = Rs.10,000
­­­­­­­­­­­­­­
Total Rs.27,500
­­­­­­­­­­­­­­

Total Profit = Total Contribution ­ Total fixed cost
= Rs.2,61,500 – Rs.27,500
= Rs.2,34,000

6.6.2 Make or Buy Decision
If no limiting factor is in operation th e decision to buy or to manufacture a
product rests on whether the bought ­out price is hither or lower than
marginal cost. The fixed cost is irrelevant for our decision because fixed
cost will not change as a result of buying the product/component from
outside.
If the bought ­out price of an article is lower than its marginal cost, it will
be profitable to buy the article from outside in all circumstances.
If a limiting factor is in operation, the excess of bought out price over
marginal cost per unit of th e limiting factor is to be considered. The
article having the lowest excess of bought out price over its marginal cost
per unit of the limiting factor will be least costly.

Illustration 6.4
The Cost of manufacturing and bought out prices of the four arti cles are as
follows:
­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­
Articles A B C D

Production cost per article:
Marginal cost Rs.10 Rs.12. Rs.15 Rs.15
Fixed out Rs. 2 Rs. 4 Rs. 5 Rs.15
­­­­­­­­ ­­­­­­­­ ­­­­­­­­ ­­­­­­
Total Rs.12 Rs.16 Rs.20 Rs.30
­­­­­­­­ ­­­­­­­­ ­­­­­­­­ ­­­­­­­
Production per man hour 0.25 0.20 0.20 0.33
Production per machine Hour 1.00 0.50 0.25 0.20
­­­­­­ ­­­­­­ ­­­­­­ ­­­­­­
Bought out Price Rs.9 Rs.17 Rs.22 Rs.26
­­­­­­ ­­­­­­­­ ­­­­­­­­ ­­­­­­ munotes.in

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128
Rank the products in order of your preference for buying them from
outside (i) when there is no limiting factor; (ii) if man power is the
limiting factor; (iii) if machine capacity is the limiting factor.
Solution
A B C D
Bought out price per unit Rs.9 Rs.17 Rs.22 Rs.26
Marginal cost (per unit)
of production Rs.10 Rs.12 Rs.15 Rs.15

Excess of brought out
Price over marginal cost
Per article 100 5.00 7.00 11.00
Per manhour ­100x2 5 ­5x20 ­7x20 ­11x33
­ 0.25 ­ 100 ­ 140 ­ 363
per machine hour ­ 1x1 ­5x50 ­7x25 ­11x20
­ 1.00 ­ 2.50 ­ 1.75 ­2.20

In case of article A, the bought – out price is lower than the marginal cost,
hence to purchase A from outsiders always profitable.
Ranking ofprodu cts in order ofpreference for buying out :
(1) Whe n there is no limiting factor 1st A
2nd B
3rd C
4th D

(2) When m anpower is the limiting factor 1st A
2nd B
3rd C
4th D
(3) When machine capacity is the limiting factor 1st A
2nd C
3rd D
4th B

Following Points may be taken in to account while making your
Rankings -
(1) The application of marginal costing technique reveals that it is least
desirable to buy not the article whose excess of bought out price over
its marginal cost is the highest because the extra cost of buying results
in loss of contribution.
Even when production facilities are available, it is desirable to purchase
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129 their marginal cost of production because this would result in additional
contribution.
(2) Contribution per unit cannot be the basis for make or buy decisions,
as contribution involves the use of selling price. Sale is not re levant
because decision to make or buy in no way affects the sale volume or
the selling price. “the only relevant information is extra cost of
buying as opposed to contribution.
(3) The following non cost factors are impor5ant in ‘make’ or buy
decisions;
(a) Loss of control over the source of supply; Reliability of the source
of supply is important because costs which arise due to material shortage
are very high for most of the organizations.
(b) Laying off of employees may impair the employer employee
relations.
6.6.3 Decision on Methods of Manufacturing
Marginal Costing technique can be used in deciding which of the
alternative methods of manufacturing should be adopted., the method
which generates the highest contribution is the ,most desirable method .
The decision, therefore, rests on the contribution per unit or the
contribution per unit of the limiting factor when l9miting factor is in
operation.
Illustration 6.5
AN undertaking is producing a PRODUCT, the selling price of which is
Rs.20 per unit. A decision has to be taken whether:
To produce by hand (Method A)
To produce by machine o ne operator to one machine (Method B)
To produce by machine one operator to two machines (Method C)
To produce by machine, one operator to three machines (Method D);
The cost of manufacturing the article by different methods are as follows:
Method A B C D
Cost per article (Rs)
Material 1 unit 5.00 5.00 5.00 5.00
Direct labour @ Rs.3 per
Man hour 5.00 3.00 1.70 1.50
Variable over head @ Rs.2
Per man hour 3.30 2.00 1.10 1.00
Variable overheads @ Rs.1
Per man hour ­ 1.00 1.10 1.50
­­­­­­ ­­­­­­­­ ­­­­­­­ ­­­­­­­­
Total marginal cost 13.30 11.00 8.90 9.00
Fixed overhead @ Re.1/ ­
Per man hour 1.70 1.00 0.60 0.50
Fixed overhead at Rs.6 per
Machine hour ­ 6.00 6.90 9.00 munotes.in

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130 ­­­­­­ ­­­­­­ ­­­­­­ ­­­­­­­­
Total cost Rs.15.00 18.00 16.40 18.50
­­­­­­­­­­­ ­­­­­­­ ­­ ­­­­­­­­­ ­­­­­­­­
Production per man hour 0.60 1 1.75 2.00
Production per machine hour ­­ 1 0.875 0.66

Solution
Method A B C D
Selling price per unit (Rs) 20.00 20.00 20.00 20.00
Marginal cost per unit (Rs) (13.30) (11.00) (8.90) (9.00)
­­­­­­­­­ ­­­­­­­­­­ ­­­­­­­­­­­ ­­­­­­­
Contribution per unit 6.70 9.00 11.10 11.00
Contribution per unit of
Material 6.70 9.00 11.10 11.00
­­­­­­­­ ­­ ­­­­­­­ ­­­­­­­­­ ­­­­­­­
1 1 1 1
Rs.6.70 ­ Rs.9.00 ­ Rs.11.10 ­ Rs.11.00
Contrib ution
Per man hour ­6.70x6 ­9 x1 ­11.10 x1.75 ­ 11x 2
­ Rs.4.00 ­ Rs.9.00 ­ Rs.19.40 ­Rs.22.00
Contribution per
Machine hour ­ ­9.00x1 ­11.10 x 8.75 ­11x66
­ ­ Rs.9.00 ­ Rs.9.7 ­ Rs.7.30

If there is no limiting factor, Method C. should be selected as it generates
the highest contribution per unit .
If a limiting factor was in 0perati on, the method to be adopted should be
the one which gives the highest contribution per unit of the limiting factor.
Thus
(1) If material is the limiting factor, method C should be adopted.
(2) If manpower is the limiting factor, method D should be adopte d.
(3) If machine capacity is the limiting factor method c should be adopted.
Points to Remember
1. The decision would hold good till the machine capacity is fully utilised.
After that if additional production is required it could be produced by
hand.
2. The dec isions would hold good where only one product is
manufactured. If a variety of products are manufactured and full
capacity has been reached, further investigation is required. Under
such a situation the effect of various alternatives on the total
contrib ution needs to be considered.
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131 6.7 MARGINAL COST AND PRODUCT PRICING
A long ­term pricing policy should aim to recover more than the full cost to
ensure a reasonable return on capital employed. Affirm cannot survive of
it has to sell its products continuo usly below full cost.
Marginal cost may be used as a basis for Short term pricing decisions
specially with respect to non repetitive orders under difficult business
conditions when acceptance of lower contributions and profit margins may
be necessary.
When capacity is unused, acceptance of an order with lower contribution
will at l3ast particularly meet the fixed cost. Even that amount of
contribution would not be earned if the order is refused.
The following factors need to be c0osidered in fixing selling prices when
demand is below normal:
(a) the amount amounts the rate of contribution which a proposed selling
price would yield.
(b) the probability of securing an order with higher contribution during
the period of execution of the order.
(c) the proposed concession, when compared with the normal selling
price on full cost basis;
(d) the probable adverse effects on future sales
When one or more of the resources are scarce (e.g. material is scarce), the
first consideration must be to reserve the same for orders which would
yield the highest rates of contribution per unit of the scarce resource
(limiting factor).
A decision to sell at a lower price might also have an adverse upon the
firm’s general level of selling prices in its established market. This aspect
should also be carefully evaluated before accepting an order with lower
contribution.
The following may be other considerations which strongly justify
acceptance of an ordered with lower contribution at the time of adverse
trade situations :
(i) To hold together the sk illed labour force
(ii) To keep the plant and machinery in operation and the workers busy
(iii) To utilise the materials already received
(iv) To obviate the costs involved in the closing and reopening of the
plant.
(v) To maintain the sales of complem entary products at a satisfactory
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132 (vi) To maintain the established markets to obviate additional sales
promotion expenses in re establishing the markets.
Selling below full cost prices even under a normal situation, may be
adopt5ed in order to:
(i) introduce a new product
(ii) execute an order in a special market segment (say defence supply)
which is immune from other market segments
(iii) expand the export market and
(iv) dispose of a product which deteriorates fast
Illustration 6.6
The BALAJI & Company manufactures an d sells direct to consumers
10,000 jars of Balaji JARS per month at Rs.1.25 per Jar. The company’s
normal production capacity is 20,000 jars of now per month. An analysis
of cost for 10,000 jars is given below:
Rs.
Direct material 1,000
Direct labour 2,475
Power 140
Miscellaneous supplies 430
Jars 600
Fixed expenses of manufacturing, selling
And administration 7,955
­­­­­­­­
Total Rs. 12,600
­­­­­­­­­­­­­­
The Company has received on offer for the export under a different brand
name of 1,20,000 jars of at 10,000 jars per month at 75 paise a jar.
Write a short report on the advisability or otherwise of accepting the of fer.
Solution
Statement of Contribution from the Export Order
Rs.
Selling price per unit 0.7500
Variable cost per unit :
Direct materi al Rs.1,000 /10,000 0.1000
Direct labour Rs.2,475 /10,000 0.2475
Power Rs. 140 /10,000 0.0140
Misc.supplies Rs. 430 /10,000 0.0430
Jars Rs. 600 /10,000 0.0600
­­­­­­­­­
(0.4645)
­­­­­­­­­­­
Contribution margin per unit Rs.0.2855
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133 Contribution per month:
Rs.0.2855 x 10,000 Rs.2,855

Acceptance of the export order would result in incremental contribution of
Rs.2,855 per month:
The following statement reveals monthly profit with and without
acceptance of order.
Present Position Proposed Offer Total
(10000 jars ) (10,000 jars) (20000 jars)
Rs. Rs. Rs.
Sale value 12,500 7,500 20,000
Variable cost of sales
@Rs.0.4646 per unit (4,645) (4,645) (9,290)
­­­­­­­­­­­­ ­­­­­­­­­­­ ­­­­­­­­­­­
Contribution 7,855 2,855 10,710
Fixed cost (7955) ­ (7955)
­­­­­­­­­­­­ ­­­­­­­­­­ ­­­­­­­­­­­
Profit (100) 2,855 2,755
It is advisable to accept the order provided.
(i) Interest on incremental working capital would be lower than the total
contribution from the export order.
(ii) Acceptance of the export order with lower cont ribution would not
adversely affect the price in home market or the future sales.
(iii) There is no possibility for dumping i.e. re ­export to the supplier.
(iv) There is no possibility of securing an order with higher contribution
during the period of execution of th e order.
6.8 COST VOLUME PROFIT ANALYSIS
6.8.1 Introduction:
The aim of Cost Volume Profit (CVP analysis is to have a fair estimate of
the total cost, total reven7ueand thereby profit at various sale volumes.
Determination of the Breakeven point (the sal es volume at which total
sales revenue equals the total cost i.e. the point at which neither profit is
earned nor loss is made) and the Margin of safety (the difference between
Break even sale and total sales) is incidental to C.V.P analysis.
The following underlying simplistic assumptions limit the precision and
reliability of a given C.V.P. analysis:
(i) Fixed and variable cost patterns can be established with reasonable
accuracy and that fixed costs remain static and marginal costs are
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134 (ii) Selling prices are constant at all sales volumes;
(iii) Factor prices (.e.g. material prices, wage rates) are constant at all
sales volumes.
(iv) Efficiency and productivity are to be unchanged
(v) In a multi product situation there is constant sa les mix at all levels of
sales
(vi) Volume is the only relevant factor affecting cost.
(vii) The volume of production equals the volume of sales or
accretion/decretion to inventory levels are insignificant.
6.8.2 The following are the uses of C – V – P Analysis:
(i) To determine the Break even points in terms of unit or sale value;
(ii) To ascertain the Margin of Safety
(iii) To estimate profits or losses at various levels of output
(iv) To assess the likely effect of management decisions such as an
increase or a reduction in selling pr ice, adoption of a new method of
production to reduce direct labour and increase output, etc.
(v) to determine the optimum selling price.
6.8.3 Marginal Cost Equation
The fundamental concept underlying marginal costing technique can be
expressed in the form o f a mathematical equation which is as below:
Sn = Sale value of ‘n’th level of activity/
Vn = Toptal variable cost at ‘n’ the level of activity
Cn = Total contribution of ‘n’ th level of activity
F = Total fixed cost.
Pn = Profit at ‘n’ the level of activity.
It is worth nothing that F is not written as Fn(to be read as F sub
n)because fixed cost remains the same at all levels of activity.
In any given problem, if out of the four factors (i.e. Sn Vn F and Pn) any
three are known, the fourth can be worked out.
At Break even point, profit is ‘zero’, that is, contribution is equal to fixed
cost. The following diagram brings this point to focus and also reveals
that the profit is equal to contribution from the “Margin of safety”:
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135 TOTAOL SALES = BR EAK EVEN SALES + MARGIN OF SAFETY
Contribution Contribution Contribution
Equals equals equals
Fixed cost + Profit Fixed cost Profit

6.8.4 Contribution/Sales Ratio (C/S Ratio)
This is given by the formula
Cn Sn ­ Vn
C/s ratio = ­­­­­­ x 100 = ­­­­­­­­­ x 100
Sn Sn

C/S ratio expresses the percentage of sales which contribute towards fixed
costs and profit. If we assume that contribution per unit is constant. C/S
ratio will remain constant at all sale volumes.
C/S ratio is loosely referred to as P/V (Profit/volume) Ratio
6.9 BREAK -EVEN SALES
Break even sales is the sales volume, expressed either in the terms of the
number of units or in terms of sale valu7e, at which the total sales revenue
equals the total cost.
In determining Break ­even sales, we need to know
(i) Fixed cost and
(ii) Contribution per unit or C/S ratio
At Break even point total contribution eq uals the fixed costs, hence Break
even point in terms of unit is calculated by dividing total fixed costs by
contribution per unit. The following simple example illustrates the point.

Illustration 6.7
The following information is available from the annu al budget of a
company manufacturing only one item:
Budgeted output and sales 5,000 units
Budgets Selling price per unit Rs.40
Budgeted costs per unit
Material Rs.15
Direct labour Rs. 5
Variable overhead Rs.10

Fixed cost per unit Rs. 5
­­­­­­­ (35)
­­­­­­­­­­­
Budgeted profit per unit Rs.5
­­­­­­­­­­­
Calculate the Break even point both in terms of the number of units and
sale value.
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136 Solution
In the absence of any other information it is assumed that direct materials
and direct labour cost are variable costs. Contribution per unit of the
given product is as follows :
Sales price Rs.40
Material Rs.15
Direct labour 5
Variable overhead 10
­­­­ 30
­­­­­­
10
­­­­­
Fixed cost per unit, included in the total cost per unit, is average fixed cost
per unit, calculated on the basis of budgeted fixed cost (total) and budged
output. Therefore, budgeted fixed cost ( total) must be:
Rs.5 x 5,000 (i.e. Rs.25,000)
The two factors (.e.g. fixed costs and contribution margin per unit) are
now known to us and therefore we can calculate the Break even point.
Fixed cost
Break ev en point = ­­­­­­­­­­­­­­­­­­­­­­­­­­­
Contribution per unit
Rs.25,000 = ­­­­­­­­­­­­­­­­ = 2,500 units Rs.10
Proof (Not required in examination)
Sales (2 ,500 x Rs.40) Rs.1,00,0 00 Variable costs (2,500 x Rs.30) Rs.75,000
Fixed costs Rs.25,000 Rs.1,00,000 Profit Nil
 Break even point in terms of sales value is usually calculated by
using C/ ratio.
 C/S ratio can be calculated with reference to either contribution per
unit or total contribution at the given sale volume.
C/S ratio = Contribution margin per unit x 1 00
Selling price per unit
= 10 x 100 = 25% 40

or C/ S Ratio = Budgeted sales – Variable costs of sales x 100
Budged Sales
= Rs.50,000 x 100 = 25%
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137 Note :
Budgete d sales = Rs.40 x 5000 = Rs.20,00,000
Variable costs of sales = 30 x 5,000 = Rs.1,50,000
Break even sales in terms of sale value (but not in terms of units) is
calculated by dividing fixed cost by CS ratio.
Break even point = Fixed costs
C/S ratio
= Rs.25,000 = Rs.25,000
25% 25/100
= Rs.25,000 x 100
25
= Rs.1,00,000
Proof (Not required in examination)
Break even point in terms of units 2,500 units
Selling price per unit Rs.40
Break even point in terms of sales value Rs.40 x 2,500 =
Rs.1,00,000
6.10 MARGIN OF SAFETY
Margin of safety is the d98fference between the total sales and sales at the
break even point. This provide very useful information to management,
that is, by how much can sales drop below the budgeted sales before a loss
is incurred. Margin of safety is usually expressed as a percentage of
expected sales.
In our previous illustration, margin of safety is 2,500 units or 50% of
budgeted sales as calculated below:
Budgeted sales 5,000 units
Break even point (2,500 u nits)
Margin of safety 2500 units
i.e. 2,500units x 100 = 50 of
5,000 units Budgeted Sales

C/S Ratio and Break Even Point in a Multi Product Situation
In multi product situation it is not possible to express break even point in
terms of units. It is quite likely that different measuring units or used to
express sales quantity of different products, products may not be
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138 Therefore, under a multi product situation break even point needs to be
calculated in terms of sale value by using C/S ratio. This may, however,
pose a difficulty because all the products might not have the same C/S
ratio. We may obviate this difficu lty by assuming a constant mix of sales,
at all sale, volumes, in other words, it is assumed that a percentage
movement in total sales is accompanied by the same percentage movement
in sales of all the products in the product mix.
Break even point is calcu lated with the following assumptions:
(i) Constant C/S ratio for each product
(ii) Constant sales mix
(iii) Constant fixed cost.
The following are the steps involved in calculating the break even point:
(i) Calculate the C/S ratio for each product.
(ii) Calculate weighted averag e C/S ratio in relation to expected
proportion of sales
(iii) Use the weighted average C/S ratio to calculate break even pointing
terms of sale value.
Illustration 6.8
(a) Asian Paints Ltd. Manufactures and sells four types of products under
the brand names A , B, C and D.. The sales mix in value comprises 33 1%,
41 2%,, 16 2% and 8 1% of A, B, C, and D respectively. The total budgeted sales (100%) are Rs.60, 000 per month. Operating
costs are:
Variable costs:
Product A 60% of selling price
B 68% of selling price
C 80% of selling price
D 40% of selling price
Fixed cost Rs.14,700 per month
Calculate the break even point for the products as on overall basis.
(b) It has been proposed to introduce a change in the sales mix as
follows, the total sales per month remaining Rs.60,000

Product A 25%
B 40%
C 30%
D 5%
Assuming that the proposals is implemented calculate t he break even
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139 Solution
(a) C/S ratio for each product :
Product Variable cost C/S ratio
to sales ratio (100 ­Variable cost to
sales ratio)
A 60% (100­60) i.e.40%
B 68% (100­68) i.e. 32%
C 80% (100­80) i.e. 20%
D 40% (100­40) i.e. 60%
Weighted average C/S ratio:
Product C/S ratio (%age)
A 33 1/3 % x 40 13.33
B 41 2/3 % x 32 13.34
C 16 2/3 % x 20 3.33
D 08 1/3% x 60 5.00
­­­­­­­­­
35.00
­­­­­­­­­­­
Break even point : Fixed costs = Rs.14,700
C/S ratio 35%
= Rs.14,700 = Rs.14,700 x 100
35/100 35
= Rs.42,000 in term s of sale value per month

(b) Weighted average C/S ratio with changed sales mix, without any
change in individual C/S ratio :
Product C/S ratio (% age)
A 25% x 40 10.00
B 40% x 32 12.80
C 30% x 20 6.00
D 5% x 60 3.00
31.80
Break ­even p oint: Fixed cost
C/S ratio
= Rs.14,700 = Rs.14,700
31.80 % 31.80/100
= Rs.14700 x 100
31.80
= Rs.46,226

Proof (Not required in examination)
Product Old sales Mix New Sales Mix
Sales Contribution Sales Contribution
Rs. Rs. Rs. Rs.
A 60,000x331/3% 20,000x40% 60,000x235% 15,000x40%
i.e.20,000 i.e.8,000 i.e. 15,000 i.e. 6,000
B 60,000x412/3% 25,000x32% 60,000x40% 24,000x32% munotes.in

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140 i.e. 25,000 i.e.8,000 i.e.24,000 i..e 7,680
C 60,000x162/3% 10,000x20% 60,000x30% 18,000x20%
i.e. 10,000 i.e. 2 ,000 i.e.18,000 i.e.3,600
D 60,000x81/3% 5000x60% 60,000x5% 3,000x60%
i.e.5,000 i.e.3,000 i.e.3 ,000 i.e.1,800
­­­­­­­­­­­­­ ­­­­­­­­ ­­­­­­­­­­­­­­ ­­­­­­­­
Total Rs.60,00 0 Rs.21,000 Rs.60,000 Rs.19,080
Weighted average C/S ratio Weighted average C/S ratio
Rs.21,000 x 100 Rs.19,080 x 100
Rs.60,000 Rs.60,000
i.e. 3 5% i.e. 31.80%

Uses of CVP Aalysis
We have covered the basic principles of CXVP analysis which can be
applied to specific management problems. The following illustrations
Have shown the application of these principles in decision making.
Illustration 6.9
A manufacturing company produces three products P, Q and R. the
following information is available :
PER UNIT
P Q R
Rs. Rs. Rs.
Budgeted selling price 25 12 30
Standard variable costs 20 8 20
Budgeted output (units) 2,000 5,000 20,000 Budged fixed cost Rs.1,60,000
The Marketing manager is confident that he would be able to achieve
budgeted sales for products P and Q. However he is unable to estimate
correctly the sales of R. According to his estim ate it can be anything
between 10,000 units and 30,000 units
Calculate how many units of R need to be sold to achieve break even.
Assume that sales of Q will be as per budget.
Solution : Contribution per unit :
P Q R
Rs. Rs. Rs.
Selling pri ce per unit 25 12 30
Variable cost per unit (20) (8) (20)
Contri bution per unit 5 4 10
At break even point, contribution fund (i.e. total contribution from all the
products) is equal to fixed cost and, therefore, required contribution is
Rs.1.60,000. Contribution from products P and Q at budgeted output: munotes.in

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141 Product P : Rs.5 x 2,000 i.e. Rs.10,000
Product Q: Rs.4 x 5,000 = Rs.20,000
Total Rs.30,000
Required contribution from Product R :
Required contribution fu nd Rs.1,60,000
Contribution from P and Q (Rs. 30,000)
Required contribution from R Rs.1,30,000
Number of units of R to be sold to
achieve break even. Contribution required
Contribution per unit
= Rs.1,30,000
Rs.10
= 13,000 units.



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